Executive Summary

The Tax Court, in a reviewed decision, held that the Treasury Department's 2003 issuance of a final rule mandating that stock-based compensation (SBC) costs be treated as costs to be shared in a qualified cost sharing arrangement (QCSA)¹ failed to satisfy the reasoned decision-making standard ² and, thus, was invalid. Consequently, the IRS erred in allocating the taxpayer's SBC costs to its QCSA cost pool, and the taxpayer was granted partial summary judgment overturning the allocations.

Background

Altera's cost sharing arrangement

On May 23, 1997, Altera US and Altera International entered into a QCSA that was in effect from that date through 2007. Pursuant to the terms of the QCSA, Altera US and Altera International agreed to share the risks and costs of research and development (R&D) activities. In the tax years 2004- — 2007, Altera US granted stock options and other SBC to certain of its employees responsible for conducting the R&D activities covered under its QCSA with Altera International. In allocating the costs to be shared pursuant to that QCSA, Altera US included the cash compensation of its employees engaged in R&D in the shared cost pool, but excluded their SBC.

The IRS subsequently imposed transfer pricing adjustments in each of the tax years 2004- — 2007, solely on the basis of the taxpayer's failure to include SBC costs in its QCSA cost pool.

Xilinx opinions relating to the 1995 Regulations

In Xilinx, the Tax Court addressed the issue of whether SBC was properly included in the shared cost pool under a QCSA,³ as defined in the 1995 Cost Sharing Regulations (1995 Regulations).⁴ In holding that it was not, the Tax Court relied on the most basic principle underpinning any transfer pricing analysis: the arm's length standard. Specifically, the Tax Court found that the arm's length standard, by its definition, requires an analysis of what unrelated parties would do, and unrelated parties would not share SBC costs. Further, because the commensurate with income standard was intended to supplement- — not supplant- — the arm's length standard, an evidentiary showing that unrelated parties would not share the costs associated with SBC⁵ was sufficient to conclude that those costs are not properly included in the QCSA cost pool.

On considering the Commissioner's appeal, the Ninth Circuit initially ruled that SBC costs are properly included in a QCSA cost pool, on the basis that because the "all costs" language of the 1995 Regulations was irreconcilable with the arm's length standard, and because the canons of statutory construction mandate that the specific trumps the general, the "all costs" requirement was controlling. The Ninth Circuit subsequently withdrew this opinion, and the new opinion agreed that the concepts of "all costs" and arm's length were irreconcilable.⁶ However, because the "all costs" language should be construed with regard to the dominant purpose of Section 482 (i.e., parity between controlled and uncontrolled taxpayers) and because commensurate with income and the arm's length standard are to work in tandem, SBC costs should not be included in the cost pool of a QCSA.

2003 Regulations

In July 2002, the Treasury Department (Treasury) issued a notice of proposed rulemaking and notice of a public hearing (NPRM) with respect to amendments it intended to make to the 1995 Regulations. Specifically, the proposed amendments sought to establish " ... that stock-based compensations must be taken into account in determining operating expenses under [Treas. Reg.] Section 1.482-7(d)(1) ... and to provide rules for measuring stock-based compensation costs ... ."⁷ Several individuals and organizations provided comments to Treasury regarding the proposed changes, the majority of which asserted that unrelated parties do not require one party to pay or reimburse the other for amounts attributable to SBC, either within or without the context of a QCSA. Further, economic analysis provided during the comment period supported the conclusion that unrelated parties would not share SBC costs because the value of SBC is speculative, potentially large and completely outside the parties' control.

In August 2003, Treasury issued the final rule to the cost sharing regulations, clearly requiring parties to a QCSA to share SBC costs (2003 Regulations).⁸ Further, the 2003 Regulations contained an amendment that established that a controlled taxpayer's participation in a QCSA would yield an arm's length result only if the parties' costs were determined in accordance with the final rule.⁹

Tax Court's holding

Preliminary issues

As preliminary matters, the Tax Court addressed whether the final rule in the 2003 Regulations was legislative or interpretative in nature, and the appropriate standard of review to be applied. The former issue had bearing on whether the Administrative Procedure Act (APA) was applicable to Treasury's rule-making activity.

