Tax Court Overturns IRS Cost-Sharing Regulation

The U.S. Tax Court recently issued a surprising decision that invalidated the part of an IRS cost-sharing regulation – under code section 482 – which states that taxpayers are required to take the costs of stock-based compensation into account.

The decision regarding the cost-sharing regulation supports taxpayer criticism that questioned the regulatory requirement that cost-based transfer pricing must include the cost of stock-based compensation.

The case

In Altera Corporation v. Commissioner, the Tax Court held that section 482 is invalid. Therefore, taxpayers who are parties to cost-sharing arrangements with foreign affiliates can continue to share costs associated with research and development without allocating stock based compensation in the manner required by the regulation and the Service.

The IRS argued that Altera should not have been able to object that the regulations are inconsistent with the “arm’s length standard” as they are part of an “elective” regulatory regime for cost-sharing. However, the Court struck down this argument to recharacterize relevant provisions as “elective” by explaining that the IRS rejected taxpayers’ suggestions in the regulatory process to make this provision a true safe harbor. The Court noted that Treasury failed to make a connection between the choice it made in drafting the regulation and the facts it found.  Thus, the decision to adopt this regulation was held to be arbitrary and capricious.

The significance of the decision

The Tax Court’s decision is significant beyond cost-sharing and stock-based compensation costs because the IRS can no longer issue a valid transfer pricing regulation under the “arm’s length standard.” With this standard, the IRS previously attempted to interpret how related parties “should behave” in the absence of evidence that unrelated parties behave in that fashion. Therefore, despite the fact that the “arm’s length standard” does not appear in section 482, previous decisions upheld that the regulation incorporated this standard. However with this decision, the IRS’ ability to reallocate among affiliates is significantly limited.

The decision is also important because the Court took a novel approach in its review of the cost-sharing regulation. Therefore, if the decision is upheld, it could lead to more successful challenges from taxpayers to IRS regulations.

Takeaway

Taxpayers will have choices going forward if the IRS does not agree to comply with the decision and eliminate stock-based compensation stipulations under section 482. These taxpayers who take advantage of the costs of stock-based compensation in the contexts of cost-sharing and transfer pricing will have the option to continue to rely on the regulation. For instance, if a foreign company with significant stock-based compensation costs provides services or goods to an affiliate in the U.S., that entity can continue to rely on the regulations. However, taxpayers who do not benefit from cost-sharing and transfer pricing are now eligible to do so under the existing regulation.