United States: New Panel, Same Result – Ninth Circuit Upholds Controversial Cost-Sharing Regulations In Altera Case

The unfolding Altera Corporation & Subsidiaries1 v. Commissioner (Altera) saga bore witness to another taxpayer-unfriendly development on June 7, when the Ninth Circuit chose in a 2-1 vote to uphold certain Treasury Regulations that require treating stock-based compensation as a cost that must be shared among international entities participating in cost-sharing arrangements. Because cost-sharing arrangements usually allow for income to be allocated outside the U.S. to lower-taxed jurisdictions, this ruling means a hefty tax hike for many large tech companies that could otherwise choose to keep billions of dollars of deductible stock-based compensation expenses in the United States to offset their U.S. corporate income tax.

Prior to the June 7 decision, the Ninth Circuit had indicated an intent to rule the same way in an initial 2-1 panel decision, until the decision was vacated due to the untimely death of Judge Reinhardt, who had participated in the case but passed away before the decision had been finalized. The new deciding vote in this case was Judge Susan Graber, who voted with the majority to disagree with the taxpayer and uphold the controversial regulation. Prior to that, the Tax Court had ruled in favor of Altera Corp., the taxpayer, in a unanimous 15-0 decision. Certain critics of the Ninth Circuit's recent opinion have highlighted that the Ninth Circuit may have "gone out on a limb" by choosing to break with the unanimous decision of subject matter specialist Tax Court judges.

What's at Issue

Many multinational companies with substantial intangible property (IP) choose to migrate economic ownership of such IP to offshore affiliates through qualified cost-sharing arrangements (QCSAs), which by definition must comport with applicable transfer pricing Treasury Regulations under section 482 of the Internal Revenue Code (the Code). The cornerstone of both section 482 and its corresponding Treasury Regulations is memorialized in Treasury Regulation section 1.482-1(b)(1), which states that the arm's-length standard must be universally adhered to in all transfer pricing allocations. Applicable regulations further explain that the arm's-length standard, i.e., the price that would be charged to unrelated parties dealing at arm's length, is generally determined by looking at comparable transactions carried out by similarly situated parties unrelated to one another.

Section 482 of the Code also provides that, in the case of a transfer or license of intangible property, transfer pricing allocations must be "commensurate with the income" associated with the intangible.

The regulation at issue in Altera—Treasury Regulation section 1.482-7A(d)(2)—says that, in the context of QCSAs, stock-based compensation must be treated as a per se expense to be allocated between related parties. There's just one problem—there is no evidence that unrelated parties dealing at arm's length actually choose to share such costs with one another—and the evidence that does exist all appears to indicate that they would not. Therefore the conundrum created is that, in the context of QCSAs, the Treasury Regulations arguably do not appear to follow the arm's-length standard.

Under this regulation and Altera's Advanced Pricing Agreement governing its cost-sharing agreement with Altera International, its Cayman affiliate, stock-based compensation costs would need to follow the allocation of income within the affiliated group and would generally therefore be pushed out of the U.S. to lower-taxed jurisdictions (here, the Cayman Islands) where tax deductions would be worth much less, if anything at all. In the technology company world, where stock-based compensation numbers in the billions of dollars and is a veritable staple of doing business, this translates to a significant industry-wide tax increase.

The Ninth Circuit's Reasoning

Notwithstanding the addition of Judge Graber's perspective, the Ninth Circuit's recent majority decision largely followed its reasoning in the preliminary opinion that had been vacated last August. The crux of this reasoning was that, with respect to stock-based compensation under QCSAs, Treasury had the authority to employ the "commensurate with income" standard in lieu of the "arm's-length standard" and sufficiently followed the requirements specified in both the Administrative Procedure Act (APA) and the Chevron case, both of which afford significant deference to agencies authorized to promulgate regulations. Under the APA, regulations must not be "arbitrary or capricious"; under step 2 of the Chevron analysis, regulations must be "reasonable" or "permissible." Unlike the arm's-length standard, which requires allocation of payments based on allocations present in comparable transactions involving unrelated parties, the commensurate with income standard would allow the IRS to allocate more income to the transferor in connection with a transferred intangible. Treasury and the IRS sought to justify the expansion of the "costs" provision under the cost-sharing rules by tying this into the broader regulatory authority applicable to transfers of intangibles.

The taxpayer unsuccessfully contended that promulgation of the regulations violated the APA because the Treasury department did not sufficiently comply with the APA's Notice and Comment procedure. The taxpayer maintained that the agency action in defense of the regulations centered on why it believed the regulations comported with the arm's-length standard. As a result, the taxpayer claimed that, if it had been the agency's intent to promulgate regulations instead under an alternative commensurate with income standard, this would amount to a change in policy that would require both notice of the change and the allowance of an opportunity for interested parties to comment. Further, the taxpayer pointed out—and Judge O'Malley agreed in a well-reasoned, if not brilliant, dissent—that the statutory authority allowing for use of the commensurate with income standard appeared to only be applicable in the case of transfers or licenses of existing (as opposed to future) intangibles.

What's Next?

While it seems likely that Altera Corp. will appeal this month's decision, it has not yet indicated how it plans to proceed. Possibilities include a petition to have a larger panel of the Ninth Circuit rehear the case en banc, or perhaps even a bypass of the entire rehearing process in favor of seeking review by the U.S. Supreme Court. If a petition for rehearing en banc is made to the Ninth Circuit, which seems more likely, Altera will have 45 days from June 7, the date of the decision, July 22, to file its petition. A petition for certiorari to the Supreme Court would be due either 90 days from the June 7 opinion, September 5, or 90 days from a denial of rehearing en banc if rehearing is sought first.

Some Concluding Questions

The Altera saga highlights some interesting (and yet unanswered) questions under both tax and administrative law.

Some of the questions that emerge from Altera are as follows:

  • Is the "commensurate with income" standard a completely different standard from the arm's-length standard, or are they one and the same?
  • The Preamble to the regulations at issue in the Altera saga of cases (as well as "predecessor" cases such as Xilinx) indicates that Treasury believed it needed to conform to both the arm's-length standard and the actions of taxpayers in comparable transactions when it promulgated the regulations at issue; however, the Altera decision suggests that Treasury had the authority to completely ignore comparables if it wanted to. Even if Treasury does have this power, is this not a change in position for which it needed to provide notice during the Notice and Comment stage? And if so, wouldn't Treasury have violated the APA?
  • Critics of the Ninth Circuit's decision have pointed out that unrelated parties never choose to share stock-based compensation, and neither the government nor anyone else has yet presented evidence to the contrary. Given this, how can the regulation at issue in this case be viewed, as the Ninth Circuit suggests, as commanding an "arm's-length result?"
  • Is Chevron deference as we know it on life support? Many think that Chevron is a thing of the past and that, on a prospective basis, Treasury Regulations will face heightened scrutiny. Is Altera just the tip of the iceberg? 


1 Altera Corp. & Subsids. v. Comm'r, __F.3d__, 2019 WL 2400999 (9th Cir. June 7, 2019.)

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