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Altera Corp. v. Commissioner of Internal Revenue

United States Court of Appeals, Ninth Circuit

July 24, 2018

Altera Corporation & Subsidiaries, Petitioner-Appellee,
Commissioner of Internal Revenue, Respondent-Appellant.

          Argued and Submitted October 11, 2017 San Francisco, California

          Appeal from a Decision of the United States Tax Court Nos. 6253-12, 9963-12

          Arthur T. Catterall (argued), Richard Farber, and Gilbert S. Rothenberg, Attorneys; Diana L. Erbsen, Deputy Assistant Attorney General; Caroline D. Ciraolo, Acting Assistant Attorney General; Tax Division, United States Department of Justice, Washington, D.C.; for Respondent-Appellant.

          Donald M. Falk (argued), Mayer Brown LLP, Palo Alto, California; Thomas Kittle-Kamp and William G. McGarrity, Mayer Brown LLP, Chicago, Illinois; Brian D. Netter and Travis Crum, Mayer Brown LLP, Washington, D.C.; A. Duane Webber, Phillip J. Taylor, and Joseph B. Judkins, Baker & McKenzie LLP, Washington, D.C.; for Petitioner-Appellee.

          Susan C. Morse, University of Texas School of Law, Austin, Texas; Stephen E. Shay, Harvard Law School, Cambridge, Massachusetts; for Amici Curiae J. Richard Harvey, Leandra Lederman, Ruth Mason, Susan Morse, Stephen Shay, and Bret Wells.

          Jonathan E. Taylor, Gupta Wessler PLLC, Washington, D.C.; Clint Wallace, Vanderbilt Hall, New York, New York; for Amici Curiae Anne Alstott, Reuven Avi-Yonah, Lily Batchelder, Joshua Blank, Noel Cunningham, Victor Fleischer, Ari Glogower, David Kamin, Mitchell Kane, Sally Katzen, Edward Kleinbard, Michael Knoll, Rebecca Kysar, Zachary Liscow, Daniel Shaviro, John Steines, David Super, Clint Wallace, and George Yin.

          Larissa B. Neumann, Ronald B. Schrotenboer, and Kenneth B. Clark, Fenwick & West LLP, Mountain View, California, for Amicus Curiae Xilinx Inc.

          Christopher J. Walker, The Ohio State University Moritz College of Law, Columbus, Ohio; Kate Comerford Todd, Steven P. Lehotsky, and Warren Postman, U.S. Chamber Litigation Center, Washington, D.C.; for Amicus Curiae Chamber of Commerce of the United States of America.

          John I. Forry, San Diego, California, for Amicus Curiae TechNet.

          Alice E. Loughran, Michael C. Durst, and Charles G. Cole, Steptoe & Johnson LLP, Washington, D.C.; Bennett Evan Cooper, Steptoe & Johnson LLP, Phoenix, Arizona; for Amici Curiae Software and Information Industry Association, Financial Executives International, Information Technology Industry Council, Silicon Valley Tax Directors Group, Software Finance and Tax Executives Counsel, National Association of Manufacturers, American Chemistry Council, BSA | the Software Alliance, National Foreign Trade Council, Biotechnology Innovation Organization, Computing Technology Industry Association, The Tax Council, United States Council for International Business, Semiconductor Industry Association.

          Kenneth P. Herzinger and Eric C. Wall, Orrick Herrington & Sutcliffe LLP, San Francisco, California; Peter J. Connors, Orrick Herrington & Sutcliffe LLP, New York, New York; for Amici Curiae Charles W. Calomiris, Kevin H. Hassett, and Sanjay Unni.

          Roderick K. Donnelly and Neal A. Gordon, Morgan Lewis & Bockius LLP, Palo Alto, California; Thomas M. Peterson, Morgan Lewis & Bockius LLP, San Francisco, California; for Amicus Curiae Cisco Systems Inc.

          Christopher Bowers, David Foster, Raj Madan, and Royce Tidwell, Skadden Arps Slate Meagher & Flom LLP, Washington, D.C.; Nathaniel Carden, Skadden Arps Slate Meagher & Flom LLP, Chicago, Illinois; for Amicus Curiae Inc.

          Before: Sidney R. Thomas, Chief Judge, and Stephen Reinhardt [*] and Kathleen M. O'Malley [**] Circuit Judges.



