Petition for Writ of Certiorari — Altera Corporation & Subsidiaries, Petitioner v. Commissioner of Internal Revenue

Supreme Court briefFeb 10, 2020

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APPENDICES

APPENDIX A

FOR PUBLICATION

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

Altera Corporation &

Subsidiaries,

Petitioner-Appellee,

Nos. 16-70496

16-70497

Tax Ct. Nos.

6253-12

9963-12

Commissioner of Internal

Revenue,

Respondent-Appellant.

OPINION

Appeal from Decisions of the

United States Tax Court

Argued and Submitted October 16, 2018

San Francisco, California

Filed June 7, 2019

Before: Sidney R. Thomas, Chief Judge,

and Susan P. Graber and Kathleen M. O’Malley,

Circuit Judges.

Opinion by Chief Judge Thomas;

Dissent by Judge O’Malley



The Honorable Stephen R. Reinhardt was originally assigned

to this panel. Following his death, the Honorable Susan P. Graber was drawn by lot to replace him on the panel.



The Honorable Kathleen M. O’Malley, United States Circuit

Judge for the U.S. Court of Appeals for the Federal Circuit, sitting by designation.

SUMMARY

Tax

The panel reversed a decision of the Tax Court that

26 C.F.R. § 1.482-7A(d)(2), under which related entities must share the cost of employee stock compensation in order for their cost-sharing arrangements to be

classified as qualified cost-sharing arrangements, was

invalid under the Administrative Procedure Act.

At issue was the validity of the Treasury regulations implementing 26 U.S.C. § 482, which provides

for the allocation of income and deductions among related entities. The panel first held that the Commissioner of Internal Revenue did not exceed the authority delegated to him by Congress under 26

U.S.C. § 482. The panel explained that § 482 does not

speak directly to whether the Commissioner may require parties to a QCSA to share employee stock compensation costs in order to receive the tax benefits associated with entering into a QCSA. The panel held

that the Treasury reasonably interpreted § 482 as an

authorization to require internal allocation methods

in the QCSA context, provided that the costs and income allocated are proportionate to the economic activity of the related parties, and concluded that the

regulations are a reasonable method for achieving the

results required by the statute. Accordingly, the regulations were entitled to deference under Chevron,



This summary constitutes no part of the opinion of the court.

It has been prepared by court staff for the convenience of the

reader.

U.S.A., Inc. v. Natural Resources Defense Council,

Inc., 467 U.S. 837 (1984).

The panel next held that the regulations at issue

were not arbitrary and capricious under the Administrative Procedure Act.

Dissenting, Judge O’Malley would find, as the Tax

Court did, that 26 C.F.R. § 1.482-7A(d)(2) is invalid as

arbitrary and capricious.

COUNSEL

Arthur T. Catterall (argued), Richard Farber, and Gilbert S. Rothenberg, Attorneys; Travis A. Greaves,

Deputy Assistant Attorney General; Richard E. Zuckerman, Principal Deputy Assistant Attorney General;

Tax Division, United States Department of Justice,

Washington, D.C.; for Respondent-Appellant.

Donald M. Falk (argued), Mayer Brown LLP, Palo

Alto, California; Thomas Kittle-Kamp and William G.

McGarrity, Mayer Brown LLP, Chicago, Illinois;

Brian D. Netter and Travis Crum, Mayer Brown LLP,

Washington, D.C.; A. Duane Webber, Phillip J. Taylor, and Joseph B. Judkins, Baker & McKenzie LLP,

Washington, D.C.; for Petitioner-Appellee.

Susan C. Morse, University of Texas School of Law,

Austin, Texas; Stephen E. Shay and Allison Bray,

Certified Law Students, Harvard Law School, Cambridge, Massachusetts; for Amici Curiae J. Richard

Harvey, Reuven Avi-Yonah, Lily Batchelder, Joshua

Blank, Noël Cunningham, Victor Fleischer, Ari

Glogower, David Kamin, Mitchell Kane, Michael

Knoll, Rebecca Kysar, Leandra Lederman, Zachary

Liscow, Ruth Mason, Susan Morse, Daniel Shaviro,

Stephen Shay, John Steines, David Super, Clinton

Wallace, and Bret Wells.

Jonathan E. Taylor, Gupta Wessler PLLC, Washington, D.C.; Clint Wallace, Vanderbilt Hall, New York,

New York; for Amici Curiae Anne Alstott, Reuven AviYonah, Lily Batchelder, Joshua Blank, Noel Cunningham, Victor Fleischer, Ari Glogower, David Kamin,

Mitchell Kane, Sally Katzen, Edward Kleinbard, Michael Knoll, Rebecca Kysar, Zachary Liscow, Daniel

Shaviro, John Steines, David Super, Clint Wallace,

and George Yin.

Larissa B. Neumann, Ronald B. Schrotenboer, and

Kenneth B. Clark, Fenwick & West LLP, Mountain

View, California, for Amicus Curiae Xilinx Inc.

Christopher J. Walker, The Ohio State University

Moritz College of Law, Columbus, Ohio; Kate Comerford Todd, Steven P. Lehotsky, and Warren Postman,

U.S. Chamber Litigation Center, Washington, D.C.;

for Amicus Curiae Chamber of Commerce of the

United States of America.

John I. Forry, San Diego, California, for Amicus Curiae TechNet.

Alice E. Loughran, Michael C. Durst, and Charles G.

