Source: https://www.copetax.com/altera-raises-the-bar-for-treasury-regulations
Timestamp: 2019-04-20 04:42:15+00:00

Document:
The recent decision of the Tax Court in Altera v. Commissioner characterizes a Treasury regulation issued under the Treasury’s general rule making authority, section 7805(a), as a “legislative regulation,” which, under the Administrative Procedure Act (“APA”) generally is subject to certain mandatory notice and comment requirements. In addition, under the APA and the relevant case law, legislative regulations generally are subject to a different standard of review by the courts than has been applied to tax regulations. The Tax Court found the regulations at issue in Altera to be “arbitrary and capricious” and therefore invalid. Should other courts adopt the Tax Court’s analysis when reviewing Treasury regulations, some existing Treasury regulations may be held invalid by the courts, and the Treasury and IRS will need to be more careful in following the APA’s requirements when promulgating regulations. This surprising decision is likely to be appealed to the Court of Appeals for the Ninth Circuit, and in the author’s view, it stands a good chance of being affirmed.
The taxpayer, Altera Corporation, develops, manufactures and sells programmable logic devices and related software. In 1997, Altera Corporation (“Altera”) and a subsidiary formed under the laws of the Cayman Islands, Altera International (“International”), entered into a cost-sharing arrangement to share the cost of developing certain intellectual property to be used in the business. Under the agreement, Altera would own the US rights to the newly developed intellectual property, and International would own the rights to exploit the intellectual property in the rest of the world.
Treasury regulations issued under section 482 set out requirements that related parties entering into a cost-sharing agreement must satisfy. The Treasury regulations in effect for the years at issue, 2004-2007, required, inter alia, that the cost of stock-based compensation (e.g., stock options) of the employees developing the intellectual property that was the subject of the cost-sharing arrangement be shared by Altera and International. Altera employed the individuals doing the development work, so International was required by the regulations to make a payment to Altera to reimburse it for International’s share of the compensation. Stock-based compensation of the type at issue in this case is generally deductible by the employer in computing its income tax liability under section 83(h) of the Internal Revenue Code, so International’s reimbursement would offset Altera’s deduction.
Altera, believing the rule in the regulations relating to stock-based compensation was invalid, did not seek reimbursement from International. The IRS determined that International should have paid Altera approximately $80 million during the years at issue and accessed a tax deficiency for those years. Altera contested the deficiency in the Tax Court. In a motion for summary judgment, Altera argued that the regulation, in so far as it required the cost of stock-based compensation to be shared by the parties, was “arbitrary and capricious” and therefore invalid under the relevant standard of review (as discussed below). The Tax Court agreed and granted the motion in favor of Altera.
Altera is not the first time that the Tax Court has considered the correct treatment of stock-based compensation under the Treasury’s cost-sharing regulations. In 2005, in Xilinx, Inc. v. Commissioner,. the Tax Court considered whether, under an earlier version of the Treasury’s cost-sharing regulations (the “1995 Regulations”), the cost of stock-based compensation should be shared by the parties to a cost-sharing arrangement.
The 1995 Regulations did not explicitly mention stock-based compensation. The regulations referred to “operating expenses… other than depreciation or amortization expense, plus… the charge for the use of any tangible property made available to the qualified cost-sharing arrangement.” In its opinion, the Tax Court held that the arm’s-length standard (and Reg. § 1.482-1) applies to cost-sharing arrangements. After considering expert testimony offered by the taxpayer and the IRS, the Tax Court held for the taxpayer reasoning that unrelated parties would not share the cost of stock-based compensation (whether measured by the value of the option at the date of issue or the spread between the share value on the date of exercise and the exercise price).
Stock-based compensation is often a significant deduction for U.S. software, pharmaceutical and technology companies, which typically are the types of companies that enter into cost-sharing arrangements. Once the Treasury and the IRS were aware that taxpayers did not read the 1995 regulations to require stock-based compensation to be treated as a shared cost, the Treasury and the IRS moved to revise the regulations to explicitly address stock-based compensation. In July 2002, the Treasury issued a notice of proposed rulemaking stating the cost-sharing regulations would be amended to clarify that stock-based compensation must be taken into account in determining the operating expenses to be shared under a cost-sharing arrangement.
Interested parties responded to the notice by providing written comments. Consistent with the expert testimony to be provided later in Xilinx, these comments offered evidence that unrelated parties would not share the cost of stock-based compensation when entering into joint business arrangements. Some noted that the speculative and potentially large value of stock-based compensation caused parties to exclude such amounts from their agreements. Some economists also offered their view that stock-based compensation was not an “economic cost” to a company. In its opinion in Altera, the Tax Court takes note of these comments.
