The Tax Court in Altera Corp. v. Commissioner, 145 T.C. No. 3 (2015) has determined that Treas. Reg. §1.482-7(d)(2) requiring related taxpayers to share stock-based compensation (SBC) in a cost sharing arrangement (CSA) is invalid. The court ruled in favor of Altera’s motion for summary judgment that Treasury did not follow the Administrative Procedure Act (APA), noting that Treasury's conclusion that sharing SBC was arm’s length was “contrary to all of the evidence before it.”
The IRS has had little success with this issue over the last several decades. Indeed, this invalidated regulation, adopted in 2003, was essentially designed to prevent the taxpayer’s victory in Xilinx on exactly the same issue.
But now what? Will the IRS finally concede the issue or appeal? And what should companies with this issue − or related issues − now do?
In a CSA, two related parties share the costs of developing intangible property, and, in exchange, each party receives the rights to exploit such property in its respective territory. The “costs” to be shared certainly include compensation, such as engineers’ salaries, but whether costs also include SBC (such as non-qualified stock options, ISOs or RSUs) has been the subject of intense debate.
The issue came close to trial in Seagate, relating to tax years 1990, 1991 and 1992. Both the IRS and taxpayer lost cross-motions for summary judgment, as the Tax Court indicated that the issue was inherently factual, not simply a legal issue, and a trial was therefore necessary. Apparently having no evidence that unrelated parties share SBC, the IRS conceded the Seagate case. The IRS also conceded the issue for all taxpayers for years prior to the revised 1995 Section 482 cost sharing regulations. However, the IRS believed the 1995 regulations provided the result it wanted, so it did not concede the issue going forward from 1995. As it turned out, the IRS’s reliance on the 1995 regulations was misplaced.
In 2005, the Tax Court in Xilinx held that, even under the 1995 regulations, participants do not need to share SBC costs because unrelated parties would not share such costs. Xilinx presented a variety of evidence and its own executives’ opinions that unrelated parties do not share SBC. The IRS did not offer any evidence that unrelated parties shared SBC on the basis that whether such parties actually shared SBC was irrelevant because the 1995 regulations required that “all costs” relating to the development of intangible property covered by a CSA must be shared. In the view of the IRS, SBC was a cost that must be shared whether or not the cost would be shared by unrelated parties engaged in a comparable intangible development arrangement. The taxpayer countered that the regulations mandated that the arm’s length standard needed to be applied “in every case” and, therefore, whether uncontrolled parties shared SBC in arrangements comparable to a CSA was relevant.
The outcome of the Xilinx case essentially turned on the inconsistency in the regulations between the “arm’s length in every case” requirement vs. the “all costs” requirement. In 2010, the Ninth Circuit ultimately affirmed the 2005 Tax Court decision, determining that the overarching purpose of the Section 482 regulations is to put controlled parties on par with uncontrolled parties, so the IRS “all costs” requirement must yield.
Even as the Xilinx trial was under way, Treasury proposed a new regulation expressly requiring SBC to be included in CSAs. The proposed regulation asserted that such inclusion is consistent with the arm’s length standard. During the comment period mandated by the APA, comments were received from taxpayer groups and tax advisory firms that unrelated parties do not actually share SBC costs in joint development agreements and similar arrangements. Several commentators (including one of these authors) provided industry surveys and analyses of SEC filings to support their point. But the Treasury regulation was finalized in 2003 anyway, with the Preamble indicating that the commentators’ support for uncontrolled parties not sharing SBC was not convincing.
In practice, most multinationals with CSAs and SBC followed the 2003 regulation − except for Altera. It purposefully took a position contrary to the regulation. In somewhat of an odd twist, Altera is one of Xilinx’s key competitors in the semiconductor industry. Perhaps it followed the Xilinx case developments more intensely than most.
Altera challenged the validity of Treas. Reg. §1.482-7(d)(2) under the APA, which generally requires federal agencies to undertake prescribed notice-and-comment procedures before promulgating regulations. Following the Supreme Court’s 2011 decision in Mayo, it seemed nearly impossible for a taxpayer to challenge the validity of any Treasury regulation. Notwithstanding, several key Tax Court findings in Altera were as follows:
- Although Treasury had claimed that the regulation follows the arm’s length standard, Treasury did not cite any source of information in the Preamble supporting the regulatory conclusion that unrelated parties share SBC costs.
- The assertion that Treasury need not look for unrelated party transactions similar to cost sharing because they cannot be found is illogical. Rather, it is only after a search that one can conclude something cannot be found.
- When the IRS argued that comparable third-party transactions could not be found because CSAs involve high-profit (i.e., crown jewel) intangibles, the Court questioned why Treasury would lump all CSAs together − even those not involving crown jewels.
- Treasury did not adequately respond to the mountain of comments submitted by commentators, which provided that third parties in joint ventures and other co-development arrangements do not share SBC costs: “[a]lthough Treasury’s failure to respond to an isolated comment or two would probably not be fatal to the final rule, Treasury’s failure to meaningfully respond to numerous relevant and significant comments certainly is.”
