Altera Corp. v. Comm'r

ALTERA CORPORATION AND SUBSIDIARIES, PETITIONER v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 6253–12, 9963–12. Filed July 27, 2015.

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 oper-

ating 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. P is an affiliated group of corporations that

filed consolidated returns for the years in issue. A–US, the

parent company, is a Delaware corporation, and A–I, a sub-

sidiary of A–US, is a Cayman Islands corporation. A–US and

A–I entered into a QCSA. During its 2004–07 taxable years

A–US granted SBC to its employees. A–US did not share the

SBC costs with A–I. R determined deficiencies based on I.R.C.

sec. 482 allocations R made pursuant to the final rule. P and

R have filed cross-motions for partial summary judgment. P

contends that the final rule is arbitrary and capricious under

5 U.S.C. sec. 706(2)(A) and Motor Vehicle Mfrs. Ass’n of the

U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983). R

contends that the final rule is valid under Chevron, U.S.A.,

Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), or

alternatively, under State Farm. Held: The final rule is a

legislative rule—i.e., it is not an interpretive rule under 5

U.S.C. sec. 553(b)—because it has the force of law. See Am.

Mining Cong. v. Mine Safety & Health Admin., 995 F.2d 1106,

1109 (D.C. Cir. 1993). The final rule has the force of law

because in I.R.C. sec. 7805(a) ‘‘Congress has delegated legisla-

tive power to’’ Treasury, id., and Treasury ‘‘intended to exer-

cise that power’’ when it issued the final rule, id. Held, fur-

ther, whether State Farm or Chevron supplies the standard of

review is immaterial because Chevron step 2 incorporates the

reasoned decisionmaking standard of State Farm, see

Judulang v. Holder, 565 U.S. ll, ll, 132 S. Ct. 476, 483

n.7 (2011), and we are being asked to decide whether

Treasury reasonably concluded that the final rule is con-

sistent with the arm’s-length standard. Held, further,

Treasury failed to support its belief that unrelated parties

would share SBC costs with any evidence in the administra-

tive record, see State Farm, 463 U.S. at 43; failed to articulate

why all QCSAs should be treated identically, see id.; and

failed to respond to significant comments, see Home Box

Office, Inc. v. FCC, 567 F.2d 9, 35 (D.C. Cir. 1977). Addition-

ally, Treasury’s ‘‘explanation for its decision * * * runs

91

92 145 UNITED STATES TAX COURT REPORTS (91)

counter to the evidence before’’ it. State Farm, 463 U.S. at 43.

Held, further, the harmless error rule of 5 U.S.C. sec. 706 is

inapplicable because it is not clear that Treasury would have

adopted the final rule if it had been determined to be incon-

sistent with the arm’s-length standard. Held, further, the final

rule fails to satisfy State Farm’s reasoned decisionmaking

standard and is therefore invalid. See 5 U.S.C. sec. 706(2)(A);

State Farm, 463 U.S. at 43.

Andrew P. Crousore, Donald M. Falk, Joseph B. Judkins,

Thomas Lee Kittle-Kamp, William G. McGarrity, Kristyn A.

Medina, Brian D. Netter, Phillip J. Taylor, and Allen Duane

Webber, for petitioner.

Farhad Asghar, Kevin G. Croke, Anne O’Brien

Hintermeister, Allan Lang, Aaron T. Vaughan, and Mary E.

Wynne, for respondent.

OPINION

MARVEL, Judge: These consolidated cases are before the

Court on the parties’ cross-motions for partial summary judg-

ment under Rule 121. 1 The issue presented by the parties’

cross-motions is whether section 1.482–7(d)(2), Income Tax

Regs. (final rule)—which the Department of the Treasury

(Treasury) issued in 2003 and which requires participants in

qualified cost-sharing arrangements (QCSAs) to share stock-

based compensation costs to achieve an arm’s-length result—

is arbitrary and capricious and therefore invalid.

Background

Petitioner is an affiliated group of corporations that filed

consolidated Federal income tax returns for the years at

issue. During all relevant years, Altera Corp. (Altera U.S.),

the parent company, was a Delaware corporation, and Altera

International, a subsidiary of Altera U.S., was a Cayman

Islands corporation. When petitioner filed its petitions with

this Court, the principal place of business of Altera U.S. was

in California.

1 Unless otherwise indicated, all section references are to the Internal

Revenue Code (Code) in effect at all relevant times, and all Rule references

are to the Tax Court Rules of Practice and Procedure. All APA section ref-

erences are to the Administrative Procedure Act (APA), 5 U.S.C. secs. 551–

559, 701–706 (2012).

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 93

I. Petitioner’s R&D Cost-Sharing Agreement

Petitioner develops, manufactures, markets, and sells

programmable logic devices (PLDs) and related hardware,

software, and pre-defined design building blocks for use in

programming the PLDs (programming tools). Altera U.S. and

Altera International entered into concurrent agreements that

became effective May 23, 1997: a master technology license

agreement (technology license agreement) and a technology

research and development cost-sharing agreement (R&D

cost-sharing agreement).

Under the technology license agreement, Altera U.S.

licensed to Altera International the right to use and exploit,

everywhere except the United States and Canada, all of

Altera U.S.’ intangible property relating to PLDs 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 activi-

ties they performed on or after May 23, 1997. The R&D cost-

sharing agreement was in effect from May 23, 1997, through

2007.

During each of petitioner’s taxable years ending December

31, 2004, December 30, 2005, December 29, 2006, and

December 28, 2007 (2004–07 taxable years), Altera U.S.

granted stock options and other stock-based compensation to

certain of its employees. Certain of the employees of Altera

U.S. who performed research and development activities sub-

ject to the R&D cost-sharing agreement received stock

options or other stock-based compensation. The employees’

cash compensation was included in the cost pool under the

R&D cost-sharing agreement. Their stock-based compensa-

tion was not included.

94 145 UNITED STATES TAX COURT REPORTS (91)

Pursuant to the R&D cost-sharing agreement, Altera Inter-

national made the following cost-sharing payments to Altera

U.S. for its 2004–07 taxable years:

Year Cost-sharing payment

2004 .............................. $129,469,233

2005 .............................. 160,722,953

2006 .............................. 164,836,577

2007 .............................. 192,755,438

II. Petitioner’s Tax Reporting and Respondent’s Section 482

Allocations

Petitioner timely filed its Forms 1120, U.S. Corporation

Income Tax Return, for its 2004–07 taxable years.

Respondent timely mailed notices of deficiency to petitioner

with respect to its 2004–07 taxable years. The notices of defi-

ciency allocated, pursuant to section 482, income from Altera

International to Altera U.S. by increasing Altera Inter-

national’s cost-sharing payments for 2004–07 by the fol-

lowing amounts:

Cost-sharing

Year payment adjustment

2004 .............................. $24,549,315

2005 .............................. 23,015,453

2006 .............................. 17,365,388

2007 .............................. 15,463,565

Bringing petitioner into compliance with the final rule was

the sole purpose of the cost-sharing adjustments in the notice

of deficiency.

III. Section 482

A. Arm’s-Length Standard

Section 482 authorizes the Commissioner to allocate

income and expenses among related entities to prevent tax

evasion and to ensure that taxpayers clearly reflect income

relating to transactions between related entities. The first

sentence of section 482 provides, in relevant part, as follows:

In any case of two or more organizations, trades, or businesses * * *

owned or controlled directly or indirectly by the same interests, the Sec-

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 95

retary[2] may distribute, apportion, or allocate gross income, deductions,

credits, or allowances between or among such organizations, trades, or

businesses, if he determines that such distribution, apportionment, or

allocation is necessary in order to prevent evasion of taxes or clearly to

reflect the income of any of such organizations, trades, or businesses.

* * *

Section 1.482–1(a)(1), Income Tax Regs., explains the pur-

pose of section 482 as follows:

The purpose of section 482 is to ensure that taxpayers clearly reflect

income attributable to controlled transactions and to prevent the avoid-

ance of taxes with respect to such transactions. Section 482 places a con-

trolled taxpayer[3] on a tax parity with an uncontrolled taxpayer by

determining the true taxable income of the controlled taxpayer. * * *

Section 1.482–1(b)(1), Income Tax Regs., provides that

[i]n determining the true taxable income of a controlled taxpayer, the

standard to be applied in every case is that of a taxpayer dealing at

arm’s length with an uncontrolled taxpayer. A controlled transaction

meets the arm’s length standard if the results of the transaction are con-

sistent with the results that would have been realized if uncontrolled

taxpayers had engaged in the same transaction under the same cir-

cumstances (arm’s length result). However, because identical trans-

actions can rarely be located, whether a transaction produces an arm’s

length result generally will be determined by reference to the results of

comparable transactions under comparable circumstances. * * *

The arm’s-length standard is also incorporated into

numerous income tax treaties between the United States and

foreign countries. See, e.g., Convention for the Avoidance of

Double Taxation and the Prevention of Fiscal Evasion With

Respect to Taxes on Income and on Capital Gains, U.S.-U.K.

(2001 U.S.-U.K. Income Tax Convention), art. 9, July 24,

2001, Tax Treaties (CCH) para. 10,901.09, at 201,019; U.S.

Model Income Tax Convention of Nov. 15, 2006 (2006 U.S.

Model Income Tax Convention), art. 9, Tax Treaties (CCH)

para. 209.09, at 10,559; Treasury Department Technical

Explanation of the 2001 U.S.-U.K. Income Tax Convention,

art. 9, Tax Treaties (CCH) para. 10,911, at 201,306 (‘‘This

Article incorporates in the Convention the arm’s-length prin-

2 The term ‘‘Secretary’’ means the Secretary of the Treasury or his dele-

gate. Sec. 7701(a)(11)(B).

3 The term ‘‘controlled taxpayer’’ means ‘‘any one of two or more tax-

payers owned or controlled directly or indirectly by the same interests, and

includes the taxpayer that owns or controls the other taxpayers.’’ Sec.

1.482–1(i)(5), Income Tax Regs.

96 145 UNITED STATES TAX COURT REPORTS (91)

ciple reflected in the U.S. domestic transfer pricing provi-

sions, particularly Code section 482.’’); Treasury Department

Technical Explanation of the 2006 U.S. Model Income Tax

Convention, art. 9, Tax Treaties (CCH) para. 215, at 10,640

(same).

B. Commensurate-With-Income Standard

In 1986 Congress amended section 482 by adding, in rel-

evant part, the following sentence: ‘‘In the case of any

transfer (or license) of intangible property * * *, the income

with respect to such transfer or license shall be commensu-

rate with the income attributable to the intangible.’’ Tax

Reform Act of 1986, Pub. L. No. 99–514, sec. 1231(e)(1), 100

Stat. at 2562.

The House report that accompanied the House version of

the 1986 amendment to section 482 states, in relevant part,

as follows:

Many observers have questioned the effectiveness of the ‘‘arm’s length’’

approach of the regulations under section 482. A recurrent problem is

the absence of comparable arm’s length transactions between unrelated

parties, and the inconsistent results of attempting to impose an arm’s

length concept in the absence of comparables.

* * * * * * *

The problems are particularly acute in the case of transfers of high-

profit potential intangibles. Taxpayers may transfer such intangibles to

foreign related corporations or to possession corporations at an early

stage, for a relatively low royalty, and take the position that it was not

possible at the time of the transfers to predict the subsequent success

of the product. Even in the case of a proven high-profit intangible, tax-

payers frequently take the position that intercompany royalty rates may

appropriately be set on the basis of industry norms for transfers of much

less profitable items.

