On July 24, 2018, in Altera Corp. v. Commissioner, a divided panel of the U.S. Court of Appeals for the Ninth Circuit upheld the validity of a Treasury Department regulation that requires a U.S. taxpayer to allocate a portion of stock-based compensation costs to a foreign affiliate that is a participant in a cost-sharing arrangement for the development of intangible assets. In the decision, the court reversed the Tax Court’s prior unanimous decision in favor of Altera, which had held that the Treasury Department failed to engage in “reasoned decisionmaking” in promulgating the regulation, contrary to the requirements set forth by the Supreme Court in Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Auto Insurance Co. (“State Farm”).
The decision in Altera is noteworthy in two broad respects. First, the Ninth Circuit, like the Tax Court, closely examined the history of the Treasury regulation under both State Farm and Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc. (“Chevron”), reaffirming the increasing significance of general administrative law principles in tax cases. Focusing primarily on the “reasoned decisionmaking” standard of State Farm, the court held that Treasury had adequately explained how it arrived at its decision in the notice of proposed rulemaking and the preamble to the final regulations. Second, the majority opinion agreed with the IRS that strict application of the traditional “arm’s length” standard for U.S. transfer pricing analysis was not required in this case under section 482 of the Internal Revenue Code. Historically, the arm’s length standard has been understood to require U.S. taxpayers to report income from transactions with their foreign affiliates in a manner consistent with the price that would be agreed upon if the transaction were between uncontrolled parties. Instead, the court reasoned that section 482 could be read to allow the IRS to reallocate income and expense if such reallocations are “fair and reasonable,” regardless of what happens between parties dealing at arm’s length. This reasoning could embolden the IRS to take more aggressive approaches in promulgating section 482 regulations in the future.
Altera’s Challenge to the Validity of Treasury’s Stock-Based Compensation Allocation Regulation
When a U.S. taxpayer transacts with a foreign affiliate under common control, the U.S. taxpayer must determine whether, and to what extent, income or expense relating to such transactions are attributable to the U.S. taxpayer and the foreign affiliate. This process of allocation of income and deductions between or among U.S. taxpayers and their foreign affiliates is known as “transfer pricing.”
Taxpayers that are part of commonly controlled multinational groups generally have an incentive to allocate greater income and fewer deductions to jurisdictions with relatively low tax rates and less income and greater deductions to jurisdictions with relatively high tax rates. As a result, the IRS often closely scrutinizes the transfer pricing policies adopted by U.S. taxpayers and their foreign affiliates. Under section 482, the Secretary has been delegated broad authority to reallocate the income and expenses of taxpayers under common control, and the Treasury Department has issued transfer pricing regulations describing various methods by which a taxpayer can determine an “arm’s length” price to avoid such reallocation.
In the relevant tax years, Altera Corporation (“Altera”), a U.S. corporation, and its subsidiaries, designed, manufactured, marketed and sold programmable logic devices, which are electronic components used to build circuits. In 1997, Altera entered into a licensing agreement and a “cost-sharing” agreement with a Cayman Island subsidiary. Under the licensing agreement, Altera granted to the Cayman subsidiary, in exchange for royalties, a license to use preexisting intangible property everywhere in the world except the United States and Canada. Under the cost sharing agreement, the parties agreed to pool their resources to share research and development (R&D) costs in proportion to the benefits anticipated from new technologies.
On its tax returns for the taxable years 2004 through 2007, Altera did not allocate any of its R&D-related stock-based compensation expenses to the Cayman subsidiary. Although the 2003 regulation then in effect required such an allocation, Altera’s tax return position was based on the 2005 decision of the U.S. Tax Court in Xilinx v. Commissioner, which upheld a challenge to an IRS reallocation under a previous regulation and which the Ninth Circuit later upheld. On audit, the IRS challenged Altera’s position, citing the 2003 Treasury regulation, Treas. Reg. § 1.482-7A(d)(2), which requires the allocation of such stock-based compensation expenses between a U.S. taxpayer and a foreign affiliate operating under a cost sharing agreement.
