Government's Appeal Takes Aim at Tax Court Analysis in Altera

On January 23, 2012, the IRS issued a notice of deficiency to the Altera consolidated group with respect to its 2005, 2006, and 2007 tax years. (ER105.) On April 20, 2012, within 90 days after the date of that notice, the group timely filed a petition for redetermination in the Tax Court (Tax Court docket no. 9963-12). (ER230.) The Tax Court had jurisdiction under I.R.C. § 6213(a). See I.R.C. § 7442.

The Tax Court entered a decision in docket no. 6253-12 on December 1, 2015, and it entered a decision in docket no. 9963-12 on December 28, 2015. (ER1-7.) Those decisions constitute final judgments, disposing of all claims of all parties. See I.R.C. § 7459(a). On February 19, 2016, within 90 days after entry of each decision, the Commissioner timely filed notices of appeal with the Tax Court. (ER79-88.) See I.R.C. § 7483. This Court has jurisdiction under I.R.C. § 7482(a)(1).

One of those amendments clarified that the existing definition of "costs" that related entities must share under a qualified cost-sharing arrangement (QCSA) -- a definition that clearly encompassed compensation expense -- includes stock-based compensation costs (e.g., costs associated with compensatory stock options). See Treas. Reg. § 1.482-7(d)(2) (2003). Other amendments clarified that the existing rule requiring QCSA participants to share the defined set of costs in proportion to their reasonably anticipated benefits from the arrangement must be satisfied in order for the QCSA to produce an arm's-length result, the attainment of which limits the IRS's authority to reallocate the resulting deductions among the related entities pursuant to I.R.C. § 482. See Treas. Reg. §§ 1.482-1(b)(2)(i) (2003) (second sentence), 1.482-7(a)(3) (2003).²

B. Statutory and regulatory framework

The resulting regulations -- proposed in 1965 and finalized in 1968 -- provided rules specific to several types of transactions, including those involving the transfer or use of intangible property. See Treas. Reg. § 1.482-2(d) (1968). The intangibles regulation contained a special rule applicable to "bona fide cost sharing arrangements," defined as "an agreement . . . between two or more members of a group of controlled entities providing for the sharing of the costs and risks of developing intangible property in return for a specified interest in the intangible property that may be produced." Treas. Reg. § 1.482-2(d)(4) (1968). Under that rule, the IRS would "not make allocations with respect to such [an arrangement] except as may be appropriate to reflect each participant's arm's length share of the cost and risks of developing the property." Id. The rule further provided:

The corresponding Conference Report specifically refers to cost-sharing arrangements as "an appropriate method of allocating income attributable to intangibles among related parties, if and to the extent such agreements are consistent with the purposes of this provision that the income allocated among the parties reasonably reflect the actual economic activity undertaken by each." H.R. Conf. Rep. No. 99-841, at 11-638 (1986) (the "1986 Conference Report"). That report further provides that participants in such cost-sharing arrangements would be expected to share "all research and development costs" in proportion to their shares of expected profits from the intangible property. Id. Finally, the report expresses "[t]he conferees ['] belie[f] that a comprehensive study of intercompany pricing rules by the Internal Revenue Service should be conducted and that careful consideration should be given to whether the existing regulations could be modified in any respect." Id.

Treasury and the IRS issued the requested transfer-pricing study -- over 100 single-spaced pages, not counting appendices³ -- in October 1988. See Notice 88-123, 1988-2 C.B. 458 (the "White Paper"). "At the conceptual heart of the White Paper was an extended discussion of economic arguments, to which the 1986 Act's legislative history had alluded," regarding the dominance of the integrated business operation in the emerging global economy,⁴ the resulting decrease in nonintegrated businesses "that might serve as the source of comparables within the relevant industry," and the implications for "the traditional conception of the arm's length standard." Michael C. Durst & Robert E. Culbertson, Clearing Away the Sand: Retrospective Methods and Prospective Documentation in Transfer Pricing Today, 57 Tax L. Rev. 37, 66, 68 (Fall 2003); see Notice 88-123, 1988-2 C.B. at 482, 484, 485 (referring to the "traditional arm's length approach" and an "alternative application of the arm's length approach" that "does not directly rely upon comparable transactions"). Treasury reiterated, however, that it "continue[d] to adhere to th[e] view" that, in enacting the commensurate-with-income requirement, "Congress intended no departure from the arm's length standard" itself, which is "embodied in all U.S. tax treaties." 1988-2 C.B. at 475.⁵

At about the same time that Treasury and the IRS issued the White Paper, Congress enacted the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, 102 Stat. 3342 ("TAMRA"). As part of that legislation, Congress identified several provisions of the 1986 Act with respect to which "a harmonious reading of the [provision] and U.S. tax treaties is not possible." H.R. Rep. No. 100-795, at 303 (1988); S. Rep. No. 100-445, at 320 (1988); see TAMRA § 1012(a)(a)(2), (3), 102 Stat, at 3531 (providing in most instances that the treaty obligation would prevail to the extent it was inconsistent with the 1986 Act provision). The commensurate-with-income requirement was not among the listed provisions. Moreover, in their respective committee reports, the House Ways and Means and Senate Finance Committees listed several specific instances in which "the committee does not believe that any [such] conflict exists." H.R. Rep. No. 100-795, at 303; S. Rep. No. 100-445, at 320. Among the provisions that each committee "believe[d] [to be] fully consistent with U.S. treaty obligations" were "the provisions requiring that payments with respect to intangibles be commensurate with the income attributable to the intangible ([1986] Act sec. 1231)." H.R. Rep. No. 100-795, at 304; S. Rep. No. 100-445, at 320.

