August 26, 2016 At Court

The Tax Court’s Decision in Altera and the “Commensurate with Income” Standard Under Section 482

By Clint Wallace, Acting Assistant Professor of Tax Law, New York University School of Law, New York, NY

The government is appealing the Tax Court’s decision in Altera,1 and filed its opening brief with the Ninth Circuit at the end of June. I was part of a group of 19 tax law and administrative law professors who filed an amicus brief on July 5 supporting a reversal of the Tax Court. This piece provides an overview of the tax law and administrative law issues in the Altera case, as presented in our brief.2 This overview differs from what might be drawn from the Tax Court opinion because, as described below and as we presented to the Ninth Circuit, that opinion misapplied significant administrative law precedent. As a result, it misconstrued the Department of Treasury’s authority under section 482 (the statute authorizing the regulation at issue in the case).

Section 482, Arm’s Length, and Commensurate-with-Income

Section 482 grants Treasury and the IRS authority to police transfer pricing. As is familiar in the tax community, these prices can be very important for tax purposes: multinational corporations seeking to avoid paying taxes can arrange affairs and set transfer prices so that income arises in low-tax jurisdictions like the Cayman Islands, rather than high-tax jurisdictions like the United States. Section 482 authorizes Treasury to “distribute, apportion, or allocate gross income, deductions, credits, or allowances” between two related organizations if necessary “to prevent evasion of taxes or clearly to reflect the income of any of such organizations.”3

Since the 1930s, Treasury has provided regulations establishing that the so-called “arm’s-length standard” should be used to determine adjustments made under section 482.4 The basic rule under this standard is that true taxable income should be determined by reference to “comparable transactions under comparable circumstances” carried out between unrelated parties.5 The operating theory of this approach is that if related parties use approximately the same prices as unrelated parties, there is no tax advantage to be had in related-party transactions.

Some transactions between related parties, however, do not have unrelated-party analogues to use as a point of reference. This problem is particularly acute with intangible property. Congress identified this limitation to the arm’s-length standard in 1986 and added additional authority under section 482. This second sentence of section 482 provides that in transactions involving the transfer or license of intangible property, “the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.”6 In other words, the “commensurate-with-income” authority looks to the income generated by the intangible property and does not rely on comparable transactions which, as Congress acknowledged in the legislative history (discussed below), may not exist for certain intangible property.

In the most straightforward scenario, a parent corporation transfers intangible property (for example, the code for computer software) to its subsidiary in exchange for a royalty to be paid as that software generates income for the subsidiary. Commensurate-with-income authority allows the IRS to make adjustments to income based on the income generated by the software in the hands of the subsidiary.7

The Cost-Sharing Regulation

Cost-sharing agreements are another mechanism for transferring intangible property between related entities. These agreements provide that, in exchange for sharing the costs of developing intangible property, parties can share the proceeds derived from that property. In 2003, Treasury finalized section 1.482-7A(d)(2) of the regulations,8 which lays out rules for how cost-sharing agreements must account for costs and allocate benefits to satisfy section 482. The rules act as a safe harbor: if a taxpayer conforms to the cost-sharing regulation, that taxpayer will not face adjustments under section 482.

The dispute in the Altera case concerns what costs must be included in the “cost pool,” i.e., the total costs to be shared. The regulation calls for the cost pool to include the cost of stock-based compensation (for example, stock options given to employees developing the intangible property). Altera did not include this cost.

