In Altera Corp. v. Commissioner, the U.S. Tax Court (USTC) held that a Treasury regulation requiring participants in a qualified cost sharing arrangement (QCSA) to share stock-based compensation costs (SBC) is invalid.
The Altera decision was the outcome of cross-motions for partial summary judgment filed by the parties. Altera Corp. and the IRS have reached an agreement in principle to settle the remaining issues that were before the court, paving the way for a decision to be entered in the USTC. At that time, the United States government will have to decide whether to appeal the decision in the case. The likely appellate venue for this case is the U.S. Court of Appeals for the Ninth Circuit, unless the parties agree otherwise pursuant to I.R.C. Section 7482(b)(2). Given that the Ninth Circuit affirmed a USTC decision adverse to the IRS on a very similar issue in Xilinx Inc. v. Commissioner, 125 T.C. 37 (2005) and 598 F.3d 1191 (9th Cir. 2010), it is unlikely that the taxpayer, which relied heavily on Xilinx as precedent in its motion for partial summary judgment in Altera, would agree to a change in venue.
Altera affects a large number of taxpayers that, following the Xilinx decision, included "clawback" provisions in their QCSAs, as well as taxpayers entering into new QCSAs (and may now be considering "reverse clawback" provisions). The typical clawback provision provides for a triggering event predicated on the change in the validity of the regulation (such as a final court decision finding Treas. Reg. 1.482-7(d)(1)(2003) (which required participants in a QCSA to share SBC) invalid, for example) that would result in a contractual right to reverse the inclusion of SBCs in the QCSA intangible development costs for all closed and open years, regardless of Treas. Reg. 1.482-7(d)(1)(2003).
Whether or not Altera has triggered such a clawback provision depends on the exact language used in the agreement. Clawback provisions that are vague or do not require a final court decision (for example, if the clauses do not require that all appeals be exhausted, the deadline to file appeals to have passed, or the IRS to acquiesce to a decision) may have been triggered by Altera and thus require taxpayers to carefully examine the best course of action to reverse the inclusion of past SBCs in IDCs. Taxpayers also must consider the treatment of SBCs going forward, including tax return disclosures on Form 8275R to notify the IRS of a position contrary to the regulations.
Although the topic is outside the scope of this article, taxpayers should be aware of potential limitations on their ability to amend U.S. tax returns resulting in a decrease of U.S. taxable income under Treas. Reg. 1.482-1(a)(3), even in the case of an error (see Intersport v. Commissioner, 103 Fed. Cl. 396 (Fed. Cl. 2012)), and potential collateral tax and treasury consequences, for example, under Internal Revenue Code Section 267 (requiring an actual payment to be made to claim the deduction) and Section 956 when setting up an accounts receivable under Revenue Procedure 99-32. Other factors including cash flow management and financial statement impact also need to be considered.
Although the same issue with respect to the inclusion of SBCs in Treas. Reg. 1.482-9 intercompany services regulations was in dispute, the IRS and the taxpayer in Altera stipulated the issue out of litigation. Thus, the Altera decision is limited to the validity of Treas. Reg. 1.482-7(d)(1)(2003), although it has broader implications beyond the specific contentious issue of inclusion of SBCs in QCSAs.
Purely from a legal perspective, but of significant importance to taxpayers facing large proposed deficiencies (where the USTC is the only prepayment forum to litigate), the reviewed regular decision in Altera conveys the position of the USTC as a national court. Thus, the USTC's analysis of the issue in Altera should be considered highly precedential, as its analysis would govern its view of other taxpayers facing the identical issue that are located nationwide.
More generally, the reason Altera may have far-reaching implications is the court's finding that Treas. Reg. 1.482-7(d)(1)(2003) was invalid because it was promulgated in violation of the "reasoned decision-making" standard of Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Automobile Insurance Co, 463 U.S. 29 (1983), which set guidelines for invalidation of federal regulations promulgated since the enactment of the Administrative Procedures Act (APA), 5 U.S.C. SS 511-599.
Although in Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, 57 (2011), the Supreme Court of the United States affirmed that the APA applies to tax rules and regulations, Treasury has historically maintained the position that regulations issued under the authority granted by IRC Section 7805(a) are not subject to the notice and comment requirements in the APA because they were merely "interpretive regulations" that clarified statutory language rather than created new law. Until 2014, the Internal Revenue Manual provided that "it was not necessary to justify rules that are being proposed or adopted or alternatives that were considered." Although this sentence is now removed in the current manual, it is an indication of the IRS position on this issue at the time the 2003 regulations at issue in Altera were promulgated.
Some commentators may believe, therefore, that Altera casts reasonable doubts on the validity of (i) other sections of the regulations that have been promulgated without State Farm-level "reasoned decision-making" (such as the inclusion of SBC in Treas. Reg. 1.482-9 transactions); (ii) reliance on temporary regulations that were never finalized (and hence lack a final "reasoned decision-making" process); (iii) retroactive application of regulations (where no "reasoned decision-making" existed at the time of a transaction being challenged); and (iv) implementation in the Treasury regulations of Organization for Economic Cooperation and Development (OECD) base erosion and profit shifting (BEPS) findings and recommendations that lacked empirical support and were thus subject to extensive showing by commentators that such guidance violated empirically observed arm's length behaviors (for example, requiring cost contribution arrangement (CCA) participants to share costs at value rather than at cost).
Altera is arguably one of the most significant U.S. judicial decision on IRC Section 482 given the potentially far-reaching implications for a number of existing provisions in the regulations, and the empirically driven "reasoned decision-making" threshold of State Farm it imposes. With respect to the SBC issue, Treasury and the IRS could potentially consider (i) rewriting Treas. Reg. 1.482-1(b)(1) to provide an interpretation of the arm's length standard grounded in the "thought experiment" argument used by Treasury and the IRS in Xilinx rather than on the behavioral interpretation thereof used by the court; and (ii) impose an all-costs requirement -- inclusive of SBC -- and ground its validity in State Farm "reasoned decision-making" based on the application of the new Treas. Reg. 1.482-1(b)(1). The U.S. Court of Appeals for the Ninth Circuit suggested this avenue in its concurrence with the U.S. Tax Court decision in Xilinx. This approach could provide the government with an alternative to appealing Altera, although such regulations would likely only have prospective effect. However, after the Mayo decision and now Altera, appealing Altera and reliance upon the State Farm empirically driven "reasoned decision-making" threshold under the APA to justify previously issued regulations may be limited avenues available to the government.