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Altera again petitions Tax Court to invalidate section 482 stock-based compensation rules

Altera Corp. v. Commissioner, TC Docket No. 31538-15 (petition filed on Dec. 18, 2015).

Altera Corp. has filed a new petition with the Tax Court to challenge IRS again on whether related parties entering into qualified cost sharing arrangements (CSAs) are required to share stock-based compensation (SBC) costs under Code Sec. 482. The Tax Court recently ruled in favor of Altera Corp. on the same issue for tax years 2004 through 2007, invalidating the requirement in 2003 final CSA regs to share SBC costs among related parties. In the petition, Altera Corp. has questioned the validity of “materially the same” rules in the 2009 temporary and 2011 final CSA regs that are applicable to tax years 2010 and 2011.

Background on CSA arrangements.An entity owning intangible property (IP) may transfer ownership or use of the IP to a related entity in a number of ways—e.g., via a sale, exchange, or license. The transfer or license of the IP has the potential of shifting income attributable to the IP from one jurisdiction to another—say, from the U.S. to the Cayman Islands.

Code Sec. 482 operates to limit the shifting of income through the transfer or license of IP. It authorizes IRS to distribute, allocate, or apportion gross income, credits, or allowances between related parties to clearly reflect the income of those taxpayers or to prevent the evasion of taxes.

On the transfer or license of IP in a controlled transaction, the consideration must be “commensurate with the income attributable to the intangible.” To achieve a clear reflection of each taxpayer’s income, IRS considers what each taxpayer’s income would be had the related taxpayers been dealing with one other at “arm’s length” (i.e., the arm’s-length standard). (Reg. § 1.482-1(b)(1))

In connection with the transfer or license of existing IP, an entity owning such IP may enter into a qualified CSA with one or more related parties, whereby the parties agree to share the costs and risks of developing future IP in proportion to the share of benefits that each party reasonably anticipates deriving from the exploitation of such cost shared IP. Such costs are “intangible development costs” (IDCs) and include all costs, other than certain excluded costs, incurred after the formation of a qualified CSA that are directly identified with, or reasonably allocable to, “intangible development activities.” (Reg. § 1.482-7(d)(1)(iii))

In 2003, when IRS issued the final CSA regs, it amended the ’95 CSA regs and provided that SBC costs must be taken into account as an IDC, requiring controlled participants entering into qualified CSAs to share SBC costs. (Reg. § 1.482-7(d)(1)(iii)) SBC includes restricted stock, nonstatutory stock options, statutory stock options (ISOs and ESPPs), stock appreciation rights, and phantom stock. (Reg. § 1.482-7(d)(3)(i))

For this purpose, a controlled participant is a controlled taxpayer (any one of two or more taxpayers owned or controlled directly or indirectly by the same interests; includes the taxpayer that owns or controls the other taxpayers) that is a party to the contractual agreement that underlies the CSA, and that reasonably anticipates that it will derive benefits from exploiting one or more cost shared intangibles. (Reg. § 1.482-7(j)(1)(i) and Reg. § 1.482-1(i)(5))

Facts.Altera Corp. is the publicly-held parent company of a group of U.S. and foreign companies (Altera Group). During the years at issue, the Altera Group included Altera International, a Cayman Islands company.

The Altera Group develops, manufactures, markets, and sells programmable logic devices (PLDs), application-specific integrated circuits, and related hardware, software, and pre-defined design building blocks known as IP cores for use in programming the PLDs (Programming Tools).

Effective May 23, ’97, Altera Corp. and Altera International entered into a Master Technology Licensing Agreement (License Agreement) and a Technology Research and Development Cost Sharing Arrangement (R&D CSA). Under the Licensing Agreement, Altera Corp. licensed Altera International the right to use and exploit, everywhere except in the U.S. and Canada, all of Altera Corp.’s IP related to PLDs and Programming Tools that existed before the R&D CSA (i.e., the existing IP). In exchange, Altera International paid royalties to Altera Corp. for each year from ’97 through 2003. As of Dec. 31, 2003, Altera International owned a “fully paid-up license” to use the existing IP rights in its territory.

Under the R&D CSA, Altera Corp. and Altera International agreed to pool their respective resources to conduct R&D using the existing IP. They agreed to share the risks and costs of R&D activities that they perform on or after May 23, ’97. The R&D CSA was in effect from May 23, ’97 through 2011 (and remains in effect as of the date of the Tax Court petition).

During its 2004-2007 tax years, Altera Corp. granted SBC to its employees, but Altera Corp. did not share the SBC costs with Altera International. On audit, IRS determined deficiencies based on Code Sec. 482 allocations it made pursuant to Reg. § 1.482-7(d)(2). The taxpayer and IRS filed cross-motions for partial summary judgment.

In July 2015, the Tax Court found in favor of Altera Corp., invalidating Reg. § 1.482-7(d)(2) (i.e., the 2003 final SBC reg). According to the Tax Court, “Treasury failed to respond to significant comments when it issued the [2003] final [SBC] rule, and Treasury’s conclusion that the [2003] final [SBC] rule is consistent with the arm’s-length standard is contrary to all of the evidence before it.” It characterized Treasury’s actions in this regard as “arbitrary and capricious decisionmaking.” (Altera Corporation and Subsidiaries, (2015) 145 TC No. 3145 TC No. 3) See Weekly Alert ¶  22  07/30/2015 for coverage of the earlierAlteracase.

RIA observation:The Tax Court’s decision inAlteramay still be subject to appeal. On an Ernst & Young webcast, David Varley, Acting Director in the IRS office of Transfer Pricing Operations (TPO), expressed personal disappointment with the decision. At the time, he indicated that it was too early for him to comment on behalf of the government with respect to appealing the decision.

The petition.In its petition dated December 18, Altera Corp. has petitioned for a redetermination of tax deficiencies for tax years 2010 and 2011, requesting adjustments to its taxable income by approximately $36 million due to invalid Code Sec. 482 SBC rules.

The petition states:

  • For tax years 2010 and 2011, Altera Corp. granted SBC to some of its employees, including certain U.S. employees who performed R&D activities subject to the R&D CSA;
  • Reg. § 1.482-7T(d)(1)(iii) and Reg. § 1.482-7T(d)(3) (i.e., the 2009 temporary CSA regs) and Reg. § 1.482-7(d)(1)(iii) and Reg. § 1.482-7(d)(3) (i.e., the 2011 final CSA regs), applicable to tax years 2010 and 2011, contain “materially the same” provision and flaws as the 2003 final SBC rule;
  • IRS’s allocations for tax years 2010 and 2011 are “arbitrary, capricious, and unreasonable” and represent an abuse of its discretion under Code Sec. 482; and
  • IRS also made computational errors in determining the amount of Altera Corp.’s tax deficiencies.

References:For qualified cost sharing arrangements, see FTC 2d/FIN ¶  D-1155  ; United States Tax Reporter ¶  4824.05  ; TaxDesk ¶  641,523  .