On July 14,2018, the Ninth Circuit Court in the United States overturned a 2015 Tax Court decision in Altera vs Commissioner of Internal Revenue by a count of 2-1. This decision reversed a judgement in a case that involved both the 2003 Cost Sharing Regulations along with the commensurate-with-income (“CWI”) standard introduced in 1986. The ruling serves as a rare victory for the IRS and reinforces both the CWI standard and the notion that stock option expenses should be included in cost sharing pools.
In the original Tax Court finding, the court has ruled that the IRS had not complied with certain aspects of the Administrative Procedures Act (“APA”), a long-standing US statute that governs how government agencies such as the US Treasury propose and establish regulations. The lower court had found that the Treasury had failed to adhere to certain components of the APA with respect to the 2003 Cost Sharing Regulations, thus rendering certain aspects of them invalid. The Ninth Circuit decision stated that the Commissioner “complied with the APA” and thus the 2003 Cost Sharing Regulations were valid for the IRS to enforce.
The Altera decision has ramifications in addressing three main questions:
- Should related parties engaged in cost sharing arrangements (“CSAs”) share the costs associated with stock options, which are commonly used to compensate individuals engaged in R&D work used to create intangible value?
- Is the CWI standard a valid approach for intangibles with no comparables?
- Were the 2003 Cost Sharing Regulations invalid as they were “arbitrary and capricious”?
It is very common for multinational enterprises to use CSAs in cases where intellectual property is being developed. Often, multiple related parties both develop and exploit an intellectual property, commonly splitting the geographic territory rights for the intangible asset being developed. As part of the 2003 Cost Sharing Regulations, a requirement was made to include cost related to stock options in the allocable pool of expenses to be shared by the CSA parties. Given many of the persons involved in developing an intangible asset might receive some form of compensation (sometimes substantial) through stock options in the parent company, the dollar value of stock option costs is often not insubstantial. The sharing of costs is consistent with the CWI standard, since, in theory, each CSA participant should offset its revenues from exploiting an intellectual property with all associated costs, on a proportionate basis. Otherwise, US companies could deduct all stock options expenses on their income statements while non-US affiliates (often in jurisdictions with lower corporate tax rates) could exploit the technology without similar deductions.
The CWI standards were introduced in 2006 to address this potential iniquity. The standard also serves to promote less reliance on comparables in situations where they are hard to find such as with emerging technologies. In the past, many US taxpayers had used existing transfer pricing rules to shift technology at an undervalued price that resulted in potentially substantial profits outside of the US. While substantial profits are still possible under the CWI standard, they require stock option expense costs to be shared amongst the participants. This has the effect of increasing the taxable income of US corporate participants.
The term “arbitrary and capricious” is commonly used in US law and refers to a decision made by a court that is not fully supported by the facts at hand. In such cases, a higher court can overturn the decision on this basis. Tax regulations (such as the Internal Revenue Code and its related Regulations) can also be found to be arbitrary and capricious where they are found in a court case to have been written without sufficient logic and support. In the original Altera Tax Court decision, the CWI and the 2003 Cost Sharing Regulations were invalidated on these grounds. The recent Ninth Circuit judgement, however, reverses this decision, and once again validates the concepts of the CWI standard along with including stock option expenses in its cost pools.
What are the next possible steps? Most likely, the taxpayer is expected to request an en banc review. Such a review involves all the judges of the Ninth Circuit to attend a hearing. Such review requests must be of important matters and are not necessarily automatically heard. However, it is not inconceivable given some of the issues wrestled with in this case that such a review might be undertaken. The matter is further muddied by the death of Judge Reinhardt (one of the approving voices) two months before the decision was publicly released.
Until an en banc review is granted, or the case goes to the US Supreme Court, Altera will serve as a rare victory for the IRS.