         The panel reversed a decision of the Tax Court that 26 C.F.R. § 1.482-7A(d)(2), under which related entities must share the cost of employee stock compensation in order for their cost-sharing arrangements to be classified as qualified cost-sharing arrangements and thus avoid an IRS adjustment, was invalid under the Administrative Procedure Act. The panel reasoned that the Commissioner of Internal Revenue did not exceed the authority delegated to him by Congress under 26 U.S.C. § 482, that the Commissioner's rule-making authority complied with the Administrative Procedure Act, and that therefore the regulation is entitled to deference under Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

         Dissenting, Judge O'Malley would find, as the Tax Court did, that 26 C.F.R. § 1.482-7A(d)(2) is invalid as arbitrary and capricious.


          THOMAS, Chief Judge:

         In this case, we consider the validity of 26 C.F.R. § 1.482-7A(d)(2), [1] under which related entities must share the cost of employee stock compensation in order for their cost-sharing arrangements to be classified as qualified cost-sharing arrangements ("QCSA") and thus avoid an IRS adjustment. We conclude that the regulations withstand scrutiny under general administrative law principles, and we therefore reverse the decision of the Tax Court.


         Corporations often elect to conduct business through international subsidiaries. Transactions between related companies can provide opportunities for minimizing or avoiding taxes, particularly when a foreign subsidiary is located in a low tax jurisdiction. For example, a parent company in a high tax jurisdiction can sell property to its subsidiary in a low tax jurisdiction and have its subsidiary sell the property for profit. The profits from those sales are thus taxed in a lower tax jurisdiction, resulting in significant tax savings for the parent. This practice, known as "transfer pricing" can result in United States companies shifting profits that would be subject to tax in America offshore to avoid tax. Similarly, related companies can identify and shift costs between American and foreign jurisdictions to minimize tax exposure. In recent years, United States corporations have used these techniques to develop intangible property with their foreign subsidiaries, and to share the cost of development between the companies. Under these arrangements, a U.S. corporation might enter into a research and development ("R&D") cost-sharing agreement with its foreign subsidiary located in a low tax jurisdiction and grant the offshore company rights to exploit the property internationally. The interplay of cost and income allocation between the two companies in such a transaction can result in significantly reduced taxes for the United States parent.

         To address the risk of multinational corporation tax avoidance, Congress passed legislation granting the United States Department of the Treasury the authority to allocate income and costs between such related parties. 26 U.S.C. § 482. In turn, the Secretary of the Treasury promulgated regulations authorizing the Commissioner of the Internal Revenue Service to allocate income and costs among these related entities. 26 C.F.R. §§ 1.482-0 through 1.482-9.

         At issue before us are employee stock options, the cost of which the companies in this case elected not to share, resulting in substantial tax savings for the parent-here, the tax associated with over $80 million in income. The Commissioner contends that allocation of stock compensation costs between the companies is appropriate to reflect economic reality; Altera Corporation ("Altera") and its subsidiaries contend that any cost allocation exceeds the Commissioner's authority.

         Fundamental to resolution of this dispute is an understanding of the arm's length standard, a tool that Treasury developed in the mid-twentieth century to ensure that controlled taxpayers were taxed similarly to uncontrolled taxpayers. The arm's length standard is results-oriented, meaning that its goal is parity in taxable income rather than parity in the method of allocation itself. 26 C.F.R. § 1.482-1(b)(1) ("A controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm's length result)."). A traditional arm's length analysis looks to comparable transactions among non-related parties to achieve an arm's length result. The issue in this case is whether Treasury can permissibly allocate between related parties a cost that unrelated parties do not agree to share.

         Altera asserts that the arm's length standard always demands a comparability analysis, meaning that the Commissioner cannot allocate costs between related parties in the absence of evidence that unrelated parties share the same costs when dealing at arm's length. Altera argues that, because uncontrolled taxpayers do not share the cost of employee stock options, the Commissioner cannot require related parties to share that cost.

         The Commissioner argues that he may, consistent with the arm's length standard, apply a purely internal method of allocation, distributing the costs of employee stock options in proportion to the income enjoyed by each controlled taxpayer. This "commensurate with income" method analyzes the income generated by intangible property in comparison with the amount paid (usually as royalty) to the parent. In the Commissioner's view, the commensurate with income method is consistent with the arm's length standard because controlled cost-sharing arrangements have no equivalent in uncontrolled arrangements, and Congress has provided that the Commissioner may dispense with a comparability analysis where comparable transactions do not exist in order to achieve an arm's length result.

