Altera: Ninth Circuit Reverses US Tax Court And Holds That Treasury Regulation Allocating Stock-Based Compensation Expenses Is Valid

On July 24, 2018, in Altera Corp. v. Commissioner, a divided panel of the U.S. Court of Appeals for the Ninth Circuit upheld the validity of a Treasury Department regulation that requires a U.S. taxpayer to allocate a portion of stock-based compensation costs to a foreign affiliate that is a participant in a cost-sharing arrangement for the development of intangible assets.[1] In the decision, the court reversed the Tax Court's prior unanimous decision in favor of Altera, which had held that the Treasury Department failed to engage in "reasoned decisionmaking" in promulgating the regulation, contrary to the requirements set forth by the Supreme Court in Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Auto Insurance Co. ("State Farm").[2]

The decision in Altera is noteworthy in two broad respects. First, the Ninth Circuit, like the Tax Court, closely examined the history of the Treasury regulation under both State Farm and Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc. ("Chevron")[3], reaffirming the increasing significance of general administrative law principles in tax cases. Focusing primarily on the "reasoned decisionmaking" standard of State Farm, the court held that Treasury had adequately explained how it arrived at its decision in the notice of proposed rulemaking and the preamble to the final regulations. Second, the majority opinion agreed with the IRS that strict application of the traditional "arm's length" standard for U.S. transfer pricing analysis was not required in this case under section 482 of the Internal Revenue Code.[4] Historically, the arm's length standard has been understood to require U.S. taxpayers to report income from transactions with their foreign affiliates in a manner consistent with the price that would be agreed upon if the transaction were between uncontrolled parties. Instead, the court reasoned that section 482 could be read to allow the IRS to reallocate income and expense if such reallocations are "fair and reasonable," regardless of what happens between parties dealing at arm's length. This reasoning could embolden the IRS to take more aggressive approaches in promulgating section 482 regulations in the future.

ALTERA'S CHALLENGE TO THE VALIDITY OF TREASURY'S STOCK-BASED COMPENSATION ALLOCATION REGULATION

When a U.S. taxpayer transacts with a foreign affiliate under common control, the U.S. taxpayer must determine whether, and to what extent, income or expense relating to such transactions are attributable to the U.S. taxpayer and the foreign affiliate.[5] This process of allocation of income and deductions between or among U.S. taxpayers and their foreign affiliates is known as "transfer pricing."

Taxpayers that are part of commonly controlled multinational groups generally have an incentive to allocate greater income and fewer deductions to jurisdictions with relatively low tax rates and less income and greater deductions to jurisdictions with relatively high tax rates. As a result, the IRS often closely scrutinizes the transfer pricing policies adopted by U.S. taxpayers and their foreign affiliates. Under section 482, the Secretary has been delegated broad authority to reallocate the income and expenses of taxpayers under common control, and the Treasury Department has issued transfer pricing regulations describing various methods by which a taxpayer can determine an "arm's length" price to avoid such reallocation.

In the relevant tax years, Altera Corporation ("Altera"), a U.S. corporation, and its subsidiaries, designed, manufactured, marketed and sold programmable logic devices, which are electronic components used to build circuits. In 1997, Altera entered into a licensing agreement and a "cost-sharing" agreement with a Cayman Island subsidiary. Under the licensing agreement, Altera granted to the Cayman subsidiary, in exchange for royalties, a license to use preexisting intangible property everywhere in the world except the United States and Canada. Under the cost sharing agreement, the parties agreed to pool their resources to share research and development (R&D) costs in proportion to the benefits anticipated from new technologies.

On its tax returns for the taxable years 2004 through 2007, Altera did not allocate any of its R&D-related stock-based compensation expenses to the Cayman subsidiary.[6] Although the 2003 regulation then in effect required such an allocation, Altera's tax return position was based on the 2005 decision of the U.S. Tax Court in Xilinx v. Commissioner, which upheld a challenge to an IRS reallocation under a previous regulation and which the Ninth Circuit later upheld.[7] On audit, the IRS challenged Altera's position, citing the 2003 Treasury regulation, Treas. Reg. § 1.482-7A(d)(2), which requires the allocation of such stock-based compensation expenses between a U.S. taxpayer and a foreign affiliate operating under a cost sharing agreement.

In a petition filed in the U.S. Tax Court, Altera disputed the IRS's allocation of stock-based compensation expenses to the Cayman subsidiary on the ground that the 2003 Treasury regulation was invalid under the Supreme Court decisions in State Farm and Chevron. On cross-motions for partial summary judgment, the Tax Court agreed with Altera and held the regulation to be invalid.[8] The Tax Court reasoned that the complete absence of any evidence in the administrative record that parties dealing at arm's length would share...