As we reach the end of the year and assess the legal landscape of tax cases that could have a significant impact, we turn our attention to Altera Corp. & Subsidiaries v. Commissioner, 926 F.3d 1061 (2019), a case addressing the inclusion of stock-based compensation expenses under cost sharing agreements. Altera Corporation (Altera), now a subsidiary of publicly traded Intel, challenged a June 7, 2019, decision from a three-judge Ninth Circuit panel, who sided with the IRS after reversing the Tax Court’s decision. On November 12, 2019, a panel of judges from the Ninth Circuit denied Altera’s request for en banc review. It remains an open question as to whether Altera will file a petition for certiorari with the Supreme Court.
If the June 7th ruling stands, multinational companies, at least those in the 9th circuit (pretty important as California and Washington State are covered), that share intellectual property costs with offshore subsidiaries would not be able deduct the full cost of stock option payments from taxable income. A reversal from the Ninth Circuit, however, would have significant implications not only for Altera, but also for all multinational companies because companies could allocate stock-based pay to U.S. operations and benefit from business-expense deductions against domestic tax rates. A result either way will also have implications for how Treasury is able to flex its administrative authority to draft and enforce regulations.
A bit of background on the case. Altera was a semiconductor company, party to a research and development (R&D) cost sharing agreement with its Cayman Islands subsidiary. For the tax years at issue, Altera granted stock options and other stock-based compensation to certain employees, but did not include such stock-based compensation expenses in the cost pool shared under the R&D cost sharing agreement.
The Service took the position that Altera’s failure to share the stock-based compensation expenses with the Cayman subsidiary violated Treasury Regulations issued in 2003, which mandated how companies account for stock and other compensation when allocating costs between parent companies and foreign subsidiaries. As such, the Service increased Altera’s taxable income by about $80 million. Altera, however, challenged the Service and took the position that including stock-based compensation expenses did not meet the regulatory arm’s length standard, even though the regulations on their face required such inclusion for the tax years at issue.
Altera then took the case to Tax Court, and in 2015, a unanimous en banc panel found for Altera, holding that that Treasury’s stock-based compensation rule was invalid. Moreover, the Tax Court found that Treasury and IRS had failed to provide a valid rationale to explain how the stock-based compensation rule was consistent with the arm’s length standard, since public comments solicited during the regulatory process showed that unrelated parties in similar arrangements would not share stock-based compensation costs. The regulations had not explained why these comments were ignored. The Service appealed to the Ninth Circuit.
On July 24, 2018, the Ninth Circuit released an opinion to overturn the Tax Court. However, on August 7, 2018, the Ninth Circuit withdrew the opinion since Judge Reinhardt, who had sided with the majority in overturning the Tax Court, passed away between the time of the hearing the publication about the opinion. The three-judge panel was then reconstituted with a new judge, and the Ninth Circuit released a decision on June 7, 2019, again siding with the Service and overturning the Tax Court.
The Ninth Circuit
The opinion focused on the validity of the amendments to the cost sharing Treasury Regulations of 2003 and whether Treasury can allocate a cost between related parties that unrelated parties do not share. Altera argued that the arm’s length standard prohibited the Commissioner from allocating costs between related parties when there was no evidence that unrelated parties shared the same costs in an arm’s length deal. In other words, Altera took issue with the Commissioner requiring Altera to share the cost of employee stock options when uncontrolled taxpayers do not share a similar cost.
The Commissioner, however, argued that a purely internal method of allocation may be used and is indeed consistent with the arm’s length standard because controlled cost-sharing arrangements do not have an equivalent arrangement in an uncontrolled deal. Moreover, the Commissioner argued that Congress has allowed the Commissioner to dispense with a comparability analysis when such comparable transactions are nonexistent to achieve an arm’s length result.
Thus, the central issue for the 9th Circuit was deciding not the meaning of the arm’s length standard, but rather, whether Treasury can define the standard it uses. Significantly, the Ninth Circuit found that Treasury had met the requirements of the Administrative Procedures Act (APA) in promulgating the regulations at issue and that “Treasury understood §482 to authorize it to employ a purely internal, commensurate with income approach where comparable transactions are not comparable.” The panel found that the comparable transaction analysis that Altera claimed was essential to the arm’s length standard was not the exclusive method to assess an appropriate transfer price under section 482.
The panel also clarified that litigants may levy a challenge to regulations under Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Auto Insurance Co., 463 U.S. 29 (1983), Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), or both. Additionally, the Ninth Circuit opinion rejected Altera’s argument that the 1986 commensurate with income amendment was inapplicable, and “reasonably concluded that Congress intended to hone the definition of the arm’s length standard so that it could work to achieve an arm’s length result, instead of forcing application of a particular comparability method.” Thus, the Ninth Circuit found the 2003 regulations were valid, and the adjustments the IRS made to Altera’s tax return were upheld.
On July 22, 2019, Altera filed a Petition for a Rehearing En Banc, in which it characterized the 9th Circuit’s decision as “remarkable: The panel allowed the IRS to say that it is complying with the arm’s-length standard, while imposing a result that is exactly the opposite of what companies actually do at arm’s length.” This case has captivated the attention of big-name tech companies and public accounting firms, like Amazon, Cisco Systems, Inc., Deloitte Tax LLP, PwC LLP, and KPMG LLP, who have all filed briefs in support of Altera as amicus curiae. We will continue to monitor this case to see what the next stage of its appellate journey is–will its next stop be on petition for certiorari before the Supreme Court.