Appeals court says key cost sharing regulation is valid
On July 24, the U.S. Ninth Circuit court of appeals overturned the U.S. Tax Court’s unanimous 2015 decision in Altera v. Commissioner, holding that the IRS did not violate the rulemaking procedures required by the Administrative Procedures Act (APA). In Altera, the taxpayer challenged IRS regulations that required participants in qualified cost sharing arrangements (QCSAs) to share stock based compensation (SBC) costs. The Tax Court had invalidated those regulations, in part because the Treasury Department failed to adequately consider significant taxpayer comments when adopting them. The Ninth Court decision reverses the Tax Court’s decision on this issue, holding that the Treasury’s rule was not arbitrary and capricious because Treasury provided a sufficient basis for its decision making. Many taxpayers have taken positions for financial accounting purposes and in protective tax returns claiming a benefit under the decision of the Tax Court. These taxpayers should immediately evaluate the impact of this appellate decision because it is unlikely the Supreme Court will entertain an appeal of this decision even if the taxpayer chooses to file a petition. Taxpayers should evaluate whether to adjust their ASC 740 reserves and whether this decision will impact Q3 tax provisions as a potential change in law.
In Altera, the IRS argued the taxpayer’s failure to include SBC in the cost pool allocated to its Cayman Island subsidiary under the company’s QCSA reduced its U.S. income. Treasury regulations issued in 2003 required controlled parties to share such SBC costs under QCSAs, but Altera argued that those regulations were arbitrary and capricious and, therefore, invalid.
The Tax Court ruled in favor of Altera and concluded that in issuing the regulations, the Treasury Department:
- Failed to rationally connect the choice it made with the facts found
- Failed to respond to significant comments when it issued the final rule
- Failed to recognize that its conclusion that the final rule is consistent with the arm's-length standard is contrary to all of the evidence before it
Ultimately, the Tax Court concluded that the final Treasury rule failed to satisfy the reasoned decision making standard established under relevant Supreme Court precedent, and therefore, was invalid. The Ninth Circuit’s decision is significant because it reverses this decision, validating the IRS’ approach to complying with its rulemaking obligations under the APA.
The Ninth Circuit’s ruling will impact taxpayers with QCSAs based on the 2003 regulations as well as many cases before the Tax Court, which invoke similar fact patterns as Altera, such as 3M v. Commissioner. Taxpayers should thoroughly consider the impact of the Altera case on their situations, especially taxpayers involved in cost sharing arrangements.