9th Circuit upholds IRS regs in Altera ruling - Updated

Stock-based compensation must be part of cost-sharing pools

Update: On Aug. 7, the 9th Circuit Court of Appeals announced it had withdrawn its decision in Altera Corp. v. Commissioner, leaving the Tax Court decision in effect for the time being. Read our Tax Hot Topics to find out why the decision was withdrawn and what can happen next in this important case.

Rear view two businessmen discussing financialIn a highly anticipated decision, the 9th Circuit Court of Appeals on July 24 reversed the Tax Court in Altera Corp. v. Commissioner, Nos. 16-70496, 16-70497 (9th Cir. 2018).  

The case relates to a 2003 amendment to the cost-sharing regulations under Treas. Reg. Sec. 1.482-7(d)(2) that required the inclusion of stock-based compensation (SBC) in cost-sharing cost pools.  In 2015, the Tax Court unanimously ruled in Altera Corp. v. Commissioner, 145 T.C. 91 (2015) that the 2003 regulations violated the Administrative Procedure Act (APA). The 9th Circuit’s split-decision reversal of the Tax Court confirms the long-standing position of the IRS and Treasury that SBC is an economic cost that must be included in cost-sharing cost pools.

The 9th Circuit’s decision in Altera is also likely to impact procedural challenges of Treasury regulations in general and may relieve some pressure on the IRS and Treasury as they draft new rules. Nonetheless, while the 9th Circuit ruled in favor of the IRS, it is possible that the taxpayer will request an en banc rehearing before the entire circuit court, which could change the outcome of the case in the years ahead. 

Overview of the Tax Court caseAltera, a U.S. corporation, entered into a qualified cost-sharing agreement (QCSA) in 1997 with its wholly-owned Cayman Islands subsidiary, Altera International, Inc. Altera executed an advance pricing agreement with the IRS to cover the QCSA for 1997 through 2003. Consistent with IRS policy, the agreement required that Altera include SBC in the cost-sharing pool. 

In 2005, relying on the Tax Court’s opinion in Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005), Altera amended the QCSA to exclude SBC from the cost pool from 2004 forward, pending a court decision regarding the validity of the 2003 regulations.  

The IRS examined Altera and issued two notices of deficiency for the years 2004 through 2007 under the 2003 regulations. The adjustments increased Altera’s taxable income for those years by approximately $81 million. Altera filed a petition with the Tax Court, arguing that the 2003 regulations were arbitrary and capricious and therefore invalid under the APA. In a reviewed unanimous decision, the Tax Court agreed.  

In the decision, the Tax Court relied heavily on its opinion in Xilinx, in which it held that (i) QSCAs are subject to the arm’s length standard; (ii) under the arm’s length standard, controlled transactions must reflect what unrelated parties do under similar circumstances; and (iii) because no evidence exists that unrelated parties share SBC under any circumstances, controlled parties do not need to share SBC in QCSAs. The Tax Court concluded in Altera that in promulgating the 2003 regulations, the IRS violated the reasoned decision-making requirements of Motor Vehicle Manufacturers Association of the United States v. State Farm Auto Insurance Co. 463 U.S. 29 (1983) (State Farm), and Chevron, U.S.A. Inc. v. Natural Resources Defense Council, Inc. 467 U.S. 837 (1984) (Chevron) and failed to consider and respond adequately to comments on the proposed regulations, as required by the APA.  

9th Circuit decisionThe IRS appealed to the 9th Circuit, where a three-judge panel reversed the Tax Court in a 2-1 decision. The panel found that the IRS’s rule-making authority complied with the APA and that the Tax Court was incorrect in requiring a purely external standard to determine what constituted arm’s length behavior in related party transactions.  

The 9th Circuit determined that the correct framework to apply was an internal one, namely the commensurate with income standard. The “commensurate with income standard” clause was added to Section 482 in 1986 to provide additional authority to the IRS. The clause “the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible” was largely meant to provide the IRS with the means to adjust income or determine true taxable income in the transfer of intangible property in the absence of comparable transactions between unrelated parties (i.e., to ensure that the share of income reasonably reflects the actual economic activity undertaken by related parties).  

Applying that standard, the 9th Circuit concluded that the use of SBC to compensate employees was an “economic development that Treasury cannot ignore without rejecting its obligations under Section 482.”  The court also reviewed the IRS and Treasury’s responses to public comments on the proposed 2003 regulations and found that those responses satisfied the APA and the reasoned decision-making requirements under applicable case law. The 9th Circuit thus concluded that the 2003 regulations were valid, and the SBC must be included in cost-sharing cost pools.

TakeawayTreatment of SBC

Following Xilinx, a number of taxpayers amended their QCSAs to include claw-back provisions to eliminate SBC from their cost pools for prior years in the event that a court invalidated the 2003 regulations. Many taxpayers decided to wait until the 9th Circuit issued its opinion in Altera before applying the claw-back provisions and amending their tax returns.  

The Tax Court’s decision in Altera put into question the status of SBC in QCSAs. The 9th Circuit’s reversal will likely not quell philosophical disputes about whether SBC is an economic cost that should be included in a cost pool, but for the moment, the decision provides taxpayers in the 9th Circuit with greater legal certainty regarding the treatment of those costs in QCSAs. At the same time, taxpayers in other circuits may continue to challenge the validity of the regulations, emboldened by the Tax Court’s prior decisions in Xilinx and Altera.  

The issue may also not be dead in the 9th Circuit, where Altera may file a motion for rehearing en banc. Moreover, it remains to be seen how the IRS will respond to this decision. In January, the Large Business and International Division issued a memorandum suspending the opening of new examinations on the SBC cost-sharing issue pending the 9th Circuit’s decision.

Regulatory challenges

The Altera case has garnered interest not only for its transfer pricing implications but also for its impact on procedural challenges to tax regulations generally. Altera represented one of the first significant challenges to regulations on procedural grounds since the Supreme Court’s decision in Mayo Foundation for Medical Education and Research v. U.S., 562 U.S. 44 (2011).  

In Mayo, the Supreme Court effectively put to rest arguments that Treasury regulations were subject to a different standard of deference than the standard established in Chevron. The Tax Court’s decision in Altera methodically applied the APA, State Farm, and Chevron to invalidate the regulations. Notably, the 9th Circuit did not take issue with applicability of these authorities, but rather took issue with how the Tax Court applied both State Farm and Chevron.  

For the time being at least, the 9th Circuit’s decision may have taken some of the wind out of the sails of tax regulatory challenges. The decision may also have taken some of the pressure off of both Treasury and the IRS as they work quickly to issue needed guidance under the Tax Cuts and Jobs Act. Recent regulations have tended to have lengthy and detailed preambles intended, at least in part, to demonstrate that the IRS complied with the APA and, more specifically, responded adequately to taxpayer comments consistent with the reasoned decision-making standard of State Farm. In any event, recent case law, shifts in the Supreme Court, and the current regulatory environment are likely to fuel continued interest in challenges to the validity of regulations for some time to come.

In the meantime, taxpayers who took positions consistent with the Tax Court’s decision in Altera may want to consider the impact of the 9th Circuit’s decision on their tax risk profile and financial statements. 

For more information contact: David Sites
National Managing Partner, International Tax Services 
Washington National Tax Office
T +1 202 861 4104

Elizabeth Askey
Managing Director, National IRS Practice and Procedure Leader
T +1 202 521 1513

Matthew Kramer
Managing Director, Transfer Pricing, International Tax Services
T +1 415 365 5442

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