In a petition filed in the U.S. Tax Court, Altera disputed the IRS’s allocation of stock-based compensation expenses to the Cayman subsidiary on the ground that the 2003 Treasury regulation was invalid under the Supreme Court decisions in State Farm and Chevron. On cross-motions for partial summary judgment, the Tax Court agreed with Altera and held the regulation to be invalid. The Tax Court reasoned that the complete absence of any evidence in the administrative record that parties dealing at arm’s length would share stock-based compensation expenses rendered the regulation “arbitrary and capricious.” Furthermore, the court held that, by failing to adequately address comments submitted during the rulemaking process, the Treasury Department failed to engage in “reasoned decisionmaking.”
The Ninth Circuit’s Opinion
Review of the History of the Arm’s Length Standard
The majority’s opinion started with an extensive review of the text, history, and purpose of section 482. Specifically, the court observed that the text in the first sentence of the statute, which dates to 1928, grants broad authority to the Secretary to reallocate income and deductions to prevent evasion of tax and to clearly reflect income. Citing the legislative history, the court concluded that the Secretary had been delegated “flexibility” to prevent “cost and income shifting between related parties.” Although section 482 remained largely unchanged over time, the court noted that Congress amended the statute in 1986 to incorporate the so-called “commensurate with income” standard for certain transactions involving intangible property. That amendment, the court pointed out, provides that, in the case of any transfer or license of intangible property, “the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.”
Citing a variety of authorities, the majority concluded that the purpose of section 482 is “to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer.” Although the court viewed tax parity to be the statute’s objective, it stated that the arm’s length standard did not always require the parties to look to comparable transactions. Importantly, the court placed considerable weight on cases that rejected “a strict application of the arm’s length standard in favor of an inquiry into whether the allocation of income between related parties was ‘fair and reasonable.’” Based on these cases, as well as articles published by commentators, the court concluded that the arm’s length standard did not always rely on analysis of comparable transactions between uncontrolled parties.
The majority regarded the 1986 commensurate with income amendment as having a far-reaching intent, stating: “Congress intended the commensurate with income standard to displace comparability analysis where comparable transactions cannot be found.” It also noted that Congress expressed an intent to have cost sharing agreements respected only if, and to the extent, that “the income allocated among the parties reasonably reflect[s] the actual economic activity undertaken by each.” Despite the frequent use of the phrase “arm’s length standard” in a 1988 white paper published by the Treasury Department, the court concluded that by then the arm’s length standard was recognized by commentators to have grown obsolete.
Evaluation Under the Administrative Procedure Act and State Farm
After completing its historical assessment of the arm’s length standard, the majority turned to the taxpayer’s specific challenge to the validity of Treasury regulation § 1.482-7A(d)(2). As its “first task,” the majority considered whether Treasury complied with the Administrative Procedure Act (“APA”) in promulgating the regulation.
Under the APA, the Ninth Circuit recognized, an agency may not act in ways that are “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” The court declared that the “touchstone” of this arbitrary and capricious review as described in State Farm is “reasoned decisionmaking.” To satisfy that requirement, the court stated that the agency “must examine the relevant data and articulate a satisfactory explanation for its action including a ‘rational connection between the facts found and the choices made.’” “However,” the court noted quoting State Farm, “courts may not set aside agency action simply because the rulemaking process could have been improved; rather, we must determine whether the agency’s ‘path may reasonably be discerned.’”
In response to the proposed rulemaking leading to the 2003 regulation, numerous interested parties had attacked the proposed rule requiring allocation of stock-based compensation as “inconsistent with the traditional arm’s length standard,” explaining that unrelated parties do not share stock-based compensation costs because of the difficulty in valuing such compensation and the expense and risk involved. In the preamble to the final regulations, Treasury dismissed these comments as irrelevant, stating that the legislative history of the 1986 commensurate with income amendment showed that Congress intended the transfer pricing determinations with respect to cost sharing agreements to “reasonably reflect the actual economic activity undertaken by each [participant].” For a cost sharing agreement to reach an arm’s length result, Treasury reasoned, it must include “such critical elements of the cost as the cost of compensating employees for providing services related to the development of the intangibles.” Moreover, Treasury distinguished the uncontrolled transactions cited by commentators as “not sharing enough characteristics of [cost sharing agreements] involving high-profit intangibles to establish that parties at arm’s length would not take stock options into account.”
