Altera deconstructed: a nuanced alteration in tax law; Tax Court's unanimous opinion deals with unusual regulatory situation.

• Author: Lerner, Matthew
• Position: TAX COURT

On July 27, the Tax Court issued a unanimous opinion (1) in Altera Corporation v. Commissioner, 145 T.C. No. 3 (2015), in which the court held that Treas. Reg. [section] 1.482-7(d)(2) is invalid. It is relatively rare for a court to invalidate Treasury regulations, and, for that reason alone, the decision is worthy of review. However, Altera arose in an unusual regulatory context, and interpreting that case as heralding a new era of judicial activism by the Tax Court is likely to lead to disappointment. The lessons from Altera are there, but they are more nuanced than a seismic shift in tax jurisprudence.

Altera Corporation is a Silicon Valley company that develops, manufactures, and markets programmable logic devices (e.g., integrated circuits). As is common in high-tech industries, Altera licensed to its foreign subsidiary, Altera International, the right to use and exploit, everywhere except within the United States and Canada, the pre-existing intellectual property for Altera's products. In exchange, Altera International agreed to pay a royalty.

In addition, Altera and Altera International entered into a cost-sharing agreement with respect to the development of future intellectual property, through which they agreed to share the cost of continuing research and development, including research using the licensed intangible property already in existence. Altera and Altera International computed all of the costs of research and development activities they performed after the date of the license and shared those costs in accordance with the reasonably anticipated benefits each would receive from exploiting the newly developed technology. Each could then exploit the new technology as it saw fit.

Capturing R&D Costs

One issue in evaluating cost-sharing agreements is whether the parties are properly capturing all of the costs attributable to the research and development activity in their cost pool. If, as is often the case, most or all of the research is conducted in the United States and the costs are understated, the payment from the foreign subsidiary to the U.S. parent will be less, resulting in lower taxable income in the United States. Altera's cost-sharing agreement included the salary cost of the personnel in the United States performing the research but not the value of stock-based compensation they received. Altera's position was that, in a cost-sharing arrangement between unrelated parties, stock-based compensation costs would not be part of the shared cost pool, so they should not be included in the computations for Altera International.

This issue had previously been decided in taxpayers' favor pursuant to prior regulations under Section 482. (2) However, for the years at issue in Altera, the Treasury Department had promulgated new Treas. Reg. [section] 1.482-7(d)(2), which requires participants in qualified cost-sharing arrangements to share stock-based compensation costs to achieve arm's-length results. In Altera, the parties cross-moved for summary judgment on the narrow legal issue of whether Treas. Reg. [section] 1.482-7(d)(2) is arbitrary and capricious and therefore invalid. In a relatively rare outcome, the Tax Court held that Treas. Reg. [section] 1.482-7(d)(2) is invalid.

The question on the minds of tax professionals is whether this decision has broader implications for judicial review of tax regulations. To answer that question, one should first consider the standards under which the validity of regulations is reviewed. After that, one should carefully analyze the unique considerations that led to the Tax Courts conclusion and determine how those considerations might be applied more broadly.

Interpreting Mayo

When the Supreme Court issued its decision in Mayo, (3) it settled an arguably open question as to the standard of review to which tax regulations are subject. Prior to Mayo, many tax practitioners believed that tax regulations were subject to a less-deferential standard of review than other agency actions, pursuant to the Supreme Court's decision in National Muffler. (4) However, Mayo held that formal Treasury rulemaking activity is subject to review under the deferential standard announced in Chevron. (5) Under Chevron, a court must first analyze whether a statute is ambiguous or has gaps that have been left for the agency to fill--whether Congress has directly addressed the question at issue. Where the...