Certain judicial interpretations of section 482 suggest that pricing

arrangements between unrelated parties for items of the same apparent

general category as those involved in the related party transfer may in

some circumstances be considered a ‘‘safe harbor’’ for related party

pricing arrangements, even though there are significant differences in

the volume and risks involved, or in other factors.* * *

In many cases firms that develop high profit-potential intangibles tend

to retain their rights or transfer them to related parties in which they

retain an equity interest in order to maximize their profits. * * *

Industry norms for transfers to unrelated parties of less profitable intan-

gibles frequently are not realistic comparables in these cases.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 97

There are extreme difficulties in determining whether the arm’s length

transfers between unrelated parties are comparable. The committee thus

concludes that it is appropriate to require that the payment made on a

transfer of intangibles to a related foreign corporation or possessions cor-

poration be commensurate with the income attributable to the intan-

gible. * * *

* * * * * * *

The basic requirement of the bill is that payments with respect to

intangibles that a U.S. person transfers to a related foreign corporation

or possessions corporation must be commensurate with the income

attributable to the intangible. * * *

In making this change, the committee intends to make it clear that

industry norms or other unrelated party transactions do not provide a

safe-harbor minimum payment for related party intangibles transfers.

Where taxpayers transfer intangibles with a high profit potential, the

compensation for the intangibles should be greater than industry aver-

ages or norms. * * *

* * * * * * *

In requiring that payments be commensurate with the income stream,

the bill does not intend to mandate the use of the ‘‘contract manufac-

turer’’ or ‘‘cost-plus’’ methods of allocating income or any other particular

method. As under present law, all the facts and circumstances are to be

considered in determining what pricing methods are appropriate in cases

involving intangible property, including the extent to which the trans-

feree bears real risks with respect to its ability to make a profit from

the intangible or, instead, sells products produced with the intangible

largely to related parties (which may involve little sales risk or activity)

and has a market essentially dependent on, or assured by, such related

parties’ marketing efforts. However, the profit or income stream gen-

erated by or associated with intangible property is to be given primary

weight.

[H.R. Rept. No. 99–426, at 423–426 (1985), 1986–3 C.B. (Vol. 2) 1,

423–426.]

The conference report that accompanied the 1986 amend-

ment to section 482 states, in relevant part, as follows:

In view of the fact that the objective of these provisions—that the divi-

sion of income between related parties reasonably reflect the relative

economic activity undertaken by each—applies equally to inbound trans-

fers, the conferees concluded that it would be appropriate for these prin-

ciples to apply to transfers between related parties generally if income

must otherwise be taken into account.

* * * * * * *

The conferees are also aware that many important and difficult issues

under section 482 are left unresolved by this legislation. The conferees

98 145 UNITED STATES TAX COURT REPORTS (91)

believe that a comprehensive study of intercompany pricing rules by the

Internal Revenue Service should be conducted and that careful consider-

ation should be given to whether the existing regulations could be modi-

fied in any respect.

In revising section 482, the conferees do not intend to preclude the use

of certain bona fide research and development cost-sharing arrange-

ments 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 allo-

cated among the parties reasonably reflect the actual economic activity

undertaken by each. Under such a bona fide cost-sharing arrangement,

the cost-sharer would be expected to bear its portion of all research and

development costs, on unsuccessful as well as successful products within

an appropriate product area, and the costs of research and development

at all relevant development stages would be included. In order for cost-

sharing arrangements to produce results consistent with the changes

made by the Act to royalty arrangements, it is envisioned that the

allocation of R&D cost-sharing arrangements generally should be propor-

tionate to profit as determined before deduction for research and

development. In addition, to the extent, if any, that one party is actually

contributing funds toward research and development at a significantly

earlier point in time than the other, or is otherwise effectively putting

its funds at risk to a greater extent than the other, it would be expected

that an appropriate return would be required to such party to reflect its

investment.

[H.R. Conf. Rept. No. 99–841 (Vol. II), at II–637 through II–638

(1986), 1986–3 C.B. (Vol. 4) 1, 637–638.]

C. Treasury’s Position That the Commensurate-With-

Income Standard Was Intended To Work Consistently

With the Arm’s-Length Standard

As the conference report suggested, Treasury and the

Internal Revenue Service (IRS) conducted a comprehensive

study of the regulations under section 482, the results of

which they published in Notice 88–123, 1988–2 C.B. 458

(1988 White Paper).

The 1988 White Paper concluded that the arm’s-length

standard is the international norm for making transfer

pricing adjustments. Id., 1988–2 C.B. at 475 (‘‘The arm’s

length standard is embodied in all U.S. tax treaties; it is in

each major model treaty, including the U.S. Model Conven-

tion; it is incorporated into most tax treaties to which the

United States is not a party; it has been explicitly adopted

by international organizations that have addressed them-

selves to transfer pricing issues; and virtually every major

industrial nation takes the arm’s length standard as its

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 99

frame of reference in transfer pricing cases.’’ (Fn. ref.

omitted.)). The 1988 White Paper further concluded that

Congress intended for the commensurate-with-income

standard to work consistently with the arm’s-length

standard. See id. (‘‘To allay fears that Congress intended the

commensurate with income standard to be implemented in a

manner inconsistent with international transfer pricing

norms and U.S. treaty obligations, Treasury officials publicly

stated that Congress intended no departure from the arm’s

length standard, and that the Treasury Department would so

interpret the new law.’’).

The 1988 White Paper explained that the commensurate-

with-income standard is consistent with the arm’s-length

standard because

[l]ooking at the income related to the intangible and splitting it

according to relative economic contributions is consistent with what

unrelated parties do. The general goal of the commensurate with income

standard is, therefore, to ensure that each party earns the income or

return from the intangible that an unrelated party would earn in an

arm’s length transfer of the intangible. [Id., 1988–2 C.B. at 472.]

Accordingly, in technical explanations to numerous income

tax treaties that the United States has entered into since

then, Treasury has repeatedly affirmed that Congress

intended for the commensurate-with-income standard to

work consistently with the arm’s-length standard. See, e.g.,

Treasury Department Technical Explanation of the 2001

U.S.-U.K. Income Tax Convention, art. 9, Tax Treaties (CCH)

para. 10,911, at 201,307 (‘‘It is understood that the ‘commen-

surate with income’ standard for determining appropriate

transfer prices for intangibles, added to Code section 482 by

the Tax Reform Act of 1986, was designed to operate consist-

ently with the arm’s-length standard.’’); Treasury Depart-

ment Technical Explanation of the 2006 U.S. Model Income

Tax Convention, art. 9, Tax Treaties (CCH) para. 215, at

10,640–10,641 (same).

IV. 1995 Cost-Sharing Regulations

We have previously considered whether controlled tax-

payers must include stock-based compensation in the pool of

costs to be shared. Most recently, in Xilinx Inc. v. Commis-

sioner, 125 T.C. 37 (2005), aff ’d, 598 F.3d 1191 (9th Cir.

2010), we addressed the treatment of stock-based compensa-

100 145 UNITED STATES TAX COURT REPORTS (91)

tion with respect to taxable years subject to cost-sharing

regulations that Treasury finalized in 1995 (1995 cost-

sharing regulations). Because our findings and conclusions,

and the conclusions of the U.S. Court of Appeals for the

Ninth Circuit, in Xilinx are relevant in these cases, we

briefly review the 1995 cost-sharing regulations, our Opinion

in Xilinx, and the opinions of the U.S. Court of Appeals for

the Ninth Circuit in that case.

A. Regulatory Provisions

The 1995 cost-sharing regulations prohibited the District

Director from making allocations under section 482 ‘‘except

to the extent necessary to make each controlled participant’s

share of the costs * * * of intangible development under the

qualified cost-sharing arrangement equal to its share of

reasonably anticipated benefits attributable to such develop-

ment’’. T.D. 8632, 1996–1 C.B. 85, 90. The 1995 cost-sharing

regulations further provided that ‘‘a controlled participant’s

costs of developing intangibles * * * [include] all of the costs

incurred by that participant related to the intangible

development area’’. Id., 1996–1 C.B. at 92.

B. Our Opinion in Xilinx

In Xilinx Inc. v. Commissioner, 125 T.C. 37, the taxpayer

challenged deficiencies determined under the 1995 cost-

sharing regulations on the basis of the Commissioner’s deter-

mination that the taxpayer should have included the value

of stock-based compensation in the intangible development

cost pool. Assuming arguendo that the value of stock-based

compensation is a cost under the 1995 cost-sharing regula-

tions, we held that the Commissioner’s allocations failed to

satisfy the arm’s-length standard of section 1.482–1(b)(1),

Income Tax Regs. See id. at 53.

In reaching this holding we concluded that, consistent with

the 1995 cost-sharing regulations, (1) in determining the true

taxable income of a controlled taxpayer, the arm’s-length

standard applies in all cases, see id. at 54–55; (2) the arm’s-

length standard requires an analysis of what unrelated enti-

ties would do, see id. at 53–54; (3) the commensurate-with-

income standard was never intended to supplant the arm’s-

length standard, see id. at 56–58; and (4) unrelated parties

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 101

would not share the exercise spread or grant date value 4 of

stock-based compensation, see id. at 58–62.

In concluding that unrelated parties would not share either

the exercise spread or grant date value of stock-based com-

pensation, (1) we observed that the Commissioner’s expert

agreed that unrelated parties would not explicitly share the

exercise spread or grant date value of stock-based compensa-

tion because unrelated parties would find it hard to agree

how to measure such value and because doing so would leave

them open to potential disputes, see id. at 58; (2) we found

that the taxpayers proved that companies do not take into

account either the exercise spread or grant date value of

stock-based compensation for product pricing purposes, see

id. at 59; (3) we observed that the Commissioner produced no

credible evidence showing that unrelated parties implicitly

share the exercise spread or grant date value of stock-based

compensation, see id.; (4) we credited the testimony of the

taxpayers’ numerous fact witnesses who testified that unre-

lated parties do not share either the exercise spread or grant

date value of stock-based compensation in cost-sharing agree-

ments, see id.; (5) we found that the taxpayers proved that

‘‘if unrelated parties believed that the spread and grant date

value were costs’’, they ‘‘would be very explicit about their

treatment’’, id.; (6) we credited the testimony of the tax-

payers’ expert who testified that unrelated parties would not

agree to share spread-based cost because doing so would

create perverse incentives for each party to diminish the

stock price of the other, see id. at 61; and (7) we observed

that during the years in issue the grant value of stock-based

compensation was generally not treated as an expense for tax

and financial accounting purposes, see id. at 61–62.

C. The Ninth Circuit Opinions in Xilinx

The U.S. Court of Appeals for the Ninth Circuit initially

reversed our Opinion in Xilinx. The majority opinion by

Judge Fisher reasoned that ‘‘[b]ecause the all costs require-

ment [of the 1995 cost-sharing regulations] is irreconcilable

4 The exercise spread value is the spread between the option strike price

and the price of the underlying stock when the option is exercised. See

Xilinx Inc. v. Commissioner, 125 T.C. 37, 47 (2005), aff ’d, 598 F.3d 1191

(9th Cir. 2010). The grant date value is the fair market value of the option

on its grant date. See id. at 50.

102 145 UNITED STATES TAX COURT REPORTS (91)

with the arm’s length standard,’’ the more specific all costs

requirement controls. Xilinx Inc. v. Commissioner, 567 F.3d

482, 489 (9th Cir. 2009), rev’g and remanding 125 T.C. 37,

withdrawn, 592 F.3d 1017 (9th Cir. 2010). The dissenting

opinion by Judge Noonan agreed that the regulations were

irreconcilable, see id. at 497 (Noonan, J., dissenting), but con-

cluded that the all costs requirement should be construed as

not applying to stock-based compensation because (1) the

regulations should be interpreted in the light of the domi-

nant purpose of the statute—‘‘parity between taxpayers in

uncontrolled transactions and taxpayers in controlled trans-

actions’’, id. at 498; (2) any inconsistencies in the regulations

should be construed against the Government, see id.; and (3)

Treasury’s technical explanation of the income tax conven-

tion between the United States and Ireland confirms that the

commensurate-with-income standard is meant to work

consistently with the arm’s-length standard, see id. at

498–500 (‘‘This article incorporates in the Convention the

arm’s[-]length principle reflected in the U.S. domestic

transfer pricing provision, particularly Code section 482.