         Because this case involves a challenge to regulations, the ultimate issue is not what the arm's length standard should mean but rather whether Treasury may define the standard as it has. We conclude that the challenged regulations are not arbitrary and capricious but rather a reasonable execution of the authority delegated by Congress to Treasury.


         At issue is Altera's tax liability for the years 2004 through 2007. During the relevant period, Altera and its subsidiaries designed, manufactured, marketed, and sold programmable logic devices, electronic components that are used to build circuits.

         In May of 1997, Altera entered into a cost-sharing agreement with one of its subsidiaries, Altera International, Inc., a Cayman Islands corporation ("Altera International"), which had been incorporated earlier that year. Altera granted to Altera International a license to use and exploit Altera's preexisting intangible property everywhere in the world except the United States and Canada. In exchange, Altera International paid royalties to Altera. The parties agreed to pool their resources to share R&D costs in proportion to the benefits anticipated from new technologies.

         Altera and the IRS agreed to an Advance Pricing Agreement covering the 1997-2003 tax years. Pursuant to this agreement, and consistent with the cost-sharing regulations in effect at the time, Altera shared with Altera International stock-based compensation costs as part of the shared R&D costs. The Treasury regulations were amended in 2003, and Altera and Altera International amended their cost-sharing agreement to comply with the modified regulations, continuing to share employee stock compensation costs.

         The agreement was amended again in 2005 following the Tax Court's opinion in Xilinx, Inc. v. Commissioner, involving a challenge to the allocation of employee stock compensation costs under the 1994-1995 cost-sharing regulations. 125 T.C. 37 (2005). The parties agreed to "suspend the payment of any portion of [a] Cost Share . . . to the extent such payment relates to the Inclusion of Stock-Based Compensation in R&D Costs" unless and until a court upheld the validity of the 2003 cost-sharing regulations. The following provision explains Altera's reasoning:

The Parties believe that it is more likely than not that (i) the Tax Court's conclusion in Xilinx v. Commissioner, 125 T.C. [No.] 4 (2005), that the arm's length standard controls the determination of costs to be shared by controlled participants in a qualified cost sharing arrangement should also apply to Treas. Reg. § 1.482-7[A](d)(2) (as amended by T.D. 9088), and (ii) the Parties' inclusion of Stock-Based Compensation in R&D Costs pursuant to Amendment I would be contrary to the arm's length standard.

         Altera and its U.S. subsidiaries did not account for R&D-related stock-based compensation costs on their consolidated 2004-2007 federal income tax returns. The IRS issued two notices of deficiency to the group, applying § 1.482-7(d)(2) to increase the group's income by the following amounts:


$ 24, 549, 315


$ 23, 015, 453


$ 17, 365, 388


$ 15, 463, 565

         The Altera group timely filed petitions in the Tax Court. The parties filed cross-motions for partial summary judgment, and the Tax Court granted Altera's motion. Sitting en banc, the court held that § 1.482-7A(d)(2) is invalid under the Administrative Procedure Act ("APA"). Altera Corp. & Subsidiaries v. Comm'r, 145 T.C. 91 (2015).

         The Tax Court unanimously determined that the Commissioner's allocation of income and expenses between related entities must be consistent with the arm's length standard, and that the arm's length standard is not met unless the Commissioner's allocation can be compared to an actual transaction between unrelated entities. The court reasoned that the Commissioner could not require related parties to share stock compensation costs because the Commissioner had not considered any unrelated party transactions in which the parties shared such costs. The court concluded that the agency decision-making process was fundamentally flawed because: (1) it rested on speculation rather than hard data and expert opinions; and (2) it failed to respond to significant public comments, particularly those identifying uncontrolled cost-sharing arrangements in which the entities did not share stock compensation costs. Altera, 145 T.C. at 122-31.

         The Tax Court's decision rested largely on its own opinion in Xilinx, in which it held that "the arm's-length standard always requires an analysis of what unrelated entities do under comparable circumstances." Id. at 118 (citing Xilinx, 125 T.C. at 53-55). In its decision in this case, the Tax Court reinforced its conclusion that the Commissioner cannot require related entities to share stock compensation costs unless and until it locates uncontrolled transactions in which these costs are shared. Id. at 118-19.

