The IRS’s cost-sharing rule requiring controlled entities that enter into qualified cost-sharing agreements to include stock-based compensation in the shared costs is arbitrary and capricious and therefore invalid, the Tax Court held in Altera Corp.,145 T.C. No. 3 (2015). Accordingly, the court granted Altera’s motion for summary judgment.
The regulation at issue, Regs. Sec. 1.482-7(d)(2), which was finalized in 2003, requires participants in qualified cost-sharing arrangements to share stock-based compensation to achieve an arm’s-length result. The IRS finalized the rule without adequately responding to the many comments it received opposing the rule, the court held.
Altera is an affiliated group of corporations that filed consolidated federal income tax returns for the years at issue. Altera Corp., the parent, is a Delaware corporation, and Altera International is a Cayman Islands corporation. The affiliated group is in the business of developing, manufacturing, and selling programmable logic devices.
The two related companies entered into a master technology license agreement and a technology research and development cost-sharing agreement. Their agreements included the costs of the parent company’s employees’ cash compensation but not the cost of the stock-based compensation the company also paid. Under the agreements, the foreign company made significant cost-sharing payments in the years at issue (2004–2007) of between $129 million and $192 million, which were reported on the tax returns for those years. The IRS nonetheless issued a notice of deficiency increasing these payments under Regs. Sec. 1.482-7(d)(2) to reflect the stock-based compensation. The adjustments were $24.5 million for 2004, $23 million for 2005, $17.4 million for 2006, and $15.5 million for 2007.
The taxpayers petitioned the Tax Court, arguing that the requirement in Regs. Sec. 1.482-7(d)(2) that parties share stock-based compensation costs to achieve arm’s-length results was arbitrary and capricious and therefore the regulation was invalid.
In determining that the IRS’s rule was invalid, the court first determined that, contrary to the IRS’s position, the rule was a legislative rule, not an interpretive rule, and was therefore subject to Section 553 of the Administrative Procedure Act, which requires the agency to publish a notice of proposed rulemaking in the Federal Register and provide interested parties an opportunity to participate by submitting written comments and other data, and that the IRS was required to respond to significant comments.
The Tax Court also found that it was required to decide whether the IRS reasonably concluded that the final rule is consistent with the arm’s-length standard. In making its decision, the court applied the reasoned decision-making standard of review from Motor Vehicle Mfrs. Ass’n of the U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983). The IRS argued that the standard of review from Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), should be applied, but the Tax Court determined that it was immaterial whether the standard from State Farm or from Chevron was applied because step 2 of the Chevron analysis incorporates the reasoned decision-making standard from State Farm.
After reviewing the administrative record, the Tax Court found that the IRS failed to support its belief that unrelated parties would share stock-based compensation costs with any evidence in the administrative record, failed to articulate why all qualified cost-sharing agreements should be treated identically, and failed to respond to significant comments when it proposed the regulations. Additionally, the IRS’s explanation for its decision ran counter to the evidence. Thus, the court held that the final rule failed to satisfy the State Farm reasoned decision-making standard and was invalid.
—Sally P. Schreiber (email@example.com) is a JofA senior editor.