The US Tax Court’s ruling in Altera Corp. (the “Taxpayer”) v. Commissioner (IRS), on July 2015 may alter some portion of the regulations in IRC Section 482. These regulations were amended in 2003 (the “Amended Rules”) to specifically include stock-based compensation (SBC) costs as part of the total costs related to intangible development activity. The court’s decision may cause the taxpayers involved in cost sharing arrangements to reevaluate whether to continue including SBC costs as part of the total costs under the “all cost rule regulations” in Section 482. The IRS appealed this decision in the Ninth Circuit Court of Appeals on February 19, 2016. The appeals court will determine whether the Amended Rules are consistent with the arm’s length standard as required under the regulations in Section 482. In a different case, Xilinx Inc. v. Commissioner, prior to passing the Amended Rules, the Ninth Circuit court ruled against the former version of the all cost rule that did not specifically mention SBC costs.

There were two additional important implications of the Altera Case for U.S. taxpayers:

  1. The IRS’s implementation of the arm’s-length standard.
  2. All Treasury regulations that are not based on “reasoned decision making” supported by evidence may be overturned.

The Ninth Court’s decision will have significant implications for all tax payers that participated in related-party cost sharing arrangements and will affect the ability of tax-payers to challenge the reasoning behind tax regulations.


IRC Section 482:
The prices charged between division of a business (mostly multinational or related entities) for products and/or services exchanged (controlled transactions) can have a large impact on the ultimate tax bill of a business and overall corporate-wide profitability. This is primarily due to varying tax rates among different tax jurisdictions in which the company’s divisions conduct business. Therefore, businesses must obtain or prepare analysis of the prices of intercompany transfers, to minimize a firm’s tax liability and receive the approval of tax authorities.

The purpose of IRC section 482 is to ensure taxpayers clearly reflect income attributable to controlled transactions and to prevent avoidance of taxes as a result of such transactions. Section 482 of the Internal Revenue Code of 1986 (as amended) provides that the IRS has the power to make allocations to clearly reflect the income of organizations, trades or businesses. It also provides that the income received through transfer or license of intangible property should be arms-length and consistent with the income attributable to the intangible.

Transactions between controlled taxpayers may involve loans or advances, services, sale or leases of tangible property, sale or lease of intangible properties, or Cost Sharing Arrangements.

Cost-Sharing Arrangements:
Divisions of a business (e.g. a U.S.-based parent division “Parent”) and a foreign-based subsidiary division (“Subsidiary”) that want to develop intangible property jointly may enter into Cost-Sharing Arrangements to share the costs proportionally relating to the development of intangible property based on their anticipated share of the benefits to be derived from that property. Cost-sharing arrangements have been popular among U.S. software developers, high-tech companies and biotech companies with affiliated entities abroad.

The entities that are developing intellectual property such as patents may adopt one of the two strategies; (1) enter into a Cost Sharing Arrangement with the Subsidiary in a different tax jurisdiction to develop the intellectual property, or (2) either the Parent or Subsidiary develop the intellectual property unilaterally and then license it to the other to collect royalty payments for the licensed intellectual property.

If the Parent operates in a higher tax jurisdiction than does the Subsidiary, and the cost of developing the patent is less than the market-based royalty payments, the firm would chose the first option to reduce its worldwide tax liability by implementing a cost-sharing agreement instead of adopting royalty-based transfer prices.

BACKGROUND of Altera Corp. v. Commissioner (IRS), 145 T.C. No. 3 (2015)

Altera Corp., the taxpayer (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. (the Parent Company incorporated in the U.S.) and Altera International (a subsidiary corporation incorporated in the Cayman Islands) entered into a technology license agreement and a technology research and development cost-sharing agreement (R&D cost sharing agreement), on May 23, 1997. This agreement met the requirements of a QCSA under the 2003 cost sharing regulations.

Under the technology license agreement, Altera U.S. licensed to Altera International, the right to use and exploit, everywhere except the United States and Canada, 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. Certain 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 during Altera’s 2004-07 tax years and these SBCs were not included in the R&D cost sharing pool under the QCSA. As a result of this, the IRS sent Altera notices of deficiency for those tax years under the all costs rule requiring that such SBC be included in the joint cost pool for the QCSA.

The following are the cost-sharing payment adjustment made by IRS:

Year Amount
2004 $ 24,549,315
2005 $ 23,015,453
2006 $ 17,365,388
2007 $ 15,456,565

Tax Court Decision:
Altera challenged the adjustments and contested the validity of the all costs rule. One of the arguments of Altera was that the IRS had violated the Administrative Procedure Act (APA) in adopting the all costs rule. The Tax Court agreed with Altera unanimously on July 27, 2015, and concluded that the regulation was invalid because the IRS and Treasury had failed to satisfy the requirements of the APA. Specifically,

  1. No fact finding process performed: when the IRS and the Treasury issued the final rule, the files they maintained did not contain any expert opinions, empirical data, published or unpublished articles, papers, surveys, or reports supporting a determination that the amounts attributable to SBC costs must be included in the cost pool of the QCSA to achieve an arm’s length result.
  2. Lack of Evidence from Uncontrolled Transactions: when the IRS and the Treasury issued the final rule, they were not aware of any written contracts between unrelated parties, whether in a cost sharing arrangement or not, that required one party to pay or reimburse the other for amounts attributable to SBC costs.
  3. No sufficient rebuttal: the Tax Court found that the IRS’ response to Altera’s comments of inconsistency in the application of the arm’s length standard with respect to inclusion of SBC costs in the total cost pool of the QCSA.

The ruling in the Altera case is generally regarded as a win for the taxpayer. In light of the Altera decision, U.S. corporations that have been following the final regulation requiring the allocation of SBC in cost sharing arrangements, may want to think about removing these costs going forward and filing protective amended returns for prior years to preserve their ability to claim refunds.

There were two additional important implications of the Altera Case for U.S. taxpayers:

  1. The IRS’s implementation of the arm’s-length standard under Section 482 must be supported by the transaction data between unrelated parties; also an important transfer pricing principal.
  2. Administrative Procedure Act (APA) is the U.S. federal statute that governs the way in which administrative agencies of the Federal Government of the United States may propose and establish regulations. By this principle, all Treasury regulations are subject to the APA requirements. The APA also sets up a process by which United States Federal courts can directly administer a review of agency decisions. In the Altera case, the Tax Court held that all Treasury regulations that are not based on “reasoned decision making” supported by evidence may be overturned. This holding has far reaching implications for the tax regulations, as it opens the gates in the future for taxpayers to challenge the rationality of tax regulations.