and Submitted October 11, 2017 San Francisco, California
from a Decision of the United States Tax Court Nos. 6253-12,
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.
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.
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
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
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.
I. Forry, San Diego, California, for Amicus Curiae TechNet.
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
Before: Sidney R. Thomas, Chief Judge, and Stephen Reinhardt
Kathleen M. O'Malley [**] Circuit Judges.
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).
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
THOMAS, Chief Judge:
case, we consider the validity of 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 ("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.
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.
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
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
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.
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.
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.
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.
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.
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.
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.
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
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.
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
$ 24, 549, 315
$ 23, 015, 453
$ 17, 365, 388
$ 15, 463, 565
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).
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.
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.
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.
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?
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
relevant time,  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.
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).
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
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).
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.").
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).
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
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
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.
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.
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.
intended the commensurate with income standard to displace a
comparability analysis where comparable transactions cannot
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