         The court reached five holdings: (1) that the 2003 amendments constitute a final legislative rule subject to the requirements of the APA; (2) that Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Auto Insurance Co., 463 U.S. 29 (1983) provides the appropriate standard of review because the standard set forth in Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), incorporates State Farm's reasoned decisionmaking standard; (3) that Treasury failed to adequately support its decision to allocate the costs of employee stock compensation between related parties; (4) that Treasury's failure was not harmless error; and (5) that § 1.482-7A(d)(2) is invalid under the APA. Id. at 115-33.

         On appeal, the Commissioner does not dispute the first holding regarding the applicability of State Farm, although he argues that the appropriate standard is more deferential and less empirically minded than the standard actually applied by the Tax Court. Nor does he claim that any error in the decisionmaking process, if it existed, was harmless. The challenged holdings-(2), (3), and (5)-are all part of the same broader question: did Treasury exceed its authority in requiring Altera's cost-sharing arrangement to include a particular distribution of employee stock compensation costs?


         The Commissioner's position is founded on 26 U.S.C. § 482. Because an understanding of § 482 and its history is integral to resolution of each of the issues raised by the parties, a brief overview of the statute and its history is important.

         At the relevant time, [2] 26 U.S.C. § 482 appeared to provide a nearly limitless grant of authority to Treasury to allocate income between related parties:

In any 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. 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.

         The first sentence has remained substantively unchanged since 1928, Revenue Act of 1928, ch. 852, § 45, 45 Stat. 791, 806 (1928), and it provides the statutory authority for the arm's length standard, which first appeared in the 1934 tax regulations, Regulations 86, Art. 45-1(b) (1935). The second sentence sets forth the commensurate with income standard, and it was added to the statute in 1986. Tax Reform Act of 1986, Pub. L. No. 99-514, § 1231(e)(1), 100 Stat. 2085, 2562 (1986).


         From the beginning, § 482's precursor was designed to give Treasury the flexibility it needed to prevent cost and income shifting between related entities for the purpose of decreasing tax liability. See H.R. Rep. No. 70-2, at 16-17 (1927) ("[T]he Commissioner may, in the case of two or more trades or businesses owned or controlled by the same interests, apportion, allocate, or distribute the income or deductions between or among them, as may be necessary in order to prevent evasion (by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of 'milking'), and in order clearly to reflect their true tax liability."); accord S. Rep. No. 70-960, at 24 (1928). The purpose of the statute is "to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer . . . ." Comm'r v. First Sec. Bank of Utah, 405 U.S. 394, 400 (1972) (quoting Treas. Reg. § 1.482-1(b)(1) (1971)). This parity is double-edged: as much as § 482 works to ensure controlled taxpayers are not overtaxed, the concern expressed on the face of § 482, even before the 1986 amendment, is preventing tax avoidance by controlled taxpayers.

         After 1934, when the arm's length standard appeared in the regulations-in what is essentially its modern form- courts did not hold related parties to the standard by looking for comparable transactions. For example, in Seminole Flavor Co. v. Commissioner, the Tax Court rejected a strict application of the arm's length standard in favor of an inquiry into whether the allocation of income between related parties was "fair and reasonable." 4 T.C. 1215, 1232 (1945); see also id. at 1233 ("Whether any such business agreement would have been entered into by petitioner with total strangers is wholly problematical."); Grenada Indus., Inc. v. Comm'r, 17 T.C. 231, 260 (1951) ("We approve an allocation . . . to the extent that such gross income in fact exceeded the fair value of services rendered . . . ."). And in 1962, this Court collected various allocation standards and outright rejected the superiority of the arm's length standard over all others:

[W]e do not agree . . . that "arm's length bargaining" is the sole criterion for applying the statutory language of § 45 in determining what the "true net income" is of each "controlled taxpayer." Many decisions have been reached under § 45 without reference to the phrase "arm's length bargaining" and without reference to Treasury Department Regulations and Rulings which state that the talismanic combination of words-"arm's length"-is the "standard to be applied in every case."
For example, it was not any less proper . . . to use here the "reasonable return" standard than it was for other courts to use "full fair value," "fair price including a reasonable profit," "method which seems not unreasonable," "fair consideration which reflects arm's length dealing," "fair and reasonable," "fair and reasonable" or "fair and fairly arrived at," or "judged as to fairness," all used in interpreting § 45.