In holding that the final rule to the 2003 Regulations was legislative, the Tax Court cited Section 7805(a), which authorizes the Secretary of Treasury to "prescribe all needful rules and regulations for the enforcement of" the Code. Noting that the regulations carry the force of law, and that the Code itself imposes penalties for failure to adhere to regulations prescribed thereunder, the Tax Court concluded that Congress had delegated legislative power to Treasury. Furthermore, the Tax Court found that Treasury intended for the final rule to have the force of law, a conclusion supported by the taxpayer's and the Service's stipulation that the Service's adjustments to Altera US's income would only be sustained if the final rule was deemed to be valid. Thus, having concluded that the final rule was legislative, a determination of whether the agency met the requirements of APA Sections 553(b) and (c) in promulgating the final rule was relevant insofar as it might indicate the extent to which Treasury took the public comments on the proposed amendments to the 1995 Regulations into account when reaching its decision.¹⁰

On the issue of the standard of review, the Tax Court adopted the "reasoned decision-making" standard espoused in State Farm. In rejecting the Service's contention that State Farm should not apply because the interpretation and implementation of Section 482 does not involve "empirical analysis," the Tax Court noted that Xilinx stands for the proposition that a proper arm's length analysis inquires as to what unrelated parties would do in similar circumstances. And in promulgating the final rule, Treasury explicitly considered whether unrelated parties would share SBC costs in the context of a QCSA, thereby implicating the arm's length standard.¹¹ Accordingly, when it concluded that its final rule was consistent with the arm's length standard,¹² Treasury decided an empirical question, and the State Farm standard of review was appropriate.¹³

Whether the final rule in the 2003 Regulations satisfied the reasoned decision-making standard

In determining whether the final rule was invalid because it did not meet State Farm's reasoned decision-making, the Tax Court addressed four arguments set forth by the petitioner:

1. The final rule lacks a basis in fact.

2. Treasury failed to rationally connect the choice it made with the facts it found.

3. Treasury failed to respond to significant comments.

4. The final rule is contrary to the evidence before Treasury.

On the first issue, the Tax Court concluded that Treasury did not "rationally connect" the choice it made with the facts it found, based on the Service's concession that Treasury engaged in no fact-finding. Specifically, the Service allowed that Treasury (1) took the position that it was not obligated to engage in fact-finding or follow evidence-gathering procedures; (2) maintained files devoid of any empirical or other evidence supporting its belief that unrelated parties would share stock-based compensation costs in the context of a QCSA; (3) did not have records in any of its files evidencing its search of any databases containing unrelated party agreements; and (4) was unaware of any written agreements- — or any transactions- — between unrelated parties requiring payment or reimbursement of stock-based compensation costs. Thus, because it engaged in no fact-finding and failed to support its interpretation with an evidentiary record, the final rule lacked a basis in fact.

On the second issue, the Tax Court agreed with the petitioner, and found that the preamble's contention that SBC costs would be shared in QCSAs involving "high value intangibles" where SBC was often a "significant component" of employees' compensation as justification for the rule was not supported by the final rule itself, which failed to make any distinction between QCSAs with these specific characteristics and those without. Accordingly, Treasury's explanation for the final rule was inadequate to support a finding of a rational connection between the facts found and the final rule promulgated.

In addressing Treasury's response to the public comments it received, the Tax Court noted that Treasury did not refute contradicting evidence directly, but instead concluded that its final rule was not inconsistent with the arm's length standard because relevant data showing that unrelated parties would share SBC costs may not have been available. In fact, the language in the preamble indicates that Treasury rejected evidence supporting the proposition that unrelated parties would not share SBC costs simply by asserting that the examples offered in the comments were factually distinguishable from the QCSAs to which the final rule was meant to apply- — namely, those involving high-value intangibles in which SBC was a significant component of the employees' compensation.

In light of the foregoing, the Tax Court agreed with the petitioner that the final rule was contrary to the evidence presented by Treasury. Notably, according to the Tax Court, Treasury never alleged that the evidence supporting the assertion that unrelated parties would not share SBC in the context of a QCSA was not credible. Moreover, there was nothing in the evidentiary record to support Treasury's contention that unrelated parties would share these costs. Thus, Treasury's explanation in support of the final rule was not supported by the evidence before it.