* * * It is understood that the ‘commensurate with income’

standard for determining appropriate transfer prices for

intangibles, added to Code section 482 by the Tax Reform Act

of 1986, was designed to operate consistently with the arm’s-

length standard.’’ (quoting Treasury Department Technical

Explanation of the Convention for the Avoidance of Double

Taxation and the Prevention of Fiscal Evasion with Respect

to Taxes on Income and Capital Gains Signed at Dublin on

July 28, 1997, and the Protocol Signed at Dublin on July 28,

1997 (1997 U.S.-Ir. Income Tax Convention and Protocol),

U.S.-Ir., Tax Treaties (CCH) para. 4435, at 103,223)).

The Court of Appeals subsequently withdrew its opinion in

Xilinx and issued a new opinion affirming our Opinion in

Xilinx. The new opinion by Judge Noonan was in substance

similar to his original dissenting opinion, with the exception

that the new opinion did not rest its reasoning on the notion

that inconsistencies in the regulations should be resolved

against the Government. See Xilinx Inc. v. Commissioner,

598 F.3d at 1191–1197 (Noonan, J.).

Judge Fisher’s concurring opinion first explained the par-

ties’ ‘‘dueling interpretations of the ‘arm’s length standard’ ’’.

Id. at 1197 (Fisher, J., concurring). According to Judge

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 103

Fisher, Xilinx contended that the arm’s-length standard

required ‘‘controlled parties * * * [to] share only those costs

uncontrolled parties share.’’ Id. By contrast, the Commis-

sioner contended that

analyzing comparable transactions is unhelpful in situations where

related and unrelated parties always occupy materially different cir-

cumstances. As applied to sharing * * * [employee-stock-option (ESO)]

costs, the Commissioner argues (consistent with the tax court’s findings)

that the reason unrelated parties do not, and would not, share ESO costs

is that they are unwilling to expose themselves to an obligation that will

vary with an unrelated company’s stock price. Related companies are

less prone to this concern precisely because they are related—i.e.,

because XI is wholly owned by Xilinx, it is already exposed to variations

in Xilinx’s overall stock price, at least in some respects. * * * [Id.]

Judge Fisher concluded ‘‘that Xilinx’s understanding of the

regulations is the more reasonable even if the Commis-

sioner’s current interpretation may be theoretically plau-

sible.’’ Id. at 1198. He further explained that ‘‘we need not

defer to * * * [the Commissioner’s interpretation of the

arm’s-length standard] because he has not clearly articulated

his rationale until now.’’ Id. (citing United States v. Thomp-

son/Ctr. Arms Co., 504 U.S. 505, 518–519 & n.9 (1992)). In

a footnote Judge Fisher added: ‘‘It is an open question

whether these flaws have been addressed in the new

regulations Treasury issued after the tax years at issue

in this case.’’ Id. n.4. Notwithstanding Judge Fisher’s con-

cerns, Judge Reinhardt, dissenting, would have continued to

adhere to the panel’s original opinion. See id. at 1199–1200

(Reinhardt, J., dissenting).

V. 2003 Cost-Sharing Regulations

A. Notice of Proposed Rulemaking

In July 2002 Treasury issued a notice of proposed rule-

making and notice of a public hearing (NPRM) with respect

to proposed amendments to the 1995 cost-sharing regula-

tions. The NPRM set a public hearing on the proposed

amendments for November 20, 2002. See 67 Fed. Reg. 48997

(July 29, 2002). The preamble to the NPRM states that the

proposed amendments to the 1995 cost-sharing regulations

sought to clarify

104 145 UNITED STATES TAX COURT REPORTS (91)

that stock-based compensation must be taken into account in deter-

mining operating expenses under § 1.482–7(d)(1)[, Income Tax Regs.,]

and to provide rules for measuring stock-based compensation costs * * *

[, and] to include express provisions to coordinate the cost sharing rules

of § 1.482–7[, Income Tax Regs.,] with the arm’s length standard as set

forth in § 1.482–1[, Income Tax Regs.]. [Id. at 48998.]

B. Comments Submitted in Response to the Proposed Regu-

lations

In response to the NPRM the following persons and

organizations submitted written comments to Treasury: (1)

American Electronics Association (AeA); (2) Baker &

McKenzie, LLP, on behalf of the Software Finance and Tax

Executives Council (SoFTEC); (3) Deloitte & Touche, LLP; (4)

Ernst & Young LLP, on behalf of the Global Competitiveness

Coalition (Global); (5) Fenwick & West, LLP (Fenwick); (6)

Financial Executives International (FEI); (7) Information

Technology Association of America; (8) Information Tech-

nology Industry Council; (9) KPMG, LLP; (10) Pricewater-

houseCoopers, LLP (PwC); (11) Irish Office of the Revenue

Commissioners; (12) Joseph A. Grundfest, W.A. Franke Pro-

fessor of Law and Business, Stanford Law School; (13) Xilinx

Inc. Additionally, the following four persons spoke at the

November 20, 2002, public hearing: (1) Eric D. Ryan, of PwC;

(2) Ron Schrotenboer, of Fenwick; (3) John M. Peterson, Jr.,

of Baker & McKenzie, LLP and on behalf of SoFTEC; and (4)

Caroline Graves Hurley, of AeA. 5

Several of the commentators informed Treasury that they

knew of no transactions between unrelated parties, including

any cost-sharing arrangement, service agreement, or other

contract, that required one party to pay or reimburse the

other party for amounts attributable to stock-based com-

pensation.

AeA provided to Treasury the results of a survey of its

members. AeA member companies reviewed their arm’s-

length codevelopment and joint venture agreements and

found none in which the parties shared stock-based com-

pensation. For those agreements that did not explicitly

address the treatment of stock-based compensation, the

5 Tax Analysts prepared a written transcript of the November 20, 2002,

hearing. Treasury did not request or pay for the transcript and did not

identify it as an ‘‘official’’ transcript.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 105

companies reviewed their accounting records and found none

in which any costs associated with stock-based compensation

were shared.

AeA and PwC represented to Treasury that they conducted

multiple searches of the Electronic Data Gathering, Analysis,

and Retrieval (EDGAR) system 6 and found no cost-sharing

agreements between unrelated parties in which the parties

agreed to share either the exercise spread or grant date

value of stock-based compensation.

Several commentators identified arm’s-length agreements

in which stock-based compensation was not shared or

reimbursed. For example, (1) AeA identified, and PwC pro-

vided, a 1997 collaboration agreement between Amylin

Pharmaceuticals, Inc., and Hoechst Marion Roussel, Inc.

(Amylin-HMR collaboration agreement), that did not include

stock options in the pool of costs to be shared; (2) PwC identi-

fied a joint development agreement between the bio-

technology company AgraQuest, Inc., and Rohm & Haas

under which only ‘‘out-of-pocket costs’’ would be shared; (3)

PwC identified a 1999 cost-sharing agreement between soft-

ware companies Healtheon Corp. and Beech Street Corp.

that expressly excluded stock options from the pool of

expenses to be shared. Additionally, in written comments,

and again at the November 20, 2002, hearing, Ms. Hurley

offered to provide Treasury with more detailed information

regarding several agreements involving AeA member compa-

nies, provided that the companies received adequate assur-

ances that their proprietary information would not be dis-

closed. 7

FEI submitted model accounting procedures from the

Council of Petroleum Accountant Societies (COPAS) for

sharing costs among joint operating agreement partners in

the petroleum industry. FEI noted that COPAS recommends

that joint operating agreements should not allow stock

6 EDGAR is maintained by the Securities and Exchange Commission

(SEC) and is a public and searchable database that provides users with

free access to registration statements, periodic reports, and other forms

filed by companies, including ‘‘material contracts’’ that are required by law

to be attached as exhibits to certain SEC forms.

7 Respondent admits that Treasury never had any discussions with the

AeA member companies regarding the arm’s-length cost-sharing agree-

ments that the AeA member companies offered to discuss.

106 145 UNITED STATES TAX COURT REPORTS (91)

options to be charged against the joint account because they

are difficult to accurately value.

AeA, SoFTEC, KPMG, and PwC cited the practice of the

Federal Government, which regularly enters into cost-

reimbursement contracts at arm’s length. They noted that

Federal acquisition regulations prohibit reimbursement of

amounts attributable to stock-based compensation. 8

AeA, Global, and PwC explained that, from an economic

perspective, unrelated parties would not agree to share or

reimburse amounts related to stock-based compensation

because the value of stock-based compensation is speculative,

potentially large, and completely outside the control of the

parties. SoFTEC provided a detailed economic analysis from

economists William Baumol and Burton Malkiel reaching the

same conclusion.

Finally, the Baumol and Malkiel analysis concluded that

there is no net economic cost to a corporation or its share-

holders from the issuance of stock-based compensation. Simi-

larly, Mr. Grundfest asserted that a company’s ‘‘decision to

grant options to employees * * * does not change its oper-

ating expenses’’ and does not factor into its pricing decisions.

C. Final Rule

1. Regulatory Provisions

In August 2003 Treasury issued the final rule. The final

rule explicitly required parties to QCSAs to share stock-

based compensation costs. See sec. 1.482–7(d)(2), Income Tax

Regs. The final rule also added sections 1.482–1(b)(2)(i)

through 1.482–7(a)(3), Income Tax Regs., to provide that a

QCSA produces an arm’s-length result only if the parties’

costs are determined in accordance with the final rule. See

T.D. 9088, 2003–2 C.B. 841, 847–848.

The final rule provides two methods for measuring the

value of stock-based compensation: a default method and an

elective method. Under the default method, ‘‘the costs attrib-

utable to stock-based compensation generally are included as

intangible development costs upon the exercise of the option

and measured by the spread between the option strike price

8 Federal acquisition regulations prohibit contractors from charging the

Government for stock-based compensation. See 48 C.F.R. sec. 31.205–6(i)

(2013).

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 107

and the price of the underlying stock.’’ Id., 2003–2 C.B. at

844. Under the elective method, ‘‘the costs attributable to

stock options are taken into account in certain cases in

accordance with the ‘fair value’ of the option, as reported for

financial accounting purposes either as a charge against

income or in footnoted disclosures.’’ Id. The elective method,

however, is available only with respect to options on stock

that is publicly traded ‘‘on an established United States secu-

rities market and is issued by a company whose financial

statements are prepared in accordance with United States

generally accepted accounting principles for the taxable

year.’’ Sec. 1.482–7(d)(3)(iii)(B)(2), Income Tax Regs.

2. Lack of Evidence From Uncontrolled Transactions

When it issued the final rule, the files maintained by

Treasury relating to the final rule did not contain any expert

opinions, empirical data, or published or unpublished arti-

cles, papers, surveys, or reports supporting a determination

that the amounts attributable to stock-based compensation

must be included in the cost pool of QCSAs to achieve an

arm’s-length result. Those files also did not contain any

record that Treasury searched any database that could have

contained agreements between unrelated parties relating to

joint undertakings or the provision of services. Additionally,

Treasury was unaware of any written contract between unre-

lated parties, whether in a cost-sharing arrangement or

otherwise, that required one party to pay or reimburse the

other party for amounts attributable to stock-based com-

pensation; or any evidence of any actual transaction between

unrelated parties, whether in a cost-sharing arrangement or

otherwise, in which one party paid or reimbursed the other

party for amounts attributable to stock-based compensation.

3. Response to Comments

The preamble to the final rule responded to comments that

asserted that the proposed amendments to the 1995 cost-

sharing regulations were inconsistent with the arm’s-length

standard, in relevant part, as follows:

Treasury and the IRS continue to believe that requiring stock-based

compensation to be taken into account for purposes of QCSAs is con-

sistent with the legislative intent underlying section 482 and with the

arm’s length standard (and therefore with the obligations of the United

108 145 UNITED STATES TAX COURT REPORTS (91)

States under its income tax treaties and with the OECD transfer pricing

guidelines). The legislative history of the Tax Reform Act of 1986

expressed Congress’s intent to respect cost sharing arrangements as con-

sistent with the commensurate with income standard, and therefore con-

sistent with the arm’s length standard, if and to the extent that the

participants’ shares of income ‘‘reasonably reflect the actual economic

activity undertaken by each.’’ See H.R. Conf. Rep[t]. No. 99–481 [Vol. II],

at II–638 (1986). * * * In order for the costs incurred by a participant

to reasonably reflect its actual economic activity, the costs must be

determined on a comprehensive basis. Therefore, in order for a QCSA to

reach an arm’s length result consistent with legislative intent, the QCSA

must reflect all relevant costs, including such critical elements of cost as

the cost of compensating employees for providing services related to the

development of the intangibles pursuant to the QCSA. Treasury and the

IRS do not believe that there is any basis for distinguishing between

stock-based compensation and other forms of compensation in this con-

text.

