The U.S. Tax Court’s recent decision in Altera v. Comr. affirmed that that the arm’s length standard controls over another specific regulatory provision, in this case the commensurate-with-income standard of Treas. Reg. 367(d). The decision in Altera found that stock-based compensation is not an expense that should be pooled and shared under a qualifying cost sharing arrangement.
Altera’s support for its position was largely empirical, and stood on the shoulders of the case built in Xilinx for exclusion of stock-based compensation from a cost pool in a cost sharing arrangement. This empirical evidence consisted of a number of joint venture and other collaboration agreements submitted by commentators to the 2003 proposed cost sharing regulations. The Tax Court was persuaded that not only is stock-based compensation not shared between cooperating independent parties; it held that stock-option expense should not be considered as an element of the comprehensive set of costs considered by Treasury to be “relevant costs” in a qualifying cost sharing arrangement.
These agreements included certain elements of labor compensation that parties to the agreements consented to share, but did not include stock-based compensation among those expenses. Agreements from the software industry, comparable to the industry in which Altera operated during the years at issue were produced and viewed as sufficiently comparable to the Altera arrangement at issue. These agreements proved persuasive in Altera, and served to amplify the effect of the failure of Treasury to consider the submissions from commentators to the 2003 proposed cost sharing regulations.
Neither Treasury, as part of its finalization of the 2003 regulations, nor the IRS in Altera produced evidence of an agreement between third parties that included stock option cost. Proof of arm’s length behaviour with respect to stock option expense was therefore delivered in the form of a negative empirical result.
To rebut the arguments advanced by the taxpayer, the IRS relied on the commensurate-with-income standard, and did not present any expert opinion that supported its position that stock-based compensation must be included in the cost pool of a qualifying cost sharing arrangement to achieve an arm’s-length result.
If the U.S. Tax Court can strike down regulations that are not consistent with the arm’s length standard, one might think about the prospects for other aspects of Treasury Regs. Section 482 that are not based entirely on empirically supported independent corporate conduct, or consistent with the definition of the arm’s length standard in Section 482-1(b)(1). Some areas to consider might be:
- The empirical support for the factor of 1.3 used in Section 482-2(a)(2)(iii)(B)(1) to set arm’s length interest rates based on the AFR, or the use of the AFR more generally
- The relevance of the lists of specified covered services, excluded activities, or the concept of low-margin covered services in the Section 482-9 services regulations when compared with documented business practices concerning the price of certain services types
- Joint venture arrangements or other transaction evidence used as comparables for intangible assets transactions that do not depend on a valuation technique akin to the income method
Oddly, this self-criticism may be good for the U.S. Treasury Department at a time of threat to the arm’s length standard from the G20/OECD BEPS project, which is due to report finally on October 5, 2015. The Treasury Department has consistently debated the proposed use of a ‘special measure’ resembling the commensurate-with-income standard to effect post-transaction value adjustments in the case of “hard-to-value” intangible assets. Temporary 482-1 Regulations issued September 14 however attempt to reconcile intangible asset expatriation transactions under Section 482 and Section 367.
Let’s hope that Altera has served as a useful caution to the OECD BEPS project, and shown that that country rules that depart from the arm’s length principle and that are based on the OECD transfer pricing guidelines will be subjected to litigation challenge, with the possible unwelcome result that the general OECD guidance will be undermined.
If the arm’s length principle is to survive, as is widely expected, careful analysis and empirical support will be critical to supporting a transfer pricing position. The beliefs of taxpayers and tax administrations about what transacting parties would or would not do, mechanical or categorical rules, and simple statements of principle may well lose out to good evidence more often in the future.
*Portions of this article appeared in a co-authored article published in the Ruchelman PLLC August 2015 Insights newsletter.
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