INSIGHT: A Second Bite at the APA: Altera’s Rehearing and the Potential Invalidity of Cost-Sharing Regulations—Part One

After a series of dramatic reversals, the final outcome of Altera Corp. v. Commissioner, one of the most controversial transfer pricing cases in recent memory, remains uncertain. At its core, Altera addresses whether U.S. multinational taxpayers can minimize their U.S. tax liability by retaining stock-based compensation deductions in the U.S. in cost-sharing arrangements with foreign affiliates. Because stock-based awards are a linchpin of compensation in the technology company industry, billions in tax liability are at stake in the near term, and potentially billions more may be at stake if the outcome has the indirect, albeit plausible, effect of calling into question the procedural viability of other similarly promulgated regulations. Thus, it is hardly surprising that both the tax and technology communities are paying close attention as the Altera saga unfolds.

During the years at issue (2004 to 2007), Altera Corporation (Altera U.S.), a U.S.-based microprocessor producer, had a cost-sharing arrangement with its Cayman Islands subsidiary that did not treat stock-based compensation awarded to the employees of Altera U.S. as an allocable cost. Altera U.S. is currently a subsidiary of Intel Corporation, which acquired Altera U.S. in 2015 but, in the years at issue, Altera U.S. stock was publicly traded. The Internal Revenue Service challenged the arrangement as a direct contravention of applicable Treasury regulations, which specifically state that stock-based compensation is a cost that must be shared between the entities that are party to the cost-sharing arrangement. (Treas. Reg. 1.482-7A(d)(2) (2009).) In response, Altera U.S. contended that promulgation of the Treasury regulations violated the Administrative Procedure Act (APA) (5 U.S.C. Sections 551–559, 701–706 (2012).) and that the regulations were therefore invalid. In 2015, the Tax Court held in favor of Altera in a unanimous 15-0 decision, invalidating the regulations.

On July 24, 2018, however, a three-judge panel of the U.S. Court of Appeals for the Ninth Circuit Court reversed the Tax Court in a 2-1 decision, determining the regulations to be valid. Only a few weeks later, on Aug. 2, 2018, the Ninth Circuit issued an order announcing that Judge Susan P. Graber had been appointed to the panel hearing the case, replacing Judge Stephen Reinhardt, who had died in March 2018. Then, on Aug. 7, 2018, the newly constituted panel issued an order withdrawing the July 24 opinion to allow the reconstituted panel to confer on the appeal and, on Aug. 16, 2018, the new panel issued an order setting the new oral argument for Oct. 16, 2018.

On Sept. 28, 2018, the panel issued an order advising the parties to be prepared to discuss at oral argument whether the six-year statute of limitations applicable to procedural challenges under the APA applies to Altera and, if so, what the implications may be. The order permitted the parties to submit supplemental briefs on this question on or before Oct. 9, 2018. The IRS subsequently conceded the issue.

Because Judge Reinhardt had voted with the majority in the Ninth Circuit’s now-withdrawn 2-1 decision, if the other two members of the panel—Judge Sidney Thomas and Judge Kathleen O’Malley—do not change their votes going forward, Judge Graber will be the deciding vote in the court’s forthcoming determination. The call for new oral arguments may be an indication that Judge Graber wants an opportunity to question the parties in oral argument.

A review of the substantive and procedural aspects of the Altera landscape reveals the extent of what is at stake. In Part I of this article, we discuss background, including the statutes and regulations applicable to the relevant arguments in the case. By the end of the series it will become clear that upholding the validity of Treas. Reg. 1.482-7A(d)(2) amounts to an approach that allows the commensurate-with-income standard to be used to the exclusion of consideration of empirical evidence of comparable transactions under the arm’s-length standard. The weight of authority suggests that such an approach is at odds with the governing statute and regulations.

I. BACKGROUND

U.S. multinational corporations often operate in foreign jurisdictions through related, controlled affiliates. Due to the great disparity in worldwide corporate tax rates, such enterprises have an ever-present opportunity to adjust prices and expenses in transactions with these controlled affiliates in order to maximize income in low-taxed jurisdictions while maximizing tax-deductible expenses (and thereby minimizing income) in the U.S., resulting in a lower U.S. tax cost to the organization as a whole. To combat this practice, Congress enacted tax code Section 482, which allows the U.S. Treasury Department to promulgate transfer pricing regulations which, if not followed, permits the Internal Revenue Service to reallocate income and expenses between such related parties.

A. Section 482

Section 482 went largely unchanged from its appearance in the tax code in 1928 until 1986. Immediately before being revised by 1986 legislation, the entirety of Section 482 read as follows:

“In the case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.”

The one-sentence section of the tax code had long earned notoriety as one of the most powerful single sentences in the tax code when the Tax Reform Act of 1986 modified it with the addition of a second sentence:

In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

Section 482 was amended again in 2017 to add a third sentence, unrelated to our discussion here, which reads: “For purposes of this section, the Secretary shall require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers.” 2017 tax act (known during legislative proceedings as the Tax Cuts and Jobs Act), Pub. L. No. 115-97, 131 Stat. 2054, 2219 (2017).

