Press Room: Tax Release

July 30, 2015

Tax Court Holds the Sec. 482 Cost Sharing Regulations Requiring Allocation of Stock-based Compensation to Non-U.S. Entity Not Valid

The Tax Court, in Altera Corporation and Subsidiaries v. Commissioner (145 T.C. 3 (2015)), has held invalid the Sec. 482 cost-sharing regulations that require controlled entities entering into qualified cost-sharing agreements (QCSAs) to share stock-based compensation (SBC) costs. If employee stock-based compensation is included in cost-sharing payments, in most cases this would result in significant additional costs being allocated to the foreign low-taxed entity and generally reduce the after-tax benefit of its QCSA.

Background

Beginning in 1997, Altera, a U.S. company, entered into a QCSA with its affiliate in the Cayman Islands. During each of the company’s tax years 2004-07, it issued SBC to certain of its employees, most of whom were in the United States. In 2003 Treasury issued transfer pricing regulations (Reg. 1.482-7(d)(2)) (the 2003 Regulations) requiring participants to a QCSA to share SBC costs. Pursuant to the 2003 Regulations, Altera would be required to allocate a share of SBC costs to its Cayman affiliate.

Decision

By definition, the arm’s length standard in Sec. 482 represents the terms to which unrelated parties would agree. In challenging the validity of the 2003 Regulations, Altera presented economic analyses showing there is no evidence that the sharing of SBC is a practice routinely observed between unrelated parties. Accordingly, Altera claimed that in the absence of any contrary analysis and/or data, the 2003 Regulations do not by definition meet the arm’s length standard. In its opinion, the Tax Court affirmed Altera’s challenge because:

  1. The rule is not based on any industry/economic facts;
  2. Treasury did not support its position by reference to any relevant facts it developed;
  3. Treasury did not respond to significant comments before adopting the rule; and
  4. The rule is contrary to evidence provided to Treasury.

The takeaway

Taxpayers who have QCSAs in place should consider filing a claim for refund for tax years in which SBCs were allocated, particularly years for which the statute of limitations is closing. IRS will likely appeal the decision so it is probable the claims would not be acted on at least until that appeal is resolved or IRS determines further action.

This decision highlights an important issue in transfer pricing disputes. Taxpayers and practitioners have long observed that while the burden of proof rests squarely on their shoulders prior to an audit, IRS examiners have tended not to carry their burden of proof in challenging transfer pricing. For years taxpayers have complied with Treasury’s onerous transfer pricing documentation requirements, investing significant resources in the process. And yet, after having produced the analyses and documentation as required, many have found audit outcomes in which a substantial income adjustment is asserted by IRS with only limited analyses or facts referenced by IRS to support the adjustments.

The Altera decision demonstrates the importance of establishing transfer pricing positions based on the specific facts and circumstances that drive the business operations, and confirms its significance in overcoming an IRS challenge. 

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