Altera Corporation & Subsidiaries (Altera Corp.) is battling the IRS in court over the validity of a federal income tax regulation that concerns Section 482 of the Internal Revenue Code (IRC).  

Most recently, and in a truly surprising fashion, the Court of Appeals for the Ninth Circuit withdrew its recent July 24 decision in Altera Corp. v. Comm., 122 AFTR 2d 2018-5389 (Altera). This move occurred just two weeks after reversing the 2015 Tax Court decision Altera, 145 T.C. 91, 2015 (Altera, 145). In withdrawing the decision, the Ninth Circuit stated that it withdrew its opinion, “To allow time for the reconstituted panel to confer.”

The reconstituted panel includes Judge Susan Graber who replaced Judge Stephen Reinhardt. Judge Reinhardt had formally concurred with the majority opinion in the July decision before he died. The newly comprised Circuit Court will now hear this case again in October.

At issue in the case are allowable deductions taken by related parties and the IRS’s ability to fashion rules in consonance with legislative intent while abiding by the bounds imposed by administrative law.

These two issues will likely be raised again on October 16, when the case is reheard before the reconstituted panel of the Ninth Circuit.

Section 482

The case centers on a Treasury regulation for Section 482 of the IRC. Section 482 empowers the IRS to reallocate items of income and expense among related parties to clearly reflect income or to prevent tax evasion. Related parties often find themselves outside the bounds of natural market forces and therefore may be susceptible to reporting income and expense items differently than parties acting at arm’s length. In such cases, the IRS may then step in to reallocate income and expenses in its attempt to more reflect what the IRS sees as the economic substance of the transaction. The IRS assesses related party transactions by comparing them to transactions between unrelated parties dealing at arm’s length.

One of the essential components of Section 482 is to make the consideration transferred between related parties for intangible property commensurate with the income that would be attributable to that intangible. Known as the “commensurate with income standard,” Congress endeavored to create as much parity as possible between controlled transactions and arm’s length transactions by linking the income attributable to an intangible with the consideration paid for it.

IRS Rulemaking

As a government agency, the IRS’s rulemaking procedures are governed by administrative law. In 2003, the IRS finalized Treasury Reg. 1.482-7A(d)(2)(ii) to require controlled entities to share costs in the development of intangible property in proportion to the benefits they anticipate to receive. The IRS explicitly required in this regulation that those involved in “qualifying cost sharing arrangements” (QCSA) share stock-based compensation (SBC) costs to receive the tax benefits associated with QCSAs. The IRS reasoned that entities dealing at arm’s length would share these SBC costs, and therefore, the regulation requires controlled entities to share these costs as well.

At the Tax Court proceeding, Altera Corp., a subsidiary of Intel, disagreed with the treatment of SBCs contained in this regulation. The business community, as well as many commentators, generally believed that unrelated companies entering QCSAs at arm’s length in the open market would not agree to share SBC costs. In their view, the IRS had no factual basis to include the sharing of SBC costs as a requirement for getting the benefits of a QCSA. The facts presented during the rulemaking process did not seem to comport with the requirements of the regulation.

The Facts of Altera

The taxpayer, Altera Corp., is a group of affiliated corporations that develop intangible property in the United States and abroad. Part of this group is a Cayman Islands based company and a U.S. based company that entered a QCSA in 1997 to share the costs of developing certain intangible property. From 2004-2007, the U.S. based company granted SBC to its employees but did not share the SBC costs with the Cayman Islands company. Without sharing the SBC costs, the U.S. company could decrease its taxable income and tax liability beyond what the IRS believed would have occurred in an arm’s length transaction between two unrelated companies. Therefore, the IRS determined deficiencies pursuant to the Reg. 1.482-7A(d)(2)(ii).

The Altera Cases

In 2015, the Tax Court in Altera, 145 decided in favor of Altera Corp., and held that the Treasury regulation was invalid because it failed to satisfy the “reasoned decision standard” of Motor Veh. Mfrs. Ass’n v. State Farm Ins., 463 U.S. 29, 1983 (State Farm). The U.S. Supreme Court established in State Farm that the IRS must give a reasoned explanation for promulgating a regulation that includes a rational connection between the facts found and the decision made. Per the Tax Court, for the regulation to be valid under the “reasoned decision standard,” the IRS needed evidence of arm’s length transactions that included SBC costs in QCSAs for the IRS to impose this requirement on related entity transactions. Because the IRS had no evidence (articles, reports, empirical data, or expert opinions) to support its assertion that unrelated parties dealing at arm’s length would share SBC costs in QCSAs, the court stated that there was no established connection between the facts found by the IRS and the ensuing regulation promulgated. Therefore, failing this “reasoned decision standard,” the Tax Court deemed the regulation invalid and the IRS without authority to reallocate items of income and expense related to Altera’s SBC costs.

