Altera Corp. v. Comm'r of Internal Revenue, Nos. 16-70496

• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)
• Writing for the Court: THOMAS, Chief Judge
• Citation: 926 F.3d 1061
• Parties: ALTERA CORPORATION & SUBSIDIARIES, Petitioner-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
• Docket Number: Nos. 16-70496,16-70497
• Decision Date: 07 June 2019

926 F.3d 1061

ALTERA CORPORATION & SUBSIDIARIES, Petitioner-Appellee,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.

Nos. 16-70496
16-70497

United States Court of Appeals, Ninth Circuit.

Argued and Submitted October 16, 2018 San Francisco, California
Filed June 7, 2019

THOMAS, Chief Judge:

926 F.3d 1067

This appeal presents the question of the validity of 26 C.F.R. § 1.482-7A(d)(2),¹ under which related business 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"). Although the case appears complex, the dispute between the Department of the Treasury and the taxpayer is relatively straightforward. The parties agree that, under the governing tax statute, the "arm's length" standard applies; but they disagree about how the standard may be met. The taxpayer argues that Treasury must employ a specific method to meet the arm's length standard: a comparability analysis using comparable transactions between unrelated business entities. Treasury disagrees that the arm's length standard requires the specific comparability method in all cases. Instead, the standard generally requires that Treasury reach an arm's length result of tax parity between controlled and uncontrolled business entities. With respect to the transactions at issue here, the governing statute allows Treasury to apply a purely internal method of allocation, distributing the costs of employee stock options in proportion to the income enjoyed by each related taxpayer.

Our task, of course, is not to assess the better tax policy, nor the wisdom of either approach, but rather to examine whether Treasury's regulations are permitted under the statute. Applying the familiar tools used to examine administrative agency regulations, we conclude that the regulations withstand scrutiny. Therefore, we reverse the judgment of the Tax Court.

I

For many years, Congress and the Treasury have been concerned with American businesses avoiding taxes through the creation and use of related business entities. In the last several decades, Congress has directed particular attention to the potential for tax abuse by multinational corporations with foreign subsidiaries. If, for example, the parent business entity is in a high-tax jurisdiction, and the foreign subsidiary is in a low-tax jurisdiction, the business enterprise can shift costs and revenue between the related entities so that more taxable income is allocated to the lower tax jurisdiction. Similarly, a parent and foreign subsidiary can enter into significant tax-avoiding cost sharing arrangements.

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This potential for tax abuse is generally not present when similar transactions occur between unrelated business entities. In those instances, each separate unrelated entity has the incentive to maximize profit, and thus to allocate costs and income consistent with economic realities. However, among related parties, those incentives do not exist. Rather, among related parties, after-tax maximization of profit may depend on how costs and income are allocated between the parent and the subsidiary regardless of economic reality, given that after-tax profits are commonly shared.

The concern about tax avoidance through the use of related business entities is not new. In the Revenue Act of 1928, Congress granted the Secretary of the Treasury the authority to reallocate the reported income and costs of related businesses "in order to prevent evasion of taxes or clearly to reflect the income of any such trades or businesses." Revenue Act of 1928, ch. 852, § 45, 45 Stat. 791, 806. This statute was designed to give Treasury the flexibility it needed to prevent transaction-shuffling 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 was "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, 92 S.Ct. 1085, 31 L.Ed.2d 318 (1972) (quoting 26 C.F.R. § 1.482-1(b)(1) (1971) ). In short, the primary aim of the statute was to prevent tax evasion by related business taxpayers.²

In 1934, the Commissioner adopted regulations implementing the statute and first adopted the familiar "arm's length" standard: "The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer." Treas. Reg. 86, art. 45-1(b) (1935). In the context of a controlled transaction, the arm's length standard is satisfied "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)." 26 C.F.R. § 1.482-1(b)(1). The relevant regulation also noted: "However, because identical transactions can rarely be located, whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances." Id.

Although the Secretary adopted the arm's length standard, courts did not hold related parties to that standard by exclusively requiring the examination of 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

926 F.3d 1069

an allocation ... to the extent that such gross income in fact exceeded the fair value of the services rendered ...."). And in 1962, we collected various allocation standards and outright rejected the superiority of the arm's length bargaining analysis over all others:

[W]e do not agree ... that "arm's length bargaining" is the sole criterion for applying the statutory language of [ 26 U.S.C. § 482 ] in determining what the "true net income" is of each "controlled taxpayer." Many decisions have been reached under [ § 482 ] 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."

Frank v. Int'l Canadian Corp. , 308 F.2d 520, 528–29 (9th Cir. 1962).

Frank noted that "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 [the statute]." Id. (footnotes omitted). We later limited Frank to situations in which "it would have been difficult for the court to hypothesize an arm's-length transaction." Oil Base, Inc. v. Comm'r , 362 F.2d 212, 214 n.5 (9th Cir. 1966). However, Frank 's central point remained: the arm's length standard based on comparable transactions was not the sole basis of reallocating costs and income under the statute.

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 multinational business entities, Congress considered reworking the Tax 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 28–30 (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 26 U.S.C. § 482. H.R. REP. NO 87-2508, at 19 (1962) (Conf. Rep.), as reprinted in 1962 U.S.C.C.A.N. 3732, 3739. Legislators believed that § 482 authorized the Secretary to employ a profit-split allocation method without amendment. Id. ; H.R. REP. NO 87-1447, at 28–29. In 1968, following Congress's entreaty, Treasury finalized the first regulation tailored to the issue of intangible property development in QCSAs. 26 C.F.R. § 1.482-2(d) (1968).

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...