At the same time, Section 367(d) was added, requiring that if an intangible is transferred to a foreign corporation, the transferor shall be required to include in income an amount commensurate with the income from the intangible over the useful life of the intangible.

The House Ways and Means Committee stated that it was “concerned” that Section 482 and the regulations thereunder “may not be operating to assure adequate allocations to the U.S. taxable entity of income attributable to intangibles,” and the addition of the “commensurate with income” language was designed to rectify a “recurrent problem…the absence of comparable arm’s length transactions between unrelated parties, and the inconsistent results of attempting to impose an arm’s-length concept in the absence of comparables.” (H.R. Rep. No. 99-426, pt. 1, at 423–424 (1985) (House Ways and Means Committee Report).)

As will be discussed in more detail in Part II, the debated meaning and import of this second sentence in Section 482 and its “commensurate with income” language has emerged as the crux of the conflict in Altera. In particular, it is necessary to determine to what extent this sentence should be read in conjunction with qualified cost-sharing arrangements (QCSAs) within the meaning of applicable transfer pricing Treasury regulations.

Looking at the 1986 legislative history of Section 482, cost-sharing arrangements that meet the statutory standards are explicitly referenced in both the House Explanation and the Conference Report. The House Explanation provides:

“The standard also applies in determining the minimum amount of the ‘cost-sharing payment’ to be made under the cost-sharing option in the case of an electing section 936 corporation. As discussed in greater detail in connection with the changes made by the bill affecting possessions corporations, the bill requires that the cost-sharing payment must be at least as great as the royalty the possessions corporation would have to pay to an affiliate under section 367 or 482 with respect to manufacturing intangibles the possessions corporation is treated as owning by virtue of electing the cost-sharing option.” (H.R. Rep. No. 99-426, pt. 1, at 426 (1985) (House Ways and Means Committee Report).)

The Conference Report also described cost-sharing arrangements that would meet the statutory standards as follows:

“In revising section 482, the conferees do not intend to preclude the use of certain bona fide research and development cost-sharing arrangements as an appropriate method of allocating income attributable to intangibles among related parties, if and to the extent such agreements are consistent with the purposes of this provision that the income allocated among the parties reasonably reflect the actual economic activity undertaken by each. Under such a bona fide cost-sharing arrangement, the cost-sharer would be expected to bear its portion of all research and development costs, on unsuccessful as well as successful products within an appropriate product area, and the costs of research and development at all relevant development stages would be included. In order for cost-sharing arrangements to produce results consistent with the changes made by the Act to royalty arrangements, it is envisioned that the allocation of R&D cost-sharing arrangements generally should be proportionate to profit as determined before deduction for research and development. In addition, to the extent, if any, that one party is actually contributing funds toward research and development at a significantly earlier point in time than the other, or is otherwise effectively putting its funds at risk to a greater extent than the other, it would be expected that an appropriate return would be required to such party to reflect its investment.” (H.R. Rep. No. 99-841, pt. 2, at 638 (1986) (Conf. Rep.).)

B. The Transfer Pricing Treasury Regulations

Regardless of the intent of the added “commensurate with income” language, the transfer pricing regulations under Section 482 have largely followed what is known as the “arm’s-length standard,” which demands that pricing between controlled entities conform to pricing among unrelated parties in comparable transactions. This arm’s-length standard has become the bedrock of U.S. transfer pricing. The standard is reflected in Treas. Reg. 1.482-1(b)(1), which states:

“In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” [Emphasis added.]

Cost-sharing agreements such as the one employed by Altera have traditionally been one of the primary means by which U.S. multinationals have been able to allocate future income from U.S.-based intangible property to an offshore affiliate without running afoul of either U.S. transfer pricing standards or other anti-deferral rules applicable to foreign corporations controlled by U.S. multinationals. To what extent this practice is likely to continue in the years following the 2017 tax act, during which the U.S. corporate tax rate will be substantially lower, remains to be seen. These agreements are governed by a complex series of rules in Treas. Reg. 1.482-7. Under these regulations, a U.S. entity holding intangible property will agree to share costs to further develop and market the intangible property with a foreign affiliate in exchange for the foreign affiliate making a platform contribution to the U.S. entity (i.e., an initial contribution or buy-in) with respect to the existing intangibles.

As a result of the arrangement, a portion of the income attributable to the intangible property in the future can be allocated to the multinational’s affiliate in a lower-tax jurisdiction, reducing the multinational’s overall tax burden. Once the foreign affiliate owns a share of the base technology, and because it then contributes to the cost of further R&D, it is entitled to partial tax ownership of the subsequently developed intangible property and profits arising therefrom, without the need for any transfer of the subsequently developed intangible property. While the transfer pricing regulations generally allow the IRS to reallocate income from foreign jurisdictions back to the U.S., a cost-sharing arrangement that meets the standards for a QCSA under the regulations will be insulated from such a reallocation.