Consistent with the White Paper, the 1995 cost-sharing regulation (§ 1.482-7) incorporated the "cost share/benefit principle" from the 1986 Conference Report by providing that the IRS would "not make allocations with respect to a qualified cost sharing arrangement except to the extent necessary to make each controlled participant's share of the costs (as determined under paragraph (d) of this section) of intangible development . . . equal to its share of reasonably anticipated benefits attributable to such development." Treas. Reg. § 1.482-7(a)(2) (1995). "[P]aragraph (d)," in turn, provided that "a controlled participant's costs of developing intangibles for a taxable year mean[s] all of the costs incurred by that participant related to the intangible development area," as determined by reference to the definition of "operating expenses" contained in § 1.482-5(d)(3) (other than depreciation or amortization expense). Treas. Reg. § 1.482-7(d)(1) (1995). The term "operating expenses" was defined as "all expenses not included in cost of goods sold except for interest expense, foreign . . . [and] domestic income taxes, and any other expenses not related to the operation of the relevant business activity." Treas. Reg. § 1.482-5(d)(3) (1994).

The Tax Court rejected the IRS's argument in Xilinx that the "all costs" requirement of the 1995 cost-sharing regulation encompassed stock-based compensation costs. After noting the "absence of [evidence of] . . . transactions in which unrelated parties agree to share" such costs, the court turned to the "effect [of that] fact[ ] . . . on [the IRS's] authority to make allocations pursuant to section 1.482-1." 125 T.C. at 54. The IRS had argued (1) that the enactment of the commensurate-with-income requirement in 1986, together with the legislative history of that amendment, "establish[ ] that, for purposes of determining the arm's-length result in [the context of] cost-sharing arrangements, Congress intended to supplant the use of comparable transactions with internal measures of cost and profit," id. at 55-56, and (2) that the foregoing conclusion was entirely consistent with § 1.482-1(b)(1), the 1994 amendment of which provided that the arm's-length result is generally determined by reference to comparable uncontrolled transactions. See id. at 55.

The Tax Court rejected the IRS's interpretation of the word "generally" in § 1.482-1(b)(1), concluding that the regulation "simply states that 'comparable transactions' are the broad exception available when there are no identical transactions." 125 T.C. at 55. The court further concluded that legislative and regulatory history supported its "holding that the arm's-length standard is applicable" to § 1.482-7. Id. at 56 (emphasis added).⁸ Based on "uncontradicted evidence" presented by Xilinx, id. at 59, 61, the court then found that unrelated parties would not share stock-based compensation costs. See id. at 58-62. Accordingly, the court concluded that the IRS's interpretation of the "all costs" requirement of § 1.482-7(d)(1) as encompassing stock-based compensation costs was "inconsistent with section 1.482-1." Id. at 62.

On appeal, a divided panel of this Court initially reversed the Tax Court, holding that the "all costs" language of § 1.482-7(d)(1) was just as unambiguous as the "in every case" language of § 1.482-1(b)(1), and that § 1.482-7(d)(1), "as the more specific of the two provisions, controls." Xilinx Inc. v. Commissioner, 567 F.3d 482, 488, 496 (9th Cir. 2009), withdrawn, 592 F.3d 1017 (9th Cir. 2010).⁹ On rehearing, the panel issued a superseding opinion, this time affirming -- again by a 2-1 vote -- the Tax Court's decision. See Xilinx Inc. v. Commissioner, 598 F.3d 1191 (9th Cir. 2010). In that opinion, the Court "conclude[d] that when related to each other, [ §§ 1.482-1(b)(1) and 1.482-7(d)(1)] establish an ambiguous standard for determining which costs must be shared," and that the ambiguity should be resolved in favor of § 1.482-1(b)(1) "based on the dominant purpose of the regulations" -- which the Court identified as "parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions" -- and on treaty considerations. Id. at 1196-1197. In a concurring opinion, Judge Fisher (who had authored the withdrawn opinion) agreed that the regulations were ambiguous, concluding that the ambiguity should be resolved in favor of "what appears to have been the understanding of corporate taxpayers in similar circumstances," who "ha[d] not been given clear, fair notice of how the regulations w[ould] affect them." Id. at 1198 (Fisher, J. concurring).

In a dissenting opinion, Judge Reinhardt noted that "[t]he stated purpose of the regulatory scheme is 'to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions.'" 598 F.3d at 1199 (Reinhardt, J., dissenting) (quoting Treas. Reg. § 1.482-1(a)(1) (1994)). Thus, "the 'all costs' regulation may simply reflect the conclusion that, whatever uncontrolled parties might do, requiring controlled parties to share such costs 'ensure[s] that taxpayers clearly reflect [the] income attributable to [the] controlled transaction[ ]' as a whole." Id. (alterations in original). In Judge Reinhardt's view, "[t]he Commissioner['s] . . . determination]" in that regard "does not appear to be unreasonable." Id.

After receiving written comments and holding a public hearing, Treasury issued the proposed amendments in final form in August 2003. See T.D. 9088, 2003-2 C.B. 841. Although the final amendments included minor changes to certain administrative rules in response to comments, the substance of the rules remained unchanged. In rejecting "comments that assert that taking stock-based compensation into account in the QCSA context would be inconsistent with the arm's length standard in the absence of evidence that parties at arm's length take stock-based compensation into account in similar circumstances," Treasury and the IRS reasoned that (1) compliance with the statutory commensurate-with-income requirement achieves "an arm's length result consistent with legislative intent," (2) the 1986 Conference Report clearly contemplates that a cost-sharing arrangement will satisfy the commensurate-with-income requirement if costs are shared in proportion to reasonably anticipated benefits, and (3) there is no basis (i.e., from an economic standpoint) "for distinguishing between stock-based compensation and other forms of compensation in this context." 2003-2 C.B. at 842.

