Altera Corp. v. Cir
926 F.3d 1061 (2019)
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Rule of Law:
Treasury Regulation § 1.482-7A(d)(2), requiring controlled participants in a qualified cost-sharing arrangement (QCSA) to share employee stock compensation costs, is a valid and reasonable interpretation of 26 U.S.C. § 482 and withstands challenge under the Administrative Procedure Act.
Facts:
- In 1928, Congress enacted 26 U.S.C. § 482, granting the Secretary of the Treasury authority to reallocate income and costs among related businesses to prevent tax evasion or clearly reflect income.
- In 1986, Congress amended § 482 by adding the "commensurate with income" clause for transfers or licenses of intangible property, aiming to address difficulties in applying the arm's length standard to high-profit intangibles without readily available comparables.
- In May 1997, Altera Corporation ("Altera") entered into a cost-sharing agreement with its foreign subsidiary, Altera International, Inc. ("Altera International"), a Cayman Islands corporation, to pool resources and share research and development (R&D) costs for new technologies.
- Under this agreement, Altera granted Altera International a license to use and exploit Altera’s preexisting intangible property everywhere except the United States and Canada, in exchange for royalties, and both parties agreed to share R&D costs in proportion to anticipated benefits.
- Pursuant to an Advance Pricing Agreement covering the 1997–2003 tax years, Altera shared stock-based compensation costs with Altera International as part of the shared R&D costs.
- In 2003, Treasury issued regulations, including 26 C.F.R. § 1.482-7A(d)(2), which explicitly classified employee stock compensation as a cost to be allocated between QCSA participants.
- Following the 2003 amendments, Altera and Altera International amended their cost-sharing agreement to comply with the modified regulations, continuing to share employee stock compensation costs.
- In 2005, following a Tax Court opinion in Xilinx Inc. & Consolidated Subsidiaries v. Commissioner, Altera and Altera International again amended their cost-sharing agreement to suspend sharing stock-based compensation costs unless and until a court upheld the validity of the 2003 cost-sharing regulations.
- For its consolidated 2004–2007 federal income tax returns, Altera and its U.S. subsidiaries did not account for R&D-related stock-based compensation costs.
Procedural Posture:
- The IRS issued two notices of deficiency to Altera Corporation & Subsidiaries for the 2004-2007 tax years, increasing their income by applying 26 C.F.R. § 1.482-7A(d)(2) to include stock-based compensation costs.
- Altera Corporation & Subsidiaries timely filed petitions in the United States Tax Court challenging the notices of deficiency.
- The parties filed cross-motions for summary judgment in the Tax Court.
- The United States Tax Court, sitting en banc, granted Altera's motion for summary judgment, holding that 26 C.F.R. § 1.482-7A(d)(2) was invalid under the Administrative Procedure Act as arbitrary and capricious.
- The Commissioner of Internal Revenue (Respondent-Appellant) appealed the Tax Court's decision to the United States Court of Appeals for the Ninth Circuit.
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Issue:
Is 26 C.F.R. § 1.482-7A(d)(2), which mandates that related business entities share employee stock compensation costs in qualified cost-sharing arrangements (QCSAs), a valid regulation under 26 U.S.C. § 482 and the Administrative Procedure Act?