Frank v. Int'l Canadian Corp., 308 F.2d 520, 528-29 (9th Cir. 1962) (footnotes omitted).[3]

         In the 1960s, the problem of abusive transfer pricing practices created a new adherence to a stricter arm's length standard. In response to concerns about the undertaxation of multinationals, Congress considered reworking the Code to resolve the difficulty posed by the application of the arm's length standard to related party transactions. H.R. Rep. No. 87-1447, at 28-29 (1962). However, it instead asked Treasury to "explore the possibility of developing and promulgating regulations . . . which would provide additional guidelines and formulas for the allocation of income and deductions" under § 482. H.R. Conf. Rep. No. 87-2508, at 19 (1962), reprinted in 1962 U.S.C.C.A.N. 3732, 3739. Legislators believed that § 482, at least in theory, authorized the Secretary to employ a profit-split allocation method without amendment. Id.; H.R. Rep. No. 87-1447, at 28-29 ("This provision appears to give the Secretary the necessary authority to allocate income between a domestic parent and its foreign subsidiary.").

         In 1968, following Congress's entreaty, Treasury finalized the first regulation tailored to the issue of intangible property development in cost-sharing arrangements. Treas. Reg. § 1.482-2(d) (1968). The novelty of the 1968 regulations was their focus on comparability. Compare Treas. Reg. § 1.482-2(d)(2) ("An arm's length consideration shall be in a form which is consistent with the form which would be adopted in transactions between unrelated parties in the same circumstances.") with Regulations 86, Art. 45-1(b) (1935) (focusing on arm's length results rather than arm's length form). The 1968 regulations "constituted a radical and unprecedented approach to the problem they addressed- notwithstanding their being couched in terms of the 'arm's length standard,' and notwithstanding that that standard had been the nominal standard under the regulations for some 30 years . . . ." Stanley I. Langbein, The Unitary Method and the Myth of Arm's Length, 30 Tax Notes 625, 644 (1986).

         Despite the asserted focus on comparability, the arm's length standard has never been used to the exclusion of other, more flexible approaches. Indeed, a study determined that direct comparables were located and applied in only 3% of IRS's adjustments prior to the 1986 amendment. U.S. Gen. Accounting Office, GGD-81-81, IRS Could Better Protect U.S. Tax Interests in Determining the Income of Multinational Corporations 29 (1981). The decades following the 1968 regulations involved

a gradual realization by all parties concerned, but especially Congress and the IRS, that the [arm's length standard], firmly established . . . as the sole standard under section 482, did not work in a large number of cases, and in other cases its misguided application produced inappropriate results. The result was a deliberate decision to retreat from the standard while still paying lip service to it.

         Reuven S. Avi-Yonah, The Rise & Fall of Arm's Length: A Study in the Evolution of U.S. International Taxation, 15 Va. Tax Rev. 89, 112 (1995); see also James P. Fuller, Section 482: Revisited Again, 45 Tax L. Rev. 421, 453 (1990) ("[T]he 1986 Act's commensurate with income standard is not really a new approach to § 482."). The arm's length standard had proven to be similarly illusory in international contexts. Langbein, supra, at 649.


         As controlled transactions increased in frequency and complexity, Congress determined that legislative action was necessary. The Tax Reform Act of 1986 reflected Congress's view that strict adherence to the arm's length standard prevented tax parity.

         The House Ways and Means Committee recommended the addition of the commensurate with income clause because it was "concerned" that the current statute and regulations "may not be operating to assure adequate allocations to the U.S. taxable entity of income attributable to intangibles . . . ." H.R. Rep. No. 99-426, at 423 (1985). The clause was intended to correct 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." Id. at 423-24.

         Congress intended the commensurate with income standard to displace a comparability analysis where comparable transactions cannot be found:

A fundamental problem is the fact that the relationship between related parties is different from that of unrelated parties. . . . [M]ultinational companies operate as an economic unit, and not "as if" they were unrelated to their foreign subsidiaries.
. . .
Certain judicial interpretations of section 482 suggest that pricing arrangements between unrelated parties for items of the same apparent general category as those involved in the related party transfer may in some circumstances be considered a "safe harbor" for related party pricing arrangements, even though there are significant differences in the volume and risks involved, or in other factors. . . . [S]uch an approach is sufficiently troublesome where transfers of intangibles are concerned that a statutory modification to the intercompany pricing rules regarding transfers of intangibles is necessary.
. . .
. . . There are extreme difficulties in determining whether the arm's length transfers between unrelated parties are comparable. The committee thus concludes that it is appropriate to require that the payment made on a transfer of intangibles to a related foreign corporation . . . be ...

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