Make a Lovely Sight?

No, not if you remember The Crests’ 1959 hit; that was about candles. Maybe, if you’re Altera Corporation and Subsidiaries, rejoicing in your win over Treas. Reg. 1.482-7(d)(2), in 145 T. C. 3, filed 7/27/15, with ten (count ‘em, ten) lawyers on your side and six (6) for IRS.

The kerfuffle is about whether SBCs have to be included in QCSAs. If you’re partial to offshore Base Erosion and Profit Shifting, this is your cup of Lapsang Souchong.

Altera made a license deal with its Cayman Islands (surprise, surprise) sub, giving the sub  “the right to use and exploit, everywhere except the United States and Canada, all of Altera U.S.’s intangible property relating to [programmable logic devices] and programming tools that existed before the R&D cost-sharing agreement (pre-cost-sharing intangible property). In exchange for the rights granted under the technology license agreement, Altera International paid royalties to Altera U.S. in each year from 1997 through 2003. As of December 31, 2003, Altera International owned a fully paid-up license to use the pre-cost-sharing intangible property in its territory.

“Under the R&D cost-sharing agreement, Altera U.S. and Altera International agreed to pool their respective resources to conduct research and development using the pre-cost-sharing intangible property. Under the R&D cost-sharing agreement, Altera U.S. and Altera International agreed to share the risks and costs of research and development activities they performed on or after May 23, 1997. The R&D cost-sharing agreement was in effect from May 23, 1997, through 2007.” 145 T. C. 3, at pp. 5-6.

Of course the Cayman Islands are chock-a-block with programmers and software developers. Roger that, as I said in an earlier incarnation.

Also of course, “In Xilinx Inc. v. Commissioner, 125 T.C. 37 (2005), aff’d, 598 F.3d 1191 (9th Cir. 2010), we held that, under the 1995 cost-sharing regulations, controlled entities entering into qualified cost-sharing agreements (QCSAs) need not share stock-based compensation (SBC) costs because parties operating at arm’s length would not do so. In 2003 Treasury issued sec. 1.482-7(d)(2), Income Tax Regs. (final rule). The final rule requires controlled parties entering into QCSAs to share SBC costs.” 145 T. C. 3, at p. 1.

And, per the reg, it doesn’t matter if there are no comparables, let it all hang out.

So we have a Chevron (or maybe State Farm, Motor Vehicle Mfrs. Ass’n of the U.S. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983)) faceoff. Was Treasury arbitrary and capricious or in manifest disregard of the law by requiring stock-based compensation to be included in Qualified Cost-Sharing Agreements?

Judge Marvel says yes.

There are no arms’-length comparables for stock-based compensation in cost-sharing deals among unrelateds. Testimony during the comment period preceding the final reg featured all the white-shoe and big-four players, who uniformly agreed that stock-based compensation was too speculative to value at inception, was subject to variables beyond the control of the parties to the cost-sharing agreement, could be uncontrollably large, and besides, you could look at EDGAR and see nobody did it, and so an arms’-length comparable didn’t exist.

And courts can’t substitute their own judgment for the agency’s, and can’t go beyond what the agency said. All a court can do is consider the factors the agency articulated (sound like Chenery to you? It’s actually State Farm), and if any meets the test (and would have been followed even if the agency articulated defective reasons), the reg must be sustained.

And we all remember the Chevron two-part test. But mox nix.

“Because the validity of the final rule turns on whether Treasury reasonably concluded that it is consistent with the arm’s-length standard, the final rule must–in any event–satisfy State Farm’s reasoned decision-making standard. Accordingly, we will examine whether the final rule satisfies that standard without deciding whether Chevron or State Farm provides the ultimate standard of review.” 145 T. C. 3, at p. 48.

In any case, this is legislative regulating and has the force of law. And any Treasury booboos aren’t harmless error.

Judge Marvel nails Treasury and the reg thus: “Because the final rule lacks a basis in fact, Treasury failed to rationally connect the choice it made with the facts found, Treasury failed to respond to significant comments when it issued the final rule, and Treasury’s conclusion that the final rule is consistent with the arm’s-length standard is contrary to all of the evidence before it, we conclude that the final rule fails to satisfy State Farm’s reasoned decisionmaking standard and therefore is invalid.” 145 T. C. 3, at p. 69.

Bad day at 1111 Constitution Ave, NW.