Law Office of Charles W. Cope, PLLC | Altera Decision Raises the Bar for Treasury Regulations
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  • Altera Decision Raises the Bar for Treasury Regulations
    July 2015

    The recent decision of the Tax Court in Altera v. Commissioner[1] characterizes a Treasury regulation issued under the Treasury’s general rule making authority, section 7805(a), as a “legislative regulation,” which, under the Administrative Procedure Act (“APA”) generally is subject to certain mandatory notice and comment requirements. In addition, under the APA and the relevant case law, legislative regulations generally are subject to a different standard of review by the courts than has been applied to tax regulations. The Tax Court found the regulations at issue in Altera to be “arbitrary and capricious” and therefore invalid. Should other courts adopt the Tax Court’s analysis when reviewing Treasury regulations, some existing Treasury regulations may be held invalid by the courts, and the Treasury and IRS will need to be more careful in following the APA’s requirements when promulgating regulations. This surprising decision is likely to be appealed to the Court of Appeals for the Ninth Circuit, and in the author’s view, it stands a good chance of being affirmed.
    The taxpayer, Altera Corporation, develops, manufactures and sells programmable logic devices and related software. In 1997, Altera Corporation (“Altera”) and a subsidiary formed under the laws of the Cayman Islands, Altera International (“International”), entered into a cost-sharing arrangement to share the cost of developing certain intellectual property to be used in the business.[2] Under the agreement, Altera would own the US rights to the newly developed intellectual property, and International would own the rights to exploit the intellectual property in the rest of the world.
    Treasury regulations issued under section 482 set out requirements that related parties entering into a cost-sharing agreement must satisfy.[3] The Treasury regulations in effect for the years at issue, 2004-2007, required, inter alia, that the cost of stock-based compensation (e.g., stock options) of the employees developing the intellectual property that was the subject of the cost-sharing arrangement be shared by Altera and International. Altera employed the individuals doing the development work, so International was required by the regulations to make a payment to Altera to reimburse it for International’s share of the compensation. Stock-based compensation of the type at issue in this case is generally deductible by the employer in computing its income tax liability under section 83(h) of the Internal Revenue Code, so International’s reimbursement would offset Altera’s deduction.
    Altera, believing the rule in the regulations relating to stock-based compensation was invalid, did not seek reimbursement from International. The IRS determined that International should have paid Altera approximately $80 million during the years at issue and accessed a tax deficiency for those years. Altera contested the deficiency in the Tax Court. In a motion for summary judgment, Altera argued that the regulation, in so far as it required the cost of stock-based compensation to be shared by the parties, was “arbitrary and capricious” and therefore invalid under the relevant standard of review (as discussed below). The Tax Court agreed and granted the motion in favor of Altera.
    The Xilinx Case
    Altera is not the first time that the Tax Court has considered the correct treatment of stock-based compensation under the Treasury’s cost-sharing regulations. In 2005, in Xilinx, Inc. v. Commissioner,.[4] the Tax Court considered whether, under an earlier version of the Treasury’s cost-sharing regulations (the “1995 Regulations”), the cost of stock-based compensation should be shared by the parties to a cost-sharing arrangement.
    The 1995 Regulations did not explicitly mention stock-based compensation. The regulations referred to “operating expenses… other than depreciation or amortization expense, plus… the charge for the use of any tangible property made available to the qualified cost-sharing arrangement.” In its opinion, the Tax Court held that the arm’s-length standard (and Reg. § 1.482-1) applies to cost-sharing arrangements. After considering expert testimony offered by the taxpayer and the IRS, the Tax Court held for the taxpayer reasoning that unrelated parties would not share the cost of stock-based compensation (whether measured by the value of the option at the date of issue or the spread between the share value on the date of exercise and the exercise price).
    The IRS appealed the Tax Court’s decision to the Court of Appeals for the Ninth Circuit, and in May 2009, the Circuit Court issued an opinion reversing the Tax Court. Xilinx then petitioned the Ninth Circuit for a rehearing of its case. In March 2010, the same three-judge panel that had issued an opinion in favor of the government reversed itself. In finding for Xilinx, the Ninth Circuit stated: “the purpose of the regulations is parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions.… If Xilinx cannot deduct all of its stock-option costs, Xilinx does not have tax parity with an independent taxpayer.”
