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Final Section 482 Reg Invalid; Fails to Satisfy "Reasoned Decision Making" Standard.

(Parker Tax Publishing August 5, 2015)

In issuing Reg. Sec. 1.482-7(d)(2), which requires controlled parties entering into qualified cost-sharing agreements to share stock-based compensation (SBC) costs, the IRS failed to support its belief that unrelated parties would share SBC costs, failed to satisfy the reasoned decision making standard in Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mutual Auto Ins. Co., 463 U.S. 29 (1983), and had no reasonable explanation for adopting the regulation; thus the regulation is invalid. Altera Corporation and Subs v. Comm'r, 145 T.C. No. 3 (2015).


Altera Corporation (Altera U.S.) is the parent company of an affiliated group of corporations filing a consolidated tax return. Altera International is a Cayman Islands subsidiary of Altera U.S. In 1997, Altera U.S. and Altera International entered into concurrent agreements: a master technology license agreement (technology license agreement) and a technology research and development cost-sharing agreement (R&D cost sharing agreement).

Under the technology license agreement, Altera U.S. licensed to Altera International the right to use and exploit, everywhere except the United States and Canada, all of Altera U.S.'s intangible property relating to programmable logic devices and programming tools that existed before the R&D cost-sharing agreement (pre-cost-sharing intangible property). In exchange for the rights granted under the technology license agreement, Altera International paid royalties to Altera U.S. As of December 31, 2003, Altera International owned a fully paid-up license to use the pre-cost-sharing intangible property in its territory.

Under a cost-sharing agreement, Altera U.S. and Altera International agreed to pool their respective resources to conduct R&D using pre-cost-sharing intangible property owned by Altera International. Under the R&D cost sharing agreement, Altera U.S. and Altera International agreed to share the risks and costs of R&D activities they performed on or after May 23, 1997. The R&D cost-sharing agreement was in effect from May 23, 1997, through 2007.

From 2004 through 2007, Altera U.S. granted stock options and other stock-based compensation (SBC) to certain employees. Some of the employees of Altera U.S. who performed R&D activities subject to the R&D cost sharing agreement received stock options or other SBC. The employees' cash compensation was included in the cost pool under the R&D cost sharing agreement, but Altera U.S. did not share the SBC costs with Altera International. Altera International made cost-sharing payments to Altera U.S. during 2004-2007 of approximately $648 million.

The IRS assessed a deficiency in Altera U.S.'s taxes for 2004-2007 based on Code Sec. 482 allocations made by the IRS pursuant to Reg. Sec. 1.482-7(d)(2). The regulation, which was issued in 2003, requires participants in qualified cost-sharing arrangements (QCSAs) to share SBC costs to achieve an arm's-length result. Code Sec. 482 authorizes the IRS to allocate income and expenses among related entities to prevent tax evasion and to ensure that taxpayers clearly reflect income relating to transactions between related parties. Under Reg. Sec. 1.482-1(b)(1), 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.


Altera U.S. argued that Reg. Sec. 1.482-7(d)(2) did not apply because the regulation is arbitrary and capricious under Administrative Procedure Act (APA) Section 706(2)(A) and Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983). The IRS countered that the final regulation was valid under Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), or alternatively, under State Farm.

In State Farm, the U.S. Supreme Court said that, pursuant to APA Section 706(2)(A), a court must hold unlawful and set aside agency actions, findings, and conclusions that the court finds to be arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law. A court's review under this standard is narrow and a court cannot substitute its judgment for that of the agency. However, the Supreme Court said, a reviewing court must ensure that the agency engaged in reasoned decision making and, to engage in reasoned decision making, 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 choice made.

The Tax Court sided with Altera U.S. and held that Reg. Sec. 1.482-7(d)(2) was invalid. The court pointed out that it had previously considered whether controlled taxpayers must include SBC in the pool of costs to be shared. In Xilinx Inc. v. Comm'r, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010), the court held that, under 1995 cost-sharing regulations, controlled entities entering into QCSAs need not share SBC costs because parties operating at arm's length would not do so. Under Reg. 1.482-7(d)(2), the court noted, a QCSA produces an arm's-length result only if controlled parties entering into QCSAs share SBC costs.

In reviewing the validity of Reg. Sec. 1.482-7(d)(2), the Tax Court said it was immaterial whether State Farm or Chevron supplied the standard for review because Chevron incorporates the reasoned decision making standard of State Farm and the validity of the regulation turned on whether the IRS reasonably concluded that the regulation was consistent with the arm's length standard. According to the court, the final regulation had to, in any event, satisfy State Farm's reasoned decision making standard.

The Tax Court concluded that the final regulation did not meet this standard because, in issuing it, the IRS failed to support its belief that unrelated parties would share SBC costs. According to the court, there was no evidence in the administrative record to support such reasoning, the IRS failed to articulate why all QCSAs should be treated identically, and the IRS failed to respond to significant comments. Additionally, the court said, the IRS's explanation for its decision to issue the regulation ran counter to the evidence before it.

For a discussion of the rules relating to transfers of intangible property to foreign corporations, see Parker Tax ¶47,560. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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