Emphasizing Treasury’s citations to the legislative history of the commensurate with income standard in the preamble, the majority concluded that “Treasury communicated its understanding that Congress had called upon it to move away from the traditional arm’s length standard.” Rejecting Altera’s argument that Treasury had walked away from the arm’s length standard in dismissing empirical evidence showing the absence of any cost sharing agreements that included stock-based compensation in the expenses allocating between the participants, the court characterized the conflict between the commentators and Treasury as a legal dispute. Specifically, the court stated: “That commentators disagreed with Treasury’s interpretation of the law does not make the rulemaking process defective.” The court summed up Treasury’s action as relying on congressional rejection of the “primacy” of the “traditional arm’s length standard.”
Evaluation Under Chevron
Having addressed the APA and State Farm, the majority proceeded to the two-step analysis of Chevron. With regard to the first step—whether Congress has directly spoken to the precise question at issue—the court found that section 482 “does not speak directly to whether the [IRS] may require parties to a [cost sharing agreement] to share employee stock compensation costs,” and that, to the contrary, “Congress intended to provide Treasury with the flexibility it needed to prevent improper cost and income allocation.” With regard to step two—whether the agency’s interpretation of section 482 was “permissible”—the court again reviewed the legislative history of the commensurate with income amendment, as it had under the State Farm analysis, noting that it reflected “Congress’s recognition that the traditional arm’s length standard did not serve the purpose” of section 482. Similarly, the court again reviewed the reasons offered by Treasury in the preamble to the final regulations for discounting the relevance of evidence regarding actual controlled transaction. The court found that “Treasury’s conclusion is entirely consistent with Congress’s rationale for amending [section 482] in the first place.” The court stated further: “As Congress noted, the goal of parity is not served by a constant search for comparable transactions.” Accordingly, the court found that the regulation was “not ‘arbitrary and capricious in substance.’”
Altera further contended that Congress did not intend the 1986 commensurate with income amendment to alter the arm’s length standard, citing the canon of statutory construction that provides that amendments by implication, like repeals by implication, are not favored. The majority disagreed, stating “It is illogical to argue that an amendment does not change the meaning of the statute that is amended.” The court said that Altera’s reading would limit the amendment’s operation to two circumstances: (1) to allow the IRS to adjust prices initially assigned following a comparability analysis; and (2) to reflect a party’s contribution of existing intangible property, or “buy-in,” to a cost sharing arrangement. The court found such an interpretation was unduly narrow in light of the text and history of section 482.
Implications of Departing from the Arm’s Length Standard for US Tax Treaties
The majority next dismissed the concern raised by Altera that rejection of the traditional arm’s length standard would frustrate the treaty obligations between the United States and its treaty partners. To this concern, the court responded: “[T]here is no evidence that the unworkable empiricism for which Altera argues is also incorporated into our treaty obligations.” Moreover, in the court’s view, nearly a century of interpretation establishes that “the arm’s length standard is aspirational, not descriptive. It reflects neither how related parties behave nor how they are taxed.”
Impact of Ninth Circuit’s Previous Decision in Xilinx
Finally, the majority rejected Altera’s argument that the Xilinx decision is controlling. Though the court acknowledged that the Xilinx court could have ruled in a way that would control the outcome in Altera’s case, it concluded that the Xilinx court had not done so. In the court’s view, the Xilinx court decided the case under prior version of the cost sharing regulations as a matter of interpretation, not executive authority.