To understand the tax effect of Altera excluding stock-based compensation from the cost pool, consider the following stylized example. Altera plans to undertake research and development (“R&D”) activities that will cost $100 million. Absent any cost-sharing agreement, Altera U.S. (the U.S. parent) would bear the entire $100 million of those costs and would have rights to the worldwide exploitation of any new intangible property it develops. If Altera U.S. and its wholly-owned subsidiary, Altera Cayman, enter into a cost-sharing agreement, Altera U.S. can maintain the right to exploit any newly developed intangible property in North America (assume this is 30% of the worldwide market) and Altera Cayman can obtain the right to exploit it in the rest of the world (70%). The agreement would—if it conforms to the cost-sharing regulation—provide for a cost pool of the entire $100 million. Altera Cayman would then make payments to Altera U.S. in proportion to Altera Cayman’s share of the anticipated benefits from the new circuit—here, 70% of $100 million ($70 million). Thus, under the agreement, Altera U.S.’s net costs would be $30 million.  As a result, Altera U.S. would have only $30 million (instead of $100 million) of deductible net expenses for purposes of U.S. federal income tax.

If, however, $25 million of the $100 million R&D expense consists of stock-based compensation costs for employees working on developing the intangible property, Altera U.S. and Altera Cayman benefit by excluding that cost from the cost pool. If the stock-based compensation cost is left out of the cost pool, the total cost pool would be $75 million and Cayman Sub would make a cost-sharing payment of only $52.5 million (70% of $75 million) rather than $70 million. That would decrease Altera U.S.’s income by $17.5 million (because it receives a $52.5 million cost-sharing payment, rather than $70 million), thus decreasing its income tax liability by approximately $6.125 million (assuming the 35% corporate tax rate). Furthermore, Altera U.S. would still get to place all its profits from outside North America in the Cayman Islands, which has no income tax.

Indeed, Altera’s tax returns and cost-sharing agreements for the relevant years revealed that the cost-sharing agreement between Altera U.S. and its Cayman Islands subsidiary did not include the costs of stock-based compensation. These costs were disproportionately incurred by Altera U.S.; consequently, the Cayman subsidiary paid far less than its proportionate share of the actual costs of R&D activities. Following an examination, the IRS increased Altera’s U.S. income by between $15 million and $24.5 million per year, thus increasing Altera’s U.S. income tax liability.

Defending the Cost-Sharing Regulation

The Tax Court held that the cost-sharing regulation was not a reasonable application of the arm’s-length standard. Because it determined that the regulation failed to conform to the arm’s-length standard, the Tax Court indicated that it did not matter whether the commensurate-with-income authority provided an independent basis for the regulation. That position, however, is incorrect under leading administrative law precedent.9

The Ninth Circuit has held that if an agency’s determination can be supported on “any rational basis,” it must be upheld.10 The commensurate-with-income standard provides a reasonable basis for the cost-sharing regulation. Crucially, the legislative history makes clear that Congress considered how the commensurate-with-income authority should apply to cost-sharing agreements, and described the challenge of dealing with transfer pricing of intangible property.11

When Congress enacted the “commensurate-with-income” authority, the legislative history included an explanation that, for a cost-sharing agreement to satisfy the commensurate-with-income requirement, “the income allocated among the parties” should “reasonably reflect the actual economic activity undertaken by each,” meaning that “the cost-sharer would be expected to bear its portion of all research and development costs.”12 That is, the Conference Report provides that “all research and development costs” is a sufficient proxy for “actual economic activity.”13 Under these conditions, the Conference Report explains that cost-sharing agreements are “an appropriate method of allocating income attributable to intangibles.”14

When the regulation was proposed, commenters offered two primary critiques, each of which the Tax Court adopted in its opinion while faulting Treasury for not responding sufficiently when it finalized the cost-sharing regulation in 2003. First, some commenters claimed that cost-sharing agreements between unrelated parties do not account for stock-based compensation. Treasury responded to this evidence in the preamble to the final rule:

The uncontrolled transactions cited by commentators do not share enough characteristics of [cost-sharing agreements under the regulation] involving the development of high-profit intangibles to establish that parties at arm’s length would not take stock options into account in the context of an arrangement similar to a [cost-sharing agreement under the regulation].15

Further, as Treasury noted in the preamble, “the legislative history of the Tax Reform Act of 1986,” explains that “there is little, if any, public data regarding [unrelated-party] transactions involving high-profit intangibles.”16 In short, the lack of comparable unrelated-party transactions is precisely the issue that Congress sought to address when it enacted the commensurate-with-income authority, which validates the need for a cost-sharing regulation that does not rely on unrelated-party transactions.