    The 2003 Regulations
    Stock-based compensation is often a significant deduction for U.S. software, pharmaceutical and technology companies, which typically are the types of companies that enter into cost-sharing arrangements. Once the Treasury and the IRS were aware that taxpayers did not read the 1995 regulations to require stock-based compensation to be treated as a shared cost, the Treasury and the IRS moved to revise the regulations to explicitly address stock-based compensation. In July 2002, the Treasury issued a notice of proposed rulemaking stating the cost-sharing regulations would be amended to clarify that stock-based compensation must be taken into account in determining the operating expenses to be shared under a cost-sharing arrangement.
    Interested parties responded to the notice by providing written comments. Consistent with the expert testimony to be provided later in Xilinx, these comments offered evidence that unrelated parties would not share the cost of stock-based compensation when entering into joint business arrangements. Some noted that the speculative and potentially large value of stock-based compensation caused parties to exclude such amounts from their agreements. Some economists also offered their view that stock-based compensation was not an “economic cost” to a company. In its opinion in Altera, the Tax Court takes note of these comments.
    The Treasury proceeded to issue the regulations in final form in August 2003 – two years prior to the Tax Court’s decision in Xilinx and seven years prior to the Ninth Circuit’s opinion. The preamble to the final regulations states, inter alia, “the final regulations provide that stock-based compensation must be taken into account in the context of QCSA’s [Qualified Cost-Sharing Arrangements] because such a result is consistent with the arm’s-length standard.”
    The 2003 Regulations Are Legislative Regulations
    The Administrative Procedure Act distinguishes between “legislative” and “interpretive” rules and regulations. Under section 553 of the APA an agency issuing legislative regulations must first publish the regulations in proposed form, provide interested parties an opportunity to submit written comments on the proposed regulations and the agency must then consider the submissions of interested parties and “incorporate in the rules adopted a concise general statement of their basis and purpose.”[5] These requirements do not apply to interpretive regulations.
    The IRS takes the position that regulations issued under its general rulemaking authority of section 7805(a) are interpretive regulations. Nevertheless, the IRS generally follows the notice and comment procedures of section 553 of the APA.
    Altera argued that 2003 Regulations were legislative regulations, and the Tax Court agreed for the following reasons.[6] Section 7805(a) authorizes the Secretary of the Treasury to “prescribe all needful rules and regulations for the enforcement” of the Internal Revenue Code. The Tax Court concluded that this is a delegation of legislative power to the Treasury. The Tax Court also concluded that the 2003 Regulations have the “force of law.”
    The Standard for Judicial Review
    In general, tax regulations have been reviewed by the courts under the standard set out by the Supreme Court in Chevron U.S.A. Inc. v. Natural Res. Def. Council,[7] and the government argued that the Chevron standard was the appropriate standard for review of the 2003 Regulations. Altera argued that because the 2003 Regulations were legislative regulations, they were subject to review under the “reasoned decision-making” standard of section 706(2)(A) of the APA and the decision of the Supreme Court in Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Automobile Insurance Co.[8]
    The Chevron standard typically is applied to review the validity of an agency’s interpretation of a statute, and the Supreme Court applied the Chevron standard to all tax regulations in Mayo Foundation for Medical Education and Research v. United States.[9] Although the Tax Court declined to endorse either the Chevron or the State Farm standard for reviewing legislative tax regulations, the Tax Court reasoned that even if the Chevron standard were applicable, the Treasury addressed an empirical question when it issued the 2003 Regulations and therefore the State Farm standard was relevant:
    “Ultimately, however, whether State Farm or Chevron supplies the standard of review is immaterial because Chevron step 2 incorporates the reasoned decision-making standard of State Farm [footnote and citations omitted].”
    Applying the State Farm Standard
    The Tax Court next considered whether the Treasury satisfied the State Farm standard when it promulgated the 2003 Regulations.  The court found the government’s methods lacking.
    When it issued the final rule, the files maintained by Treasury relating to the final rule do not contain any expert opinions, empirical data, or published or unpublished articles, papers, surveys, or reports supporting a determination that the amounts attributable to stock-based compensation must be included in the cost pool of QCSA’s to achieve an arm’s-length result. Those files also did not contain any record that Treasury searched any databases they could have contained agreements between unrelated parties relating to joint undertakings or the provision of services. Additionally, Treasury was unaware of any written contract between unrelated parties, whether in a cost-sharing arrangement or otherwise, that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation; or any evidence of any actual transaction between unrelated parties, whether in a cost-sharing arrangement or otherwise, in which one party paid to reimburse the other party for amounts attributable to stock-based compensation.”