Treasury and the IRS do not agree with the 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. Section 1.482–1(b)(1)[, Income Tax

Regs.,] provides 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

the same transaction under the same circumstances.’’ * * * While the

results actually realized in similar transactions under similar cir-

cumstances ordinarily provide significant evidence in determining

whether a controlled transaction meets the arm’s length standard, in the

case of QCSAs such data may not be available. As recognized in the

legislative history of the Tax Reform Act of 1986, there is little, if any,

public data regarding transactions involving high-profit intangibles. H.R.

Rep[t]. No. 99–426, at 423-[4]25 (1985). The uncontrolled transactions

cited by commentators do not share enough characteristics of QCSAs

involving the development of high-profit intangibles to establish that

parties at arm’s length would not take stock options into account in the

context of an arrangement similar to a QCSA. Government contractors

that are entitled to reimbursement for services on a cost-plus basis

under government procurement law assume substantially less entrepre-

neurial risk than that assumed by service providers that participate in

QCSAs, and therefore the economic relationship between the parties to

such an arrangement is very different from the economic relationship

between participants in a QCSA. The other agreements highlighted by

commentators establish arrangements that differ significantly from

QCSAs in that they provide for the payment of markups on cost or of

non-cost-based service fees to service providers within the arrangement

or for the payment of royalties among participants in the arrangement.

Such terms, which may have the effect of mitigating the impact of using

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 109

a cost base to be shared or reimbursed that is less than comprehensive,

would not be permitted by the QCSA regulations. * * *

The regulations relating to QCSAs have as their focus reaching results

consistent with what parties at arm’s length generally would do if they

entered into cost sharing arrangements for the development of high-

profit intangibles. These final regulations reflect that at arm’s length the

parties to an arrangement that is based on the sharing of costs to

develop intangibles in order to obtain the benefit of an independent right

to exploit such intangibles would ensure through bargaining that the

arrangement reflected all relevant costs, including all costs of compen-

sating employees for providing services related to the arrangement. Par-

ties dealing at arm’s length in such an arrangement based on the

sharing of costs and benefits generally would not distinguish between

stock-based compensation and other forms of compensation.

For example, assume that two parties are negotiating an arrangement

similar to a QCSA in order to attempt to develop patentable pharma-

ceutical products, and that they anticipate that they will benefit equally

from their exploitation of such patents in their respective geographic

markets. Assume further that one party is considering the commitment

of several employees to perform research with respect to the arrange-

ment. That party would not agree to commit employees to an arrange-

ment that is based on the sharing of costs in order to obtain the benefit

of independent exploitation rights unless the other party agrees to

reimburse its share of the compensation costs of the employees. Treasury

and the IRS believe that if a significant element of that compensation

consists of stock-based compensation, the party committing employees to

the arrangement generally would not agree to do so on terms that ignore

the stock-based compensation.

[T.D. 9088, 2003–2 C.B. at 842–843.]

The preamble to the final rule responded to comments that

asserted that stock-based compensation does not constitute

an economic cost, or relevant economic cost, as follows:

Treasury and the IRS continue to believe that requiring stock-based

compensation to be taken into account in the context of QCSAs is appro-

priate. The final regulations provide that stock-based compensation must

be taken into account in the context of QCSAs because such a result is

consistent with the arm’s length standard. Treasury and the IRS agree

that the disposition of financial reporting issues does not mandate a par-

ticular result under these regulations. [Id., 2003–2 C.B. at 843.]

The preamble to the final rule responded to comments that

asserted that parties at arm’s length would not share either

the exercise spread or grant date value of stock-based com-

pensation because they would produce results that are too

speculative or not sufficiently related to the employee serv-

ices that are compensated, as follows:

110 145 UNITED STATES TAX COURT REPORTS (91)

Treasury and the IRS believe that it is appropriate for regulations to

prescribe guidance in this context that is consistent with the arm’s

length standard and that also is objective and administrable. As long as

the measurement method is determined at or before grant date, either

of the prescribed measurement methods can be expected to result in an

appropriate allocation of costs among QCSA participants and therefore

would be consistent with the arm’s length standard. [Id., 2003–2 C.B. at

844.]

Finally, the preamble to the final rule states that ‘‘[i]t has

also been determined that [APA] section 553(b) * * * does

not apply to these regulations.’’ Id., 2003–2 C.B. at 847.

Discussion

I. Summary Judgment

Rule 121(a) provides that either party may move for sum-

mary judgment upon all or any part of the legal issues in

controversy. Full or partial summary judgment may be

granted only if it is demonstrated that there is no genuine

dispute as to any material fact and that a decision may be

rendered as a matter of law. See Rule 121(b); Sundstrand

Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff ’d, 17

F.3d 965 (7th Cir. 1994). We conclude that there is no gen-

uine dispute as to any material fact relating to the issue pre-

sented by the parties’ cross-motions for partial summary

judgment and that the issue may be decided as a matter of

law.

II. Applicable Principles of Administrative Law

A. Notice and Comment Rulemaking

Pursuant to APA sec. 553, in promulgating regulations

through informal rulemaking an agency must (1) publish a

notice of proposed rulemaking in the Federal Register, 9 see

APA sec. 553(b); (2) provide ‘‘interested persons an oppor-

tunity to participate in the rule making through submission

of written data, views, or arguments with or without oppor-

tunity for oral presentation’’, id. subsec. (c); and (3) ‘‘[a]fter

9 The notice of proposed rulemaking must include ‘‘(1) a statement of the

time, place, and nature of public rule making proceedings; (2) reference to

the legal authority under which the rule is proposed; and (3) either the

terms or substance of the proposed rule or a description of the subjects and

issues involved.’’ APA sec. 553(b).

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 111

consideration of the relevant matter presented, * * * incor-

porate in the rules adopted a concise general statement of

their basis and purpose’’, id. These requirements do not

apply to interpretive rules, 10 see id. subsec. (b)(A), or when

an agency for good cause finds—and incorporates its findings

in the rules issued—that ‘‘notice and public procedure

thereon are impracticable, unnecessary, or contrary to the

public interest’’, id. para. (B).

Generally, interpretive rules merely explain preexisting

substantive law. See Hemp Indus. Ass’n v. DEA, 333 F.3d

1082, 1087 (9th Cir. 2003). Substantive (or legislative) rules

by contrast, ‘‘create rights, impose obligations, or effect a

change in existing law’’. Id. Stated simply, ‘‘legislative rules,

unlike interpretive rules, have the ‘force of law.’ ’’ Id. (quoting

Am. Mining Cong. v. Mine Safety & Health Admin., 995 F.2d

1106, 1109 (D.C. Cir. 1993)); see also Chrysler Corp. v.

Brown, 441 U.S. 281, 301–302 (1979).

A rule has the force of law ‘‘only if Congress has delegated

legislative power to the agency and if the agency intended to

exercise that power in promulgating the rule.’’ Am. Mining

Cong., 995 F.2d at 1109 (citing Am. Postal Workers Union v.

USPS, 707 F.2d 548, 558 (D.C. Cir. 1983)). The U.S. Court

of Appeals for the Ninth Circuit, to which an appeal in these

cases appears to lie absent a stipulation to the contrary, see

sec. 7482(b)(1)(B), (2), has held that we can infer that an

agency intends for a rule to have the force of law in any of

the following circumstances: ‘‘(1) when, in the absence of the

rule, there would not be an adequate legislative basis for

enforcement action; (2) when the agency has explicitly

invoked its general legislative authority; or (3) when the rule

effectively amends a prior legislative rule,’’ Hemp Indus., 333

10 We have previously referred to regulations issued pursuant to specific

grants of rulemaking authority as legislative regulations and regulations

issued pursuant to Treasury’s general rulemaking authority, under sec.

7805(a), as interpretive regulations. See, e.g., Tutor-Saliba Corp. v. Com-

missioner, 115 T.C. 1, 7 (2000). Because the terms ‘‘legislative’’ and ‘‘inter-

pretive’’ have different meanings in the administrative law context, see

Hemp Indus. Ass’n v. DEA, 333 F.3d 1082, 1087 (9th Cir. 2003), we will

refer to regulations issued pursuant to specific grants of rulemaking au-

thority as specific authority regulations and regulations issued pursuant to

Treasury’s general rulemaking authority, under sec. 7805(a), as general

authority regulations.

112 145 UNITED STATES TAX COURT REPORTS (91)

F.3d at 1087 (citing Am. Mining Cong., 995 F.2d 1106), or

‘‘effect[s] a change in existing law or policy’’, D.H. Blattner &

Sons, Inc. v. Sec’y of Labor, Mine Safety & Health Admin.,

152 F.3d 1102, 1109 (9th Cir. 1998) (alteration in original)

(quoting Powderly v. Schweiker, 704 F.2d 1092, 1098 (9th

Cir. 1983)). In determining whether a rule is interpretive or

legislative we ‘‘need not accept the agency characterization at

face value.’’ Hemp Indus., 333 F.3d at 1087 (citing Gunderson

v. Hood, 268 F.3d 1149, 1154 n.27 (9th Cir. 2001)).

The notice and comment requirements of APA sec. 553 ‘‘are

intended to assist judicial review as well as to provide fair

treatment for persons affected by a rule.’’ Home Box Office,

Inc. v. FCC, 567 F.2d 9, 35 (D.C. Cir. 1977). Accordingly,

‘‘there must be an exchange of views, information, and criti-

cism between interested persons and the agency.’’ Id.

Additionally, because ‘‘the opportunity to comment is mean-

ingless unless the agency responds to significant points

raised by the public’’, an agency is required to respond to

significant comments. 11 Id. at 35–36. However, ‘‘[t]he failure

to respond to comments is significant only insofar as it dem-

onstrates that the agency’s decision was not based on a

consideration of the relevant factors.’’ Sherley v. Sebelius, 689

F.3d 776, 784 (D.C. Cir. 2012) (quoting Covad Commc’ns v.

FCC, 450 F.3d 528, 550 (D.C. Cir. 2006)).

B. Judicial Review of Agency Decisionmaking—State Farm

Review

Pursuant to APA sec. 706(2)(A), a court must ‘‘hold unlaw-

ful and set aside agency action, findings, and conclusions’’

that the court finds to be ‘‘arbitrary, capricious, an abuse of

discretion, or otherwise not in accordance with law’’. A

court’s review under this ‘‘standard is narrow and a court is

not to substitute its judgment for that of the agency.’’ Motor

Vehicle Mfrs. Ass’n of the U.S. v. State Farm Mut. Auto. Ins.

11 ‘‘[O]nlycomments which, if true, raise points relevant to the agency’s

decision and which, if adopted, would require a change in an agency’s pro-

posed rule cast doubt on the reasonableness of a position taken by the

agency. Moreover, comments which themselves are purely speculative and

do not disclose the factual or policy basis on which they rest require no

response.’’ Home Box Office, Inc. v. FCC, 567 F.2d 9, 35 n.58 (D.C. Cir.

1977); see also Am. Mining Cong. v. EPA, 965 F.2d 759, 771 (9th Cir. 1992)

(citing Home Box Office, 567 F.2d at 35 & n.58).

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 113

Co., 463 U.S. 29, 43 (1983); see also Judulang v. Holder, 565

U.S. ll, ll, 132 S. Ct. 476, 483 (2011); Citizens to Pres.

