Executive summary

In a 2-1 ruling, the Ninth Circuit reversed the Tax Court's holding in Altera v. Comm'r, 145 T.C. 91 (2015), and upheld a 2003 regulation that requires participants in a cost sharing arrangement (CSA) to treat stock-based compensation costs (SBC costs) as compensable. The appellate court concluded that the regulations were valid under general administrative law principles and that under current law SBC costs should be treated as shared by participants in a CSA.

Detailed discussion

Before the Tax Court, the taxpayer argued that the 2003 version of Treas. Reg. Section 1.482-7, requiring that SBC costs be included in intangible development costs (IDCs), which are shared in a CSA, was invalid because the IRS did not follow the procedural requirements of the Administrative Procedure Act (APA) when the regulation was adopted.

After hearing cross-motions for partial summary judgment, on July 27, 2015, the Tax Court, in a fully reviewed opinion, agreed with the taxpayer's position, noting that the question of whether the inclusion of such costs is consistent with the arm's-length standard is an empirical determination. The Tax Court concluded that since commentators had provided significant evidence that unrelated parties, acting at arm's length, would never agree to share each other's SBC costs, a final rule requiring related parties to share SBC costs "lack[ed] a basis in fact. [Because] Treasury failed to rationally connect the choice it made with the facts found, Treasury failed to respond to significant comments when it issued the final rule, and Treasury's conclusion that the final rule is consistent with the arm's-length standard is contrary to all the evidence before it, we conclude that the final rule … is invalid."

The government appealed the Tax Court's opinion and the Ninth Circuit panel, in a 2-1 decision, reversed the Tax Court. The first issue that the Ninth Circuit panel considered is whether the 2003 regulation failed to comply with the requirement established by the APA that Treasury "give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments … ." 5 U.S.C. Section 553(c). More specifically, the taxpayer had argued that although Treasury solicited public comments on the proposed regulations, it did not adequately respond to those comments rendering the regulations arbitrary and capricious under the standards established by Motor Vehicle Manufacturers Association of the U.S. vs. State Farm, 463 U.S. 837 (1984). However, the Ninth Circuit panel concluded that Treasury "gave sufficient notice of what it intended to do and why; it considered the comments but it rejected them," thereby meeting the reasoned decision-making standard established by State Farm and the APA. The panel also held that the government's conclusion that stock-based compensation should be treated as a cost was adequately supported in the record and its position was not a policy change.

Having found that Treasury complied with the APA, the Court then applied the Chevron standard in examining the agency's interpretation of the statute that defines the scope of its authority. Chevron v. NRDC, 467 U.S. 837 (1984). The Ninth Circuit panel observed that the commentators' objections to the proposed regulations are based on the proposed regulations being "inconsistent with the traditional arm's length standard" because the evidence demonstrated that unrelated parties operating at arm's length never agreed to share SBC costs. The Ninth Circuit panel found "the thrust of the objection was that Treasury misinterpreted [Section] 482. But that is a separate question — one properly addressed in the Chevron analysis. That commentators disagreed with Treasury's interpretation of the law does not make the rulemaking process defective."

The first step under Chevron is for the court to "apply the traditional rules of statutory construction to determine whether 'Congress has directly spoken to the precise question at issue.' " The Ninth Circuit panel concludes that "Section 482 does not speak directly to whether the Commissioner may require parties to a [CSA] to share employee stock compensation costs in order to receive the tax benefits associated with a [CSA]." The Court then "move[s] on to Chevron step two to consider whether Treasury's interpretation of [Section] 482 as to allocation of employee stock option costs is permissible." The Court notes that the 1986 Amendments to Section 482 added the commensurate with income standard, which the Court describes as a "purely internal standard" in that "Congress's objective in amending [Section] 482 was to ensure that income follows economic activity." Consequently, the court concludes that "Treasury's decision to dispense with a comparability analysis was reasonable. … Treasury reasonably understood [Section] 482 as an authorization to require internal allocation methods in the [CSA] context, provided that the costs and income allocated are proportionate to the economic activity of the related parties." Therefore, it views Treasury's interpretation in the 2003 regulations as permissible under the Chevron standard.

One judge on the Ninth Circuit panel dissented from the majority decision and would have found, as the Tax Court did, that the regulations are invalid. The judge specifically notes that "I … would find, as the Tax Court did, that Treasury's explanation of its rules did not satisfy the State Farm standard; that Treasury did not provide adequate notice of its intent to change its longstanding practice of employing the arm's length standard; and that its new rule is invalid as arbitrary and capricious." The judge also notes that Treasury should be bound by its initial explanation of the regulations and suggests the Ninth Circuit cannot merely accept Treasury's invitation to "recreate the record in order to justify [Treasury's] decision-making." Having concluded that the regulation fails the State Farm test, the judge does not apply the Chevron standard.

The taxpayer has 45 days (September 7, 2018) to seek rehearing by the panel or rehearing en banc by the full Ninth Circuit. If no rehearing is sought, the taxpayer has 90 days (October 22, 2018) to submit a petition for certiorari with the US Supreme Court. The due date for the petition for certiorari would be extended if the Ninth Circuit considers a petition for rehearing. It is important to note that under Treas. Reg. Section 1.6662-4(d)(3)(iii) and Golsen v. Commissioner, 54 T.C. 742 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971)), the Tax Court's taxpayer favorable opinion is still precedent and authority for taxpayers located in geographical areas outside of the Ninth Circuit's jurisdiction.

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