On July 17, 2015, the US Tax Court (en banc) ruled in favor of the taxpayer in Altera Corporation v. Commissioner,1 holding that Treas. Reg. 1.482-7(d)(2), which was issued in 2003 requiring participants in qualified cost-sharing arrangements ("QCSAs") to share stock-based compensation costs to achieve an arm's-length result, was arbitrary and capricious and therefore invalid.
Altera US, the parent company of an affiliated group of corporations, developed, manufactured and sold programmable logic devices ("PLDs") and related hardware and software for use in programming the PLDs ("programming tools"). Altera US entered into a technology license agreement with its subsidiary, Altera International, granting Altera International the right to use and exploit, everywhere except the United States and Canada, all of Altera US's intangible property relating to PLDs and programming tools. In exchange for the right granted, Altera International paid royalties to Altera US each year through 2003. Under an existing R&D cost-sharing agreement, Altera US and Altera International agreed to pool their resources to conduct research and development relating to the PLDs and programming tools. Under the R&D cost-sharing agreement, Altera US and Altera International agreed to share the risks and costs of research and development activities they performed between May 23, 1997 through 2007.
During each of taxable years ending December 31, 2004, December 30, 2005, December 29, 2006 and December 28, 2007, Altera US granted stock options and other stock-based compensation to certain of its employees. Certain of these employees who received stock options and other stock-based compensation performed R&D activities subject to the R&D cost-sharing agreement. The stock-based compensation was $24,549,315 (2004); $23,015,453 (2005); $11,365,388 (2006) and $15,463,565 (2007). The stock-based compensation was not included in the cost pool under the R&D cost-sharing agreement. The IRS audited petitioner and issued Notices of Deficiency with respect to the 2004-2007 taxable years. The Notices of Deficiency allocated, pursuant to Section 482, income from Altera International to Altera US by increasing Altera International's cost-sharing payments for 2004-2007.
Section 482 – Arm's-Length Standard
Section 482 authorizes the Commissioner to allocate income and expenses among related entities. The first sentence of Section 482 provides, in relevant part, as follows:
In any case of two or more organizations, trades or businesses * * * owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. * * *
The purpose of Section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions.2 In 1986, Congress amended Section 482 by adding the following: "In the case of any transfer (or license) of intangible property * * *, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible."3 This commensurate-with-income approach was adopted because of the recognition that there may be extreme difficulties in determining whether the arm's-length transfer between unrelated parties are comparable.
A later study by Treasury and the IRS explained that the commensurate-with-income standard is consistent with the arm's-length standard because:
[l]ooking at the income related to the intangible and splitting it according to relative economic contributions is consistent with what unrelated parties do. The general goal of the commensurate-with-income standard is, therefore, to ensure that each party earns the income or return from the intangible that an unrelated party would earn in an arm's-length transfer of the intangible.4
In Xilinx Inc. v. Commissioner,5 the Tax Court addressed the treatment of stock-based compensation between controlled entities that entered into a qualified cost-sharing agreement. The Tax Court held that the Commissioner's allocation of stock-based compensation failed to satisfy the arm's-length standard of Section 1.482-1(b)(1).
In reaching this holding the Tax Court concluded that, consistent with the 1995 cost-sharing regulations: (1) in determining the true taxable income of a controlled taxpayer, the arm's-length standard applies in all cases; (2) the arm's-length standard requires an analysis of what unrelated entities would do; (3) the commensurate-with-income standard was never intended to supplant the arm's-length standard; and (4) unrelated parties would not share the exercise spread or grant date value of stock-based compensation.6 In so holding, the Tax Court observed, in part, that the IRS's expert agreed that unrelated parties would not share the stock-based compensation costs, and found that the taxpayer proved that companies do not take into account either the exercise spread or grant date value of stock-based compensation for producing pricing purposes. The Ninth Circuit initially reversed the Tax Court, but subsequently withdrew its opinion in Xilinx and issued a new opinion affirming the Court.7
The Circuit Court affirmed the finding that all costs requirement should be construed as not applying to stock-based compensation because the regulations should be interpreted in the light of the dominant purpose of the statute—parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions.
2003 Cost-Sharing Regulations
The Xilinx opinion did not sit well with the IRS. In 2002 Treasury issued a notice of proposed rulemaking and notice of a public hearing with respect to proposed amendments to the cost-sharing regulations. The purpose of the proposed amendments to the cost-sharing regulations was to clarify "that stock-based compensation must be taken into account in determining operating expenses under § 1.482-7(d)(1), and to provide rules for measuring stock-based compensation costs."8 A public hearing on the proposed amendments was held on November 20, 2002.