C. Factual background of the instant case

During the years at issue (2004-2007), Altera was the publicly traded parent company of a multinational enterprise that developed, manufactured, marketed, and sold programmable logic devices and related hardware, software, and pre-defined design building blocks for use in programming those devices.¹⁰ (ER106.) One of its subsidiaries during that period was Altera International, Inc., a Cayman Islands corporation ("Altera-Cayman"). (ER12.)

Altera-Cayman was incorporated on January 22, 1997. (ER129.) Effective May 23, 1997, Altera and Altera-Cayman entered into a Technology Research and Development Cost Sharing Agreement. (ER107.) Pursuant to that agreement, Altera and Altera-Cayman agreed to share research and development (R&D) costs in proportion to the companies' respective anticipated benefits from any resulting new technology, based on a division of beneficial ownership that would permit Altera to exploit the technology in the United States and Canada while permitting Altera-Cayman to exploit the technology in the rest of the world. (ER108-109.)

In December 1999, Altera entered into an Advance Pricing Agreement with the IRS covering Altera's 1997-2003 tax years. (ER139.) Under the terms of that agreement, Altera agreed to (and did) include its R&D-related stock-based compensation costs in the pool of costs to be shared with Altera-Cayman each year pursuant to their cost-sharing agreement. (ER139.)

Effective December 27, 2003 (the first day of Altera's 2004 tax year), Altera and Altera-Cayman amended their cost-sharing agreement to reflect the 2003 cost-sharing amendments. (ER183-185.) Among other things, the amendment revised the definition of "R&D Costs" to include stock-based compensation as defined in Treas. Reg. § 1.482-7(d)(2) (2003), subject to Altera's "right to challenge the [regulation's] validity." (ER184.)

Altera and Altera-Cayman amended their cost-sharing agreement again after the Tax Court issued its opinion in Xilinx (i.e., regarding the 1995 cost-sharing regulation) in August 2005. (ER186-189.) The amendment expresses "[t]he Parties['] belie[f] that it is more likely than not" that, in light of that opinion, the "inclusion of Stock-Based Compensation in R&D Costs pursuant to [the December 2003 amendment to their agreement] would be contrary to the arm's length standard." (ER186.) Accordingly, the parties agreed that, unless and until a court decision upholding the validity of Treas. Reg. § 1.482-7(d)(2) (2003) became final, they would "suspend the payment of any portion of [a] Cost Share . . . to the extent such payment relates to" stock-based compensation costs. (ER188.)

D. The present dispute

In two notices of deficiency covering the Altera consolidated group's 2004-2007 tax years, the IRS increased the group's income by the following amounts to reflect the increased cost-sharing payments from Altera-Cayman to Altera that would result from compliance with § 1.482-7(d)(2):

      2004                     $24,549,315

Before undertaking its State Farm analysis, the court noted the IRS's contention that, "because the interpretation and implementation of section 482 do not require empirical analysis," the validity of the final rule should be reviewed under Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), rather than under State Farm. (ER51.) In response, the court characterized its opinion in Xilinx as holding that "the arm's-length standard always requires an analysis of what unrelated entities do under comparable circumstances." (ER52-53.) "Similarly," the court continued, "in promulgating the final rule Treasury explicitly considered whether unrelated parties would share stock-based compensation costs in the context of a QCSA." (ER53.)

Treasury therefore "necessarily decided an empirical question when it concluded that the final rule was consistent with the arm's-length standard." (ER53.)

The court then opined that "whether State Farm or Chevron supplies the standard of review is immaterial because Chevron step 2 incorporates the reasoned decisionmaking standard of State Farm." (ER55-56 [fn. ref. omitted].) According to the court, "[b]ecause 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 decisionmaking standard." (ER56.) The court therefore declined to decide "whether Chevron or State Farm provides the ultimate standard of review." (ER56.)

Having concluded (ER54) that Treasury's determination that the final rule "is consistent with the arm's-length standard . . . is necessarily . . . empirical," and in light of Treasury's belief when it issued the rule that its determination was not one requiring "fact finding" or "evidence gathering" (ER60), the court found that Treasury's determination "lack[ed] a basis in fact," that "Treasury failed to rationally connect" its determination "with the facts it found," that Treasury did not adequately "respond to . . . comments" "'resting on solid data,'" and that the determination was "contrary to the evidence before Treasury." (ER56, 78.) The court also rejected the IRS's argument that, "pursuant to the harmless error rule of APA sec. 706, any deficiencies in Treasury's reasoning should not invalidate the final rule." (ER74.) Based on the foregoing, the court held that the final rule "fail[ed] to satisfy State Farm's reasoned decisionmaking standard and therefore is invalid." (ER77.) The court added that, as a result of that holding, the regulation "would be invalid even if we were to conclude that Chevron supplies the ultimate standard of review." (ER77 n.29.) The Commissioner now appeals.

1. The 2003 cost-sharing amendments, in addition to clarifying that stock-based compensation expense is a cost, make clear that comparability analysis plays no role in determining the costs that must be shared under a QCSA in order to achieve an arm's-length result. In light of these "coordinating" amendments, the Tax Court's interpretation of § 1.482-1(b)(1) in Xilinx is no longer viable. The Tax Court failed to appreciate that those coordinating amendments changed the legal landscape, and the court thus erroneously regarded the regulatory scheme at issue here to be substantially the same scheme that was at issue in Xilinx. Similarly, the coordinating amendments serve to supersede this Court's general understanding of the arm's-length standard as reflected in its opinion affirming the Tax Court's Xilinx decision. Because Treasury did not decide an empirical question when it determined that requiring the sharing of stock-based compensation costs is consistent with the arm's-length standard, the Tax Court erred in evaluating the reasonableness of Treasury's decisionmaking on the basis of the "empirical data" aspect of the Supreme Court's opinion in State Farm.

