The 9th Circuit Court of Appeals has reversed the Tax Court in Altera Corp v. Commissioner
(Nos. 17-70496, 16-70497
), supporting the long-held IRS position that stock-based compensation (SBC) is an economic cost that must be included in the cost pools for cost-sharing purposes.
The court initially reversed the case by a 2-1 split decision on July 18, 2018. However, one of the judges who participated in that decision died four months before it was published, prompting the 9th Circuit to withdraw its decision to allow the reconstituted panel to confer on the appeal. The reconstituted panel has again reached a 2-1 split decision in favor of the IRS.
The case centers on a 2003 amendment to the cost-sharing regulations under Treas. Reg. Sec. 1.482-7(d)(2), which required the inclusion of SBC in cost-sharing cost pools. The Tax Court in 2015 unanimously ruled that the 2003 regulations violated the Administrative Practice Act (APA) and were invalid.
Tax Court case
Altera, a U.S. corporation, entered into a qualified cost-sharing agreement (QCSA) in 1997 with its wholly-owned Cayman subsidiary, Altera International, Inc. Altera executed an advance pricing agreement with the IRS for 1997 through 2003, including SBC in the cost-sharing cost pool. In 2005, in reliance on the Tax Court 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 for 2004-2007 and issued notices of deficiency under the 2003 regulations of approximately $81 million. Altera petitioned 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. 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.
Initial 9th Circuit decision
The IRS appealed the Altera Tax Court case 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” clause added to Section 482 in 1986 to provide additional authority to the IRS. It 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 responses to public comments on the proposed 2003 regulations and found that those responses satisfied the APA and the reasoned decision-making requirements. It thus concluded that the 2003 regulations were valid, and the SBC must be included in cost-sharing cost pools.
Latest 9th Circuit decision
In a case with great factual complexity, the court mainly focused on differences in the application of the arm’s length standard by the two parties. Altera argued that the IRS must apply a comparable analysis using comparable transactions between unrelated business entities. The IRS countered that the arm’s length standard does not require specific comparability in all cases.
The 9th Circuit disagreed with the Tax Court that the 2003 regulations were “arbitrary and capricious” under the APA standard of review, in a decision consistent with its earlier holding. It held that the arm’s length standard requires that IRS reach the arm’s length result of tax parity between controlled and uncontrolled business entities, but that Section 482 allows the IRS to apply a purely internal method of allocation, distributing the costs of SBC between related taxpayers in proportion to the income enjoyed by each from the cost-shared intangibles.
The Tax Court Altera
decision called into question the common taxpayer practice of excluding SBC from cost-sharing cost pools for allocation among the cost-sharing participants. The 9th Circuit reversal provides taxpayers in the 9th Circuit with greater legal certainty that SBC should be included in cost-sharing cost pools. However, Altera may file a request for en banc review, in which the case will be reheard before 11 judges from the 9th Circuit, deemed to be the entire bench, as opposed to the typical three-judge panel.
Taxpayers should review their cost-sharing pools in light of the decision. The Tax Court is not governed by the 9th Circuit result in other circuits, so taxpayers who aren’t in the 9th Circuit could conceivably follow the Tax Court Altera
decision. In January 2018, the IRS Large Business & International Division issued a memorandum suspending the opening of new examinations of the SBC issue pending the 9th Circuit Altera
decision. No changed guidance has been announced but could be forthcoming.
For more information contact:
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