On July 24, 2018, the US Court of Appeals for the Ninth Circuit in Altera Corporation v. Commissioner overturned a unanimous decision by the Tax Court invalidating Treas. Reg. § 1.482-7A(d)(2), which provides that a cost-sharing arrangement among related entities for the development of intangibles is not considered qualified unless the entities share the cost of stock-based compensation. The Ninth Circuit held that the Treasury’s process in adopting the regulation passed muster as “reasoned decisionmaking” under the Administrative Procedure Act (APA), applying the standard set forth in Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). Having been validly adopted, the regulation was entitled deference under Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984) because it was a reasonable interpretation of section 482.

The Ninth Circuit’s reversal of the Tax Court highlights the uncertainties inherent in applying the State Farm test to tax regulations, which have not traditionally been subject to this type of APA analysis. Treasury has traditionally taken the position that Internal Revenue Service (IRS) regulations are not subject to the APA because section 7805 provides an independent source of authority. The taxpayer in Altera may seek a rehearing en banc from the Ninth Circuit, or may file a petition for certiorari with the US Supreme Court. The resolution of the APA issues in Altera is likely to have far-reaching effects with respect to many other regulations, where the preambles may have been drafted in reliance solely on section 7805 and may not contain the type of reasoned analysis required under the APA.


In 1997, the taxpayer, Altera Corporation (Altera), licensed to its Cayman Islands subsidiary the use of certain intangible property outside of the United States and Canada. Altera and its subsidiary also agreed to a cost-sharing arrangement for the costs of research and development. Pursuant to an Advance Pricing Agreement with the IRS for the 1997-2003 tax years, the cost-sharing arrangement split the costs of stock-based compensation between the parties. This arrangement was consistent with the IRS’s interpretation of the 1995 cost-sharing regulations, which did not specifically cover stock-based compensation costs.

In 2003, Treasury amended the cost-sharing regulations to specifically provide that stock-based compensation costs must be shared among the parties to a cost-sharing arrangement. The preamble did not consider evidence of uncontrolled transactions, rejected comments asserting that the inclusion of stock-based compensation in a cost-sharing arrangement was inconsistent with agreements between unrelated parties, and asserted that the inclusion of stock-based compensation in a cost-sharing payment was consistent with the section 482 “commensurate-with-income” standard applicable to transfers of intangibles and therefore was also consistent with the arm’s length standard.

In 2005, following the Tax Court’s opinion in Xilinx Inc. v. Commissioner, 125 T.C. 37 (2005), which invalidated the 1995 cost-sharing regulations as applied to stock-based compensation, Altera and its subsidiary amended their cost-sharing arrangement to eliminate stock-based compensation from the shared costs until a court upheld the validity of the 2003 regulations. In 2010, the Ninth Circuit affirmed the Tax Court’s decision in Xilinx.

For Altera’s 2004-2007 tax years, the IRS issued a statutory notice of deficiency, increasing Altera’s income by approximately $80 million, reflecting stock-based compensation that the IRS maintained should have been shared with its Cayman Islands subsidiary pursuant to the cost-sharing arrangement. Altera filed a petition in Tax Court to dispute the adjustment. In 2015, Altera became a subsidiary of Intel Corporation.

Tax Court Decision

The Tax Court’s decision in Altera was a unanimous reviewed opinion by Judge L. Paige Marvel. The Tax Court held that Treas. Reg. § 1.482-7A(d)(2) was invalid because it was “arbitrary and capricious” under State Farm's reasoned decisionmaking standard and thus violated the APA. In the court’s view, in finalizing the 2003 regulations, the Treasury Department had not adequately considered the arm’s length standard, which pervades the section 482 regulations and is reflected in US tax treaties. The Tax Court reasoned that a determination of whether a transaction is at arm’s length is necessarily an empirical determination, and there was no evidence that Treasury had considered empirical evidence of uncontrolled transactions or adequately addressed the comments pointing out that unrelated parties operating at arm’s length would not have shared stock-based compensation costs. The court found this lack of evidentiary consideration especially important because of the court’s decision in Xilinx, which had held that cost-sharing arrangements must be consistent with the arm’s length standard. The court rejected the notion that the commensurate-with-income standard could be applied as an alternative to the arm’s length standard because Treasury had indicated that the commensurate-with-income standard was intended to work consistently with the arm’s length standard.