2. The coordinating amendments -- which provide that related parties in a QCSA must share all R&D-related costs in a prescribed ratio in order to achieve an arm's-length result -- are substantively valid under Chevron because they are based on a permissible construction of § 482. Under the commensurate-with-income requirement added to § 482 in 1986, adherence to the arm's-length principle implicit in the first sentence of § 482 entails a comparison of the two sides of the related-party transaction under scrutiny. The 1986 House Report makes clear that Congress enacted that purely internal benchmark because it determined that transactions between unrelated parties involving intangible property do not provide a sufficiently reliable basis of comparability to related-party transactions to be exclusively determinative of the arm's-length result.

The 1986 Conference Report goes even further in the context of cost-sharing arrangements, setting forth the basic economic terms that a cost-sharing arrangement must contain in order to satisfy the commensurate-with-income requirement -- and, by necessary implication, the arm's-length standard -- with no suggestion that related parties could deviate from those terms based on evidence of purportedly comparable arrangements involving unrelated parties. The coordinating amendments incorporate those same basic terms and, by tying them to the arm's-length result, make clear what is implicit in the 1986 Conference Report: the arm's-length result in this context is not determined by reference to cost-sharing arrangements between unrelated parties. The coordinating amendments therefore reflect not only a permissible construction of § 482, but a construction directly supported by the relevant legislative history.

3. The coordinating amendments, moreover, are procedurally valid under the APA because they are the product of reasoned decisionmaking. The preambles accompanying their issuance emphasized that, in requiring the sharing of all R&D-related costs as a condition to achieving an arm's-length result for a QCSA, Treasury was implementing congressional intent as reflected in the legislative history of the 1986 amendment to § 482. An agency's determination and implementation of legislative intent is the epitome of reasoned decisionmaking, and as long as the agency provides a basic foundation for its conclusions in that regard, as Treasury clearly did here, its actions cannot be arbitrary or capricious.

The decisions of the Tax Court are erroneous and should be reversed.

A. Introduction

The Tax Court's analysis reflects a fundamental misunderstanding of the arm's-length standard as formulated by the agency that issued the regulations being challenged here. Based largely on its prior decision in Xilinx, involving tax years not governed by those regulations, the Tax Court started from the premise that "the arm's-length standard always requires an analysis of what unrelated entities do under comparable circumstances." (ER52-53.) This was manifest error.

Treasury amended its regulations for later tax years not involved in Xilinx -- a course of action the Tax Court acknowledged (in Xilinx) that Treasury was free to take, see 125 T.C. at 58 -- to make clear that, in the context of a QCSA, the arm's-length standard does not require consideration of actual transactions between unrelated parties. As we will show, those amendments, which were issued pursuant to the very broad grant of authority in § 482 and follow the blueprint of the 1986 Conference Report regarding the acceptable terms of a cost-sharing arrangement, are valid. Therefore, contrary to the premise underlying the Tax Court's State Farm analysis, Treasury did not "decide[ ] an empirical question" (ER53) when it determined that requiring the sharing of stock-based compensation costs was consistent with the arm's-length standard. Rather, that determination followed from the agency's studied conclusion regarding how Congress, in enacting the commensurate-with-income requirement in 1986, intended the arm's-length standard to operate in the context of intangibles transactions in general, and cost-sharing arrangements in particular. The Tax Court's transmogrification of this legal determination into an empirical determination is wrong and requires reversal by this Court.

B. Framework of analysis

Significantly, the cost-share/benefit principle itself does not appear to be controversial. For example, a report recommending changes to the § 482 regulations in the wake of the 1986 legislation, submitted to Treasury in July 1987 by 24 multi-national companies -- including the current parent corporation of Altera -- contained the following statement:

Similarly, in objecting to § 1.482-7(a)(3) "only insofar as it incorporates by reference § 1.482-7(d)(2)" (ER102 n.3), Altera essentially invited the Tax Court to consider whether, as a general proposition, Treasury can require related parties in a QCSA to share all costs in a prescribed ratio as a condition to achieving an arm's-length result (i.e., whether the coordinating amendments would be valid if Treasury had issued them without issuing the SBC rule). As demonstrated below (and as explained in the preambles to both the proposed and final amendments), that general authority derives from the 1986 amendment to § 482 and the 1986 Conference Report, neither of which suggests that the commensurate-with-income requirement or the cost-share/benefit principle, respectively, is informed by evidence of actual transactions between unrelated parties. And once the validity of the coordinating amendments is established, it follows that the validity of the SBC rule does not turn on an empirical analysis of whether unrelated parties in analogous situations have shared stock-based compensation costs; rather, it simply turns on whether Treasury reasonably determined that R&D-related stock-based compensation costs are "costs" for purposes of § 1.482-7.

Before undertaking its review, the Court discussed the applicable standard of review at length:

A year after issuing its opinion in State Farm, the Court issued its opinion in Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). Chevron involved the Environmental Protection Agency's implementation of a statutorily mandated permit program regulating the "construction and operation of new or modified major stationary sources" of air pollution. 42 U.S.C. § 7502(b)(6) (1982). At issue was an EPA regulation adopting a "plantwide" definition of the statutory term "stationary source," thereby allowing existing plants containing several pollution-emitting devices to "install or modify one piece of equipment without meeting the permit conditions if the alteration [did] not increase the total emissions from the plant." 467 U.S. at 840.

