By Reuven Avi-Yonah (Irwin I. Cohn Professor of Law, University of Michigan)
On July 24, 2018, the Ninth Circuit Court of Appeals reversed the US Tax Court decision in Altera Corp. v. Commissioner, 145 T.C. 91 (July 27, 2015), which had invalidated Treas. Reg. § 1.482- 7A(d)(2).
The regulation requires taxpayer to include the cost of employee stock options in the pool of costs that must be shared under a qualified cost sharing arrangement. The Ninth Circuit held that this regulation was not arbitrary or capricious, and therefore, that the Commissioner did not exceed the authority delegated to him under IRC § 482, that the Commissioner’s rule-making authority complied with the Administrative Procedure Act (APA), and that, therefore, the regulation is entitled to deference under Chevron, USA., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
In reaching this conclusion, the majority held that the regulation was not incompatible with the arm’s length standard as modified by the “commensurate with income” rule adopted by Congress in 1986.
The main issue in Altera
The principal issue in Altera was the purported incompatibility of the cost sharing regulation with the arm’s length standard. In Xilinx v. Comm’r (598 F.3d 1191, 1193–94 (9th Cir. 2010)), the Ninth Circuit held that a previous version of the cost sharing regulation did not require sharing the cost of stock option because Treasury had not indicated that it was modifying the arm’s length standard and that requiring related parties to include the cost of stock options under a qualified cost sharing arrangement was incompatible with the arm’s length standard since unrelated parties would not have agreed to share such costs.
In response, Treasury adopted the version of the regulation challenged in Altera, which expressly classified employee stock compensation as a cost to be allocated between qualified cost sharing arrangement participants. In addition, the “coordinating” amendments clarified Treasury’s understanding that the cost- sharing regulations, including § 1.482-7A(d)(2), operate to produce an arm’s length result. The former rule was challenged by Altera and invalidated by the Tax Court.
The incompatibility between the regulation and the arm’s length standard
The Ninth Circuit could have reversed the Tax Court just on its finding that the process by which the regulation was adopted violated the APA. The Tax Court based its holding on the fact that all the comments received by Treasury on the proposed regulation were adverse to it. However, as the Ninth Circuit stated, “Treasury’s refusal to credit oppositional comments is not fatal to a holding that it complied with the APA. Treasury gave sufficient notice of what it intended to do and why; it considered the comments, but it rejected them.” This holding is important because otherwise Treasury would never be able to issue regulations adverse to the interests of taxpayers with millions of dollars at stake, because only they can be relied upon to comment on the regulation.
However, the Ninth Circuit went further to discuss the alleged incompatibility between the challenged regulation and the arm’s length standard. Here, the key observation is:
The arm’s length standard is results-oriented, meaning that its goal is parity in taxable income rather than parity in the method of allocation itself. 26 C.F.R. § 1.482- 1(b)(1) … A traditional arm’s length analysis looks to comparable transactions among non- related parties to achieve an arm’s length result.
In the case of cost options, it is clear that no comparables can be found, because unrelated parties are fundamentally different than related parties. Unrelated parties would not agree to share the cost of stock options because the value of the option will depend on the performance of the stock of an entity they do not control, but that is not true for related parties where the performance of the stock depends on both parties.
As the Altera panel found, until 1986 the ALS required strict comparability. However, no comparables could be found in many cases, and therefore Congress added the commensurate with income language to section 482, which requires the results under the arm’s length standard to be “commensurate with” the true economic income of the parties regardless of whether comparables can be found.
Where there are no comparables, any result is compatible with the ALS, because by definition it cannot be proven that unrelated parties would have reached a different result.
This is why the Altera panel correctly held that the regulation was perfectly compatible with section 482 as amended in 1986. The amendment modified the traditional (comparables-based) arm’s length standard to require results that are commensurate with income where comparables cannot be found, and Treasury did not act arbitrarily or capriciously in following this Congressional mandate.
This decision has potentially broad implications, because its logic suggests that in the absence of comparables, any reasonable method (including formulary apportionment) is compatible with the arm’s length standard. Thus, as I have argued elsewhere, formulas can and should be used to allocate the residual profit under the profit split method, because residuals only arise where no comparables exist.
 Altera Corp. v. Commissioner, 145 T.C. 91 (2015), rev’d, — F.3d – (9th Cir. 2018), http://cdn.ca9.uscourts.gov/datastore/opinions/2018/07/24/16-70496.pdf
 Compensatory Stock Options Under Section 482 (Proposed), 67 Fed. Reg. at 48,998; Treas. Reg. § 1.482-7A(d)(2)
 Compensatory Stock Options Under Section 482 (Proposed), 67 Fed. Reg. at 49,000; Treas. Reg. § 1.482-7A(a)(3)
 Altera, 32
 Altera, 7 (emphasis added)
 See Avi-Yonah, The Rise and Fall of Arm’s Length: A Study in the Evolution of U.S. International Taxation, 15 Virginia Tax Rev. 89 (1995), cited in Altera
 Avi-Yonah, Between Formulary Apportionment and the OECD Guidelines: A Proposal for Reconciliation, 2 World Tax J. 3 (2010)