Also, it is keenly obvious that the Tax Court itself is aware of whether or not unrelated parties share SBC, having gone through extensive evidence on the issue during the Xilinx trial, and having seen no evidence to the contrary from the IRS in either Seagate or Xilinx. That is, the 2003 regulation is squarely at odds with the Tax Court’s own determination of arm’s length behavior from evidence in an adversarial forum.
Accordingly, the Tax Court held that Treas. Reg. §1.482-7(d)(2) was not the product of “reasoned decision making” under State Farm, making it arbitrary and capricious under the APA and therefore invalid as a matter of law. The decision was signed by 14 Tax Court judges, with two abstentions and no dissents.
The immediate reaction from the IRS is that the agency will study what to do next, with one highly ranked official publicly describing the defeat as a “personal disappointment.” The IRS has 90 days from the date when the final decision is entered to decide whether to appeal to the Ninth Circuit or take other action. It seems unlikely that the IRS will ask the Tax Court for any sort of a re-hearing.
Immediate impact on multinational companies with CSAs and SBC
2015 tax year. Taxpayers may now have good support to stop sharing SBC in 2015. However, because the case may be appealed and the 2015 tax return is not due until September 2016 (for calendar year taxpayers), it may be best to wait and see if the IRS appeals before a company modifies its handling of SBC.
Unfiled 2014 tax year. If the company’s 2014 tax return has not been filed, then the company could take a position to no longer share SBC. Based on Altera, a company may have “substantial authority” to remove SBC on its 2014 return. If it does so, the company should file Form 8275-R to avoid accuracy-related penalties for taking a position contrary to a regulation. Furthermore, a FIN48 reserve may be necessary. The concern for companies is that the IRS has 90 days to appeal the decision, and the deadline for filing the 2014 return is September 15, 2015. If the case is appealed, it may be years before the issue is ultimately settled, leaving taxpayers in the unenviable position of taking a position on a return without knowing what lies ahead.
Past years. For past years that are already filed, the road may be more difficult. Amending past returns may not be possible because Treas. Reg. §1.482-1(a)(3) denies any taxpayer-initiated transfer pricing adjustment for past years that would result in a decrease in US taxable income, and this harsh regulation was recently upheld in Intersport. However, Notice 2013-78 suggests that companies might be able to use the treaty Mutual Agreement Procedure to circumvent this prohibition and self-initiate an adjustment that does not involve “after-the-fact tax planning or fiscal evasion or is otherwise inconsistent with sound tax administration,” which might include an adjustment due to an invalidated regulation.
A second option may be to count the overpaid portion of past cost sharing payments as an advance credit against the 2014 or 2015 cost sharing payments, if the cost sharing agreement provides for this alternative.
Note that Treas. Reg. §1.482-1(g)(4) does allow “setoffs” of intercompany payments between the same parties in the same tax year. This might be the case if the IRS is asserting increases in valuations of PCTs or other cross-charges between the same entities. Thus, the US taxpayer could set off an unfavorable PCT or other IRS audit adjustment with its claim for refund on the Altera issue, in the context of an audit.
Companies should be cautioned, however, that, for any tax year, the situation would certainly become tricky if action is taken now, the case is appealed and the Tax Court opinion is reversed.
On its face, the Altera decision only invalidates the sharing of SBC under the -7 regulations relating to cost sharing. However, query whether a taxpayer may make logical extensions of the Court’s rationale to impact other areas of Section 482.
Sharing of SBC under the -9 Service Regulations. Currently, Treas. Reg. §1.482-9(j) requires a service provider to charge a portion of its SBC to a service recipient in intercompany transactions. The -9 regulations were drafted subsequent to the -7 regulations and provide similar support for charging out SBC under controlled service transactions, stating “[t]otal services costs include all costs in cash or in kind (including stock-based compensation).” Query whether a taxpayer may argue that the IRS’ reliance upon the arm’s length standard under -9 may also be invalidated under the Altera decision. At the very least, Altera provides ammunition to a taxpayer willing to fight the IRS on the issue. To be sure, theAltera decision likely falls short of invalidating the -9 regulations, as the Court’s holding was limited to the -7 regulations. However, because the IRS seemed to apply the same logic and reasoning to support the -9 regulations, an opportunity exists for a taxpayer to invalidate -9 as well.
Supporting the RPSM for PCTs. Prior to the IRS adopting the income method as its preferred PCT valuation methodology, taxpayers routinely used the RPSM (e.g., a declining royalty over a period of years) to value their buy-in / PCTs. This methodology was approved as arm’s length in Veritas; however, the IRS did not acquiesce to the decision, and now mandates use of the income method while prohibiting the RPSM in the new regulations. If Altera stands for the proposition that the arm’s length principle governs over unrestrained regulatory deference, the Veritas case may become a crucial ally to taxpayers wishing to challenge the income method as the preferred valuation methodology. At the very least, it allows an opportunity for taxpayers to attack the income method “on the merits” and / or assert that the “sandbox” is big enough for the RPSM too.
In conclusion, Altera is another landmark victory for taxpayers on a long-disputed issue. Multinational companies with CSAs and SBC need to watch this area closely in the next few months and be ready to take action.