The Court prefaced its analysis with the following discussion:

The Tax Court drew a distinction below between State Farm review and Chevron review by referring to the former as "Judicial Review of Agency Decisionmaking" and the latter as "Judicial Review of Agency Statutory Construction." (ER44, 46.) State Farm review focuses on the propriety of an agency's explanation of the reasons for its action, while Chevron review comes into play where the validity of the agency's action turns on the agency's interpretation of the statute it administers. See, e.g., Dominion Res., Inc. v. United States, 681 F.3d 1313, 1319 (Fed. Cir. 2012) (holding that a tax regulation was neither based on a permissible construction of the statute nor -- inasmuch as Treasury "provided no rationale" for the rule -- the product of reasoned decisionmaking).

The Commissioner argued below that the Chevron framework of analysis is the "superior choice" for adjudicating the validity of the 2003 cost-sharing amendments, primarily because State Farm review "is best suited to cases where Congress demands fact-finding and empirically-based solutions, but Congress made no such demands when it granted broad authority to Treasury under section 482." (ER90, 91.) The relevant point here is that reasoned decisionmaking in this context -- i.e., where the rulemaking process is not a fact-finding endeavor -- simply means that "the process by which [the agency] reaches [its] result must be logical and rational." Michigan v. E.P.A., 135 S. Ct. 2699, 2706 (2015) (internal quotation marks omitted) (focusing solely on whether the agency considered the relevant factors and all important aspects of the problem when it concluded that regulation of certain power plants was "appropriate and necessary"). As discussed below, the 2003 cost-sharing amendments easily satisfy that standard (and are based on a permissible construction of § 482, as required by Chevron step 2).

C. The Tax Court erred in failing to consider the effect of the coordinating amendments on the proper interpretation of § 1.482-1(b)(1)

The Tax Court's threshold -- and, we submit, erroneous -- conclusion that Treasury necessarily made an empirical determination in issuing the 2003 cost-sharing amendments was based primarily on its prior holding in Xilinx that "the arm's-length standard always requires an analysis of what unrelated entities do under comparable circumstances." (ER52-53.) That Xilinx holding, in turn, was based on the third sentence of Treas. Reg. § 1.482-1(b)(1) (1994) (italicized below):

And therein lies the Tax Court's fundamental error in the case at bar: in concluding that the issue whether the final rule is consistent with the arm's-length standard presents an empirical question, the court relied on its interpretation of § 1.482-1(b)(1) within the pre-2003 regulatory scheme at issue in Xilinx, without considering whether the coordinating amendments governing later tax years render that interpretation untenable. See, e.g., Maracich v. Spears, 133 S. Ct. 2191, 2203 (2013) (noting that "an interpretation of a phrase of uncertain reach is not confined to a single sentence when the text of the whole statute gives instruction as to its meaning"). Those amendments plainly changed the legal landscape by making clear that, contrary to the Tax Court's conclusion below (ER53), the arm's-length standard in the context of a QCSA does not "require [ ] an analysis of what unrelated entities do under comparable circumstances." Because the Tax Court's reading of § 1.482-1(b)(1) in Xilinx has been superseded by regulatory clarification, the court erred in relying on that interpretation in resolving the case at bar.

For essentially the same reasons, the coordinating amendments supersede this Court's understanding of the arm's-length standard as reflected in its own Xilinx opinion. In that opinion, the Court did not rely on the Tax Court's analysis of the third sentence of § 1.482-1(b)(1) (relating to comparable uncontrolled transactions). Rather, the Court looked to the first sentence of that provision and concluded that the arm's-length standard itself -- viz., "the standard . . . of a taxpayer dealing at arm's length with an uncontrolled taxpayer" -- precluded the Commissioner from applying the "all costs" requirement of § 1.482-7(d)(1) to require related parties to share stock-based compensation costs in light of evidence that uncontrolled parties do not share such costs. That understanding of the arm's-length standard, however, was reached without any consideration of the coordinating amendments, which were not applicable to the tax years at issue in Xilinx. Indeed, in his concurring opinion in Xilinx, Judge Fisher noted that it was an open question whether the flaws in the regulatory scheme before the Court had been remedied by the 2003 amendments at issue here. 598 F.3d at 1198 n.4. As demonstrated below, those amendments overcome the regulatory deficiencies that this Court identified in Xilinx.

D. The coordinating amendments are valid

There is no question that an agency faced with litigation over the meaning of one of its statute-implementing regulations is free to amend the regulatory scheme prospectively in order to clarify its position, provided the statute does not "'directly address [ ] the precise question at issue'" and the regulatory amendment "'is based on a permissible construction of the statute.'" Mayo Found, for Med. Educ. & Research v. United States, 562 U.S. 44, 52, 54 (2011) (quoting Chevron, 467 U.S. at 843); see id. at 55 (noting that it is "immaterial to [the] analysis that a 'regulation was prompted by litigation'") (quoting Smiley v. Citibank (South Dakota), N.A., 517 U.S. 735, 741 (1996)). Here, in the midst of litigation over whether Treasury could, consistent with the formulation of the arm's-length standard in § 1.482-1(b)(1), require cost-sharers to share all R&D-related costs as a condition to achieving an arm's-length result, Treasury amended the regulatory scheme to provide just that. Inasmuch as "[t]he parties agree that sec. 482 is ambiguous" and that "[t]hese cases would therefore be resolved at Chevron step 2" (ER55 n.16), Treasury's authority to issue the coordinating amendments turns on whether those amendments are based on a permissible construction of § 482.

