Ninth Circuit Upholds Validity of Cost-Sharing Regulations that Stray from Arm's-Length Standard

by Orrick, Herrington & Sutcliffe LLP

Orrick, Herrington & Sutcliffe LLP

On July 24, 2018, in the Altera Corp v. Commissioner[1] decision, the Ninth Circuit overturned a 2015 U.S. Tax Court opinion and upheld the validity of regulations requiring taxpayers to treat stock-based compensation as a cost for purposes of cost-sharing arrangements between related parties.

Altera, a subsidiary of Intel Inc., a U.S.-based microprocessor producer, had devised a cost-sharing arrangement with its Cayman Islands subsidiary that the IRS challenged as in direct contravention of applicable Treasury Regulations. Altera contended that promulgation of the Treasury Regulations violated the Administrative Procedure Act and that the regulations were therefore invalid. In 2015, the Tax Court held in favor of Altera in a 15-0 decision, invalidating the regulations. On July 24, 2018, the Ninth Circuit reversed by a count of 2-1, upholding the validity of the regulations.

The Altera decision is a startling departure from the arm's-length standard because uncontrolled taxpayers generally do not treat stock-based compensation as costs that parties share. If it withstands further review, the Altera decision will have both a substantive and procedural impact on the large number of corporate taxpayers who possess valuable or potentially valuable intellectual property ("IP") and who also pay significant stock-based compensation to their employees. Specifically:

  • Stock-based compensation costs will now have to be shifted into low-tax jurisdictions in order to match similarly shifted profit—an issue which disproportionately impacts the tech industry. The Wall Street Journal has estimated that this issue is worth more than $3.5 billion to Google alone.
  • Transfer pricing regulations that adopt a "commensurate-with-income" standard in the context of qualified cost-sharing arrangements in lieu of the more usual "arm's-length" standard will not be rendered invalid (i.e., arbitrary and capricious) merely for failure to adhere to the arm's-length standard.
  • Taxpayers will be more restricted in how they choose to allocate such costs as between affiliates in foreign jurisdictions, making it in turn more difficult to allocate income out of the U.S. and into lower-taxed jurisdictions.
  • Taxpayers may be required to amend returns to reflect the additional cost-sharing payments if they have previously filed returns in reliance on the Tax Court's ruling.
  • Taxpayers in general (i.e., not just tech companies) may find it more difficult in the future to challenge the validity of Treasury regulations under the Administrative Procedure Act.


Because multinational corporations often operate outside the United States through related affiliates, there is an ever-present possibility for such enterprises to manipulate prices and expenses in controlled transactions in order to maximize income in low-taxed jurisdictions while maximizing expenses in the United States, resulting in a lower overall U.S. tax cost to the company. To combat this practice, Congress enacted section 482, which allows the U.S. Treasury ("Treasury") to promulgate transfer pricing regulations which, if not followed, permit the IRS to reallocate income and expenses between such related parties.

Section 482, as amended in 1986, provides that allocation of income resulting from a transfer of intangible property shall be "commensurate with the income" generated by the intangible property. Nevertheless, the transfer pricing regulations under section 482 have largely followed what is known as the "arm's-length standard," which demands that pricing as between controlled entities should conform to pricing charged by unrelated parties in similar transactions. This arm's-length standard has become the bedrock of U.S. transfer pricing principles and has become the standard upon which multinational companies have relied to transfer economic ownership of IP outside the United States.

Qualified cost-sharing agreements ("QCSAs"), such as the one employed by Altera, have traditionally been one of the primary means to transfer economic ownership of IP from a U.S. entity 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. In a QCSA, under the standards provided in the transfer pricing regulations, a U.S. entity holding IP will agree to share costs to further develop and market the IP with a foreign affiliate in exchange for the foreign affiliate making a platform contribution to the U.S. entity. Having transferred the effective economic ownership (but not the legal or tax ownership) of the IP out of the United States, a portion of the income attributable to the IP in the future can be allocated to affiliates in lower-tax jurisdictions, reducing the overall tax burden. While the transfer pricing regulations generally allow the IRS to reallocate income from foreign jurisdictions back to the United States, a cost-sharing arrangement that meets the standards for a QCSA under the regulations will be insulated from such reallocation under a potential IRS challenge.

With this in mind, many companies in the tech 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.

To combat this phenomenon, Treasury Regulation § 1.482-7A(d)(2) explicitly provides that related entities must share the cost of employee stock-based compensation in order for their cost-sharing arrangements to be classified as QCSAs. At the same time, the regulations reference the arm's-length standard as an overarching principle, which has led to considerable confusion in light of the fact that unrelated parties are overwhelmingly not sharing the cost of stock-based compensation.

Case History

Tax Court Decision

In July 2015, Altera successfully challenged the stock-based compensation regulation in the Tax Court under the Administrative Procedure Act. The Tax Court held that the IRS had failed, in its promulgation of the regulations, to follow proper procedures which would have demanded that such regulations (1) consider and account for hard data and expert opinions on comparability rather than "speculation" and (2) otherwise respond to commentary from the public identifying and characterizing comparable uncontrolled transactions, in which such unrelated entities were overwhelmingly opting not to share the "costs" of stock-based compensation—a pattern that was starkly at odds with what the regulation required.

