The Ninth Circuit Court of Appeals reversed the Tax Court in Altera Corp. in the latest chapter of the dispute over the validity of cost-sharing regulations. The decision, issued on July 24, revives certain regulatory provisions previously invalidated by the Tax Court. (See Altera Corp. v. Commissioner, Dkt. Nos. 16-70597 & 16-70497 (9th Cir. 2018) rev'g 145 T.C. 91 (2015)). These regulations govern the allocation of stock-based compensation costs to a foreign subsidiary in qualified cost-sharing agreements (QCSA). U.S. corporations enter into QCSAs to allocate research and development costs with a foreign subsidiary usually located in a low tax jurisdiction and to grant the foreign subsidiary rights to exploit the developed property internationally. The Ninth Circuit Court of Appeals' decision to uphold the validity of Treas. Reg. § 1.482-7A(d)(2) means that parties to a QCSA must allocate stock-based compensation between themselves. By avoiding an allocation of stock-based compensation costs to the foreign subsidiary, profits could otherwise be maximized in the low tax foreign jurisdiction and taxes of the U.S. parent would be significantly reduced.
As background, Altera Corporation challenged transfer pricing adjustments proposed by the IRS, arguing in part that Treas. Reg. § 1.482-7A(d)(2), which provides that parties to a QCSA must allocate stock-based compensation between themselves, was invalid. Siding with the taxpayer, the Tax Court in Altera Corp. concluded that the requirement to include stock-based compensation costs in a QCSA under final regulations issued in 2003 had an insufficient factual basis and conflicted with comments received on the proposed regulations that unrelated parties do not share such costs. As a result, the Tax Court concluded that the rule was arbitrary and capricious and therefore invalid under the Administrative Procedure Act (APA) and existing Supreme Court authority (citing Motor Vehicles Mfrs. Ass’n v. State Farm, 463 U.S. 29 (1983); Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984)).
The issue concerning the inclusion of stock-based compensation costs in QCSAs has been hotly contested and was the subject of two prior high profile cases, Xilinx Inc. v. Commissioner, 125 T.C. No. 4 (2005), aff’d 598 F.3d 1191 (9th Cir. 2010), and Seagate Technology (which was ultimately conceded by the IRS). However, those cases dealt with the issue prior to the 2003 issuance of final regulations requiring the inclusion of stock-based compensation costs in QCSAs.
On appeal, the government argued that the Tax Court erroneously relied on its prior opinion in Xilinx for the proposition that the arm’s-length standard, as articulated in transfer pricing regulations, always requires an analysis of what unrelated parties do under comparable circumstances. Further, the government argued that the requirement to share all R&D-related costs in a prescribed ratio in order to achieve an arm’s-length result is substantively valid based on a permissible construction of Section 482 that requires only a comparison of the two sides of the related-party transaction under scrutiny (relying on the "commensurate with income" standard applicable to income generated by intangible property). Finally, the government argued that the regulatory amendments are procedurally valid under the APA because they are the product of reasoned decision-making, and that the arm’s-length standard does not require (in the context of a QCSA) an analysis of what unrelated entities do under comparable circumstances.
The Ninth Circuit agreed. In a 2-1 decision, Chief Judge Sidney Thomas writing for the majority reversed the Tax Court and held that the IRS did not exceed the authority delegated to the IRS under Section 482, that the Commissioner's exercise of rulemaking authority complied with the APA, and that the regulation was entitled to deference under the Chevron doctrine.
The Ninth Circuit emphasized the historic origins of Section 482 authorizing the IRS to apportion, allocate, or distribute income or deductions among two or more businesses owned or controlled by the same interest in order to prevent evasion and to reflect the true tax liability of the commonly controlled interests. In tracing this principle through the iterations of regulations that were issued, the court noted that application of the arm's length standard based on comparability has never been used to the exclusion of other, more flexible approaches. Further, in connection with allocations attributable to intangibles, the court observed that "Congress intended the commensurate with income standard to displace a comparability analysis where comparable transactions cannot be found."
With respect to whether Treasury complied with the APA, the Ninth Circuit rejected the Tax Court's finding that the IRS did not consider and respond to significant comments received during the period for public comment. Rather, the court cited to the fact that Treasury clearly indicated it was relying on the commensurate with income provision in its published notice of proposed rulemaking, and that it was attempting to synthesize potentially disparate standards found within Section 482 in coordinating the new regulations with the arm's-length standard. To the extent commenters attacked the proposed regulations as inconsistent with the traditional arm's-length standard because unrelated parties do not share stock compensation costs, Chief Judge Thomas noted "Treasury's refusal to credit oppositional comments is not fatal to a holding that it complied with the APA." He concluded, "[b]ecause the comments had no bearing on 'relevant factors' to the rulemaking, nor any bearing on the final rule, there was no APA violation."
Finally, applying a Chevron analysis, the Ninth Circuit found that Section 482 does not speak to whether the IRS may require parties to a QCSA to share stock compensation costs, thus giving deference to the agency's action so long as it is based on a permissible construction of the statute. Because the legislative history of Section 482 supports Treasury's application of the commensurate with income standard in the context of QCSAs, the Ninth Circuit found that "Treasury's decision to dispense with a comparability analysis was reasonable." Therefore, the contested regulations are not arbitrary and capricious.
The Altera decision does not likely represent the last word on the validity of the cost-sharing regulations. Altera could seek en banc review, but such review is rarely granted in the Ninth Circuit. Further, because no other circuit has ruled on this issue, it is doubtful that the Supreme Court would entertain hearing the issue at this time. However, the ruling has significant implications for multinational corporations with R&D costs shared under a QCSA. Indeed, public financial filings indicate that U.S. based multinationals have billions of dollars riding on this issue. Thus, in time, other circuit courts of appeal will surely address this issue as well.
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