Opinions:
Majority - Chief Judge Thomas
Yes, 26 C.F.R. § 1.482-7A(d)(2) is a valid regulation because it represents a permissible and reasonable interpretation of 26 U.S.C. § 482 and was not promulgated in an arbitrary and capricious manner under the Administrative Procedure Act. The court first found that Section 482 does not directly address whether the Commissioner may require parties to a QCSA to share employee stock compensation costs, thus leaving a statutory ambiguity for Treasury to interpret. The broad phrasing "any transfer...of intangible property" in § 482 can reasonably be read to include the transfer of future distribution rights to intangibles developed in a QCSA. Moving to Chevron step two, the court determined that Treasury's interpretation was permissible. The congressional purpose behind § 482, particularly the 1986 "commensurate with income" amendment, was to achieve tax parity and ensure income reflects actual economic activity, especially where comparable transactions for high-profit intangibles are difficult to find. Treasury's decision to adopt internal allocation methods for QCSAs, without strict reliance on external comparables, was reasonable in light of this legislative history and the historical fluidity of the arm's length standard. The court also held that Treasury complied with the APA's procedural requirements. Treasury provided adequate notice of its proposed rulemaking and its reliance on the commensurate with income provision. It reasonably responded to comments arguing for comparable transactions by explaining that the cited uncontrolled transactions lacked sufficient characteristics to be comparable to QCSAs involving high-profit intangibles, thus reinforcing the need for its chosen internal allocation method. Treasury's position that employee stock compensation is a cost was adequately supported by generally accepted accounting principles and its classification as a deductible expense under 26 U.S.C. § 162(a). The court concluded that the 2003 regulations constituted a clarification of prior policy, not a major shift requiring a more searching Fox review, as the underlying policy changes were prompted by the 1986 statutory amendment. Finally, the court distinguished Xilinx, noting that it involved regulatory interpretation for pre-2003 tax years and did not address the Commissioner's statutory authority or the specific 2003 regulation at issue, which explicitly coordinates the arm's length standard with cost-sharing provisions.
Dissenting - Judge O’Malley
No, 26 C.F.R. § 1.482-7A(d)(2) is invalid as arbitrary and capricious because Treasury's explanation for the rule was insufficient under the State Farm standard, it failed to provide adequate notice of a significant policy change, and its interpretation of § 482 is incorrect. Judge O'Malley argued that Treasury violated the Chenery doctrine by offering post-hoc rationalizations for its decision that were not articulated during the rulemaking process. Treasury never explicitly stated its belief that QCSAs constitute "transfers of intangible property" under the second sentence of § 482, nor did it adequately communicate an intention to entirely dispense with comparability analysis as the cornerstone of the arm's length standard. The Tax Court correctly found Treasury's explanation for its belief that unrelated parties would share stock-based compensation costs to be inadequate and unsupported, especially given the significant contrary evidence from commentators and the factual finding in Xilinx I. Furthermore, even if procedurally valid, Treasury's interpretation is impermissible under Chevron step two. Section 482 unambiguously limits the "commensurate with income" standard to "transfers (or licenses) of intangible property," whereas QCSAs involve the development of intangibles, where rights to later-developed property spring ab initio to the participants, not through a transfer. The dissent criticized the majority's view that "imperfect comparables are tantamount to the absence of comparables," asserting that this allows Treasury to arbitrarily disregard the arm's length standard. Finally, Judge O'Malley contended that Xilinx II should control, as it previously affirmed the primacy of the arm's length standard (requiring comparability analysis) over the "all costs" provision for pre-2003 regulations, finding no evidence that unrelated parties would share stock-based compensation costs. The 2003 regulations, rather than a mere clarification, represented an unexplained, fundamental shift in administrative policy that was not contemplated by Congress in 1986.
Analysis:
This case significantly reinforces the broad deference given to Treasury regulations under the Chevron framework, particularly when Congress explicitly delegates authority or a statutory gap exists. It clarifies that the "commensurate with income" standard in 26 U.S.C. § 482 can justify the use of internal allocation methods even without perfect external transactional comparables, especially for complex intangible development costs like employee stock options, consistent with the goal of ensuring tax parity for controlled transactions. The decision also definitively distinguishes Xilinx, highlighting Treasury's ability to coordinate regulatory provisions to avoid conflict and emphasizing the ongoing tension between a strict arm's length comparability analysis and the broader policy objective of preventing tax evasion through income shifting. This ruling has implications for multinational corporations with cost-sharing arrangements, particularly those in high-tech industries reliant on stock-based compensation, by solidifying the requirement to include such costs in their shared pools.