Accordingly, the court concluded that Treasury's final rule fails to meet the reasoned decision-making standard established in State Farm, and is therefore invalid. The court also indicated that it would have reached the same conclusion had it applied the standard of review in Chevron rather than the standard in State Farm. Specifically, the court noted that under Chevron step 2, the final rule would have been found to be "arbitrary or capricious" and, therefore, invalid. As such, having found Treas. Reg. Section 1.482-7(d)(2) invalid, the Tax Court also concluded that the Service erred in making Section 482 adjustments to the taxpayer's income that included stock-based compensation costs in the QCSA cost pool, and granted the taxpayer's motion for partial summary judgment.

Implications

The Tax Court's opinion is notable in the number of judges who joined the holding and the Court's analysis with respect to the Administrative Procedure Act. However, this single opinion concluding that Treas. Reg. Section 1.482-7(d)(2) is invalid does not strike down the regulation.

Under Treas. Reg. Section 1.6662-3(b)(2) and -3(c)(2), an accuracy-related penalty can be imposed where a taxpayer takes a position contrary to a regulation unless (i) the taxpayer presents a good faith challenge to the validity of the regulation, (ii) the contrary position has a realistic possibility of being sustained on its merits, and (iii) the position is disclosed on a Form 8275-R, Regulation Disclosure Statement.

The Altera opinion should be sufficient at this time to establish (i) a good faith challenge to the validity of the regulation and (ii) a realistic possibility of the position being sustained on its merits. If a taxpayer wishes to take a position on a federal tax return that is consistent with the Altera opinion, that taxpayer must disclose the position on a properly completed Form 8275-R attached to the return in order to avoid a penalty.

The case is not yet final, the IRS may appeal this particular holding (i.e., an interlocutory appeal), or the IRS may provide direction to taxpayers as to how to proceed in light of the decision.

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ENDNOTES

¹ Treas. Reg. Section 1.482-7(d)(2).

² See Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983).

³ Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005).

⁴ Treas. Reg. Section 1.482-7 (1995).

⁵ Neither the exercise spread value, nor the grant date value.

⁶ Xilinx, Inc. v. Commissioner, 567 F.3d 482 (9th Cir. 2009); rev'g and remanding 125 T.C. 37, withdrawn, 592 F.3d 1017 (9th Cir. 2010).

⁷ 67 Fed. Reg. 48998 (July 29, 2002).

⁸ Treas. Reg. Section 1.482-7(d)(2).

⁹ See Treas. Reg. Sections 1.482-1(b)(2)(1), 1.482-7(a)(3).

¹⁰ Specifically, as Treasury did present a NPRM and offered a comment period, the key inquiry was whether the opportunity to comment was meaningful, insofar as Treasury responded to significant points raised by the public, as it is required to do by the APA. A failure to respond to comments could signify an agency's failure to base its decision on a consideration of relevant factors and, thus, would have direct bearing on whether the final rule satisfied the reasoned decision-making standard in State Farm. See Altera, ___ T.C., at 35 (2015).

¹¹ The Tax Court noted that Treasury simply could have asserted that "controlled transactions can never be comparable to uncontrolled transactions because related and unrelated parties always occupy materially different circumstances." See Altera, ___ T.C. , at note 14. Such an assertion would have necessitated a review of the final rule outside the context of the arm's length standard, perhaps necessitating a different standard of review than that espoused in State Farm specifically for empirical rulemaking.

¹² See note 11, supra. In the preamble to the 2003 Regulations, Treasury noted that it and the IRS " ... continue to believe that requiring stock-based compensation to be taken into account in the context of QCSAs is appropriate. The final regulations provide that stock-based compensation must be taken into account in the context of QCSAs because such a result is consistent with the arm's length standard." See T.D. 9088, 2003-2 C.B. at 843.

¹³ The Tax Court declined to decide whether State Farm or Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984) provides the "ultimate standard of review," but did note that such a distinction was largely irrelevant, since step two of the Chevron analysis incorporates the reasoned decision-making standard set forth in State Farm. See Altera, ___ T.C., at 47.