In response to the Notice, several commentators informed Treasury that they knew of no transactions between unrelated parties, including any cost-sharing arrangement, service agreement or other contract, that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation. Indeed, several commentators identified arm's-length agreements in which stock-based compensation was not shared or reimbursed, and several commentators cited the practice of the Federal Government and cited Federal regulations which prohibit reimbursement of amounts attributable to stock-based compensation.9
In August 2003, Treasury issued the final rule. The final rule explicitly required parties to QCSAs to share stock-based compensation costs.10 The final rule also added sections 1.482-1(b)(2)(i) through 1.482-7(a)(3), Income Tax Regs., to provide that a QCSA produces an arm's-length result only if the parties' costs are determined in accordance with the final rule.11
The final rule provides two methods for measuring the value of stock-based compensation: a default method and an elective method. Under the default method, "the costs attributable to stock based compensation generally are included as intangible development costs upon the exercise of the option and measured by the spread between the option strike price and the price of the underlying stock."12 Under the elective method, "the costs attributable to stock options are taken into account in certain cases in accordance with the 'fair value' of the option, as reported for financial accounting purposes either as a charge against income or in footnoted disclosures."13
When it issued the final rule, the files maintained by Treasury relating to the final rule did not contain any expert opinions, empirical data or published or unpublished articles, papers, surveys or reports supporting a determination that the amounts attributable to stock-based compensation must be included in the cost pool of QCSAs to achieve an arm's-length result. Those files also did not contain any record that Treasury searched any database that could have contained agreements between unrelated parties relating to joint undertakings or the provision of services.
At the outset, the parties disagreed whether the final rule was a legislative rule or an interpretative rule. If interpretative, as alleged by the Service, the requirements of APA Section 553 did not apply; thus there was no need to publish a notice of proposed rulemaking, provide interested persons an opportunity to participate in the rulemaking and incorporate a concise general statement of the rule's basis and purpose. The Tax Court concluded that the final rule was a legislative rule subject to the APA Section 553 because Treasury intended that the final rule to have the force of law. The court further concluded that the final rule must satisfy the "reasoned decision-making standard" followed in State Farm14 , because the "validity of the final rule turns on whether Treasury reasonably concluded that it is consistent with the arm's-length standard."15
Under the rubric of State Farm, the taxpayer argued that the final rule was invalid because (1) it lacked a basis in fact, (2) Treasury failed to rationally connect the choices it made with the facts if found, (3) Treasury failed to respond to significant comments, and (4) the final rule was contrary to the evidence presented to Treasury. The Tax Court agreed with the taxpayers.
The Tax Court found that the final rule lacked a basis in fact because Treasury failed to provide a reasoned basis for its conclusions from any evidence in the administrative record. According to the court, there was no evidence in the record that supported Treasury's belief that unrelated parties would share stock-based compensation costs. Moreover, the Tax Court refused to defer to Treasury's expertise because the court found that commentators introduced significant evidence showing that parties operating at arm's-length would not share stock-based compensation. The Tax Court also found that Treasury failed to respond directly to any of the evidence that unrelated parties would not share stock-based compensation costs. Specifically, the court held that "[m]eaningful judicial review and fair treatment of affected persons require 'an exchange of views, information and criticism between interested persons and the agency.' Treasury's failure to adequately respond to commentators frustrates our review of the final rule and was prejudicial to affected entities."16
Lastly, the Tax Court concluded that the final rule was contrary to the evidence before Treasury when it issued the final rule. The court noted that the significant evidence submitted by commentators demonstrated that unrelated parties to QCSAs would not share stock-based compensation costs; Treasury never found the submitted evidence incredible, and accepted the commentators' economic analysis. Accordingly, Treasury's explanation for its decision ran counter to the evidence. Because the court found that the final rule lacked a basis in fact, and was contrary to the evidence presented, the court held that the final rule failed to satisfy State Farm's reasoned decision making standard and was therefore invalid. Finally, the Tax Court held that the harmless error rule of APA Section 706 was not applicable because it was not clear that Treasury would have adopted the final rule if it had been determined to be inconsistent with the arm's-length standard.
The Altera decision is significant for taxpayers with cost-sharing agreements. The decision may also have a broad impact on future regulatory rulemaking and challenges to existing IRS regulations.
Footnotes
1 145 T.C. No. 3 at 51 (2015).
2 See Treas. Reg. 1.482-1(a)(1)
3 Tax Reform Act of 1986, Pub. L. No. 99-514, Sec. 1231(e)(1), 100 Stat. at 2562.
4 Notice 88-123, 1988-2 C.B. at 472.
5 125 T.C. 37 (2005), affd 598 F.3d 1191 (9th Cir. 2010).
6 145 T.C. No. 3 at 70-75.
7 See Xilinx Inc. v. Commissioner, 598 F.3d at 1191.
8 See 67 Fed, Reg. 48997, 48998 (July 29, 2002).
9 145 T.C. No. 3 at 72-73.
10 See Treas. Reg. § 1.482-7(d)(2).
11 See T.D. 9088, 2003-2 C.B. 841, 847-848.
12 Id., 2003-2 C.B. at 844.
13 Id. 14 United States v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983)
15 145 T.C. No. 3 at 68.
16 145 T.C. No. 3 at 74.
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