At issue in the case was whether Altera's cost-sharing agreement with its Cayman Islands subsidiary should account for the significant stock-based compensation offered by Altera to certain employees. On examination, the IRS had determined that the failure to allocate a portion of such deductible costs to the subsidiary (and therefore away from the U.S. entity) resulted in more than $80 million of income impermissibly escaping U.S. taxation. Altera, in turn, argued that comparable arrangements between unrelated taxpayers acting at "arm's-length" did not account for employee stock-based compensation and that no adjustment was proper.

This issue had previously been touched upon in Xilinx v. Commissioner,[2] a Ninth Circuit case addressing the application of older transfer pricing regulations promulgated in 1994 and 1995. Xilinx involved the allocation of employee stock options expenses between a U.S. entity and its Irish subsidiary. The primary question was whether the general rule requiring the arm's-length standard could be reconciled with a rule, similar to the current Treasury Regulation § 1.482-7A(d)(2), which required that parties to a QCSA share "all" costs incurred in developing intangibles, presumably without regard to the overarching arm's-length standard. Finding that the two provisions were irreconcilable with one another, the court in Xilinx ultimately held that the prior regulations were invalid. Notably, unlike current Treasury Regulation § 1.482-7A(d)(2), the regulations at the time of Xilinx merely referenced "all costs," without explicitly referencing stock compensation costs. As of 1997, however, Treasury began to interpret this language as encompassing stock-based compensation "costs" as well.

In 2003, subsequent to the tax years under review in Xilinx, the transfer pricing regulations were amended to cause the arm's-length regulation in Treasury Regulation § 1.482-1(b)(1) to expressly reference the cost-sharing provision that Altera would later challenge.

The Ninth Circuit's Reasoning in Altera

Fast-forwarding to the Ninth Circuit's review of the Altera case, the IRS noted that Altera's cost-sharing arrangement was in direct violation of Treasury Regulation § 1.482-7A(d)(2), which explicitly provides that related entities must share the cost of employee stock compensation. Altera, in turn, maintained that the regulation was invalid under the Administrative Procedure Act because it evidenced a patent failure to consider clear evidence of comparable transactions between unrelated parties in violation of the overarching arm's-length standard. 

Regulations specifically authorized by statute, as in the case of the section 482 transfer pricing regulations, are traditionally granted considerable deference. Procedurally, there are two steps the Altera court took in order to determine whether the regulation is valid: (1) it sought to determine that the regulation complied with the Administrative Procedure Act and (2) assuming it met the criteria of the Administrative Procedure Act, it sought to determine whether it passed muster under the standard of review provided for in the Chevron[3] and State Farm[4] cases. Under these standards, such regulations may only be invalidated to the extent they are found to be "arbitrary and capricious," are the result of an "abuse of discretion," or are otherwise devoid of observance of the procedure required by law. Such invalidation could only occur to the extent such regulations are (1) outside the scope of Treasury's authority and (2) the product of a process that was not logical and rational.

Despite the decidedly uphill battle of attacking Treasury's broad authority under the transfer pricing regulations, the Tax Court had initially breathed life into the notion that this fight could be won when it held that the IRS and Treasury had inadequately responded to valid claims that the regulation did not consider the arm's-length standard by addressing the reality of comparable transactions. The main message, as summed up by Judge L. Paige Marvel, was that "everyone…judges, practitioners, and regulators—should be paying attention to whether new rules have followed the procedural formalities."[5]

However, on July 24, 2018, by way of a 2-1 vote, the Ninth Circuit panel in Altera reversed the Tax Court decision and ruled that Congress had "clearly authorized" both the IRS and Treasury to determine what should and should not constitute a QCSA and that the failure to adhere to negative commentary at the time of promulgation did not render the regulation arbitrary and capricious within the Chevron and State Farm standards. Moreover, the Ninth Circuit panel emphasized that utilizing a commensurate-with-income standard in lieu of evaluating comparable transactions was a permissible means of allocating costs not inconsistent with the arm's-length standard for multiple reasons, including: (1) the uncontrolled transactions presented by commentators did not involve development of comparably high-profit intangibles and therefore were not sufficiently comparable to the Altera transaction (therefore mandating use of a different standard in order to effect an arm's-length result) and (2) the legislative history of section 482 (reflected in the Tax Reform Act of 1986) clearly expressed Congressional intent to respect QCSAs as consistent with the commensurate-with-income standard—and therefore consistent with the overarching arm's-length standard—if and to the extent that the participants' shares of income reasonably reflected the actual economic reality undertaken by each.

Notwithstanding the Ninth Circuit panel's opinion, while the "commensurate-with-income" standard appears to be grounded in solid statutory authority, dissenters will note that it remains unclear whether this standard, referenced in the section 482 statute itself in connection with "transfers" of certain IP, is properly applicable to QCSAs, which by their nature involve no actual transfer of such IP.

