Altera: Tax Court Invalidates Section 482 Regulation On Administrative Law Grounds

In Altera, the U.S. Tax Court invalidated regulations under Section 482 requiring participants in qualified cost-sharing agreements to include stock-based compensation costs in the cost pool to comply with the arm's-length standard. The discussion below summarizes the history of those regulations, as set forth in more detail in the Tax Court's opinion, and focuses primarily on the court's holding and the implications of that holding with respect to administrative law issues. For a discussion of other issues related to the opinion, see Tax Court Overturns Important Transfer Pricing Regulations.

Background

In 2005, the Tax Court held in Xilinx Inc. v. Commissioner, 125 T.C. 37 (2005), that, under cost-sharing regulations promulgated in 1995, controlled entities entering into qualified cost-sharing agreements need not share stock-based compensation costs because parties operating at arm's-length would not do so. The U.S. Court of Appeals for the Ninth Circuit affirmed, holding that the all costs requirement should be construed as not applying to stock-based compensation because the regulations should be interpreted to accomplish the statutory purpose of grounding the Internal Revenue Service's (IRS) allocation authority in the principle of "parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions," and Treasury's technical explanation of the income tax convention between the United States and Ireland confirmed that the commensurate-with-income standard was meant to work consistently with the arm's-length standard.

While the dispute in Xilinx was ongoing, but before the Tax Court's opinion was issued, the U.S. Department of the Treasury proposed amendments in 2002 to the 1995 cost-sharing regulations purporting to clarify that stock-based compensation must be taken into account in determining operating expenses under Treas. Reg. § 1.482-7(d)(1), to provide rules for measuring stock-based compensation costs, and to include express provisions to coordinate the cost sharing rules of Treas. Reg. § 1.482-7 with the arm's-length standard of Treas. Reg. § 1.482-1. Several individuals and organizations submitted written comments to Treasury, and four individuals spoke at a public hearing. Many of the commentators informed Treasury that they knew of no transactions between unrelated parties, including any cost-sharing arrangement, service agreement, or other contract, that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation. Additionally, several commentators identified arm's-length agreements in which stock-based compensation was not shared or reimbursed.

Despite the comments, Treasury issued final rules in 2003 explicitly requiring parties to qualified cost-sharing agreements to share stock-based compensation costs. The final rule also added regulations providing that qualified cost-sharing agreements produce an arm's-length result only if the parties' costs are determined in accordance with the final rule. Treasury's files underlying the final rules did not contain any expert opinions, empirical data, or published or unpublished articles, papers, surveys, or reporting supporting a determination that the amounts attributable to stock-based compensation must be included in the cost pool of qualified cost-sharing agreements to achieve an...