Overton Park, Inc. v. Volpe, 401 U.S. 402, 416 (1971), abro-

gated on other grounds by Califano v. Sanders, 430 U.S. 99

(1977). However, a reviewing court must ensure that the

agency ‘‘engaged in reasoned decisionmaking.’’ Judulang, 565

U.S. at ll, 132 S. Ct. at 484. To engage in reasoned

decisionmaking, ‘‘the agency must examine the relevant data

and articulate a satisfactory explanation for its action

including a ‘rational connection between the facts found and

the choice made.’ ’’ State Farm, 463 U.S. at 43 (quoting Bur-

lington Truck Lines v. United States, 371 U.S. 156, 168

(1962)).

In reviewing an agency action a court must determine

‘‘whether the decision was based on a consideration of the

relevant factors and whether there has been a clear error of

judgment.’’ Id. (quoting Bowman Transp., Inc. v. Arkansas-

Best Freight Sys., Inc., 419 U.S. 281, 285 (1974)); see also

Judulang, 565 U.S. at ll, 132 S. Ct. at 484. ‘‘Normally, an

agency rule would be arbitrary and capricious if the agency

has relied on factors which Congress has not intended it to

consider, entirely failed to consider an important aspect of

the problem, offered an explanation for its decision that runs

counter to the evidence before the agency, or is so implau-

sible that it could not be ascribed to a difference in view or

the product of agency expertise.’’ State Farm, 463 U.S. at 43.

In providing a reasoned explanation for agency action that

departs from an agency’s prior position the agency must ‘‘dis-

play awareness that it is changing position.’’ FCC v. Fox

Television Stations, Inc., 556 U.S. 502, 515 (2009) (citing

United States v. Nixon, 418 U.S. 683, 696 (1974)). However,

the agency need not demonstrate ‘‘that the reasons for the

new policy are better than the reasons for the old one’’. Id.

In examining an agency’s explanation for issuing a rule a

reviewing court ‘‘ ‘may not supply a reasoned basis for the

agency’s action that the agency itself has not given.’ ’’ State

Farm, 463 U.S. at 43 (quoting SEC v. Chenery Corp., 332

U.S. 194, 196 (1947)); see also Carpenter Family Invs., LLC

v. Commissioner, 136 T.C. 373, 380, 396 n.30 (2011). Simi-

larly, when an agency ‘‘relie[s] on multiple rationales (and

has not done so in the alternative), and * * * [a reviewing

court] conclude[s] that at least one of the rationales is defi-

114 145 UNITED STATES TAX COURT REPORTS (91)

cient,’’ Nat’l Fuel Gas Supply Corp. v. FERC, 468 F.3d 831,

839 (D.C. Cir. 2006) (citing Allied-Signal, Inc. v. U.S.

Nuclear Regulatory Comm’n, 988 F.2d 146, 150–151 (D.C.

Cir. 1993), and Consol. Edison Co. of N.Y. v. FERC, 823 F.2d

630, 641–642 (D.C. Cir. 1987)), the court cannot sustain the

agency action on the basis of the sufficient rationale unless

the court is certain that the agency would have taken the

same action ‘‘even absent the flawed rationale’’, id. However,

the reviewing court must ‘‘uphold a decision of less than

ideal clarity if the agency’s path may reasonably be dis-

cerned.’’ State Farm, 463 U.S. at 43 (quoting Bowman

Transp., 419 U.S. at 286).

C. Judicial Review of Agency Statutory Construction—

Chevron Review

A court reviews an agency’s authoritative construction of a

statute under the two-step test first articulated in Chevron,

U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837,

842 (1984). See Mayo Found. for Med. Educ. & Research v.

United States, 562 U.S. 44, 55–58 (2011). In Mayo Found.,

the Supreme Court clarified that both specific authority regu-

lations and general authority regulations are to be accorded

Chevron deference. 12 See id.

Under Chevron step 1, ‘‘applying the ordinary tools of

statutory construction,’’ City of Arlington v. FCC, 569 U.S.

ll, ll, 133 S. Ct. 1863, 1868 (2013), a court must deter-

mine ‘‘whether Congress has directly spoken to the precise

question at issue. If the intent of Congress is clear, that is

the end of the matter; for the court, as well as the agency,

must give effect to the unambiguously expressed intent of

Congress.’’ Chevron, 467 U.S. at 842–843. Under Chevron

step 2, a court must defer to the agency’s authoritative

12 The Supreme Court explained that ‘‘Chevron deference is appropriate

‘when it appears that Congress delegated authority to the agency generally

to make rules carrying the force of law, and that the agency interpretation

claiming deference was promulgated in the exercise of that authority.’ ’’

Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, 57

(2011) (quoting United States v. Mead Corp., 533 U.S. 218, 226–227

(2001)). The Supreme Court concluded that when Treasury issues general

authority regulations after full notice and comment procedures, these con-

ditions are met and those regulations are therefore entitled to Chevron def-

erence. See id. at 56–57.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 115

interpretation of an ambiguous statute ‘‘unless it is ‘arbitrary

or capricious in substance, or manifestly contrary to the

statute.’ ’’ Mayo Found., 562 U.S. at 53 (quoting Household

Credit Servs., Inc. v. Pfennig, 541 U.S. 232, 242 (2004)); see

also Judulang, 565 U.S. at ll, 132 S. Ct. at 483 n.7.

Chevron deference applies even where an agency adopts a

construction that conflicts with a prior judicial construction

of the statute. See Nat’l Cable & Telecomms. Ass’n v. Brand

X Internet Servs., 545 U.S. 967, 982–983 (2005). However, if

a precedential case holds that a statute unambiguously

expresses a congressional intent that is contrary to the

agency’s construction of the statute, the prior judicial

construction controls. See id.; see also United States v. Home

Concrete & Supply, LLC, 566 U.S. ll, ll, 132 S. Ct.

1836, 1844 (2012).

D. Harmless Error

APA sec. 706 instructs reviewing courts to take ‘‘due

account * * * of the rule of prejudicial error.’’ See also Nat’l

Ass’n of Home Builders v. Defenders of Wildlife, 551 U.S. 644,

659–660 (2007) (‘‘In administrative law, as in federal civil

and criminal litigation, there is a harmless error rule[.]’’

(quoting PDK Labs. Inc. v. DEA, 362 F.3d 786, 799 (D.C. Cir.

2004))). This rule reflects the notion that ‘‘[i]f the agency’s

mistake did not affect the outcome, if it did not prejudice the

petitioner, it would be senseless to vacate’’ the agency action.

PDK Labs., 362 F.3d at 799.

III. Preliminary Administrative Law Issues

The parties disagree whether the final rule is a legislative

rule or an interpretive rule. The parties also disagree

regarding the standard of review that we should apply. We

therefore address these issues before considering the validity

of the final rule.

A. APA Sec. 553 Applies to the Final Rule.

Petitioner contends that the final rule is a legislative rule

under APA sec. 553(b) and is therefore subject to the notice

and comment requirements of APA sec. 553 because, if valid,

it would have the force of law. Alternatively, petitioner con-

tends that if the final rule were an interpretive rule, it would

‘‘not have the force and effect of law’’, Shalala v. Guernsey

116 145 UNITED STATES TAX COURT REPORTS (91)

Mem’l Hosp., 514 U.S. 87, 99 (1995), and therefore the final

rule would not be binding on this Court. Respondent agrees

that the final rule has the force of law but disagrees with

petitioner’s contention that it is a legislative rule. However,

respondent declined to argue this issue on brief or at oral

argument.

Instead, respondent contends that we need not decide this

issue because Treasury complied with the notice and com-

ment requirements. However, petitioner contends that

Treasury failed to adequately explain the basis of the final

rule, and Treasury’s obligation to explain the basis of the

final rule depends, at least in part, on its being a legislative

rule subject to the notice and comment requirements of APA

sec. 553. See APA sec. 553(c); cf. Internal Revenue Manual

pt. 32.1.5.4.7.5.1(2) (Sept. 30, 2011) (‘‘[M]ost IRS/Treasury

regulations will be interpretative regulations because they

fill gaps in legislation or have a prior existence in the law.’’);

id. pt. 32.1.5.4.7.3(1) (‘‘In the Explanation of Provisions sec-

tion, the drafting team should describe the substantive provi-

sions of the regulation in clear, concise, plain language

* * *. It is not necessary to justify the rules that are being

proposed or adopted or alternatives that were consid-

ered.’’). 13 Petitioner also contends that Treasury failed to

respond to significant comments, and Treasury’s obligation to

respond to significant comments is derived, at least in part,

from the notice and comment requirements of APA sec. 553.

See Home Box Office, 567 F.2d at 35–36. Moreover, we

cannot avoid this issue because petitioner alternatively con-

tends that the final rule would not bind this Court if it were

an interpretive rule. Consequently, we will decide this issue.

Pursuant to section 7805(a) the Secretary is authorized to

‘‘prescribe all needful rules and regulations for the enforce-

ment of ’’ the Code. Such regulations carry the force of law,

and the Code imposes penalties for failing to follow them.

See, e.g., sec. 6662(b)(1). We therefore conclude that ‘‘Con-

gress has delegated legislative power to’’ Treasury. Am.

Mining Cong., 995 F.2d at 1109.

We further conclude that Treasury intended for the final

rule to have the force of law for the following reasons: (1) the

13 The current version of Internal Revenue Manual pt. 32.1.5.4.7.3(1)

(Oct. 20, 2014) omits the second sentence.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 117

parties stipulated—and we agree, see Xilinx Inc. v. Commis-

sioner, 125 T.C. 37—that the adjustments to petitioner’s

income can be sustained only on the basis of the final rule,

see Hemp Indus., 333 F.3d at 1087, and (2) in promulgating

the final rule Treasury invoked its general legislative rule-

making authority under section 7805(a), see id. The final rule

is therefore a legislative rule. See Am. Mining Cong., 995

F.2d at 1109.

Because it is a legislative rule and Treasury did not find

for good cause that notice and comment were impracticable,

unnecessary, or contrary to the public interest, see APA sec.

553(b)(A) and (B), APA sec. 553 applies to the final rule. We

must therefore also consider whether Treasury satisfied its

obligations under APA sec. 553(b) and (c) in issuing the final

rule.

B. The Final Rule Must Satisfy State Farm’s Reasoned

Decisionmaking Standard.

Petitioner contends that we should review the final rule

under State Farm. Respondent contends that we should

review the final rule under Chevron. For the reasons that fol-

low, we conclude that—regardless of the ultimate standard of

review—the final rule must satisfy State Farm’s reasoned

decisionmaking standard.

Respondent contends that State Farm review is not appro-

priate because the interpretation and implementation of sec-

tion 482 do not require empirical analysis. Similarly,

respondent repeatedly argues that section 482 does not

require allocations to be made with reference to uncontrolled

party conduct. But ‘‘[t]he purpose of section 482 is to place

a controlled taxpayer on a tax parity with an uncontrolled

taxpayer, by determining according to the standard of an

uncontrolled taxpayer, the true taxable income from the

property and business of a controlled taxpayer. * * * The

standard to be applied in every case is that of an uncon-

trolled taxpayer dealing at arm’s length with another uncon-

trolled taxpayer.’’ Commissioner v. First Sec. Bank of Utah,

405 U.S. 394, 400 (1972) (quoting section 1.482–1(b)(1),

Income Tax Regs. (1971)); accord sec. 1.482–1(a)(1), (b)(1),

Income Tax Regs.; Treasury Department Technical Expla-

nation of the 2001 U.S.-U.K. Income Tax Convention, art. 9;

Treasury Department Technical Explanation of the 1997

118 145 UNITED STATES TAX COURT REPORTS (91)

U.S.-Ir. Income Tax Convention and Protocol, art. 9, Tax

Treaties (CCH) para. 4435, at 103,223; Treasury Department

Technical Explanation of the 2006 U.S. Model Income Tax

Convention, art. 9. For these reasons we have previously

stated that ‘‘the determination under section 482 is essen-

tially and intensely factual’’. Procacci v. Commissioner, 94

T.C. 397, 412 (1990).