Little can be gleaned from the text of § 482 regarding the intended interaction between the commensurate-with-income requirement and traditional comparability analysis. By its terms, however, the commensurate-with-income requirement is an internal standard; its purview is limited to a comparison of the two sides of the related-party transaction. Such a purely internal requirement certainly can be implemented in conjunction with traditional comparability analysis, and Treasury has taken that approach outside the context of QCSAs. See generally Treas. Reg. §§ 1.482-4 - 1.482-6. By the same token, comparing the relative benefits realized by the parties to a related-party transaction does not require consideration of transactions between unrelated parties. It necessarily follows that a regulation identifying the arm's-length result in the QCSA context by reference to the basic economic terms a QCSA must incorporate in order to satisfy the commensurate-with-income requirement, without allowing any deviations founded on evidence (or the lack thereof) of transactions between unrelated parties, is based on a permissible construction of § 482.¹⁴

The 1986 House Report also provides guidance regarding the practical implications of the commensurate-with-income requirement. In particular, the Ways and Means Committee contemplated that the new rule would require periodic adjustments to royalty payments to reflect actual profit experience:

It is the 1986 Conference Report, however, that provides the clearest indication that the coordinating amendments are based on a permissible construction of § 482:

The 1986 Conference Report is significant in several respects. First, it expressly conditions the continued use of related-party cost-sharing arrangements (addressed at § 1.482-2(d)(4) of the 1968 regulations) on their being consistent with the purpose of the statutory commensurate-with-income requirement. Second, it identifies that purpose in strictly internal economic terms: that "the division of income [from an intangible] between related parties reasonably reflect the relative economic activity undertaken by each." H.R. Conf. Rep. No. 99-841, at 11-637. Third, it contemplates that a cost-sharing arrangement will generally satisfy that objective if costs are shared in proportion to profits. And fourth, it supports the notion that the cost pool should be comprehensive in scope. Moreover, as is the case with the periodic-adjustment requirement contemplated in the 1986 House Report, nothing in the 1986 Conference Report suggests that a taxpayer would be entitled to modify the basic parameters of the permissible cost-sharing arrangement envisioned in that report by marshaling evidence that allegedly comparable agreements between unrelated parties do not conform to those parameters in some respect. Taken together, the two committee reports confirm that the coordinating amendments are based on a permissible construction of § 482.

Thus, Treasury's promulgation of the coordinating amendments -- as is the case with the overwhelming majority of tax regulations -- did not require an "examin[ation] [of] data," "fact[-]f[i]nd[ing]," or consideration of "evidence before the agency." State Farm, 463 U.S. at 43. Reasoned decisionmaking in this context -- i.e., where the rulemaking process is not a fact-finding endeavor -- simply means that "the process by which [the agency] reaches [its] result must be logical and rational." Michigan v. E.P.A., 135 S. Ct. at 2706 (internal quotation marks omitted). Treasury's issuance of the coordinating amendments easily satisfies that standard. See Balestra v. United States, 803 F.3d 1363, 1374 (Fed. Cir. 2015) (holding that Treasury adequately explained its reasons for issuing a tax regulation that the court had already held was valid under Chevron; according to the court, Treasury's determination that the regulation was "simple, workable, and flexible" was "neither arbitrary nor capricious").

The 2002 preamble explains that the 1994 regulations formulated the arm's-length standard in terms of "the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances." 67 Fed. Reg. at 48,998. The 1995 regulation, meanwhile, "implement[ed] the commensurate with income standard in the context of cost sharing arrangements" in accordance with the 1986 Conference Report by "requiring] that controlled participants in a [QCSA] share all costs incurred that are related to the development of intangibles in proportion to their shares of the reasonably anticipated benefits attributable to that development." Id. But when Treasury interpreted the "all costs" requirement to include "compensation . . . in the form of stock options," id., affected taxpayers argued that if unrelated parties that engage in cost-sharing do not share such costs, then Treasury's interpretation would run counter to the arm's-length standard. Thus, the proposed amendments not only clarified that stock-based compensation expense is a "cost," but also "include[d] express provisions to coordinate the cost sharing rules of § 1.482-7 with the arm's length standard as set forth in § 1.482-1." Id.

The 2002 preamble clearly reveals that Treasury issued the coordinating amendments -- effectively providing that, contrary to the Tax Court's view, the arm's-length standard does not "always require[ ] an analysis of what unrelated entities do under comparable circumstances" (ER53) -- in order to implement legislative intent as expressed in the 1986 Conference Report. Treasury reasonably inferred that the conferees, in conditioning the use of cost-sharing arrangements on adherence to the cost-benefit allocation principle they identified as the purpose of the commensurate-with-income requirement, necessarily considered that purely economic benchmark to be consistent with the arm's-length standard. The coordinating amendments are entirely consistent with that economic-centric view of the arm's-length standard.

The 2003 preamble cogently explains why Treasury concluded that requiring QCSA participants to share stock-based compensation costs is consistent with the arm's-length standard, and, by extension, why providing for that result by regulation is itself consistent with the arm's-length standard. Referring to comments asserting that the SBC rule is inconsistent with the arm's-length standard in light of evidence that unrelated parties do not share such costs, Treasury responded that the only "interpretation[ ] of the arm's length standard" that matters -- at least in the realm of domestic transfer pricing law -- is Congress's. T.D. 9088, 2003-2 C.B. at 842. As it had in the 2002 preamble, Treasury explained that the 1986 Conference Report contains very specific guidance regarding the circumstances under which a cost-sharing arrangement would be deemed to be consistent with the commensurate-with-income standard, a standard that Congress in turn deemed to be fully consistent with the arm's-length standard. Id. And, inasmuch as the 1986 Conference Report articulates the purpose of the commensurate-with-income requirement in purely economic (cost-benefit) terms, id., it follows that Congress could not have subscribed to the rigid understanding of the arm's-length standard favored by those who submitted comments to the 2002 proposed amendments.