The specific regulation at issue in Altera is Treas. Reg. 1.482-7A(d)(2), which provides:

“For purposes of [section 482], a controlled participant’s operating expenses include all costs attributable to compensation, including stock-based compensation.” [Emphasis added.]

This regulation (referred to hereinafter as the “stock-award regulation”), on its face, requires that stock-based compensation be treated as a cost under a QCSA regardless of whether doing so would comport with the arm’s-length standard.

In Altera, the Ninth Circuit specifically addressed the Section 1.482-7A regulations. In Xilinx, which is discussed further in Part II, analogous regulations under Treas. Reg. 1.482-7 were at issue. The difference in numbering is due to the 2003 amendments to the regulations, under which the regulations were reorganized such that the original regulations under Treas. Reg. 1.482-7 were still in effect but were instead numbered as Treas. Reg. 1.482-7A.

As a result of regulatory amendments, the regulations governing QCSAs have been revised over time in an attempt by Treasury to draw a clearer connection to the arm’s-length principle. The regulations now explicitly profess their own conformance:

“Coordination with §1.482-1—A qualified cost sharing arrangement produces results that are consistent with an arm’s length result within the meaning of §1.482-1(b)(1) if, and only if, each controlled participant’s share of the costs (as determined under paragraph (d) of this section) of intangible development under the qualified cost sharing arrangement equals its share of reasonably anticipated benefits attributable to such development (as required by paragraph (a)(2) of this section) and all other requirements of this section are satisfied.” (Treas. Reg. 1.482-7A(a)(3).)

The regulations under Section 482 also provide explicitly, however, that an arm’s-length result is determined by examining comparable transactions that would occur as between unrelated (uncontrolled) taxpayers. Treas. Reg. 1.482-1(c)(2)(i) states specifically that “[t]he relative reliability of a method [of allocating income and expense between related taxpayers] based on the results of transactions between unrelated parties depends on the degree of comparability between the controlled transaction or taxpayers and the uncontrolled comparables….” Accordingly, many have argued that, as to QCSAs, if Treas. Reg. 1.482-7A(d)(2) is to be read at all consistently with the arm’s-length standard of Treas. Reg. 1.482-1(b)(1), controlled parties need share only those costs that uncontrolled parties would share. Similarly, the inverse would seem to apply as well—that costs that uncontrolled parties do not share do not need to be shared for purposes of QCSAs. Nonetheless, the rigid language of Treas. Reg. 1.482-7A(d)(2) does not appear to allow for any exceptions, even if it were to be made clear that unrelated parties do not in fact share the costs at issue.

This underlying contradiction—that all transfer pricing allocations must conform to the arm’s-length standard, which is necessarily determined by looking at comparable uncontrolled transactions, but that these regulations explicitly require an allocation that may not be consistent with comparable uncontrolled transactions—is the substantive source of the controversy in Altera.

To add to the complexity, it appears that the “commensurate with income” standard mentioned in connection with the 1986 amendment to Section 482 is completely separate from the arm’s-length standard, although Treasury has attempted many times to either conflate the two or marry them together in some way. Central to the analysis in Altera is a need to make sense of this confusing relationship between the two standards and, further, to ascertain what role, whether harmonic or dissonant, these standards must play in QCSAs. The questions with which the courts are grappling in the Altera-Xilinx line of cases include:

• Are the Treasury regulations at issue properly considered “legislative” regulations or “interpretive” regulations, and which standard of review applies when examining whether their promulgation represents an abuse of Treasury’s discretion?
• Is Treas. Reg. 1.482-7A(d)(2) consistent with the arm’s-length standard in requiring taxpayers to treat all costs, including stock-based compensation, as a cost for purposes of QCSAs, and, given Treasury’s broad statutory authority to promulgate transfer pricing regulations, does it have to be?
• Can Treasury promulgate regulations that themselves seek to preemptively define the arm’s-length standard without requiring empirical evidence of comparable transactions?
• Is the pooling of costs under a QCSA implementing a “transfer of intangibles” within the meaning of the statutory text of Section 482?

Legal and theoretical import aside, the Altera decision carries great practical import. Whether the cost-sharing regulations are valid will determine whether stock-based compensation must be shared in QCSAs. A determination that such sharing is not required means that many companies in the technology industry (the majority of which pay significant equity-based compensation) could reduce their taxes by billions of dollars by opting not to treat such compensation as a cost for purposes of such QCSAs. This is because U.S. companies could keep their taxable income at a low level if their foreign affiliates did not have to pay in their share of such costs.

Peter J. Connors is a tax partner in the New York office of Orrick, Herrington & Sutcliffe LLP. Barbara S. de Marigny is a tax partner and Michael R. Rodgers is a senior tax associate in the Houston office of Orrick, Herrington & Sutcliffe LLP. The authors also extend special thanks to Professor William H. Byrnes of the Texas A&M University School of Law for his helpful thoughts, comments, and suggestions.