In Altera Corp. v. Commissioner, 145 T.C. No. 3 (2015), the Tax Court struck down 2003 Treasury Regulations (T.D. 9088) (the “2003 Regulations”) requiring that taxpayers include stock-based compensation costs in the expenses of qualified cost-sharing arrangements. 


The 2003 Regulations
In 2002, Treasury issued a notice of proposed rulemaking and a notice of public hearing relating   to proposed amendments to the 1995 Regulations. In response, a number of organizations submitted comments informing Treasury that in arm’s-length transactions between unrelated parties the parties do not pay or reimburse each other for amounts attributable to stock-based compensation. Commentators stated that they knew of no transactions between unrelated parties that required one party to pay or reimburse another for amounts related to stock-based compensation. In addition, certain commentators conducted searches of the EDGAR system and found no cost-sharing agreements between unrelated parties in which the parties agreed to share either the exercise spread or grant date of stock-based compensation. Commentators also identified multiple arm’s-length agreements in which the parties did not share stock-based compensation. Finally, commentators explained that from an economic perspective unrelated parties would not agree to share costs of stock-based compensation because the value of stock-based compensation is speculative, potentially large, and is outside the control of the parties. However, despite the commentary provided to Treasury, the 2003 Regulations explicitly required parties to qualified cost-sharing agreements to share stock-based compensation costs.

Previously, in Xilinx, Inc. v. Commissioner, 598 F.3d 1191 (9th Cir. 2010), the Ninth Circuit, affirming the Tax Court’s decision, ruled against the Service’s interpretation of the 1995 cost-sharing Treasury Regulations (the “1995 Regulations”). The Service argued that under the 1995 cost-sharing Treasury Regulations, which did not specifically address stock-based compensation, taxpayers must include stock-based compensation costs in the pool of costs shared in a qualified cost-sharing agreement. However, the Ninth Circuit rejected the Service’s argument and held that stock-based compensation does not need to be included in the pool of costs. The Ninth Circuit reasoned that unrelated parties operating at arm’s length do not share such costs, and therefore the Service’s attempt to allocate such costs is contrary to the dominant purpose of the statute, which is parity between taxpayers in uncontrolled transactions and controlled transactions.

Tax Court’s Ruling in Altera
Altera Corp. and its Cayman Island subsidiary, Altera International, entered into a research and development cost-sharing agreement. Altera Corp. paid stock-based compensation to certain employees, but such stock-based compensation was not included in the cost pool under the cost-sharing agreement. The Service asserted that the failure to include the costs relating to stock-based compensation violated the 2003 Regulations. Altera Corp. challenged the validity of 2003 Regulations.

Standard of Review
The Tax Court first addressed the standard of review, concluding that the 2003 Regulations are legislative rules, and therefore the notice and comment requirements of Section 553 of the Administrative Procedure Act (“APA”). The Tax Court also concluded that the 2003 Regulations must satisfy the reasoned decisionmaking standard set forth in Motor Vehicles Manufacturers Ass’n v. State Farm Mutual Automobile Insurance Co., 463 U.S. 29 (1983) (“State Farm”).

Validity of the 2003 Regulations
The Tax Court’s analysis focused on whether Treasury, through empirical analysis, had reasonably determined that the 2003 Regulations were consistent with the arm’s length standard. The preamble to the 2003 Regulations indicates that Treasury relied on its belief that related parties entering into cost-sharing agreements to develop “high profit intangibles” would share stock-based compensation costs if such costs were a “significant element” of the compensation. Yet the requirement under the 2003 Regulations that taxpayers share stock-based compensation costs applies whether or not such agreements relate to developing “high profit intangibles” or whether such costs are a “significant element” of the compensation. Treasury defended this rule by arguing that it eased administrative burdens. However, the Tax Court rejected this argument because Treasury failed to provide any explanation of its decision in the preamble. Further, Treasury did not disclose its factual findings on the matter, so the Tax Court would not be able to evaluate whether Treasury’s conclusion was reasonable.

In addition, the Tax Court stated that Treasury failed to respond to significant comments submitted by commenters in connection with the 2002 notice of proposed rulemaking. The Tax Court noted, “[a]lthough Treasury’s failure to respond to an isolated comment or two would probably not be fatal to the final rule, Treasury’s failure to meaningfully respond to numerous relevant and significant comments certainly is.” The Tax Court also concluded that the 2003 Regulations relating to stock-based compensation are contrary to the evidence before Treasury when it issued the 2003 Regulations, based on Treasury’s failure to cite any evidence supporting its belief that unrelated parties to qualified cost-sharing agreements would share stock-based compensation costs and Treasury’s failure to respond to significant evidence submitted by commentators showing that unrelated parties would not share such costs and providing economic analysis explaining why unrelated parties would be unwilling to share such costs.

The Tax Court ruled in favor of Altera Corp., concluding that the stock-based compensation rules in the 2003 Regulations failed to satisfy State Farm’s reasoned decisionmaking standard for the following reasons : (1) Treasury failed to connect the choices it made in the 2003 Regulations with the facts found because the stock-based compensation rules issued by Treasury lacked any basis in fact, (2) Treasury failed to respond to significant comments when it issued the stock-based compensation rules and (3) Treasury’s conclusion that the stock-based compensation rules are consistent with the arm’s length standard is contrary to all evidence before it.  Accordingly, the Tax Court declared that the stock-based compensation rules in the 2003 Regulations are invalid.