Altera Corp. v. Comm'r

• Decision Date: 27 July 2015
• Docket Number: Docket No. 6253-12,145 T.C. No. 3,Docket No. 9963-12.
• Parties: ALTERA CORPORATION AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

ALTERA CORPORATION AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

145 T.C. No. 3

Docket No. 6253-12

Docket No. 9963-12.

UNITED STATES TAX COURT

July 27, 2015

In Xilinx Inc. v. Commissioner, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010), we held that, under the 1995 cost-sharing regulations, controlled entities entering into qualified cost-sharing agreements (QCSAs) need not share stock-based compensation (SBC) costs because parties operating at arm's length would not do so. In 2003 Treasury issued sec. 1.482-7(d)(2), Income Tax Regs. (final rule). The final rule requires controlled parties entering into QCSAs to share SBC costs.

P is an affiliated group of corporations that filed consolidated returns for the years in issue. A-US, the parent company, is a Delaware corporation, and A-I, a subsidiary of A-US, is a Cayman Islands corporation. A-US and A-I entered into a QCSA. During its 2004-07 taxable years A-US granted SBC to its employees. A-US did not share the SBC costs with A-I. R determined deficiencies based on I.R.C. sec. 482 allocations R made pursuant to the final rule.

P and R have filed cross-motions for partial summary judgment. P contends that the final rule is arbitrary and capricious under 5 U.S.C. sec. 706(2)(A) and Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983). R contends that the final rule is valid under Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), or alternatively, under State Farm.

Held: The final rule is a legislative rule--i.e., it is not an interpretive rule under 5 U.S.C. sec. 553(b)--because it has the force of law. See Am. Mining Cong. v. Mine Safety & Health Admin., 995 F.2d 1106, 1109 (D.C. Cir. 1993). The final rule has the force of law because in I.R.C. sec. 7805(a) "Congress has delegated legislative power to" Treasury, id., and Treasury "intended to exercise that power" when it issued the final rule, id.

Held, further, whether State Farm or Chevron supplies the standard of review is immaterial because Chevron step 2 incorporates the reasoned decisionmaking standard of State Farm, see Judulang v. Holder, 565 U.S. ___, ___, 132 S. Ct. 476, 483 n.7 (2011), and we are being asked to decide whether Treasury reasonably concluded that the final rule is consistent with the arm's-length standard.

Held, further, Treasury failed to support its belief that unrelated parties would share SBC costs with any evidence in the administrative record, see State Farm, 463 U.S. at 43; failed to articulate why all QCSAs should be treated identically, see id.; and failed to respond to significant comments, see Home Box Office, Inc. v. FCC, 567 F.2d 9, 35 (D.C. Cir. 1977). Additionally, Treasury's "explanation for its decision * * * runs counter to the evidence before" it. State Farm, 463 U.S. at 43.

Held, further, the harmless error rule of 5 U.S.C. sec. 706 is inapplicable because it is not clear that Treasury would have adopted the final rule if it had been determined to be inconsistent with the arm's-length standard.

Held, further, the final rule fails to satisfy State Farm's reasoned decisionmaking standard and is therefore invalid. See 5 U.S.C. sec. 706(2)(A); State Farm, 463 U.S. at 43.

Andrew P. Crousore, Donald M. Falk, Joseph B. Judkins, Thomas Lee Kittle-Kamp, William G. McGarrity, Kristyn A. Medina, Brian D. Netter, Phillip J. Taylor, and Allen Duane Webber, for petitioner.

Farhad Asghar, Kevin G. Croke, Anne O'Brien Hintermeister, Allan Lang, Aaron T. Vaughan, and Mary E. Wynne, for respondent.

OPINION

MARVEL, Judge: These consolidated cases are before the Court on the parties' cross-motions for partial summary judgment under Rule 121.¹ The issue presented by the parties' cross-motions is whether section 1.482-7(d)(2), Income Tax Regs. (the final rule)--which the Department of the Treasury (Treasury) issued in 2003 and which requires participants in qualified cost-sharing arrangements(QCSAs) to share stock-based compensation costs to achieve an arm's-length result--is arbitrary and capricious and therefore invalid.