Section 1.482–1(b)(1), Income Tax Regs., provides that ‘‘[i]n

determining the true taxable income of a controlled taxpayer,

the standard to be applied in every case is that of a taxpayer

dealing at arm’s length with an uncontrolled taxpayer.’’ In

Xilinx Inc. v. Commissioner, 125 T.C. at 53–55, we held that

the arm’s-length standard always requires an analysis of

what unrelated entities do under comparable circumstances.

Similarly, in promulgating the final rule Treasury explicitly

considered whether unrelated parties would share stock-

based compensation costs in the context of a QCSA. See T.D.

9088, 2003–2 C.B. at 843 (‘‘Treasury and the IRS believe that

if a significant element of that compensation consists of

stock-based compensation, the party committing employees

to the arrangement generally would not agree to do so on

terms that ignore the stock-based compensation.’’). Treasury

necessarily decided an empirical question when it concluded

that the final rule was consistent with the arm’s-length

standard.

Respondent counters that Treasury should be permitted to

issue regulations modifying—or even abandoning—the arm’s-

length standard. But the preamble to the final rule does not

justify the final rule on the basis of any modification or

abandonment of the arm’s-length standard, 14 and respondent

concedes that the purpose of section 482 is to achieve tax

parity. 15 The preamble also did not dismiss any of the evi-

14 For example, the preamble does not say that controlled transactions

can never be comparable to uncontrolled transactions because related and

unrelated parties always occupy materially different circumstances. Cf.

Xilinx Inc. v. Commissioner, 598 F.3d at 1197 (Fisher, J., concurring) (‘‘The

Commissioner * * * contends that analyzing comparable transactions is

unhelpful in situations where related and unrelated parties always occupy

materially different circumstances.’’).

15 The preamble states that ‘‘Treasury and the IRS do not agree with the

comments that assert that taking stock-based compensation into account

in the QCSA context would be inconsistent with the arm’s length standard

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 119

dence submitted by commentators regarding unrelated party

conduct as addressing an irrelevant or inconsequential factor.

See id., 2003–2 C.B. at 842–843. We therefore need not

decide whether, under Brand X, 545 U.S. at 982–983,

Treasury would be free to modify or abandon the arm’s-

length standard because it has not done so here. See Chenery

Corp., 332 U.S. at 196; Carpenter Family Invs., LLC v.

Commissioner, 136 T.C. at 380, 396 n.30.

The validity of the final rule therefore turns on whether

Treasury reasonably concluded, see State Farm, 463 U.S. at

43, that it is consistent with the arm’s-length standard, and

that is necessarily an empirical determination. The reason-

ableness of Treasury’s conclusion in no way depends on its

interpretation of section 482 or any other statute. As the

Supreme Court recently articulated, State Farm review is

‘‘the more apt analytic framework’’ where the challenged

regulation does not rely on an agency’s interpretation of a

statute. Judulang, 565 U.S. at ll n.7, 132 S. Ct. at 483.

Nevertheless, respondent contends that we should not

review the final rule under State Farm because the Supreme

Court has never, and this Court has rarely, reviewed

Treasury regulations under State Farm. However,

respondent concedes that Treasury is subject to the APA, and

respondent has not advanced any justification for exempting

Treasury regulations from State Farm review. The Supreme

Court has stated that ‘‘[i]n the absence of such justification,

we are not inclined to carve out an approach to administra-

tive review good for tax law only. To the contrary, we have

expressly ‘[r]ecogniz[ed] the importance of maintaining a uni-

form approach to judicial review of administrative action.’ ’’

Mayo Found., 562 U.S. at 55 (quoting Dickinson v. Zurko,

527 U.S. 150, 154 (1999) (alteration in original)); see also

Dominion Res., Inc. v. United States, 681 F.3d 1313, 1319

(Fed. Cir. 2012) (invalidating the associated-property rule in

section 1.263A–11(e)(1)(ii)(B), Income Tax Regs., under State

Farm).

in the absence of evidence that parties at arm’s length take stock-based

compensation into account in similar circumstances.’’ T.D. 9088, 2003–2

C.B. 841, 842. However, the preamble never suggests that the final rule

could be consistent with the arm’s-length standard if evidence showed that

unrelated parties would not share stock-based compensation costs or that

an evidentiary inquiry was unnecessary. See id., 2003–2 C.B. at 842–843.

120 145 UNITED STATES TAX COURT REPORTS (91)

Ultimately, however, whether State Farm or Chevron sup-

plies the standard of review is immaterial because Chevron

step 2 16 incorporates the reasoned decisionmaking standard

of State Farm. See Judulang, 565 U.S. at ll n.7, 132 S. Ct.

at 483 (stating that, under either standard, the ‘‘analysis

would be the same, because under Chevron step two, we ask

whether an agency interpretation is ‘arbitrary or capricious

in substance’ ’’ (quoting Mayo Found., 562 U.S. at 53));

Torres-Valdivias v. Holder, 766 F.3d 1106, 1114 n.5 (9th Cir.

2014) (citing Judulang, 565 U.S. at ll n.7, 132 S. Ct. at

483); Agape Church, Inc. v. FCC, 738 F.3d 397, 410 (D.C. Cir.

2013) (citing Judulang, 565 U.S. at ll n.7, 132 S. Ct. at

483). 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 decisionmaking 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.

IV. Whether the Final Rule Satisfies State Farm’s Reasoned

Decisionmaking Standard

Petitioner contends that the final rule is invalid because

(A) it lacks a basis in fact, (B) Treasury failed to rationally

connect the choice it made with the facts it found, (C)

Treasury failed to respond to significant comments, and (D)

the final rule is contrary to the evidence before Treasury.

Respondent disagrees.

A. The Final Rule Lacks a Basis in Fact.

Petitioner contends that the final rule lacks a basis in fact

because Treasury issued the final rule without any evidence

that unrelated parties would ever agree to share stock-based

compensation costs. Respondent contends that (1) Treasury

did not rely solely on its belief that unrelated parties

entering into QCSAs would generally share stock-based com-

pensation costs but also on the commensurate-with-income

standard and (2) Treasury was sufficiently experienced with

cost-sharing agreements to conclude that unrelated parties

16 The parties agree that sec. 482 is ambiguous. These cases would there-

fore be resolved at Chevron step 2.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 121

entering into QCSAs would generally share stock-based com-

pensation costs.

1. The Commensurate-With-Income Standard Cannot Jus-

tify the Final Rule.

Although Treasury referred to the commensurate-with-

income standard in the preamble to the final rule, it relied

on its belief that the final rule was required by—or was at

least consistent with—the arm’s-length standard. 17 In Xilinx

Inc. v. Commissioner, 125 T.C. at 56–58, we concluded that

Congress never intended for the commensurate-with-income

standard to supplant the arm’s-length standard. In the 1988

White Paper, Treasury and the IRS similarly concluded that

Congress intended for the commensurate-with-income

standard to work consistently with the arm’s-length

standard. See Notice 88–123, 1988–2 C.B. 458, 472, 475.

Treasury has since repeatedly reinforced this conclusion in

technical explanations to numerous income tax treaties. 18

See, e.g., Treasury Department Technical Explanation of the

2001 U.S.-U.K. Income Tax Convention, art. 9, Tax Treaties

(CCH) para. 10,911, at 201,306–201,307; Treasury Depart-

ment Technical Explanation of the 1997 U.S.-Ir. Income Tax

Convention and Protocol, Tax Treaties (CCH) para. 4435, at

103,223; Treasury Department Technical Explanation of the

2006 U.S. Model Income Tax Convention, art. 9, Tax Treaties

17 In its response to comments asserting that stock-based compensation

does not constitute an economic cost to the issuing corporation, Treasury

appears to have relied exclusively on the arm’s-length standard. See T.D.

9088, 2003–2 C.B. at 843 (‘‘Treasury and the IRS continue to believe that

requiring stock-based compensation to be taken into account in the context

of QCSAs is appropriate. The final regulations provide that stock-based

compensation must be taken into account in the context of QCSAs because

such a result is consistent with the arm’s length standard.’’).

18 ‘‘A tax treaty is negotiated by the United States with the active par-

ticipation of the Treasury. The Treasury’s reading of the treaty is ‘entitled

to great weight.’ ’’ Xilinx Inc. v. Commissioner, 598 F.3d at 1196–1197

(Noonan, J.) (quoting United States v. Stuart, 489 U.S. 353, 369 (1989)),

aff ’g 125 T.C. 37 (2005). Therefore, ‘‘[e]ven if the treaty and the Technical

Explanation should be held not to operate as law trumping the hapless

* * * [final rule], treaty and explanation act as guides. They tell us what

the Treasury * * * had in mind’’, Xilinx Inc. v. Commissioner, 567 F.3d

482, 500–501 (9th Cir. 2009) (Noonan, J., dissenting), rev’g and remanding

125 T.C. 37, withdrawn, 592 F.3d 1017 (9th Cir. 2010), in issuing the final

rule.

122 145 UNITED STATES TAX COURT REPORTS (91)

(CCH) para. 215, at 10,640–10,641. The preamble to the final

rule does not indicate that Treasury intended to abandon

this conclusion and we conclude that it did not. 19

Moreover, because Treasury did not rely exclusively on the

commensurate-with-income standard, we cannot sustain the

final rule solely on that basis if we decide that Treasury’s

reliance on the arm’s-length standard in issuing the final

rule was unreasonable. See Chenery Corp., 332 U.S. at 196;

Nat’l Fuel Gas Supply, 468 F.3d at 839 (citing Allied-Signal,

988 F.2d at 150–151, and Consol. Edison, 823 F.2d at 641–

642). Accordingly, the commensurate-with-income standard,

as interpreted by Treasury, cannot provide a sufficient basis

for the final rule.

2. Treasury’s Unsupported Assertion Cannot Justify the

Final Rule.

A court will generally not override an agency’s ‘‘reasoned

judgment about what conclusions to draw from technical evi-

dence or how to adjudicate between rival scientific [or eco-

nomic] theories’’. Tripoli Rocketry Ass’n v. Bureau of Alcohol,

Tobacco, Firearms & Explosives, 437 F.3d 75, 83 (D.C. Cir.

2006). However, ‘‘where an agency has articulated no rea-

soned basis for its decision—where its action is founded on

unsupported assertions or unstated inferences—* * * [a

court] will not ‘abdicate the judicial duty carefully to ‘‘review

the record to ascertain that the agency has made a reasoned

decision based on reasonable extrapolations from some reli-

able evidence.’’ ’ ’’ Id. (quoting Am. Mining Cong. v. EPA, 907

F.2d 1179, 1187 (D.C. Cir. 1990)).

Respondent concedes that (1) in adopting the final rule,

Treasury took the position that it was not obligated to

engage in fact finding or to follow evidence gathering proce-

dures; (2) the files maintained by Treasury relating to the

final rule did not contain any empirical or other evidence

supporting Treasury’s belief that unrelated parties entering

into QCSAs would generally share stock-based compensation

19 Even were we to conclude that Treasury intended to adopt a more ex-

pansive understanding of the commensurate-with-income standard, we

would be unable to sustain the final rule on that basis because Treasury

never acknowledged that it was changing its position. See FCC v. Fox Tele-

vision Stations, Inc., 556 U.S. 502, 515 (2009) (citing United States v.

Nixon, 418 U.S. 683, 696 (1974)).

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 123

costs; (3) the files maintained by Treasury relating to the

final rule did not have any record that Treasury searched

any database that could have contained agreements between

unrelated parties; and (4) Treasury was unaware of any writ-

ten agreement—or of any transaction—between unrelated

parties that required one party to pay or reimburse the other

party for amounts attributable to stock-based compensa-

tion. 20

The preamble to the final rule offered only Treasury’s

belief that unrelated parties entering into QCSAs would gen-

erally share stock-based compensation costs. Specifically, the

preamble to the final rule states that, in the context of a

hypothetical QCSA between unrelated parties to develop

patentable pharmaceutical products, ‘‘Treasury and the IRS

believe that if a significant element of that compensation

consists of stock-based compensation, the party committing

employees to the arrangement generally would not agree to

do so on terms that ignore the stock-based compensation.’’

