Ninth Circuit upholds IRS cost-sharing regulation

A transfer-pricing regulation that requires related entities to share the cost of employee stock compensation is a valid regulation, the Ninth Circuit held on Friday (Altera Corp., No. 16-70496 (9th Cir. 6/7/19)). The appeals court reversed a Tax Court decision that had held Regs. Sec. 1.482-7A(d)(2) was invalid under the Administrative Procedure Act (APA) (Altera, 145 T.C. 91 (2015)). The Ninth Circuit originally decided this case in July 2018 but withdrew its 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.

This time the Ninth Circuit once again found that the regulation, which requires related entities to share the cost of employee stock compensation for their cost-sharing arrangements to be considered qualified cost-sharing arrangements (QCSAs) and avoid IRS adjustment, withstands scrutiny under general administrative law principles and is therefore valid.

Altera Corp. (a subsidiary of Intel) challenged Regs. Sec. 1.482-7A(d)(2) on the basis that its requirement that parties share stock-based compensation costs to achieve arm’s-length results was arbitrary and capricious and therefore the regulation was invalid. The Tax Court had agreed, granting Altera’s motion for summary judgment.

Before examining whether the IRS complied with the APA, the court first examined whether the regulations were entitled to deference under Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). To decide whether regulations are entitled to Chevron deference, the court first determines whether Congress has spoken directly to the precise question at issue in the statute on which the regulation is based. If Congress has not addressed the issue, and the statute is silent or ambiguous on the issue, the court should defer to an agency’s interpretation if it is based on a permissible construction of the statute (Altera, slip op. at 24–25, citing Chevron). For these purposes, a permissible construction is one that is not arbitrary, capricious, or clearly contrary to the statute (Chevron, 467 U.S. at 844).

The court found that Sec. 482 did not speak directly to the issue at hand, and, further, the statute and legislative history indicated that Congress intended to provide the IRS with the flexibility in interpreting the statute to achieve its purpose. Moving to Chevron’s second step, the court found that the IRS’s interpretation of Sec. 482 in the regulations was not arbitrary and capricious, explaining that “Treasury reasonably understood § 482 as an authorization to require internal allocation methods in the QCSA context, provided that the costs and income allocated are proportionate to the economic activity of the related parties” (slip op. at 31). Thus, the IRS’s interpretation in the regulations was entitled to deference under Chevron.

The court then addressed the APA. For regulations to be valid, the Ninth Circuit found that they must comply with the APA. The court held that the regulations were not arbitrary and capricious and complied with the APA, stating that “we are able to reasonably discern Treasury’s regulatory path . . . While the rulemaking process was less than ideal, the APA does not require perfection” (slip op at 49).

— Sally P. Schreiber, J.D., (Sally.Schreiber@aicpa-cima.com) is a JofA senior editor.