To be sure, the 2003 preamble contains some extraneous observations. For instance, since Treasury reasonably determined that it was statutorily authorized to dispense with comparability analysis in this narrow context, there was no need for it to establish that the uncontrolled transactions cited by commentators were insufficiently comparable. Similarly, the conclusion that the "all costs" requirement produces an arm's-length result is premised on the economic assumption that if unrelated parties could enter into the same transaction under the same circumstances -- i.e., if they could enter into a cost-sharing arrangement from the same perspective as related entities -- they would agree to share all development-related costs.¹⁷ That is the sense in which Treasury "considered whether unrelated parties would share stock-based compensation costs in the context of a QCSA." (ER53.)

The "reasoned decisionmaking" standard, however, is forgiving; as indicated above, the reviewing court must "uphold a decision of less than ideal clarity if the agency's path may reasonably be discerned." State Farm, 463 U.S. at 43 (internal quotation marks omitted); see Montana Wilderness Ass'n v. Connell, 725 F.3d 988, 999 n.9 (9th Cir. 2013) (concluding that the agency's "explanation was adequate under the circumstances," even though it "could have . . . [been] more complete"). Indeed, this Court has held that "[i]f an agency's determination is supportable on any rational basis, we must uphold it." McFarland v. Kempthorne, 545 F.3d 1106, 1113 (9th Cir. 2008) (internal quotation marks omitted) (distinguishing State Farm on the ground that "the critical factor [there] was that the agency 'submitted no reasons at all' for its decision," id., quoting State Farm, 463 U.S. at 50). Here, Treasury made clear that it viewed its conclusion regarding the arm's-length standard -- viz., that specifying the arm's-length result in this narrow context was consistent with that standard -- as necessarily following from the 1986 Conference Report. And its discussion of that report reveals a rational basis for its conclusion in that regard. The reasoned decisionmaking standard requires nothing more in this context, where the agency is not engaged in a fact-finding endeavor. See Drakes Bay Oyster Co. v. Jewell, 141 F.3d 1073, 1087, 1088 n.8 (9th Cir. 2014) (agency explanation, which relied on "Congressional intent as expressed in [a] House committee report," established that the agency's "decision that [its action] would further Congress's earlier expressed [intent] . . . was rational").

E. The stock-based compensation rule is valid

The issue whether corporations incur a cost associated with the issuance of compensatory stock options is no more an empirical question than is the issue whether the arm's-length standard "always requires an analysis of what unrelated entities do under comparable circumstances." (ER53.) Thus, as is the case with the coordinating amendments, reasoned decisionmaking in the context of the SBC rule simply means that "the process by which [the agency] reache[d] [its] result [was] logical and rational." Michigan v. E.P.A., 135 S. Ct. at 2706 (internal quotation marks omitted).¹⁸ And, as is the case with the coordinating amendments, Treasury's issuance of the SBC rule easily meets that standard.

The 2002 preamble notes that "tax and other accounting principles" recognize that there is a "cost associated with stock-based compensation." 67 Fed. Reg. at 48,999. Thus, "[f]or general income tax purposes," an employer issuing compensatory stock options is generally entitled to a deduction "measured by the 'spread' between the option price and the fair market value of the underlying stock at the date of exercise." Id.; see LR.C. § 83(h); Treas. Reg. § 1.83-7(a) (1978). The 2002 preamble further notes that, since October 1995, the Financial Accounting Standards Board (FASB) had required companies to report stock-based compensation expense -- based on grant-date value -- "either as a charge to income or, at the company's option, in a pro forma footnote disclosure." 67 Fed. Reg. at 48,999. Although Treasury agreed (in response to comments to the proposed amendments) that "the disposition of financial reporting issues [with respect to stock-based compensation expense] does not mandate" similar treatment under the cost-sharing regulations, T.D. 9088, 2003-2 C.B. at 843 (emphasis added), FASB's recognition of stock-based compensation as a cost plainly provides a rational basis for Treasury's decision to specify (in § 1.482-7(d)(2)) that the term "operating expenses" includes stock-based compensation expense. And, once the status of stock-based compensation as a cost is accepted, there is simply no rational basis "for distinguishing between stock-based compensation and other forms of compensation in this context." Id. at 842.

F. A final word on the arm's-length standard

As demonstrated in Part D of the Argument, supra, Treasury's rationale for issuing the coordinating amendments was founded on its understanding of how Congress, in enacting the commensurate-with-income requirement in 1986, intended the arm's-length standard to operate in the context of intangibles transactions in general, and cost-sharing arrangements in particular. That understanding posits that Congress necessarily viewed the descriptor "arm's-length" as a term of art, since it contemplated that adherence to the arm's-length principle implicit in § 482 could be premised on economic assumptions regarding how unrelated parties would price the same transaction under the same circumstances (i.e., that they would "divi[de] [the] income" attributable to the intangible in a manner that "reasonably reflect[s] the relative economic activity undertaken by each"), rather than by reference to observed transactions between unrelated parties. H.R. Conf. Rep. No. 99-841, at 11-637.

In his concurring opinion in Xilinx, Judge Fisher recognized that there is indeed more than one way of looking at the arm's-length standard:

The arm's-length standard therefore is susceptible to more than one understanding. As a leading academic in this field explained:

² The term "arm's length result" is defined in the subjunctive as "the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances." Treas. Reg. § 1.482-1(b)(1) (1994) (second sentence).

