The Recent Altera Tax Court Decision Will Have a Significant Impact on Cost-Sharing Agreements and Could Have Far-Ranging Implications Outside Transfer Pricing

In what no doubt will be considered a precedent setting case, the Tax Court recently invalidated Treasury Regulations which require related parties who enter qualified cost-sharing arrangements (QSCAs) to share stock-based compensation (SBC).

In Altera v. Commissioner 145 T.C. No. 3, the Tax Court determined that under the Administrative Procedures Act (APA), Treasury had engaged in arbitrary and capricious decision-making in that (i) the SBC rule lacked a basis in fact, (ii) Treasury failed to rationally connect the regulations regarding the SBC rule with the facts, (iii) Treasury failed to respond to significant comments when it issued the SBC rule, and (iv) Treasury’s conclusion that the SBC rule is consistent with the arm’s-length standard of Section 482 of the Code runs contrary to evidence. Consequently, the Tax Court ruled that Altera was not required to share stock-based compensation costs with a Cayman Islands subsidiary pursuant to a QCSA between those entities.

The Altera decision is going to have far-reaching implications even beyond transfer pricing if is not overturned. To list a few of the implications:

• Taxpayers who have QCSAs will have to determine if they should file refund claims.
• Taxpayers who did not include SBC in their cost-sharing agreements will have to evaluate whether reserves under FIN 48 should be revised.
• Other regulations under Section 482 and other code sections will have to be evaluated to determine if they are potential invalid under the reasoning of the Altera case.
• Treasury is going to have to decide whether to appeal the Altera case. If they do appeal it will go to the 9th Circuit, which has already decided Xilinx (same issue prior to regulations) in the taxpayers’ favor.
• The decision may impact the OECD’s project to combat base erosion and profits shifting (BEPS). For example, the case supports a behavior approach that is being advocated by some.
• The decision may impact regulations dealing with the fee waiver transactions by private equity firms. (See Notice to Comment Blog of Yale Journal on Regulations.)
• The Altera decision has been brought to the attention of the District Court handling the Microsoft Summons.
• The issue is whether the IRS had the authority to issue regulations delegating a government responsibility to a private law firm.

Background of the Altera Decision

Altera Corp. is a U.S. corporation that entered into a technology research and development cost-sharing agreement with a Cayman Islands subsidiary. They did not include SBC in the cost pool under the cost-sharing agreement. The IRS issued a Notice of Deficiency with respect to tax years 2004 through 2007, asserting that those costs should be included in the pool, and that, as a result of this inclusion, Altera’s income should be increased by approximately $80 million in the aggregate.

In 1995, Treasury issued regulations that generally authorized the IRS “to make each controlled participant’s share of the costs…of intangible development under the qualified cost sharing arrangement equal to its share of reasonably anticipated benefits attributable to such development.”  In Xilinx, Inc. v.Commissioner, 598 F. 3d 1191 (9th Cir. 2010), the U.S. Court of Appeals for the 9th  Circuit affirmed the Tax Court’s holding that the regulations did not require the taxpayer to include employee stock options (ESOs) granted to employees engaged in development activities in the pool of costs under the cost-sharing arrangement with its subsidiary. The 9th Circuit reasoned that the term “costs” in the regulation did not include ESOs because that would not comport with the “dominant purpose” of the transfer pricing regulations as a whole, which is to put commonly controlled taxpayers at the “tax parity” with uncontrolled taxpayers. Because of the overwhelming evidence that unrelated parties dealing at arm’s length in fact do not share ESOs in similar co-development arrangements, the 9th Circuit concluded that such tax parity is best furthered by a holding that the ESOs need not be shared.

In 2003, the Treasury amended the transfer pricing regulations to explicitly address the interaction between the arm’s length standard and the cost sharing rules, and the treatment of stock-based compensation in the cost sharing context. Treas. Reg. §1.482-1(b)(2)(i) now states that “Treas. Reg. §1.482-7 provides the specific methods to be used to evaluate whether a cost sharing arrangement….produces results consistent with an arm’s length result.” Treas. Reg. §1.482-7(d)(2), as amended, specifically identifies stock-based compensation as a cost that must be shared.

The Tax Court in Altera, in a 14-0 decision reviewed by the full court, agreed with the taxpayer that the 2003 amendments to the cost sharing regulations were invalid under the APA because Treasury did not adequately consider the evidence presented by commentators during the rulemaking process that stock-based compensation costs are not shared in actual third-party transactions.

Under Section 482, cost allocation should be comparable to what is found in arm’s-length transactions. The IRS has taken the position that all compensation (including stock-based compensation) costs should be allocated. The IRS lost on the SBC issue in Xilinx because it was shown that unrelated taxpayers would not share these costs. The IRS amended the regulations to make SBC included in the allocation. Numerous commentators stated that there was no evidence that unrelated parties would share the cost.
The Tax Court held that Treasury failed to respond to significant comments and the allocation of SBC in QCSAs did not comport with economic reality.

Observations:

• This is the first time the Tax Court has fully embraced the APA notice and comment requirements.
• There are several other cases pending before the Tax Court that consider the APA requirements.
• Taxpayers who have included SBC in their QCSA may want to consider refund options.
• If a taxpayer has not included SBC in the QCSA, they may consider revising FIN 48 reserves.
• Other regulations both in the context of Section 482 and other Sections will need to be evaluated to determine if the IRS complied with the APA process.