Court of Appeals 9 (CA 9) upholds stock-based compensation cost-sharing reg again
Altera Corporation and Subsidiaries v Commr., (CA 9 06/07/2019) 16-70496
The Court of Appeals for the Ninth Circuit, reversing a Tax Court decision, has upheld the validity of a reg under Code Sec. 482that requires controlled entities entering into qualified cost-sharing agreements (QCSAs) to share stock-based compensation (SBC) costs. A dissenting opinion rejected the reg, for similar reasons as those in the Tax Court decision.
Background-allocation of income and deductions among taxpayers. Code Sec. 482 authorizes IRS to allocate income and expenses among related entities to prevent tax evasion and to ensure that taxpayers clearly reflect income relating to transactions between related entities.
Under Code Sec. 482 in the case of any transfer or license of intangible property between controlled entities, IRS may allocate income, deductions, credits, or allowances between the entities to prevent the evasion of taxes or to clearly reflect income. Congress amended Code Sec. 482 in ’86 to provide that consideration for intangible property transferred in a controlled transaction must be commensurate with the income attributable to the intangible. Background-allocation of income and deductions among taxpayers. To achieve a clear reflection of each entity’s income, IRS considers what each entity’s income would be had the controlled entities been dealing with each other at arm’s length. (Reg. § 1.482-1(b)(1) ) In Xilinx Inc. and Subsidiaries, (2005) 125 TC 37, the Tax Court rejected IRS’s Code Sec. 482 treatment of employee stock options under a taxpayer’s cost-sharing arrangement with its subsidiary.
The Court determined that the then-applicable ’95 regs did not authorize IRS to require the taxpayers to share the spread or the grant date value relating to employee stock options under the agreement. The Ninth Circuit affirmed the Tax Court’s decision that controlled entities entering into QCSAs need not share SBC costs because parties operating at arm’s length would not do so. (Xilinx Inc. and Subsidiaries, (CA 9 3/22/2010) 105 AFTR 2d 2010-1490)
In 2003, IRS issued new final regs on cost sharing arrangements. Under the regs, controlled participants must share intangible development costs in proportion to their share of reasonably anticipated benefits. Reg. § 1.482-7A(d)(2)(ii) (the final rule) explicitly requires controlled parties entering into QCSAs to share SBC costs. SBC includes restricted stock, nonstatutory stock options, statutory stock options, stock appreciation rights, and phantom stock.
Background-determining validity of regs. In Chevron U.S.A. Inc. v. Natural Resources Defense Counsel, Inc., (Sup Ct 1984) 467 U.S. 837, the Supreme Court set out a two-step analysis for a court to apply in reviewing an agency’s construction of a statute that it administers: (1) if the intent of Congress is clear, IRS and the courts must give effect to the unambiguously expressed intent of Congress; (2) if the statute is silent or ambiguous as to a specific issue, the question for a court is whether the agency’s answer is based on a permissible construction of the statute. An agency’s regs are given controlling weight unless they are “arbitrary, capricious, and manifestly contrary to the statute.”
The Administrative Procedure Act (APA) requires courts to “hold unlawful and set aside agency action, findings, and conclusions” that are “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law” or “unsupported by substantial evidence.” (5 U.S.C. § 706(2)(A), 5 U.S.C. § 706(2)(E)) In Motor Vehicle Mfrs. Ass’n of United States, Inc. v. State Farm Mut. Auto. Ins. Co., (1983) 463 U.S. 29, the Supreme Court said that Treasury must provide a reasoned explanation for adopting a reg. Specifically, State Farm requires Treasury to articulate a satisfactory explanation for its action, including a rational connection between the facts found and the choice made.
2015 Tax Court decision. The Tax Court held that Reg. § 1.482-7A(d)(2) was invalid because it failed to satisfy State Farm ‘s reasoned decision-making standard. (Altera Corporation and Subsidiaries, (2015) 145 TC 91)
CA 9 reversed, upholds reg. The Court of Appeals for the Ninth Circuit, on July 24, 2018, reversed the Tax Court and upheld the reg. It said that IRS’s rule-making complied with the APA, and its reg is entitled to Chevron deference. A dissenting opinion would have rejected the reg, for reasons similar to those of the Tax Court. (Altera Corporation and Subsidiaries v. Comm., (CA 9 7/24/2018) 122 AFTR 2d ¶2018-5068)
One of the judges that was part of the majority in the case died after oral arguments in October 2017 but before the decisions were released in July 2018.
CA 9 withdrew its opinion. The Ninth Circuit withdrew both the majority and dissenting opinions filed on July 24th, allowing time for a “reconstituted panel” of judges to confer (i.e., with a new judge taking the place of the deceased judge).
CA 9 upholds the regs again – The court first held that the reg did not exceed the authority delegated to IRS under Code Sec. 482. The court also explained that Code Sec. 482 does not speak directly to whether the IRS may require parties to a QCSA to share employee stock compensation costs in order to receive the tax benefits associated with entering into a QCSA.
The panel held that the Treasury reasonably interpreted Code Sec. 482 as an authorization to require internal allocation methods in the QCSA context, provided that the costs and income allocated are proportionate to the economic activity of the related parties and concluded that the regulations are a reasonable method for achieving the results required by the statute. Accordingly, the regulations were entitled to deference under Chevron.
Finally, the reg at issue was not arbitrary and capricious under the Administrative Procedure Act (APA). The court found that while the rulemaking process was less than ideal, the APA does not require perfection. The court found that the IRS understood Code Sec. 482 to authorize it to employ a purely internal, commensurate with income, approach where comparable transactions are not comparable. In light of the statute’s plain text and the legislative history, the IRS also 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 standard so that it could work to achieve an arm’s length result, instead of forcing application of a particular comparability method. In addition, the court found the IRS understanding of its power to use methodologies other than a pure transactional comparability analysis was reasonable and, therefore, deferred to its interpretation under Chevron.
References: For qualified cost-sharing arrangements, see FTC 2d/FIN ¶D-1155; United States Tax Reporter ¶4824.05.