Background

Petitioner is an affiliated group of corporations that filed consolidated Federal income tax returns for the years at issue. During all relevant years, Altera Corp. (Altera U.S.), the parent company, was a Delaware corporation, and Altera International, a subsidiary of Altera U.S., was a Cayman Islands corporation. When petitioner filed its petitions with this Court, the principal place of business of Altera U.S. was in California.

I. Petitioner's R&D Cost-Sharing Agreement

Petitioner develops, manufactures, markets, and sells programmable logic devices (PLDs) and related hardware, software, and pre-defined design building blocks for use in programming the PLDs (programming tools). Altera U.S. and Altera International entered into concurrent agreements that became effective May 23, 1997: a master technology license agreement (technology license agreement) and a technology research and development cost-sharing agreement (R&D cost-sharing agreement).

Under the technology license agreement, Altera U.S. licensed to Altera International the right to use and exploit, everywhere except the United States andCanada, all of Altera U.S.'s intangible property relating to PLDs and programming tools that existed before the R&D cost-sharing agreement (pre-cost-sharing intangible property). In exchange for the rights granted under the technology license agreement, Altera International paid royalties to Altera U.S. in each year from 1997 through 2003. As of December 31, 2003, Altera International owned a fully paid-up license to use the pre-cost-sharing intangible property in its territory.

Under the R&D cost-sharing agreement, Altera U.S. and Altera International agreed to pool their respective resources to conduct research and development using the pre-cost-sharing intangible property. Under the R&D cost-sharing agreement, Altera U.S. and Altera International agreed to share the risks and costs of research and development activities they performed on or after May 23, 1997. The R&D cost-sharing agreement was in effect from May 23, 1997, through 2007.

During each of petitioner's taxable years ending December 31, 2004, December 30, 2005, December 29, 2006, and December 28, 2007 (2004-07 taxable years), Altera U.S. granted stock options and other stock-based compensation to certain of its employees. Certain of the employees of Altera U.S. who performed research and development activities subject to the R&D cost-sharing agreement received stock options or other stock-based compensation. Theemployees' cash compensation was included in the cost pool under the R&D cost-sharing agreement. Their stock-based compensation was not included.

Pursuant to the R&D cost-sharing agreement, Altera International made the following cost-sharing payments to Altera U.S. for its 2004-07 taxable years:

Year

Cost-sharing payment

2004

$129,469,233

2005

160,722,953

2006

164,836,577

2007

192,755,438

II. Petitioner's Tax Reporting and Respondent's Section 482 Allocations

Petitioner timely filed its Forms 1120, U.S. Corporation Income Tax Return, for its 2004-07 taxable years. Respondent timely mailed notices of deficiency to petitioner with respect to its 2004-07 taxable years. The notices of deficiency allocated, pursuant to section 482, income from Altera International to Altera U.S. by increasing Altera International's cost-sharing payments for 2004-07 by the following amounts:

Year

Cost-sharing

payment adjustment

2004

$24,549,315

2005

23,015,453

2006

17,365,388

2007

15,463,565

Bringing petitioner into compliance with the final rule was the sole purpose of the cost-sharing adjustments in the notice of deficiency.

III. Section 482

A. Arm's-Length Standard

Section 482 authorizes the Commissioner to allocate income and expenses among related entities to prevent tax evasion and to ensure that taxpayers clearly reflect income relating to transactions between related entities. The first sentence of section 482 provides, in relevant part, as follows:

In any case of two or more organizations, trades, or businesses * * * owned or controlled directly or indirectly by the same interests, the Secretary² 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. * * *

Section 1.482-1(a)(1), Income Tax Regs., explains the purpose of section 482 as follows:

The purpose of section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions. Section 482 places a controlled taxpayer³ on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer. * * *

Section 1.482-1(b)(1), Income Tax Regs., provides that

[i]n determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer. 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). 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. * * *

The arm's-length standard is also incorporated into numerous income tax treaties between the United States and foreign countries. See, e.g., Convention for the Avoidance of Double Taxation and the Prevention of Fiscal...