The 2015 Tax Court decision was met with elation by many U.S. based companies developing intangible property in the United States and abroad. Many companies took tax positions based on the Tax Court decision and then watched closely as the case was appealed to the Ninth Circuit Court of Appeals in February 2016.   

The opinions of the Tax Court and Ninth Circuit (now withdrawn) center on the IRS’s authority to promulgate a rule based on the arm’s length standard without unrelated third-party transactions to measure it by. In Altera, 145, the Tax Court sided with Altera Corp., by looking to the facts of the rulemaking process and specifically the lack of evidence the IRS produced in support of its view of arm’s length transactions.

On appeal, the Ninth Circuit overruled the Tax Court and cited the legislative intent and underlying principle of Section 482 whereby Congress granted the IRS the flexibility to comport related party transactions as closely as possible to their unrelated arm’s length counterparts. The Ninth Circuit looked to the underlying principles of Section 482 and deemed the Treasury regulation valid and deserving of so-called Chevron deference.

In Chevron U.S.A., Inc. v. NRDC, 467 U.S. 837, 1984, the U.S. Supreme Court established a two-step analysis to determine the validity of an agency’s regulation. First, if congressional intent is clear then the courts and IRS must capitulate to the clear directive of Congress. Second, when congressional intent is ambiguous or absent altogether, the court must determine whether the agency’s regulation is based on a permissible construction of the statute. Regulations promulgated by the agency are deferred to unless they are “arbitrary, capricious, and manifestly contrary to the statute.”

The Circuit Court in Altera determined that Congress did not make clear in Section 482 whether the IRS may require parties in QCSAs to share SBC costs to get the tax benefits associated with QCSAs. However, the Circuit Court did note that part of the legislative intent behind Section 482 was to offer the IRS the flexibility needed to curtail improper income and cost allocations between related parties for tax avoidance purposes. This was the very principle the IRS relied on in promulgating the regulation by stating during the rulemaking process that it was relying on the “commensurate with income” provision of Section 482, i.e., to allocate costs commensurate with expected income from the intangible property developed. The Circuit Court even cited the House Committee Report when considering the lack of evidence produced by the IRS stating that, “there is little if any public data regarding transactions involving high profit intangibles.” There are extreme difficulties in determining whether the arm’s length transfers between unrelated parties are comparable.” (H.R. Rep. No. 99-426, at 423-25)

The Ninth Circuit to Rehear the Case

On August 7, 2018, the Ninth Circuit voluntarily withdrew its opinion to “allow time for the reconstituted panel to confer on this appeal.” Unique to this case is the effect of the withdrawal. Of the three judges on the panel of the Ninth Circuit who decided the case 2 to 1 in favor of the IRS, the swing vote was cast by Judge Stephen Reinhardt, who had passed away in March 2018, months before the July decision. The Ninth Circuit, unlike many other courts, including the U.S Supreme Court, gives power to a judge’s opinion postmortem if the judge officially signed off on the opinion before death. Here, Judge Reinhardt had fully participated in the case and formally concurred with the majority opinion months before the decision went public.

Judge Susan Graber has since been chosen to replace Judge Reinhardt. Unless either of the other two judges change their vote in the coming weeks, it seems conceivable that newly appointed Judge Graber will cast the deciding vote on the Ninth Circuit decision. The parties will likely place before her, and the other judges on the panel, the facts-based analysis of the 2015 Tax Court and the principled-base analysis of the now withdrawn Ninth Circuit decision.

As happens in many cases, the arguments give expression to the underlying policies for which each side is vying. Though the case pivots on the allocation of Altera’s deductions, it also centers on the breadth of the Treasury’s rulemaking ability: to follow a prescribed policy of holding controlled transactions to an arm’s length standard while also giving weight to the very practical endeavor of gathering support for IRS rulemaking. These issues will surface in open court at the Ninth Circuit Court of Appeals on October 16 when a now reconstituted panel assesses the line between the IRS giving expression to legislative intent and an agency overstepping its administrative bounds.

--CohnReznick Director Laurence J. Karst JD, LLM, and Senior Manager Yelena A. Belaks, CPA, contributed to this article.

Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this article and CohnReznick LLP, its members, employees, and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this article or for any decision based on it.

Michael I. Billet, JD, CPA works in the commercial tax department of CohnReznick LLP specializing in corporate taxation. He can be reached at Michael.Billet@CohnReznick.com.