The Administrative Procedure Act distinguishes between “legislative” and “interpretive” rules and regulations. Under section 553 of the APA an agency issuing legislative regulations must first publish the regulations in proposed form, provide interested parties an opportunity to submit written comments on the proposed regulations and the agency must then consider the submissions of interested parties and “incorporate in the rules adopted a concise general statement of their basis and purpose.” These requirements do not apply to interpretive regulations.
The IRS takes the position that regulations issued under its general rulemaking authority of section 7805(a) are interpretive regulations. Nevertheless, the IRS generally follows the notice and comment procedures of section 553 of the APA.
In general, tax regulations have been reviewed by the courts under the standard set out by the Supreme Court in Chevron U.S.A. Inc. v. Natural Res. Def. Council, and the government argued that the Chevron standard was the appropriate standard for review of the 2003 Regulations. Altera argued that because the 2003 Regulations were legislative regulations, they were subject to review under the “reasoned decision-making” standard of section 706(2)(A) of the APA and the decision of the Supreme Court in Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Automobile Insurance Co.
The Tax Court next considered whether the Treasury satisfied the State Farm standard when it promulgated the 2003 Regulations. The court found the government’s methods lacking.
The Altera opinion answers two questions. The first is a narrow one: whether the 2003 Regulations are valid, either under State Farm or Chevron. The Tax Court concluded the regulations are invalid under either standard. Given the Ninth Circuit’s reasoning in Xilinx and the weak logical foundation the government created for the 2003 Regulations (albeit not knowing either the reasoning or the outcome in Xilinx at the time), the Ninth Circuit probably will affirm the Tax Court’s result. The Treasury then will either have to try a new regulatory tack to disallow the deduction provided under section 83, or, less likely in this political climate, seek legislation to reverse the decision. The author would be surprised if the government abandoned the issue.
The broader question the Altera opinion considers is the appropriate standard of review of any tax regulation issued under section 7805(a). Although the Altera opinion was reviewed by the Tax Court, whether tax regulations are subject to the rigors of the APA and the appropriate standard of judicial review is more properly determined by the Circuit Courts and the Supreme Court. The Ninth Circuit, and perhaps other courts, now will weigh in.
After the Supreme Court’s decision in Mayo Foundation, most members of the tax bar (including those in the government) believed it would be difficult to successfully challenge the validity of Treasury regulations. Altera should quell that optimism. And if the Tax Court’s analysis in Altera is confirmed by the Ninth Circuit, some taxpayers surely will move to challenge tax regulations in the right situations.
Those taxpayers seeking to challenge a tax regulation can bide their time until the law becomes clearer. The government, on the other hand, does not have that luxury. Henceforth, it would be prudent for the IRS and Treasury to scrupulously follow the standards of the APA and State Farm when promulgating tax regulations. The government should also creatively consider alternative rationales in support of its regulations in order to improve the defense of its regulations in the courts.
 145 T.C. No. 3 (July 27, 2015). The decision was reviewed by the court.
 Many US technology companies have entered into cost-sharing arrangements to develop intellectual property with affiliates located in low-tax jurisdictions. When such arrangements are successful, substantial profits of the business can be earned in low tax jurisdictions and the US tax on such earnings can be deferred. The IRS has attacked these transactions in the courts and has revised its regulations to make cost-sharing arrangements less attractive to US multinationals.
 125 T.C. 37 (2005), aff’d 598 F.3d 1191 (2010) (“Xilinx”). For an analysis of Xilinx see Cope and Zollo, The Ninth Circuit Affirms the Tax Court's Decision in Xilinx , But Some Issues Remain Unresolved, 39 Tax Mgmt. Intl J. 344 (2010).
 5 U.S. Code § 553.
 The Tax Court notes that the government did not argue that the 2003 regulations were interpretive regulations either on brief or at oral argument.
 463 U.S. 29 (1983) (“State Farm”).
562 U.S. 44, 55-58 (2011).
 As discussed above, the Tax Court did not choose between the State Farm or Chevron standard, but concludes instead that Chevron incorporates the reasoned decision making standard by a citing a footnote in a recent Supreme Court opinion. Judulang v. Holder, 565 U.S. at___ n.7 ( 2011).

References: v. 
 v. 
 § 1
 v. 
 v. 
 § 553
 v.