In a 2-1 decision on July 24, 2018, the U.S. Court of Appeals for the Ninth Circuit, in Altera Corp. v. Commissioner, Nos. 16-70496 and 16-70497, reversed a rare, unanimous, court-reviewed decision of the U.S. Tax Court that invalidated the amendment to Treasury Regulations §1.482-7A(d)(2) (the 2003 Regulation) that requires commonly controlled participants in a qualified cost-sharing arrangement to include the cost of stock-based compensation in the shared development costs. In upholding the regulation, the Court of Appeals held that the Treasury Department did not violate the Administrative Procedure Act or the reasoned decision-making requirements of Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983), and that the regulation was a permissible interpretation of Internal Revenue Code § 482.
The 2003 Regulation was issued under the authority of Internal Revenue Code §482, which, as traditionally interpreted by the Treasury and the IRS, requires that commonly controlled parties report the tax results of transactions among themselves under the arm’s length standard, by reference to the economic results of unrelated parties from comparable transactions under similar circumstances. In 1986, Congress, concerned that the traditional application of § 482 to related party transfers of high-value intangible property permitted taxpayers artificially to shift income outside U.S. taxing jurisdiction, amended the statute to require that transferors of intangible property to commonly controlled transferees (including, for this purpose, licensees) report in income an amount “commensurate with the income attributable to the [transferred] intangible.” The legislative history to this amendment indicates that, while Congress supported the use of related party cost-sharing arrangements permitting co-developers of intangible property to become co-owners of the developed intangibles, it urged the government to ensure that the intangible income earned by each of the participants in such arrangements “reasonably reflect the actual economic activity undertaken by each.” H.R. Rep. No. 841, 99th Cong., 2d Sess. II-638 (1986).
After the 2003 Regulation was first proposed requiring the sharing of stock-based compensation costs in related party cost-sharing arrangements, the Treasury received numerous comments indicating that such costs were never shared by unrelated parties and urging that the requirement be removed as contrary to the empirically-based arm’s length standard – and even the commensurate-with-income standard, which Treasury and the IRS had indicated was “consistent with the arm’s length standard.” Notice 88-123, 1988-2 C.B. 458. However, while admitting that it could find no evidence that unrelated parties shared stock-based compensation costs, the Treasury retained the requirement, asserting that there was little publicly available data on unrelated party co-development of high-value intangibles and that the volatility of stock-based compensation costs – while a difficult-to-manage risk for an uncontrolled party – was much more manageable for commonly controlled parties.
Even before the issuance of the 2003 Regulation, the IRS had sought to require the sharing of stock-based compensation costs in qualified cost-sharing arrangements, but was rebuffed in Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005), aff’d, 593 F.3d 1191 (9th Cir. 2010), involving taxable years before the regulation was issued. The courts, however, reserved judgment on whether the 2003 Regulations would change the outcome.
In Altera, the Tax Court held that the Treasury, by dismissing public comments that uncontrolled parties do not share stock-based compensation costs in fashioning a regulation that applied the empirically-based arm’s length standard, had acted arbitrarily and capriciously under the State Farm rule-making public notice and comment standards and therefore that the 2003 Regulation was not entitled to the deference usually granted to agencies under the rule of Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). In reversing the Tax Court, the Ninth Circuit stated that, notwithstanding the Treasury’s position that the commensurate-with-income standard was consistent with the arm’s length standard, the legislative history accompanying the 1986 amendment to § 482 indicated that Congress intended the new standard to represent a “move away from the traditional” approach. Given that, the Treasury had the discretion to dismiss objections that focused on the lack of comparable uncontrolled party sharing of stock-based compensation costs based on “logic and industry norms” – that uncontrolled parties rarely co-develop high-value intangibles and face risks in sharing stock-based compensation that controlled parties do not.
The Ninth Circuit decision in Altera represents a potentially significant enhancement or reinforcement – depending on one’s point of view – of the Treasury’s regulatory authority in the tax area. Although the Tax Court’s invalidation of the 2003 Regulation could be viewed narrowly as a function of the uniquely empirical nature of the arm’s length standard, many commentators thought that the Tax Court opinion introduced and imposed a significantly higher standard for Treasury rule-making more generally – a view apparently shared by the more than 25 academics who weighed in as amici curiae in the Ninth Circuit proceeding. However, the Ninth Circuit opinion may not be the last word in the case. It should be noted that in Xilinx, the initial Ninth Circuit panel reversed the Tax Court, only to reverse itself on reconsideration. With the death of Judge Stephen Reinhardt, one of the two-member majority in Altera, before the opinion came down, the case could be headed to en banc reconsideration.