T.D. 9088, 2003–2 C.B. at 843. Treasury, however, failed to

provide a reasoned basis for reaching this conclusion from

any evidence in the administrative record. See Tripoli Rock-

etry, 437 F.3d at 83. Indeed, ‘‘every indication in the record

points the other way’’. State Farm, 463 U.S. at 57 (internal

quotation omitted); see infra part IV.C.

Respondent defends Treasury’s failure to provide a rea-

soned basis for its conclusion from any evidence in the

administrative record on the notion that ‘‘[t]here are some

propositions for which scant empirical evidence can be mar-

shaled’’. See Fox Television, 556 U.S. at 519. This may be

true regarding certain propositions, see id. (‘‘the harmful

effect of broadcast profanity on children is one of them’’), but

we do not agree that the belief that unrelated parties would

share stock-based compensation costs in the context of a

QCSA is one of them. First, commentators submitted signifi-

cant evidence regarding this proposition. See infra part IV.C.

20 Treasury’s failure to conduct any factfinding before issuing the final

rule is also evident in the preamble to the final rule. See T.D. 9088, 2003–

2 C.B. at 842 (‘‘While the results actually realized in similar transactions

under similar circumstances ordinarily provide significant evidence in de-

termining whether a controlled transaction meets the arm’s length stand-

ard, in the case of QCSAs such data may not be available.’’ (Emphasis

added.)).

124 145 UNITED STATES TAX COURT REPORTS (91)

Second, we were able to reach a definitive factual determina-

tion on the basis of significant evidence regarding this very

proposition in Xilinx. See Xilinx Inc. v. Commissioner, 125

T.C. at 58–62. Third, Treasury could not have rationally con-

cluded that this is a proposition ‘‘for which scant empirical

evidence can be marshaled’’, see Fox Television, 556 U.S. at

519, without attempting to marshal empirical evidence in the

first instance, which respondent concedes it did not do.

Relying on Peck v. Thomas, 697 F.3d 767 (9th Cir. 2012),

respondent further contends that we must defer to Treas-

ury’s expertise with respect to whether the parties operating

at arm’s length would share stock-based compensation. At

issue in Peck was a regulation issued by the Bureau of

Prisons that denied early release to inmates with a felony

conviction for certain enumerated offenses. In issuing the

regulation the Bureau of Prisons expressly relied on its

‘‘ ‘correctional experience’ ’’ in determining which offenses

warrant preclusion from early release but did not disclose

any statistical studies to support its conclusions. See id. at

773 (quoting 74 Fed. Reg. 1895 (Jan. 14, 2009)). The U.S.

Court of Appeals for the Ninth Circuit rejected an inmate’s

argument that the Bureau of Prisons violated the APA in

issuing this regulation because it did not develop statistical

evidence to support its conclusions. See id. at 775–776. The

Court of Appeals reasoned that the Bureau of Prisons was

entitled to rely on its experience and the APA did not require

it to develop statistical evidence to support its conclusions.

See id. (citing Sacora v. Thomas, 628 F.3d 1059, 1067, 1069

(9th Cir. 2010)).

Respondent’s reliance on Peck is misplaced. First, in Peck,

the Bureau of Prisons relied on its extensive correctional

experience in determining which offenses warrant preclusion

from early release. Here, by contrast, Treasury admits that

it had no knowledge of any transactions in which parties

operating at arm’s length shared stock-based compensation.

Second, the preamble to the regulation at issue in Peck

expressly relied on the Bureau of Prisons’ extensive, hands-

on correctional experience. Here, by contrast, the preamble to

the final rule does not rely on Treasury’s experience as a

party to arm’s-length cost-sharing agreements—or even on

any experience Treasury may have had in examining the

arm’s-length cost-sharing agreements of taxpayers it regu-

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 125

lates. Indeed, the preamble to the final rule all but dis-

claimed Treasury’s reliance on any such experience.

Third, the administrative record for the regulation at issue

in Peck contained no evidence contradicting the Bureau of

Prisons’ correctional experience. Here, by contrast, com-

mentators introduced significant evidence showing that par-

ties operating at arm’s length would not share stock-based

compensation. See infra part IV.C. Peck does not support the

contention that an agency can rely on unsupported assertions

in the face of significant contrary evidence in the administra-

tive record.

We conclude that (1) by failing to engage in any fact

finding, Treasury failed to ‘‘examine the relevant data’’, State

Farm, 463 U.S. at 43, and (2) Treasury failed to support its

belief that unrelated parties would share stock-based com-

pensation costs in the context of a QCSA with any evidence

in the record. Accordingly, the final rule lacks a basis in fact.

B. Treasury Failed To Rationally Connect the Choice It

Made With the Facts It Found.

Petitioner contends that the preamble to the final rule fails

to rationally connect the choice that Treasury made in

issuing a uniform final rule with the facts on which it pur-

ported to rely. See id. The preamble to the final rule

indicates that Treasury relied on its belief that unrelated

parties entering into QCSAs to develop ‘‘high-profit intangi-

bles’’ would share stock-based compensation if the stock-

based compensation was a ‘‘significant element’’ of the com-

pensation. T.D. 9088, 2003–2 C.B. at 842–843. However, peti-

tioner alleges, and respondent does not dispute, that (1)

many QCSAs do not deal with ‘‘high-profit intangibles’’ and

(2) stock-based compensation is often not a ‘‘significant ele-

ment’’ of the compensation of the employees of taxpayers that

enter into QCSAs. Yet the final rule does not distinguish

between QCSAs to develop ‘‘high-profit intangibles’’ in which

stock-based compensation was a ‘‘significant element’’ of the

compensation and QCSAs in which these elements are not

present. Petitioner contends—and we agree—that the pre-

amble’s explanation for Treasury’s decision is therefore inad-

equate. See State Farm, 463 U.S. at 43.

Indeed, respondent does not directly refute petitioner’s

contention. Instead, respondent defends the final rule’s

126 145 UNITED STATES TAX COURT REPORTS (91)

inflexibility by arguing that the final rule is reasonable

because it eases administrative burdens. 21

Improving administrability can be a reasonable basis for

agency action. See Mayo Found., 562 U.S. at 59 (‘‘[Treasury]

reasonably concluded that its full-time employee rule would

‘improve administrability[.]’ ’’ (quoting T.D. 9167, 2005–1 C.B.

261, 262)). However, Treasury failed to give this—or any

other—explanation for treating all QCSAs identically in the

preamble to the final rule, 22 cf. id., and we cannot reason-

ably discern, see State Farm, 463 U.S. at 43, that this was

Treasury’s rationale for adopting a uniform final rule

because the administrative benefits of a uniform final rule

are entirely speculative. 23

Moreover, even if we could discern that this was Treasury’s

intent, we would be unable to sustain the final rule on that

basis because Treasury did not disclose its factual findings

and we would therefore be unable to evaluate whether

Treasury reasonably concluded that the purported adminis-

trative benefits of a uniform final rule can justify erroneously

allocating income in some of those cases. We therefore con-

clude that, by treating all QCSAs identically, Treasury failed

to articulate a ‘‘rational connection between the facts found

21 Respondent also argues that petitioner cannot complain if the final

rule sometimes produces results that are inconsistent with the arm’s-

length standard because the QCSA regime provides an ‘‘elective assured

treatment’’. However, Treasury rejected commentators’ suggestion to issue

the final rule as a safe harbor, see T.D. 9088, 2003–2 C.B. at 843–844, and

we conclude that petitioner has not forfeited its right to challenge the va-

lidity of the final rule because it chose to structure the R&D cost-sharing

agreement as a QCSA.

22 The preamble to the final rule discusses administrability only with re-

spect to Treasury’s selection of the exercise spread method and the elective

grant date method as the only available valuation methods. See T.D. 9088,

2003–2 C.B. at 844.

23 We also note that unlike the statutory provision at issue in Mayo

Found., sec. 482 purports only to empower the Secretary to allocate income

among controlled entities but not to directly govern taxpayer conduct. See

sec. 1.482–1(a)(3), Income Tax Regs. (‘‘If necessary to reflect an arm’s

length result, a controlled taxpayer may report * * * the results of its con-

trolled transactions based upon prices different from those actually

charged.’’ (Emphasis added.)). It is accordingly unclear whether admin-

istrability concerns are relevant in the context of sec. 482. However, be-

cause we cannot reasonably discern that Treasury relied on administra-

bility concerns here, we need not resolve this question.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 127

and the choice made.’’ State Farm, 463 U.S. at 43 (quoting

Burlington Truck Lines, 371 U.S. at 168).

C. Treasury Failed To Respond to Significant Comments.

Petitioner contends that Treasury failed to respond to

significant comments submitted by commentators.

Respondent contends that Treasury was not persuaded by

the submitted comments.

Several commentators informed Treasury that they knew

of no evidence of any transaction between unrelated parties

that required one party to reimburse the other party for

amounts attributable to stock-based compensation. Addition-

ally, AeA informed Treasury that a survey of its member

companies’ arm’s-length codevelopment and joint venture

agreements found none in which the parties agreed to share

stock-based compensation costs. We found similar evidence to

be relevant in Xilinx. See Xilinx Inc. v. Commissioner, 125

T.C. at 59. Treasury never directly responded to this evi-

dence. Instead, Treasury reasoned that the final rule would

not be inconsistent with the arm’s-length standard in the

absence of evidence that unrelated parties share stock-based

compensation costs because relevant data may not be avail-

able. See T.D. 9088, 2003–2 C.B. at 842. Treasury’s response,

however, in no way refutes the commentators’ evidence that

unrelated parties never share such compensation.

AeA and PwC further represented to Treasury that they

conducted multiple searches of the EDGAR system and found

no cost-sharing agreements between unrelated parties in

which the parties agreed to share either the exercise spread

or grant date value of stock-based compensation. Treasury

never responded to this evidence.

Several commentators identified arm’s-length agreements

in which stock-based compensation was not shared or

reimbursed. Treasury responded to these comments by

stating that ‘‘[t]he uncontrolled transactions cited by com-

mentators do not share enough characteristics of QCSAs

involving the development of high-profit intangibles to estab-

lish that parties at arm’s length would not take stock options

into account in the context of an arrangement similar to a

QCSA.’’ Id. In particular, Treasury stated that

128 145 UNITED STATES TAX COURT REPORTS (91)

[t]he other agreements highlighted by commentators establish arrange-

ments that differ significantly from QCSAs in that they provide for the

payment of markups on cost or of non-cost-based service fees to service

providers within the arrangement or for the payment of royalties among

participants in the arrangement. Such terms, which may have the effect

of mitigating the impact of using a cost base to be shared or reimbursed

that is less than comprehensive, would not be permitted by the QCSA

regulations. * * * [Id.]

However, the Amylin-HMR collaboration agreement that AeA

identified and PwC submitted did not ‘‘provide for the pay-

ment of markups on cost or of non-cost-based service fees to

service providers within the arrangement or for the payment

of royalties among participants in the arrangement.’’ Id.

Respondent contends that the Amylin-HMR collaboration

agreement is not comparable to a QCSA for other reasons,

but Treasury failed to identify those reasons in the preamble

to the final rule. 24 See Chenery Corp., 332 U.S. at 196; Car-

penter Family Invs., LLC v. Commissioner, 136 T.C. at 380,

396 n.30. More significantly, Treasury did not explain why

identical transactions are necessary to prove whether unre-

lated parties would share stock-based compensation costs in

the context of a QCSA. In Xilinx Inc. v. Commissioner, 125

T.C. at 58–62, we found that unrelated parties would not

share the exercise spread or grant date value of stock-based

compensation, and in doing so we did not rely on trans-

actions that were identical or substantially similar to QCSAs.

Rather, we relied on the behavior of uncontrolled parties in

comparable business transactions as well as on other evi-

dence. See id. 25

FEI provided model accounting procedures from COPAS

that recommended against sharing stock-based compensation

because it is difficult to value. Treasury never responded to

this evidence.