The Tax Court concluded that State Farm’s reasoned decisionmaking standard had not been met because Treasury failed to rationally connect the choice it made with the facts found and failed to respond to significant comments when it issued the final rule. Treasury’s conclusion in the preamble that the final rule was consistent with the arm’s length standard was therefore contrary to all of the evidence before it, and was arbitrary and capricious in violation of the APA. The Tax Court invalidated the regulation and entered a decision for the taxpayer.

Ninth Circuit Majority

On appeal, a majority of the Ninth Circuit panel reversed the Tax Court, holding that the regulation complied with the APA and was entitled to Chevron deference. Chief Judge Sidney Thomas wrote the opinion for the court, in which Judge Stephen Reinhart formally concurred prior to his death on March 29, 2018. Judge Kathleen O’Malley dissented.

The majority began its opinion with a lengthy recitation of the history of section 482 and the associated regulations. The court characterized section 482 as a “nearly limitless grant of authority to Treasury to allocate income between related parties” and noted the “flexibility” given to Treasury to prevent cost and income shifting between related entities. The court characterized the 1986 amendments to section 482, which added the commensurate-with-income standard, as a dramatic shift that established a new standard, disagreeing with the Tax Court’s conclusion that the commensurate-with-income standard was intended to operate consistently with the arm’s length standard.

In the court’s view, Treasury’s citation of the legislative history of the commensurate-with-income standard in the notice of proposed rulemaking and in the preamble to the final regulation was enough notice to interested parties that the 2003 regulations were rejecting the arm’s length standard and instead relying on the commensurate-with-income standard. In other words, the citation to the legislative history was an indication that Treasury’s “path may reasonably be discerned” as required under State Farm. The court observed that none of the comments to the proposed regulation addressed why Treasury would have been mistaken in its understanding that it was authorized to use a method that did not take into account empirical evidence of uncontrolled transactions. The court also rejected Altera’s argument that the court was supplying a post-hoc rationale for the regulation, in violation of SEC v. Chenery Corp., 332 U.S. 194 (1947). In the court’s view, the preamble need not explicitly state that Treasury had determined that it was authorized by the commensurate-with-income standard to dispense with the comparability analysis.

Having determined that the regulation satisfied the reasoned decisionmaking standard and thus was valid under the APA, the court then turned to a Chevron analysis. The court relied again on the legislative history of the commensurate-with-income standard, determining that this amendment to section 482 represented a recognition that the arm’s length standard did not serve the purpose of section 482. In the court’s view, the commensurate-with-income standard was intended to “hone the definition of the arm’s length standard so that it could work to achieve arm’s length results instead of forcing application of arm’s length methods.” The court rejected Altera’s argument that the adoption of the commensurate-with-income standard did nothing to change the arm’s length standard, determining that this interpretation would render the 1986 amendments meaningless. Given this context, the court held that the 2003 regulations were a reasonable interpretation of section 482 and therefore were entitled to deference under Chevron.

The court also rejected Altera’s argument that a shift away from the arm’s length standard could impact US tax treaties. The court determined that “there is no evidence that the unworkable empiricism for which Altera argues is also incorporated into our treaty obligations” and that “the arm’s length standard is aspirational, not descriptive.” Moreover, the court noted that the most recent tax treaties incorporate both the arm’s length standard and the commensurate-with-income standard, citing the 2013 tax treaty with Poland.

Finally, the court distinguished its 2010 opinion in Xilinx. The court characterized the decision there as a matter of “regulatory interpretation, not executive authority” and noted that the decision did not consider the commensurate-with-income standard. The Xilinx court was justified in invalidating the regulation because the regulation was in conflict—the arm’s length rule listed specific methods of calculating an arm’s length result but the “all costs” method for cost-sharing arrangements was not one of those methods. The Xilinx court did not address the validity of the 2003 regulations.