Second, commenters claimed that stock-based compensation is not a real cost to employers. But, as the preamble and the cost-sharing regulation explain, this claim is belied by the general rules that the Code provides to measure stock-based compensation for purposes of allowing a deduction for such costs.17 These rules are the basis for calculating taxable income for employers and employees outside of the related-party context to which section 482 applies. The cost-sharing regulation reflects these general rules by providing that “the operating expense attributable to stock-based compensation is equal to the amount allowable … as a deduction for Federal income tax purposes … (for example, under section 83(h)).”18

The reality that stock-based compensation is a real cost is confirmed by Altera’s own filings with the Securities and Exchange Commission. According to Altera’s most recent annual report, its stock-based compensation cost was 4.98% of its total revenue ($96.4 million of $1.932 billion).19 Altera’s 2005 proxy statement stated that the “use of stock options has long been a vital component of Altera’s overall compensation philosophy,” and that, “without stock options or another form of equity compensation, Altera would be forced to consider cash alternatives to provide market-competitive total compensation package.”20 Of course, Treasury could not cite these filings when it finalized the cost-sharing rule (and accounting standards did not require that stock-based compensation be accounted for in income statements in 2003), but these disclosures underscore the fundamental reasonableness of Treasury’s view in 2003 that stock-based compensation is a real cost.

Policy Issues and Remedies

The professors’ Altera brief advocates for the Ninth Circuit to reverse the Tax Court and hold that the cost-sharing regulation is a reasonable exercise of Treasury’s commensurate-with-income authority. This is justified based on Treasury’s explanation of the cost-sharing regulation in the preamble, and the legislative history supporting Treasury’s approach. Additionally, the brief suggests that even if the Ninth Circuit agrees with the Tax Court that Treasury’s explanation of the cost-sharing regulation (in the preamble issued with the final rule) is inadequate, it should provide Treasury with an opportunity to clarify its explanation.

The policy issues in the Altera litigation are significant: billions of dollars of revenue are at stake under the cost-sharing regulation and its inclusion of stock-based compensation. Further, and perhaps more significantly, spillover effects could destabilize tax administration, as other Treasury regulations might be subject to similar procedural challenges. Therefore, the Ninth Circuit’s analysis and disposition of this case is important beyond the immediate outcome for the cost-sharing regulation.

The taxpayer is scheduled to file its answering brief on August 26.

1 Altera Corp. v. Commissioner, 145 T.C. 91 (2015).

2 The text that follows is based on and drawn from the brief, which is available at

3 IRC § 482 (first sentence).

6 IRC § 482 (second sentence).

8 This regulation was in effect during the years at issue in the Altera litigation.  An updated regulation, Treas. Reg. § 1.482-7(d)(3), has been in effect since January 2009.

9 See Motor Vehicle Mfrs. Ass’n of the U.S. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983) (citing S.E.C. v. Chenery, 332 U.S. 194, 196 (1947)) (even though a court “may not supply a reasoned basis for the agency’s action that the agency itself has not given,” the court should “uphold a decision of less than ideal clarity if the agency’s path may reasonably be discerned.”).

10 McFarland v. Kempthorne, 545 F.3d 1106, 1113 (9th Cir. 2008) (emphasis added).

11 See H.R. Rep. No. 99-426, at 424 (1985).

12 H.R. Rep. No. 99-841 at II-638 (1986) (Conf. Rep.).

13 Id.

14 Id.

16 Id. (citing H.R. Rep. No. 99-426, at 423-25).

19 Altera Corp., Annual Report for the Fiscal Year Ended Dec. 31, 2014 (Form 10-K) (Feb. 13, 2015).

20 Altera Corp., Proxy Statement (Form DEF 14A) A-1 at 26 (Apr. 7, 2005).