24 The Amylin-HMR collaboration agreement also would permit the shar-

ing of stock-based compensation based on the intrinsic value method,

under which options issued in-the-money would be recognized as an ex-

pense. However, the treatment of in-the-money stock options is not at

issue here, and the final rule explicitly rejected the use of the intrinsic

value method. See T.D. 9088, 2003–2 C.B. at 844.

25 Treasury appears to require a similar approach in analyzing com-

parability under the sec. 482 regulations. See sec. 1.482–1(d), Income Tax

Regs.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 129

AeA, SoFTEC, KPMG, and PwC cited regulations that pro-

hibit contractors from charging the Federal Government for

stock-based compensation. Treasury responded to this evi-

dence by stating that ‘‘[g]overnment contractors that are

entitled to reimbursement for services on a cost-plus basis

under government procurement law assume substantially

less entrepreneurial risk than that assumed by service pro-

viders that participate in QCSAs’’. See T.D. 9088, 2003–2

C.B. at 842. However, this distinction rings hollow in the face

of other evidence submitted by commentators that showed

that even parties to agreements in which the parties assume

considerable entrepreneurial risk do not share stock-based

compensation costs.

AeA, Global, and PwC explained that, from an economic

perspective, unrelated parties would be unwilling to share

stock-based compensation costs because the value of stock-

based compensation is speculative, potentially large, and

completely outside the control of the parties. SoFTEC sub-

mitted Baumol and Malkiel’s detailed economic analysis

reaching the same conclusion. We found similar evidence to

be relevant in Xilinx. See Xilinx Inc. v. Commissioner, 125

T.C. at 61. Treasury never directly responded to this evi-

dence. Instead, Treasury construed these comments as objec-

tions to Treasury’s selection of the exercise spread method

and the grant date method as the only available valuation

methods. See T.D. 9088, 2003–2 C.B. at 844. Treasury

responded that these methods are consistent with the arm’s-

length standard and are administrable. See id. Treasury,

however, never explained how these methods could be con-

sistent with the arm’s-length standard if unrelated parties

would not share them or why unrelated parties would share

stock-based compensation costs in any other way.

The Baumol and Malkiel analysis also concluded that there

is no net economic cost to a corporation or its shareholders

from the issuance of stock-based compensation. Treasury

identified this evidence in the preamble to the final rule but

did not directly respond to it. See id., 2003–2 C.B. at 843.

Instead, the preamble states that ‘‘[t]he final regulations pro-

vide that stock-based compensation must be taken into

account in the context of QCSAs because such a result is con-

sistent with the arm’s length standard.’’ Id. Treasury, how-

ever, never explained why unrelated parties would share

130 145 UNITED STATES TAX COURT REPORTS (91)

stock-based compensation costs—or how the commensurate-

with-income standard could justify the final rule—if stock-

based compensation is not an economic cost to the issuing

corporation or its shareholders. 26

Mr. Grundfest informed Treasury that companies do not

factor stock-based compensation into their pricing decisions.

We found similar evidence to be relevant in Xilinx. See Xilinx

Inc. v. Commissioner, 125 T.C. at 59. Treasury never

responded to this evidence.

Indeed, Treasury failed to respond directly to any of the

evidence that unrelated parties would not share stock-based

compensation costs, other than by asserting that the trans-

actions cited by the commentators did not ‘‘share enough

characteristics of QCSAs involving the development of high-

profit intangibles’’ to be relevant. T.D. 9088, 2003–2 C.B. at

842. This was a mere assertion; Treasury offered no analysis

addressing the extent of the supposed differences or

explaining why any differences make the cited transactions

irrelevant or unpersuasive. By contrast, in Xilinx we exam-

ined a broad array of evidence to determine whether unre-

lated parties would share such costs. See Xilinx Inc. v.

Commissioner, 125 T.C. at 58–62. Tellingly, respondent does

not even attempt to explain why Treasury failed to address

similar evidence in the preamble to the final rule.

Although Treasury’s failure to respond to an isolated com-

ment or two would probably not be fatal to the final rule,

Treasury’s failure to meaningfully respond to numerous rel-

evant and significant comments certainly is. See Home Box

Office, 567 F.2d at 35–36. Meaningful judicial review and fair

treatment of affected persons require ‘‘an exchange of views,

information, and criticism between interested persons and

the agency.’’ Id. at 35. Treasury’s failure to adequately

respond to commentators frustrates our review of the final

rule and was prejudicial to affected entities.

26 Respondent contends that the final rule is consistent with the com-

mensurate-with-income standard because stock-based compensation is eco-

nomic activity even if it is not an economic cost. However, Treasury never

made this distinction in the preamble to the final rule, see SEC v. Chenery

Corp., 332 U.S. 194, 196 (1947); Carpenter Family Invs., LLC v. Commis-

sioner, 136 T.C. 373, 380, 396 n.30 (2011), and it did not explain why unre-

lated parties would share items that are not economic costs.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 131

D. The Final Rule Is Contrary to the Evidence Before

Treasury.

Petitioner contends that the final rule is contrary to the

evidence before Treasury when it issued the final rule. We

agree.

We have already discussed Treasury’s failure to cite any

evidence supporting its belief that unrelated parties to

QCSAs would share stock-based compensation costs, see

supra part IV.A; the significant evidence submitted by com-

mentators showing that unrelated parties to QCSAs would

not share stock-based compensation costs, see supra part

IV.C; and Treasury’s failure to respond to much of the sub-

mitted evidence, see id.

Significantly, Treasury never said that it found any of the

submitted evidence incredible. Treasury also seemed to

accept the commentators’ economic analyses, which con-

cluded that—and explained why—unrelated parties to a

QCSA would be unwilling to share the exercise spread or

grant date value of stock-based compensation. Finally,

respondent has not identified any evidence in the administra-

tive record that supports Treasury’s belief that unrelated

parties to QCSAs would generally share stock-based com-

pensation costs.

Although we are mindful that ‘‘a court is not to substitute

its judgment for that of the agency’’, State Farm, 463 U.S. at

43, we conclude that Treasury’s ‘‘explanation for its decision

* * * runs counter to the evidence before’’ it, see id.

V. Harmless Error

Respondent contends that, pursuant to the harmless error

rule of APA sec. 706, any deficiencies in Treasury’s reasoning

should not invalidate the final rule because (1) Treasury had

sufficient alternative reasons for adopting the final rule and

(2) in the years following Treasury’s adoption of the final rule

the Financial Accounting Standards Board (FASB), the Inter-

national Accounting Standards Board (IASB), and the

Organisation for Economic Cooperation and Development

132 145 UNITED STATES TAX COURT REPORTS (91)

(OECD) 27 have adopted policy positions that concur with

Treasury’s. 28

A. Alternative Reasons for Adopting the Final Rule

Although the preamble refers to the commensurate-with-

income standard, we have already concluded that Treasury

never indicated that it was prepared to independently rely on

the commensurate-with-income standard—or any other rea-

son—as a basis for adopting the final rule. See supra parts

III.B and IV.A.1. Moreover, because the arm’s-length

standard is incorporated into numerous income tax treaties,

see, e.g., 2001 U.S.-U.K. Income Tax Convention, art. 9; 2006

U.S. Model Income Tax Convention, art. 9; Treasury Depart-

ment Technical Explanation of the 2001 U.S.-U.K. Income

Tax Convention, art. 9, Tax Treaties (CCH) para. 10,911, at

201,306–201,307; Treasury Department Technical Expla-

nation of the 2006 U.S. Model Income Tax Convention, art.

9; Tax Treaties (CCH) para. 215, at 10,640–10,641,

respondent cannot reasonably contend that Treasury would

have clearly adopted the final rule had it concluded that the

final rule conflicted with that standard. See PDK Labs., 362

F.3d at 799.

27 In 2004 the OECD published a report on the impact of employee stock

options on transfer pricing that ‘‘start[ed] with the premise that employee

stock options are remuneration.’’ OECD, Employee Stock Option Plans: Im-

pact on Transfer Pricing 1. In 2005, however, the OECD published a policy

study that again started with the same premise but recognized that the

arm’s-length standard required more analysis. See OECD, The Taxation of

Employee Stock Options, Tax Policy Studies No. 11, at 165 (‘‘Of course,

whether in-kind remuneration, including stock options, should be taken

into account in any particular case depends on a determination of what

independent parties acting at arm’s length would do in the facts and cir-

cumstances of that case.’’).

28 Each of the policy positions that respondent now contends support the

2003 final rule was published after Treasury promulgated the final rule.

See, e.g., Statement of Financial Accounting Standards No. 123, Account-

ing for Stock-Based Compensation (revised 2004), Share-Based Payment;

International Financial Reporting Standard No. 2, Share-based Payment,

February 2004; OECD, Employee Stock Option Plans: Impact on Transfer

Pricing; see also OECD, the Taxation of Employee Stock Options, OECD

Tax Policy Studies No. 11.

(91) ALTERA CORP. & SUBS. v. COMMISSIONER 133

B. Settled Policy

Respondent’s argument that the policy debate underlying

the final rule has long been settled is irrelevant and mis-

apprehends the role of this Court under State Farm. It is

irrelevant because Treasury expressly disavowed reliance on

financial reporting standards when it issued the final rule,

see T.D. 9088, 2003–2 C.B. at 843 (‘‘Treasury and the IRS

agree that the disposition of financial reporting issues does

not mandate a particular result under these regulations.’’),

and the policy positions to which respondent refers did not

exist and were therefore unavailable to Treasury when it

issued the final rule, see Chenery Corp., 332 U.S. at 196; Car-

penter Family Invs., LLC v. Commissioner, 136 T.C. at 380,

396 n.30. Respondent’s argument misapprehends the role of

this Court because, under State Farm, our role is not to

decide whether the final rule is good policy—it is simply to

‘‘ensur[e] that * * * [Treasury] engaged in reasoned decision-

making.’’ Judulang, 565 U.S. at ll, 132 S. Ct. at 483–484.

Because it is not clear that Treasury would have adopted

the final rule had it concluded that the final rule is incon-

sistent with the arm’s-length standard, the harmless error

rule is inapplicable.

VI. Conclusion

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. 29 See APA sec. 706(2)(A);

29 Because we conclude that the final rule fails to satisfy State Farm’s

reasoned decisionmaking standard, the final rule would be invalid even if

we were to conclude that Chevron supplies the ultimate standard of re-

view. See supra part III.B. The analysis under Chevron would proceed as

follows: The parties agree that sec. 482 is ambiguous. We would therefore

proceed to Chevron step 2. Under Chevron step 2, we would conclude the

final rule is invalid because it is ‘‘arbitrary or capricious in substance’’,

Judulang v. Holder, 565 U.S. ll, ll n.7, 132 S. Ct. 476, 483 (2011)

(quoting Mayo Found., 562 U.S. at 53), and therefore cannot be justified

Continued

134 145 UNITED STATES TAX COURT REPORTS (91)

State Farm, 463 U.S. at 43. Indeed, Treasury’s ‘‘ipse dixit

conclusion, coupled with its failure to respond to contrary

arguments resting on solid data, epitomizes arbitrary and

capricious decisionmaking.’’ Ill. Pub. Telecomms. Ass’n v.

FCC, 117 F.3d 555, 564 (D.C. Cir. 1997).

By reason of the above respondent erred in making the sec-

tion 482 allocations at issue, and petitioner is therefore enti-

tled to partial summary judgment. We will grant petitioner’s

motion and deny respondent’s motion.

We have considered the parties’ remaining arguments, and

to the extent not discussed above, conclude those arguments

are irrelevant, moot, or without merit.

To reflect the foregoing,

An appropriate order will be issued.

Reviewed by the Court.

THORNTON, COLVIN, HALPERN, FOLEY, VASQUEZ, GALE,

GOEKE, HOLMES, PARIS, KERRIGAN, BUCH, LAUBER, NEGA,

and ASHFORD, JJ., agree with this opinion of the Court.

MORRISON and PUGH, JJ., did not participate in the consid-

eration of this opinion.

f

as being a reasonable interpretation of what sec. 482 requires.