Eversheds Sutherland Observation: The majority opinion brushes away the issue of older tax treaties and the Organisation for Economic Co-operation and Development (OECD) commentary, which incorporate the arm’s length analysis. To the extent the United States uses a commensurate-with-income standard that conflicts with available comparable uncontrolled transactions, this may result in double taxation. Although the Advance Pricing Agreement or competent authority processes may provide a remedy in this situation, it is unclear how the United States will deal with empirical evidence of comparable transactions.


Judge O’Malley’s dissenting opinion agreed with the Tax Court on the significance of the 1986 addition of the commensurate-with-income standard. In the dissent’s view, the addition of the commensurate-with-income standard did not dislodge the arm’s length test and contemplated consideration of comparable transactions where such transactions exist. Only where comparable transactions did not exist would the commensurate-with-income standard come into play.

The dissent began with the notice of proposed rulemaking, which quoted an earlier Treasury white paper stating that “Congress intended that Treasury and the IRS apply and interpret the commensurate with income standard consistently with the arm’s length standard.” Additionally, the preamble to the final regulation stated that the treatment of stock-based compensation was required to be consistent “with the arm’s length standard (and therefore with the obligations of the United States under its income tax treaties and with the OECD transfer pricing guidelines.)” The dissent noted that the preamble repeatedly referred to the regulation as applying the arm’s length standard and responded to comments by acknowledging that comparable transactions may have been relevant. In the dissent’s view, Treasury had determined that there were no available comparable transactions, rather than that comparable transactions were irrelevant. The dissent rejected the government’s explanation that the detailed explanations in the preamble regarding the comparability analysis were “merely extraneous observations.”

The dissent argued that the APA required Treasury to explicitly state that it was rejecting the arm’s length standard in favor of the commensurate-with-income standard. Neither the notice of proposed rulemaking nor the preamble to the final regulations made that statement. The dissent concluded that Treasury had failed to put the relevant public on notice of its intention to depart from the arm’s length standard. The dissent observed that “asking Treasury to show its work in the preamble to its final rule—that is to set forth when and why the agency believed that arm’s length analysis was not required—is not, as the majority suggests, ‘excessive proceduralism’” but instead was the essence of the analysis required under State Farm.

Because the dissent believed the regulation was procedurally defective, the court’s analysis in Xilinx would be controlling, and Chevron deference to the 2003 regulations would not be warranted.

Eversheds Sutherland Observation: The taxpayer may request a rehearing of the case by the Ninth Circuit en banc, or the case may ultimately reach the Supreme Court. The majority opinion takes the position that Treasury’s authority under section 482 is “nearly limitless.” If Judge Brett Kavanaugh is confirmed as a Supreme Court justice, his relatively narrow view of agency authority, as discussed in a recent Eversheds Sutherland Law360 article, may come into play. The resolution of the APA issues in Altera is also likely to have far-reaching effects with respect to many other regulations, where the preambles may have been drafted in reliance solely on section 7805 and may not contain the type of reasoned analysis required under the APA.

Eversheds Sutherland Observation: Three days after the issuance of the Ninth Circuit’s opinion in Altera, the DC Circuit issued an opinion in Good Fortune Shipping SA v. Commissioner, No. 17-1160 (D.C. Cir. July 27, 2018), invalidating certain regulations issued by the IRS under section 883 as unreasonable under step two of Chevron. In detailing the shareholder ownership requirements of section 883, the regulations excluded shareholders who owned their interest in the corporation through bearer shares. The court found the regulation unreasonable under step two of Chevron because Treasury failed to adequately justify the exclusion. While the court in Good Fortune identified this analysis as step two of Chevron, the analysis was the same as the State Farm analysis in Altera. Because the requirements for both of these analyses are closely related, they may often overlap. See Judulang v. Holder, 565 U.S. 42, 52 n.7 (2011); Turtle Island Restoration Network v. U.S. Dep’t of Commerce, 878 F.3d 725, 733 (9th Cir. 2017). The decisions in Altera and Good Fortune Shipping highlight the increasing importance of administrative procedure to the validity of tax regulations.