Altera: Around and Around We Go!
On June 7, 2019, the U.S. Court of Appeals for the Ninth Circuit again reversed the 2015 decision of the Tax Court (Altera Corp v. Commissioner) following deliberation of a reconstituted panel.
Background
In our article, “U.S. Tax Alert: Big Victory for the IRS… Not So Fast,” we recommended that companies carry on with “business as usual” following the withdrawal of the July 24, 2018 decision by the Ninth Circuit in Altera Corp. v. Commissioner, as it would certainly not be the last to be heard from this case. The Ninth Circuit originally ruled in favor of the IRS and issued a decision requiring related parties in a qualified cost-share arrangement (“QCSA”) to share stock-based compensation (“SBC”) costs.
Following the death of Judge Stephen R. Reinhardt, a member of the three-judge panel in the Ninth Circuit adjudicating the appeal, the Ninth Circuit withdrew the July 24, 2018 decision to allow time for a reconstituted panel to confer. Fast forward one year, and the reconstituted panel of the Ninth Circuit, now including Judge Reinhardt’s replacement: Judge Susan P. Graber, has again ruled in favor of the IRS.
New Panel, Same Result
Judge Graber, who essentially became the swing vote on the issue, ruled in favor of the IRS and in agreement with the July 24 decision. At the time of the withdrawal of the decision, many believed that Judge Graber would perhaps side with Altera, but it did not turn out that way.
Altera’s argument was that unrelated parties do not share SBC costs, and therefore, requiring related parties to share SBC costs would not be consistent with the ‘arm’s length’ principal. While the Ninth Circuit agreed that the arm’s length standard must be followed, the disagreements stemmed from the different available methodologies that can be used to meet the standard. The Ninth Circuit held that the regulation requiring SBC costs to be shared did not require the use of comparable transactions to evaluate if the arm’s length standard is being followed, and instead the costs may be allocated based on the proportion of income of each related party, otherwise known as being “commensurate-with-income.” In discussing the opinion, Chief Judge Sydney R. Thomas stated that “although Altera suggests there can only be one understanding of the methodology required by the arm’s length standard, historically the definition of the arm’s length standard has been more fluid. Indeed, as we have discussed, for most of the twentieth century the arm’s length standard explicitly permitted the use of flexible methodology in order to achieve an arm’s length result.”[1]
This decision will have a significant impact on companies currently in a QCSA or considering entering one to achieve certain tax benefits, as SBC costs will now be required to be allocated to foreign affiliates and no longer fully deductible against taxable income in the U.S.
Next Steps
As expected in this long saga, Altera filed a petition on July 22 seeking an en banc rehearing of the case before a full panel of judges from the Ninth Circuit. It remains to be seen whether the request is granted, but it seems clear that Altera intends to continue fighting this issue.
A&M Taxand Take
With Altera’s request for rehearing now lodged, the final verdict is yet to be rendered. As such, companies should continue to monitor any updates that may arise. However, with this most recent decision in mind, companies not already including SBC costs should quickly analyze the impacts to their income statements of doing so and begin the process of refining their QCSA allocations. As of today, the law of the land is that these costs must be allocated to their foreign affiliates. The IRS, Altera and many other industry participants all have a lot riding on the outcome of this case, with potentially billions of tax dollars at stake. So do not be surprised if we see further challenges in the future, perhaps even all the way to the Supreme Court.
