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Ninth Circuit reverses Tax Court, upholds cost-sharing regulations

Ninth Circuit upholds cost-sharing regulations

The U.S. Court of Appeals for the Ninth Circuit today reversed a 2015 decision of the U.S. Tax Court that had found Treasury regulations were invalid. The regulations—Reg. section 1.482-7A(d)(2)—require related entities to share the cost of employee stock compensation in order for their cost-sharing arrangements to be classified as “qualified cost-sharing arrangements” and to avoid an IRS adjustment.

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The Ninth Circuit found that the regulations “withstand scrutiny under general administrative law principles” and thus reversed the Tax Court. 

The case is: Altera Corp. v. Commissioner, Nos. 16-70496, 16-70497 (9th Cir. 24 July 2018). Read the Ninth Circuit’s decision [PDF 273 KB] that includes a dissenting opinion.

The purpose of this report is to provide text of the Ninth Circuit’s decision.

 

UPDATE: The Ninth Circuit on 7 August 2018 withdrew this decision to allow a new panel to consider the appeal. Read TaxNewsFlash

Background

The Tax Court in a “reviewed opinion” (there were no dissenting opinions) held that Treasury final regulations issued in August 2003—requiring participants in qualified cost-sharing arrangements to share stock-based compensation costs to achieve an arm’s length result—failed to satisfy the required reasoning and were therefore invalid. The Tax Court held that the final regulations lacked a “basis in fact” and that Treasury had “failed to respond to significant comments” when Treasury issued the final regulations.

The taxpayer introduced information that was available at the time the regulations were in the process of being finalized, that unrelated parties do not engage in the sharing of stock-based compensation costs. The Tax Court summed up that Treasury’s conclusion that the final regulations were consistent with the arm’s length standard was contrary to all of the evidence before Treasury and that the final regulations failed to satisfy the U.S. Supreme Court’s “reasoned decisionmaking” standard of the State Farm case.

Ninth Circuit

On appeal before the Ninth Circuit, the taxpayer asserted that the arm’s length standard always demands a comparability analysis, meaning that the IRS cannot allocate costs between related parties in the absence of evidence that unrelated parties share the same costs when dealing at arm’s length. The taxpayer contended that because uncontrolled taxpayers do not share the cost of employee stock options, the IRS cannot require related parties to share that cost.

The IRS countered that it may, consistent with the arm’s length standard, apply a purely internal method of allocation, distributing the costs of employee stock options inproportion to the income enjoyed by each controlled taxpayer. This “commensurate with income” method analyzes the income generated by intangible property in comparison with the amount paid (usually as royalty) to the parent. In the view of the IRS, the commensurate with income method is consistent with the arm’s length standard because controlled cost-sharing arrangements have no equivalent in uncontrolled arrangements, and Congress has provided that the IRS Commissioner may dispense with a comparability analysis when comparable transactions do not exist in order to achieve an arm’s length result.

The Ninth Circuit noted that because the case involved a challenge to regulations, the ultimate issue was not what the arm’s length standard meant but rather whether Treasury may define the standard as it has. The majority concluded that the regulations were not arbitrary and capricious but were “a reasonable execution of the authority delegated by Congress to Treasury.”

In the dissenting opinion, Judge O’Malley stated that she would have found the regulations were “invalid as arbitrary and capricious.”

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