Page 3 - Altera And Cost-Sharing Requirements Under Section 482 By Jerald David August
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focusing on the legislative rule-making process and the burden that the IRS must carry to prove that a particular regula- tion was not arbitrary and capricious, and compare that burden with the issuance of interpretative regulations. 4
Case Overview
The taxpayer, Altera Corp., was the par- ent company of a wholly owned Delaware corporation (Altera, U.S.). Altera U.S. entered into two agreements with a second-tier, wholly owned foreign subsidiary, Altera International, which was formed and organized in the Cay- man Islands. Under a licensing agree- ment involving programmable logic devices, Altera U.S. licensed to its foreign affiliate,AlteraInternational,therightto use (and sublicense) intangible proper- ty. In a related agreement, Altera U.S. and Altera International entered into a research and development (R&D) CSA whereby the parties agreed to share the benefits, risks, and costs with respect to the R&D activities specified in the CSA.
From 2004 through 2007, Altera U.S. issued stock options and other stock- based compensation (SBC) to certain of its employees, some of whom were directly involved in the R&D activities under the Altera International CSA. While the Altera U.S. employees’ com- pensation involved in the R&D activities that were paid in the form of cash was treated as “costs” under the CSA with Altera International, the SBC with respect to such employees was not. Altera Inter- national, in meeting its obligations under the CSA, made its share of cost pay- ments directly to its U.S. parent, in reducing its taxable income to the extent such payments were not required to be capitalized. 5
As part of the 2003 amendments to Section 482, Reg. 1.482-7(d)(2) required that under CSAs, the parties must share SBC amounts as part of the arrange- ment. Accordingly, the Service mailed notices of deficiency to Altera Corp.,
imputing Altera International’s payment of over $80 million under the CSA for Altera U.S.’s SBCs.
In challenging the government’s pro- posed deficiencies Altera Corp. filed a petition with the U.S. Tax Court, claim- ing that the subject regulation was arbi- trary and capricious under the Administrative Procedure Act (5 U.S.C. § 706(a)) and the Supreme Court’s deci- sion in State Farm.6 The IRS countered by claiming the regulation was control- ling and entitled to deference in accor- dance with the Supreme Court’s decision in Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc.,7 which the government argued was the proper standard for judicial review of the 2003 regulation.
TheissuepresentedtotheTaxCourt by cross-motions for partial summary judgment was whether Reg. 1.482- 7(d)(2)(2003), which requires partici- pants in a qualified CSA to share SBC costs to achieve an arms-length result, is arbitrary and capricious and there- fore invalid.
The Tax Court opined that the reg- ulation in question is a “legislative rule” which requires the government to meet the “notice-and-comment” procedures set forth in the Administrative Proce- dure Act (APA).8 It follows that the validity of the 2003 CSA regulation, Reg. 1.483-7(d)(2), must be based on whether the IRS reasonably concluded, consistent with the arm’s-length stan- dard requirement embedded in the transfer price regulations, that the par- ties’ SBCs would be included in an arms- length CSA entered into by unrelated parties.
This in turn required, in the court’s view, the Service’s putting into evidence empirical information such as published industry practice or similar evidence supporting the position taken in the regulations, instead of it simply being the product of the tax administrator’s thoughts on what unrelated parties would do with respect to such SBC costs of a party. What was in issue was whether the SBC part of the subject reg- ulation was the product of reasoned
decision making under the standard incorporated in the second prong of the Chevron framework.
Applying State Farm, the Tax Court found that the record did not reflect that the regulation had the proper factual or empirical foundation that unrelated par- ties would have shared one party’s SBCs. Similarly, the Tax Court found that the IRS did not effectively demonstrate, as part of effective administration, that the facts in the case at bar were properly resolved by application of a uniform rule for all CSAs pertaining to intangi- bles.
Moreover, the court found that the Service, as part of the APA notice-and- comment process, did not adequately respond to comments objecting to a uniformruleforSBCsbasedontheper- ception that unrelated parties would generally not agree to share one party’s SBCs. It simply ignored such comments in issuing the rule in 2003 and did not provide evidence that unrelated parties would share SBCs in a CSA. In effect, the regulation was purely theoretical in con- trast to being factually supportable. Indeed, the failure to extract the SBCs from the regulations was not entitled to be categorized as “harmless error” as the respondent argued in obviously what was its fall-back position.
Accordingly, the Tax Court held that there were no deficiencies in tax for the years in issue with respect to the Altera Corp. consolidated group and that the regulation in question, Reg. 1.482- 7(d)(2)(2003) was arbitrary and capri- cious and therefore invalid.
Transfer Pricing Principles: Meeting the Arms-Length Pricing Standard
The transfer pricing principles and stan- dards are a central, if not predominant, feature of the international tax system. Transfer pricing standards are employed by multinational business enterprises (MBEs), including international con- solidated groups of corporations, in an effort to advantageously allocate costs and profits between a parent company
JERALD DAVID AUGUST is a partner at Kostelan- etz & Fink, LLP, and is the editor-in-chief of BUSI- NESS ENTITIES.
January/February 2016

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