³ Kathleen Matthews, Section 482 White Paper Hits the Street, 41 Tax Notes 362 (Oct. 24, 1988).

⁴ "Loosely defined, an integrated business consists of firms under common control and engaged in similar activities." Notice 88-123, 1988-2 C.B. 458, 483.

⁵ In a separate discussion of cost-sharing arrangements, the report referred to the "cost share/benefit principle" of the 1986 Conference Report, viz., "the fundamental principle that the costs borne by each of the participants should be proportionate to the reasonably anticipated benefits to be received over time by each participant from exploiting intangibles developed under the cost sharing arrangement." 1988-2 C.B. at 495. The report also posited that "the costs to be shared should include all direct and indirect costs of the research and development undertaken as part of the arrangement." Id. at 497.

⁶Accounting for Stock-Based Compensation, Statement of Financial Accounting Standards No. 123 (Fin. Accounting Standards Bd. 1995) ("SFAS 123"). SFAS 123 initially allowed companies to continue using the old "intrinsic value" method of accounting for compensatory stock options in their financial statements, provided they made pro forma disclosures of net income and earnings per share based on the "fair value" method espoused by SFAS 123. See SFAS 123, para. 11. The fair value method of SFAS 123 became mandatory in 2005. See Share-Based Payment, Statement of Financial Accounting Standards No. 123 (revised 2004) (Fin. Accounting Standards Bd. 2004).

⁷ In July 2002, during the pre-trial phase of the Xilinx case, Treasury issued (in proposed form) the 2003 cost-sharing amendments at issue here. Compensatory Stock Options Under Section 482, 67 Fed. Reg. 48,997 (July 29, 2002). Because those amendments (once finalized) had prospective application only, they did not apply to the tax years at issue in Xilinx. See pp. 20-22, infra.

⁸ The IRS never argued that the arm's-length standard, which "applie[s] in every case," Treas. Reg. § 1.482-1(b)(1) (1994), did not apply to § 1.482-7. Rather, the IRS argued that, consistent with legislative intent, compliance with the arm's-length standard in the context of a QCSA entails the sharing of all development-related costs -- including stock-based compensation costs -- in proportion to reasonably anticipated benefits.

⁹ The Court also held in that initial opinion that § 1.482-7(d)(1) did not violate the tax treaty between the United States and Ireland (the domicile of Xilinx's foreign affiliate), and that the stock-based compensation costs at issue were "costs" that were "related to" the intangible development activity within the meaning of the regulation.

¹⁰ Altera was acquired by Intel Corporation in December 2015. See https://newsroom.intel.com/news-releases/intel-completes-acquisition-of-altera/ (last visited June 13, 2016).

¹¹ Treasury also amended the "best method" rule of § 1.482-1(c)(1) to include a cross-reference to § 1.482-7 "for the applicable method in the case of a [QCSA]." Treas. Reg. § 1.482-1(c)(1) (2003).

¹²See SFAS 123 (supra note 6), para. 60 (noting that "[t]he debate on accounting for stock-based compensation . . . became so divisive that it threatened the [Financial Accounting Standards] Board's future working relationship with some of its constituents," and that "the nature of the debate threatened the future of accounting standards[-] setting in the private sector").

¹³ The Court added that, "[f]or purposes of these cases, it is also relevant that Congress required a record of the rulemaking proceedings to be compiled and submitted to a reviewing court, 15 U.S.C. § 1394, and intended that agency findings under the Act would be supported by 'substantial evidence on the record considered as a whole.'" 463 U.S. at 43-44 (citation omitted).

¹⁴ It should be noted that various other aspects of § 1.482-7 do implicate traditional comparability analysis where appropriate. See, e.g., Treas. Reg. §§ 1.482-7(g)(2), (3), (4), (5) (2003).

¹⁵ Contrast that approach with that of a House-passed (but unenacted) amendment to § 482 in 1962, which would have authorized the Commissioner to allocate income from cross-border, intra-group sales of tangible property based on a formula, unless "the taxpayer [could] establish an arm's length price" based on comparability analysis. H.R. 10650, 87th Cong. § 6(a) (1962).

¹⁶ The 1993 temporary regulations had provided that a "controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in a comparable transaction under comparable circumstances." Treas. Reg. § 1.482-1T(b)(1) (1993) (emphasis added); see T.D. 8470, 1993-1 C.B. 90, 101.

¹⁷Cf. Treas. Reg. § 1.482-1(f)(2)(ii)(A) (1994) (providing that the IRS may consider any economically preferable "alternatives [actually] available to the taxpayer [engaging in the related-party transaction] in determining whether the terms of the [related-party] transaction" -- although perhaps consistent with those observed in comparable uncontrolled transactions -- would in fact "be acceptable to an uncontrolled taxpayer faced with the same alternatives" that are available to the taxpayer).

¹⁸ Since, as demonstrated above, the coordinating amendments satisfy Chevron step 2, the SBC rule need not be separately analyzed under Chevron. That is, Treasury's statutory authority to require the sharing of all R&D-related costs as a condition to achieving an arm's-length result necessarily includes the reasonable identification of such costs.

¹⁹ The enumerated methods are those that were set forth in the 1968 regulations. See Treas. Reg. § 1.482-2(e)(2), (3), (4) (1968).

²⁰See generally Edward B. Dix, Note, From General to Specific: The Arm's-Length Standard's Evolution and its Relevancy in Determining Costs To Be Shared in Cost-Sharing Agreements, 64 Tax Law. 197 (Fall 2010).