Dissenting Opinion by Judge O’Malley
Judge O’Malley, a judge on the Federal Circuit sitting by designation, filed a sharp dissenting opinion. Fundamentally, the dissent agreed with the Tax Court that Treasury had not adequately explained the stock-based compensation allocation regulation, rendering it arbitrary and capricious under State Farm.
The dissent pointed out that, since the 1930s, the regulations under section 482 have explained consistently that “in determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” The dissent also observed that the 1986 commensurate with income amendment did not “dislodge” the arm’s length test, but merely addressed a “recurring problem” with transfers of highly valuable intangible property, for which comparable transactions were absent. To address the gap, the dissent maintained, Congress found it “appropriate to require that the payment made on a transfer of intangibles to a related foreign corporation . . . be commensurate with the income attributable to the intangible.” In its 1988 white paper, the dissent noted, Treasury explained that “[o]nly ‘in situations in which comparables do not exist’ would the commensurate with income standard apply.”
Moreover, when Treasury promulgated the regulation at issue, the dissent pointed out, it noted “the White Paper’s observation ‘that Congress intended that Treasury and the IRS apply and interpret the commensurate with income standard consistently with the arm’s length standard.’” The dissent argued also that Treasury was now bound by its repeated affirmances that it was adhering to the arm’s length standard throughout the preamble, including in the section discussing cost sharing agreements. Therefore, the dissent agreed with the Tax Court’s conclusion that Treasury’s finding that only some cost sharing agreements involved high-profit intangibles or included stock-based compensation as a significant element of compensation was insufficient to support the final regulation’s requirement that all stock-based compensation be allocated between participants in a cost sharing agreement.
The core of the dissent, however, focused on the adequacy of Treasury’s articulation of the reasons for the regulation. The dissent found the majority’s acceptance of the citations to legislative history in the preamble insufficient to support its conclusion that Treasury understood Congress to have “called upon it to move away from the historical arm’s length standard.” In the dissent’s view, Treasury may well have believed that, but “the APA required Treasury to say that it was taking this position, which departed starkly from Treasury’s previous regulations.” Further, the dissent argued, the precondition cited in the preamble for the applicability of the commensurate with income standard—i.e., the absence of real-world comparable transactions—was not met during the regulation promulgation process. In this regard, the dissent observed: “The fact that evidence of comparable transactions might support more favorable tax treatment does not mean such comparables do not exist.” The dissent expressed its view that Treasury thus failed to meet the “reasoned explanation” requirement of State Farm, explaining:
The APA’s safeguards ensure that those regulated do not have to guess at the regulator’s reasoning; just as importantly, they afford regulated parties a meaningful opportunity to respond to that reasoning. Treasury’s notice of proposed rulemaking [with respect to the allocation of stock-based compensation] ran afoul of these safeguards by failing to put the relevant public on notice of its intention to depart from traditional arm’s length analysis.
As noted at the outset, the Ninth Circuit’s opinion in Altera is significant for at least two reasons.
- First, it reaffirms the significant role that both Chevron and State Farm play in the judicial review of the validity of Treasury regulations. Although the court ultimately rebuffed Altera’s challenge, this opinion reflects yet another example of recent cases indicating that the notion of “tax exceptionalism”—the idea that tax is not subject to general administrative law principles—has largely receded. As a result, we fully expect that the reasons set forth for the adoption of regulations in Treasury Department notices of proposed rulemaking and preambles to final regulations will increasingly be subject to meaningful judicial scrutiny.
- Second, the Altera opinion appears to mark a substantial departure from the traditional arm’s length standard applied under section 482. Since the 1930s, the arm’s length standard has provided a constant and stable lodestar for transfer pricing determinations under the section 482 regulations. If not reversed by the Ninth Circuit sitting en banc, the majority’s conclusion that the 1986 commensurate with income amendment of section 482 uprooted the arm’s length standard and empowered the IRS to disregard comparable uncontrolled transactions could trigger more transfer pricing disputes relating to intangibles. It could also make resolution of such disputes, whether between the taxpayers and the IRS or between the IRS and other competent authorities (i.e., those of our treaty partners), more difficult.