On July 27, 2015, in Altera Corporation v. Commissioner, 145 T.C. No. 3 (2015), the Tax Court held Treasury regulation section 1.482-7(d)(2) (the "Regulation") invalid. This decision is significant to taxpayers who are parties to cost-sharing arrangements with foreign affiliates but, if sustained, could also have a significant impact on the IRS's regulations procedures going forward and could make it easier in some cases for taxpayers to challenge other IRS regulations.
Cost-sharing arrangements ("CSAs") enable a U.S. entity and its foreign affiliate to co-develop intellectual property ("IP") and share in the associated research and development ("R&D") costs in a tax-efficient manner. It has long been a point of controversy between the IRS and taxpayers whether, in addition to other compensation, the value of stock options and other stock-based compensation ("SBC") issued to relevant employees must be included in the costs to be shared (a "cost pool") by the participants in a CSA. In an attempt to settle the question, the IRS issued the Regulation in 2003, requiring all participants in CSAs to share any relevant SBC costs.
Altera involved a U.S. corporation ("Altera US"), which was a party to a CSA with an offshore subsidiary, International. Altera US issued SBC to employees who performed R&D activities. Although the CSA included the employees' cash compensation in the cost pool under the CSA, it did not include the value of the SBC. The IRS relied on the Regulation to increase International's cost-sharing payments to Altera US (which increased Altera US's taxable income) in the amount of International's proportionate share of the SBC. Altera US challenged the allocation on the grounds that the Regulation is invalid.
The Tax Court struck down the Regulation under the principles of Motor Vehicle Manufacturers Association of the United States, Inc. v. State Farm Mutual Automobile Insurance Co., 463 U.S. 29 (1983), and sections 553 and 706(2)(A) of the Administrative Procedure Act ("APA"). It held that issuance of the Regulation was an act of legislative rulemaking (rather than "interpretive" statutory construction), and the IRS had failed to satisfy the full bevy of notice and comment requirements imposed by the APA. Specifically, the court held that the IRS acted in an "arbitrary and capricious" manner—rather than having engaged in reasoned decision-making—because (i) the Regulation lacked a basis in fact; (ii) the IRS failed to connect rationally the requirement to include SBC costs in the face of the facts; (iii) the IRS failed to respond to significant comments received from the public that suggested unrelated parties do not typically share SBC costs; and (iv) the IRS conclusion that the Regulation is consistent with the arm's-length standard (which is referred to in the regulations but not the statute) was contrary to the evidence before it.
If upheld on appeal, Altera could have significant implications beyond just CSAs and transfer pricing. The court took a novel approach in its review of the Regulation that, if upheld, may subject similar acts of regulatory rulemaking by the IRS to additional procedural requirements in the future (and possibly expose previously promulgated regulations once thought exempt from heightened procedural requirements to similar challenges). This could potentially translate to more successful challenges to existing IRS regulations by taxpayers.
As an immediate matter, any taxpayer with a CSA should review whether during any open year it included SBC in the CSA cost pool, and if so, may want to consider filing claims for refund to protect itself in the event Alterabecomes final, either by being upheld on appeal or by a government decision not to appeal.