In a redetermination of an earlier, withdrawn decision, the Ninth Circuit again reversed a decision of the Tax Court and held regulations are valid that require related entities to share the cost of employee stock compensation for their cost-sharing agreements to be considered qualified under Sec. 482.
Facts: Altera Corp. (subsequently acquired by Intel Corp.) and its subsidiaries designed, manufactured, marketed, and sold electronic components. In May 1997, Altera entered into a cost-sharing agreement with one of its subsidiaries, Altera International, which was incorporated in the Cayman Islands that year. Altera granted to Altera International a license to use Altera's intangible property. In exchange, Altera International paid Altera royalties. The parties agreed to share research and development (R&D) costs in proportion to anticipated benefits from resulting products.
Altera and the IRS agreed to an advance pricing agreement covering the 1997—2003 tax years. In compliance with the regulations at the time, Altera shared stock-based compensation costs with Altera International as part of the R&D costs. After the regulations were amended in 2003, the related parties amended their cost-sharing agreement, continuing to share stock compensation costs. They again amended the agreement in 2005 to suspend sharing the stock-based compensation until a court specifically addressed the validity of the 2003 amendments, relying on the Tax Court's opinion in Xilinx, Inc., 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010). Xilinx involved a challenge to the allocation of employee stock compensation costs.
Altera and its U.S. subsidiaries did not account for R&D-related stock-based compensation costs on their consolidated 2004—2007 federal income tax returns. The IRS issued two notices of deficiency to the group, applying Regs. Sec. 1.482-7(d)(2) to increase the group's income by nearly $80.4 million. The Altera group challenged the IRS's determination in Tax Court.
The Tax Court held that Regs. Sec. 1.482-7A(d)(2), which requires related parties to a cost-sharing arrangement to allocate between themselves stock-based compensation, is invalid under the Administrative Procedure Act (APA) (Altera Corp., 145 T.C. 91 (2015)). The Tax Court determined that the IRS's allocation of income and expenses between related entities must be consistent with the arm's-length standard, which requires comparison with an actual transaction between unrelated parties.
The IRS appealed to the Ninth Circuit, which on July 24, 2018, held for the IRS, reversing the Tax Court. However, the Ninth Circuit withdrew that opinion because one of the judges involved, Judge Stephen Reinhardt, had died before the opinion was issued. Reinhardt was replaced on the three-judge panel by Judge Susan Graber. The reconstituted panel conferred and issued a new opinion.
Issues: Sec. 482 provides the IRS with authority to allocate income and costs between related parties to address the risk of multinational tax avoidance.
The IRS argued that allocation of stock options between the companies was appropriate to reflect economic reality. The IRS further argued that it may apply a purely internal method of allocation, distributing the costs of employee stock options in proportion to the income enjoyed by each controlled taxpayer, consistent with the arm's-length method.
Altera and its subsidiaries contended that any cost allocation exceeded the IRS's authority. The company asserted that the arm's-length standard always demands a comparability analysis and that if unrelated parties do not share the same costs when dealing at arm's length, the IRS cannot allocate those costs between related parties.
Altera also argued that the outcome of this case is controlled by the Ninth Circuit's decision in Xilinx.
Holding: The Ninth Circuit once again, with the reconstituted panel, reversed the Tax Court and held that the regulatory amendments were procedurally valid under the APA and substantively valid under the test set forth in Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). The court found that the amendments satisfied the APA because Treasury's rationale could be "reasonably discerned" from the preambles to the proposed and final implementing regulations, which discussed the legislative history of the 1986 amendment to Sec. 482. The court further held that the amendments were substantively valid under Chevron's two-step analysis because, although Sec. 482 does not speak directly to the issues addressed by the amendments, the amendments represent a permissible construction of Sec. 482 since they are consistent with Congress's rationale for amending Sec. 482 in 1986.
Regarding the Xilinx decision, the court found that it was not controlling because it "did not involve the question of statutory interpretation, the Commissioner's authority, or the regulation at issue in this appeal."
- Altera, No. 16-70496 (9th Cir. 6/7/19)
— By Maria M. Pirrone, CPA, LL.M., associate professor of taxation, St. John's University, Queens, N.Y.