    The Tax Court then concludes that the 2003 Regulations “fails to satisfy State Farm’s reasoned decision-making standard and therefore is invalid.” The Tax Court’s decision rests on the following findings: The Treasury did not (i) engage in any fact-finding and did not examine any relevant data as required by State Farm, (ii) the Treasury failed to support its belief that unrelated parties entering into a cost-sharing arrangement would share stock-based. compensation costs, (iii) the Treasury failed to articulate a rational connection between the facts found and the choice made as required by State Farm, (iv) the “Treasury failed to respond directly to any of the evidence that unrelated parties would not share stock-based compensation costs other than by asserting that the transactions cited by the commentators did not ‘share enough of the characteristics of QCSAs involving the development of high profit intangibles’ to be relevant,” and (v) the “Treasury’s ‘explanation for its decision  * * * runs counter to the evidence before’ it.”
    In a footnote, the Tax Court concludes that the 2003 Regulations also fail under the Chevron standard:
    The analysis under Chevron would proceed as follows: the parties agree that sec. 482 is ambiguous. We would therefore proceed to Chevron step 2. Under Chevron step 2, we would conclude the final rule is invalid because it is ‘arbitrary or capricious in substance’ [citations omitted] and therefore cannot be justified as being a reasonable interpretation of what sec. 482 requires.”
    The Altera opinion answers two questions.  The first is a narrow one: whether the 2003 Regulations are valid, either under State Farm or Chevron. The Tax Court concluded the regulations are invalid under either standard. Given the Ninth Circuit’s reasoning in Xilinx and the weak logical foundation the government created for the 2003 Regulations (albeit not knowing either the reasoning or the outcome in Xilinx at the time), the Ninth Circuit probably will affirm the Tax Court’s result. The Treasury then will either have to try a new regulatory tack to disallow the deduction provided under section 83, or, less likely in this political climate, seek legislation to reverse the decision. The author would be surprised if the government abandoned the issue.
    The broader question the Altera opinion considers is the appropriate standard of review of any tax regulation issued under section 7805(a).  Although the Altera opinion was reviewed by the Tax Court, whether tax regulations are subject to the rigors of the APA and the appropriate standard of judicial review is more properly determined by the Circuit Courts and the Supreme Court.[10]  The Ninth Circuit, and perhaps other courts, now will weigh in.   
    After the Supreme Court’s decision in Mayo Foundation, most members of the tax bar (including those in the government) believed it would be difficult to successfully challenge the validity of Treasury regulations. Altera should quell that optimism. And if the Tax Court’s analysis in Altera is confirmed by the Ninth Circuit, some taxpayers surely will move to challenge tax regulations in the right situations.
    Those taxpayers seeking to challenge a tax regulation can bide their time until the law becomes clearer. The government, on the other hand, does not have that luxury. Henceforth, it would be prudent for the IRS and Treasury to scrupulously follow the standards of the APA and State Farm when promulgating tax regulations. The government should also creatively consider alternative rationales in support of its regulations in order to improve the defense of its regulations in the courts.
    [1] 145 T.C. No. 3 (July 27, 2015). The decision was reviewed by the court.
    [2] Many US technology companies have entered into cost-sharing arrangements to develop intellectual property with affiliates located in low-tax jurisdictions. When such arrangements are successful, substantial profits of the business can be earned in low tax jurisdictions and the US tax on such earnings can be deferred. The IRS has attacked these transactions in the courts and has revised its regulations to make cost-sharing arrangements less attractive to US multinationals.
    [3] Reg. § 1.482-7.
    [4] 125 T.C. 37 (2005), aff’d 598 F.3d 1191 (2010) (“Xilinx”). For an analysis of Xilinx see Cope and Zollo, The Ninth Circuit Affirms the Tax Court's Decision in Xilinx , But Some Issues Remain Unresolved, 39 Tax Mgmt. Intl J. 344 (2010).
    [5] 5 U.S. Code § 553.
    [6] The Tax Court notes that the government did not argue that the 2003 regulations were interpretive regulations either on brief or at oral argument.
    [7] 467 U.S. 837(1984) (“Chevron”)
    [8] 463 U.S. 29 (1983) (“State Farm”).
    [9]562 U.S. 44, 55-58 (2011).
    [10] As discussed above, the Tax Court did not choose between the State Farm or Chevron standard, but concludes instead that Chevron incorporates the reasoned decision making standard by a citing a footnote in a recent Supreme Court opinion. Judulang v. Holder, 565 U.S. at___ n.7 ( 2011).