Notably, the 2-1 decision arrived in the wake of the tragic and unexpected death of one member of the majority, Judge Stephen Reinhardt, who passed away in March 2018, only five months after oral argument. The opinion notes, however, that Judge Reinhardt had formally concurred in the majority opinion before his untimely death.

In its decision, the Altera court distinguished Xilinx, noting that unlike Altera, Xilinx did not involve a debate of administrative authority but rather of regulatory interpretation. Moreover, unlike Altera, which dealt with the procedural permissibility of promulgating one distinct rule, Xilinx was faced with a conflict between two distinguishable rules which were in direct conflict with one another (i.e., the requirement to account for stock-based compensation as a specific allocable cost versus the requirement to account for stock-based compensation the way unrelated parties would in the course of arm's-length transactions). Rather, Altera focused on whether the procedural process of disregarding commentary as to allegedly comparable transactions when adopting the regulation rendered the process deficient under the Administrative Procedure Act.

Notwithstanding the distinguishing factors between Altera and Xilinx, it remains to be seen whether this reversal may stem the tide of the increase in administrative law challenges predicted by Judge Marvel[6] in the wake of the now reversed Tax Court decision.

Effect on Tech Industry

While the holding in Altera in a technical sense is arguably procedural in nature, touching upon what Treasury and the IRS can and cannot do in promulgating regulations, taxpayers in the software and tech industries will undoubtedly focus on the substantive impact of the controversial regulation, which targets many tech companies that are currently paying equity compensation and have entered into cost-sharing agreements with foreign affiliates. It appears certain that the Altera decision will invariably handicap such companies' ability to allocate costs in an optimally tax-effective manner. Of perhaps even greater concern is that Altera's validation of the regulation is at odds with bedrock transfer pricing principles.

The Ninth Circuit panel majority in Altera indicated that Congress had in fact authorized Treasury and the IRS to allocate income and costs between related parties even when it had been definitively established that unrelated parties in comparable transactions do not generally share such costs, stating that "(t)he arm's-length standard has never been used to the exclusion of other, more flexible approaches." In this case, the favored method is the "commensurate-with-income" standard, which analyzes the income generated by certain IP in comparison with amounts paid to the related party owner of such IP. The decision also states that use of the commensurate-with-income standard was consistent with general arm's-length standard principles because the government may dispense with a comparability analysis where comparable transactions do not exist in order to achieve an arm's-length result. Notably, this result also likely means that administrative challenges of future regulations under an "arbitrary and capricious" standard may face an even more uphill battle.


The Altera decision makes clear that a lack of adherence to comparable transactions in order to comply with the arm's-length standard is not sufficient grounds to successfully claim that transfer pricing regulations are invalid under an "arbitrary or capricious" standard. Accordingly, the decision is being viewed by many as a surprising departure from a principle that has been thought of as the bedrock of U.S. transfer pricing standards and which, longstanding practice would seem to dictate, should be adhered to in all but the narrowest of circumstances. Notwithstanding the substantive import of the decision on the cost-sharing regulations, the lasting legacy of the decision may be the obstacle it creates to future procedural challenges to Treasury regulations under the arbitrary and capricious standard of the Administrative Procedure Act. Indeed, prior to the decision, Treasury and the IRS went to great lengths to justify regulatory decisions (as an example, in the section 385 final regulations) out of concern that an Altera challenge might take place.

Opportunities for appealing the decision in Altera still exist. Altera may petition the Ninth Circuit for rehearing by either the panel or a larger 11-judge en banc court. Panel rehearing is rarely granted because judges have generally given the case full consideration and are unlikely to change their vote this late in the process. But given the passing of Judge Reinhardt, the Ninth Circuit would randomly draw a new judge to be the third member of the panel to vote on the panel rehearing petition, and that judge could side with Judge O'Malley's dissent to form a 2-1 opinion going the other way. Alternatively, the full Ninth Circuit could vote to rehear the case en banc, but such proceedings are very rare, particularly in this area of the law. Altera could also elect to bypass the entire rehearing process and ultimately seek review by the U.S. Supreme Court.

Overall, the strong dissent here, coupled with the decision's paramount importance to the technology community, will weigh in favor of further review by either the Ninth Circuit or the U.S. Supreme Court.


[1] Altera Corp v. Commissioner, Nos. 16-70496, 16-70497 (9th Cir. July 24, 2018), rev'g Altera Corp v. Commissioner, 145 T.C. No 3 (July 27, 2015).

[2] Xilinx v. Commissioner, 598 F.3d 1191 (9th Cir. 2010).

[3] Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

[4] Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983).

[5] Tax Court Chief Judge Paige Marvel, "Every Tax Lawyer Needs to Be Fluent in Administrative Law," Tax Notes, (July 24, 2018).

[6] In connection with the Tax Court decision, Judge Marvel predicted "an increase in administrative law challenges to tax regulations." Id

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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