Page 16 - Altera And Cost-Sharing Requirements Under Section 482 By Jerald David August

permitted to modify if not abandon the arms-length standard, the Tax Court raised its strong objection. The regulation was flawed in that the gov- ernment not only did not in the Pre- amble to the rule-making acknowledge the presence of industry arguments that nonrelated parties to a CSA would share SBC costs, but also failed to acknowledge that for some overriding tax administration purpose it decided to ignore such evidence. The Tax Court felt it did not have to decide whether, under National Cable & Telecommu- nications Ass’n v. Brand X Internet Ser- vices,67 the IRS would be free to modify or abandon the arm’s-length standard because it has not done so here. 68
Therefore the Tax Court felt it was obligated to apply the arms-length standard and Step 2 under Chevron or the State Farm rule to determine if there was empirical evidence that would support the regulation.69 Still the government conceded at trial that the IRS is subject to the APA and that it has not advanced any rationale or justification for exemption of regula- tions from State Farm review. In oth- er words, there is no safe passage for the IRS to simply say,“we like this rule under the regulation because it is good for tax law.”
Instead, the final rule had to satisfy the arms-length standard, and the Tax Court found based on the evidence: 1. The CSA 2003 regulation’s require-
ment that the parties to a CSA must share SBC costs lacked a basis in fact.
2. The IRS failed to rationally connect the choice it made in the regula- tions with the facts produced dur- ing the rule-making process.
3. The IRS failed to respond to sig- nificant comments.
4. The final rule is contrary to the evi- dence before the IRS.
As to the first point, the Tax Court
found that the Service, by failing to engage in any fact finding, failed to “examine the relevant data” as required under State Farm, and that it further failed to support its belief that unre- lated parties would share stock-based compensation costs in the context of a QCSA with any evidence in the record. Accordingly, the final rule lacks a basis in fact.
On the second point, a rational basis between regulation and facts, the Tax Court noted that the Preamble to the final rule indicates that the Ser- vice relied on its belief that unrelated parties entering into QCSAs to devel- op “high-profit intangibles” would
share stock-based compensation if the stock-based compensation was a “sig- nificant element” of the compensa- tion.70 But this statement lacked any empirical data or proof. There was nothing to support its finding that unrelated parties in a CUT type CSA for high-profit intangibles would share SBC. Therefore, the rationale set forth in the Preamble for the rule violated the State Farm requirement and the Service’s argument that the final rule is reasonable based on administrative convenience that all taxpayers be sub- ject to a uniform rule requiring cost sharing of SBC costs cannot be justi- fied based on more speculation in sup- port of the regulation. Moreover, the record lacked any factual findings of the government from which it could reasonably conclude that the pur- ported administrative benefits of a uniform final rule can justify erro- neously allocating income in some of those cases. The court therefore con- cluded that, by treating all QCSAs identically, the IRS failed to articulate a rational connection between the facts found and the choice made.
Failure to Respond to Comments.
A third flaw in the government’s leg- islative regulation is that it failed to respond to significant comments. The IRS retorted by stating it was not per- suaded by the commentators who stat- ed that they were not aware of any transaction between unrelated parties that required one party to reimburse the other party for amounts attribut- able to stock-based compensation. The American Electronics Association also informed the Service that a survey of its member companies’ arm’s-length codevelopment and joint venture agreements found none in which the parties agreed to share SBCs. This was also the notice and comment record in Xilinx, Inc. The IRS did not refute or challenge the commentators’ evidence that unrelated parties never share such compensation.
Several commentators identified arm’s-length agreements in which SBC was not shared (Continued on page 48)
COST-SHARING
January/February 2016
BUSINESS ENTITIES 19