In the case of Altera Corporation and Subsidiaries v. Commissioner, 145 TC No. 3 the issue before the Tax Court involved the question of whether the corporation in question had to include stock based compensation in its qualified cost sharing arrangement under IRC §482. An other item of interest is the Tax Court’s analysis of its view of the IRS’s ability to use its regulatory authority to override a position taken in a prior Court decision, with the Court finding the IRS failed to justify its revised regulation.

In Xilinx Inc. v. Commissioner, 125 T.C. 37 (2005), aff’d, 598 F.3d 1191 (9th Cir. 2010) the Tax Court held that under the 1995 version of the regulations under IRC §482 stock based compensation costs did not have to be included in qualified cost sharing arrangements (QCSA) under §482 because unrelated parties operating at an arm’s length would not consider such costs in setting the pricing between the parties.

IRC §482(a) provides in part:

In any case of two or more organizations, trades, or businesses...owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income,[2]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.

As the Tax Court points out, the IRS in Reg. §1.482-1 notes that this is to put the related entities in the same position as if unrelated parties had negotiated an arm’s length deal. [Reg. §1.482-1(a)(1), (b)(1)]

Noting issues with applying the arm’s length standard when there may be few actual transactions between unrelated parties in the area of intangibles, Congress amended IRC §482 in 1986, adding the following to the provision:

In the case of any 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.

The conference report provided that the IRS should undertake a comprehensive study in this area which the IRS published in Notice 88‑182. That study concluded the arm’s length standard was the international standard and that the commensurate with income standard should incorporate similar principles.

In Xilinx the Tax Court concluded that such stock based compensation would not be included in negotiations between unrelated taxpayers as a component of the pricing because it would be difficult to implement and taxpayers do not take this into account in determining pricing of items other than intangibles. Thus, the Court concluded that under the 1995 regulations that the cost should not be included.

In 2002 the IRS announced proposed regulations that would explicitly require the inclusion of stock-based compensation in QCSA under Reg. §1.482‑7(d)(1) and in 2003 adopted that as part of the final regulations.

So the question the Court sought to decide is whether this regulation is valid, or whether it represents an unreasonable interpretation of the law by the IRS—and the Court found for the latter.

The Court notes that comments to the proposed regulations had indicated that such costs are simply never included in arrangements—including, it turns out, arrangements the federal government enters into on cost-based contracts. In fact, federal acquisition regulations prohibit the use of such costs in an arrangement.

Against this the, the Court notes, the IRS did not have evidence of actual use of such costs in arm’s length arrangements.

When it issued the final rule, the files maintained by Treasury relating to the final rule did not contain any expert opinions, empirical data, or published or unpublished articles, papers, surveys, or reports supporting a determination that the amounts attributable to stock-based compensation must be included in the cost pool of QCSAs to achieve an arm's-length result. Those files also did not contain any record that Treasury searched any database that could have contained agreements between unrelated parties relating to joint undertakings or the provision of services. Additionally, Treasury was unaware of any written contract between unrelated parties, whether in a cost-sharing arrangement or otherwise, that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation; or any evidence of any actual transaction between unrelated parties, whether in a cost-sharing arrangement or otherwise, in which one party paid or reimbursed the other party for amounts attributable to stock-based compensation.

The Court notes that the Treasury never abandoned the arm’s-length standard in its reasoning supporting its position, so it must still be held to that standard in judging if the regulations are reasonable.

The Court found the IRS never cited evidence in its support for the regulation that the use of such costs was consistent with the arm’s-length standard. The government did not provide a reasoned basis why parties would actually consider such costs but simply asserted that would be the case. The IRS, the Court concluded, failed to connect the choice it made with the facts it found and failed to adequately respond to significant comments.

Thus the Court found the regulation was contrary to the evidence before the IRS in making this decision. Thus the Court found the regulation was invalid.