Page 5 - Altera: Why the Government Can't Count on Chevron Step Two

master licensing agreement involving program- mable logic devices; and a technology research and development CSA. Under the CSA, Altera U.S. and Altera International agreed to pool their resources for a project using pre-cost-sharing intangible prop- erty for the express purpose of sharing the benefits, risks, and costs of R&D activities specified in the CSA.28 The R&D CSA was in effect from May 1997 through 2007.
From 2004 through 2007, Altera U.S. issued stock options and other stock-based compensation to specific employees, some of whom were directly involved in the R&D activities performed as part of the CSA. Cash compensation paid to Altera U.S. employees was treated as a shared cost under the CSA, but the stock-based compensation for those employees was not. Altera U.S. alone bore the economic burden of the stock-based compensation and thus deducted it in computing the group’s taxable income.29 Altera International, in meeting its obligations under the CSA, made its share of cost payments directly to its U.S. parent and reduced its taxable income to the extent those payments were not required to be capitalized.30
Accordingly, the IRS mailed notices of deficiency to Altera Corp. imputing Altera International’s pay- ment of more than $80 million as the arm’s-length amount required to be included in its taxable in- come under reg. section 1.482-7(d)(2) (over the relevant four-year period) in sharing the cost of Altera U.S.’s stock-based compensation under the CSA.31
28A qualified CSA is an arrangement to develop intangibles that meets, in compliance with the regulations, specified admin- istrative and other requirements in which the participants to the arrangement share intangible development costs in proportion to their shares of reasonably anticipated benefits attributable to the intangibles developed under the arrangement. When the arrangement does not result in the sharing of costs proportion- ate to the reasonably anticipated benefits, the regulations permit the IRS, in accordance with section 482 and reg. section 1.482- 7(d), to reallocate those costs.
29See, e.g., sections 162(a), 83(a), 174, 409A, 421, 422(b), 423 and 424; and reg. sections 1.83-1, 1.83-7, 1.422-5, 1.423-2(a)(4), and 1.482-7(j)(3).
30The CSA payments by Altera International (rounded to the nearest half-million) were $129.5 million for 2004; $160.7 million for 2005; $164.8 million for 2006; and $192.7 million for 2007. See section 263; and reg. section 1.263(a)-5. As a foreign subsidiary, Altera International was not permitted to be part of the consoli- dated group for U.S. federal income tax purposes (section 1504(a) and (d)). Altera International was therefore a controlled foreign corporation of Altera U.S. regarding its subpart F income. See sections 951, 952 and 956.
31In its proposed deficiency in tax for the four years in issue, the IRS treated Altera International as having made the follow- ing additional payments under the R&D CSA: $24.5 million for 2004; $23 million for 2005; $17.4 million for 2006; and $15.5
(Footnote continued in next column.)
In challenging the proposed deficiencies for 2004- 2007, Altera Corp. filed a petition with the Tax Court asserting that the regulation was arbitrary and capricious under the APA and invalid under State Farm. The IRS countered by claiming that the regulation controlled the issue, was entitled to judicial deference under Chevron, and otherwise satisfied the principles announced in State Farm. The issue of the regulation’s validity was presented to the Tax Court on cross-motions for partial sum- mary judgment.
B. Xilinx
As noted, the Tax Court and the Ninth Circuit in Xilinx invalidated an earlier version of the cost- sharing regulation, which had required that ‘‘all costs’’ incurred in the development of intangible assets be included in CSAs between related parties. The IRS asserted that the cost of stock options issued by Xilinx Inc. to R&D employees should have been included in the pool of operating ex- penses covered by the company’s CSA with an Irish subsidiary. The Tax Court held that the arm’s-length standard applies to qualified CSAs, that unrelated parties wouldn’t share the cost of employee stock options, and that the IRS’s attempt to allocate those costs under section 482 was arbitrary and capri- cious.
A divided Ninth Circuit panel initially reversed the Tax Court.32 With one judge dissenting and another writing a separate concurrence, the panel concluded that although the regulation conflicted with the arm’s-length standard of reg. section 1.482- 1(b)(1), it controlled as the more specific of the two provisions. Several months later, the same panel (still divided) withdrew its initial decision and affirmed the Tax Court.
While the Xilinx litigation was pending, Treasury amended the regulation to ‘‘clarify’’ that a con- trolled participant’s operating costs include costs attributable to stock-based compensation. The pro- posed regulation further provided that a qualified CSA produces results consistent with an arm’s- length result only if all costs related to the intan- gible development, as determined in accordance with the specific guidance in reg. section 1.482-7(d), are shared in proportion to reasonably anticipated benefits.
Although the preamble to the final regulations (T.D. 9088 ) noted that the comments received in response to the proposed revised regulation did not agree with the government’s position, the final
million for 2007. This required that those imputed payments be included in Altera U.S.’s taxable income.
32Xilinx, 567 F.3d 482 (2009).
COMMENTARY / SPECIAL REPORT
TAX NOTES, June 6, 2016
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