No (Tax) Man Is Above The Law: The Tax Court Rejects Final Cost-Sharing Regulations In Altera Corporation And Subsidiaries v. Commissioner, 145 T.C. 3 (July 27, 2015)

Our 26th President Theodore Roosevelt famously contributed to the American canon the following: "No man is above the law and no man is below it; nor do we ask any man's permission when we ask him to obey it." The notion that no one, not even a powerful federal agency, is above the law is the heart of this case. In Altera, the Tax Court addressed the validity of Treasury regulations that required qualified cost-sharing agreements to share stock-based compensation costs. See Treas. Reg. § 1.482-7(d)(2) (August 25, 2003). Altera argued that Treasury ignored certain procedural requirements of the Administrative Procedure Act in the issuance of the final regulations, and therefore the regulations were invalid. The government argued that it did satisfy the APA requirements, and even if it did not any failure was harmless error and the court should defer to the regulations. The Tax Court answered two questions: (1) did the Government observe applicable APA requirements in issuing the final regulations and (2) if not, did such a failure invalidate the regulations? In a reviewed Tax Court opinion, Judge Marvel gave a very clear answer to both questions and in the process exposed the agency's penchant for governance by diktat in this arena.

BACKGROUND AND XILINX

A prior Tax Court decision, Xilinx v. Commissioner, 125 T.C. 37 (2005), aff'd 598 F.3d 1191 (9th Cir. 2010), rejected the IRS's application of pre-2003 section 482 regulations, which required cost-sharing of stock-based compensation. The regulations at issue in Xilinx did not specifically identify stock-based compensation as a cost. However, Treas. Reg. § 1.482-7(d)(1), known as the "all costs requirement," provided that controlled parties share all costs relating to intangible product development in a qualified cost-sharing agreement. Thus the IRS could easily argue, based on the broad language of the regulation, that every type of compensation was a cost to be shared. The Ninth Circuit rejected the IRS's application of the all costs requirement because it was contrary to the fundamental principle underlying section 482, i.e., that allocations should be made as if the controlled parties were uncontrolled parties dealing at arm's length. In effect, the Ninth Circuit reconciled the all costs requirement with the arm's length standard, and, because the parties stipulated that uncontrolled parties would not share stock-based compensation costs, the court decided that such costs were not a cost for section 482 purposes. It also opined on temporary regulations that, like those at issue in Altera, required stock-based compensation, specifically employee stock options, to be shared:

It is an open question whether these flaws have been addressed in the new regulations Treasury issued after the tax years at issue in this case. See 26 C.F.R. § 1.482-7T(a) & (d)(1)(iii) (2009) (stating explicitly that ESOs are costs that must be shared and that the all costs requirement is an arm's length result).

Those flaws included (i) that an application of the all costs regulation that required costs to be shared that were not shared by uncontrolled parties would undermine the arm's-length standard of section 482 and (ii) that the IRS's position would negate the arm's-length standard expressly incorporated into numerous tax treaties. See our client alert Ninth Circuit Issues Opinion in Key Transfer Pricing Case: Arm's Length Standard Vindicated for a fuller discussion of the Ninth Circuit Xilinx opinion.

FINAL 2003 REGULATIONS

Treasury issued proposed regulations in 2002. In the notice of proposed...