Cole, Steptoe & Johnson LLP, Washington, D.C.; Bennett Evan Cooper, Steptoe & Johnson LLP, Phoenix,

Arizona; for Amici Curiae Software and Information

Industry Association, Financial Executives International, Information Technology Industry Council, Silicon Valley Tax Directors Group, Software Finance

and Tax Executives Counsel, National Association of

Manufacturers, American Chemistry Council, BSA |

the Software Alliance, National Foreign Trade Council, Biotechnology Innovation Organization, Computing Technology Industry Association, The Tax Council, United States Council for International Business,

Semiconductor Industry Association.

Kenneth P. Herzinger and Eric C. Wall, Orrick Herrington & Sutcliffe LLP, San Francisco, California;

Peter J. Connors, Orrick Herrington & Sutcliffe LLP,

New York, New York; for Amici Curiae Charles W.

Calomiris, Kevin H. Hassett, and Sanjay Unni.

Roderick K. Donnelly and Neal A. Gordon, Morgan

Lewis & Bockius LLP, Palo Alto, California; Thomas

M. Peterson, Morgan Lewis & Bockius LLP, San Francisco, California; for Amicus Curiae Cisco Systems

Inc.

Christopher Bowers, David Foster, Raj Madan, and

Royce Tidwell, Skadden Arps Slate Meagher & Flom

LLP, Washington, D.C.; Nathaniel Carden, Skadden

Arps Slate Meagher & Flom LLP, Chicago, Illinois; for

Amicus Curiae Amazon.com Inc.

OPINION

THOMAS, Chief Judge:

This appeal presents the question of the validity of

26 C.F.R. § 1.482-7A(d)(2),1 under which related business entities must share the cost of employee stock

The 2003 amendments are at issue. Although they are still in

effect, the Tax Code has been reorganized, and what was

compensation in order for their cost-sharing arrangements to be classified as qualified cost-sharing arrangements (“QCSA”). Although the case appears

complex, the dispute between the Department of the

Treasury and the taxpayer is relatively straightforward. The parties agree that, under the governing tax

statute, the “arm’s length” standard applies; but they

disagree about how the standard may be met. The

taxpayer argues that Treasury must employ a specific

method to meet the arm’s length standard: a comparability analysis using comparable transactions between unrelated business entities. Treasury disagrees that the arm’s length standard requires the specific comparability method in all cases. Instead, the

standard generally requires that Treasury reach an

arm’s length result of tax parity between controlled

and uncontrolled business entities. With respect to

the transactions at issue here, the governing statute

allows Treasury to apply a purely internal method of

allocation, distributing the costs of employee stock options in proportion to the income enjoyed by each related taxpayer.

Our task, of course, is not to assess the better tax

policy, nor the wisdom of either approach, but rather

to examine whether Treasury’s regulations are permitted under the statute. Applying the familiar tools

used to examine administrative agency regulations,

we conclude that the regulations withstand scrutiny.

Therefore, we reverse the judgment of the Tax Court.

§ 1.482-7 in 2003 is now numbered § 1.482-7A. To minimize confusion, our citations are to the current version of the regulation

unless otherwise specified.

For many years, Congress and the Treasury have

been concerned with American businesses avoiding

taxes through the creation and use of related business

entities. In the last several decades, Congress has directed particular attention to the potential for tax

abuse by multinational corporations with foreign subsidiaries. If, for example, the parent business entity

is in a high-tax jurisdiction, and the foreign subsidiary

is in a low-tax jurisdiction, the business enterprise

can shift costs and revenue between the related entities so that more taxable income is allocated to the

lower tax jurisdiction. Similarly, a parent and foreign

subsidiary can enter into significant tax-avoiding cost

sharing arrangements.

This potential for tax abuse is generally not present when similar transactions occur between unrelated business entities. In those instances, each separate unrelated entity has the incentive to maximize

profit, and thus to allocate costs and income consistent with economic realities. However, among related parties, those incentives do not exist. Rather,

among related parties, after-tax maximization of

profit may depend on how costs and income are allocated between the parent and the subsidiary regardless of economic reality, given that after-tax profits

are commonly shared.

The concern about tax avoidance through the use

of related business entities is not new. In the Revenue

Act of 1928, Congress granted the Secretary of the

Treasury the authority to reallocate the reported income and costs of related businesses “in order to prevent evasion of taxes or clearly to reflect the income

of any such trades or businesses.” Revenue Act of

1928, ch. 852, § 45, 45 Stat. 791, 806. This statute was

designed to give Treasury the flexibility it needed to

prevent transaction-shuffling between related entities for the purpose of decreasing tax liability. See

H.R. Rep. No. 70-2, at 16-17 (1927) (“[T]he Commissioner may, in the case of two or more trades or businesses owned or controlled by the same interests, apportion, allocate, or distribute the income or deductions between or among them, as may be necessary in

order to prevent evasion (by the shifting of profits, the

making of fictitious sales, and other methods frequently adopted for the purpose of ‘milking’), and in

order clearly to reflect their true tax liability.”); accord S. Rep. No. 70-960, at 24 (1928). The purpose of

the statute was “to place a controlled taxpayer on a

tax parity with an uncontrolled taxpayer.” Comm’r v.

First Sec. Bank of Utah, 405 U.S. 394, 400 (1972)

(quoting 26 C.F.R. § 1.482-1(b)(1) (1971)). In short,

the primary aim of the statute was to prevent tax evasion by related business taxpayers.2

In 1934, the Commissioner adopted regulations

implementing the statute and first adopted the familiar “arm’s length” standard: “The standard to be applied in every case is that of an uncontrolled taxpayer

dealing at arm’s length with another uncontrolled taxpayer.” Treas. Reg. 86, art. 45-1(b) (1935). In the context of a controlled transaction, the arm’s length

standard is satisfied “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

(arm’s length result).” 26 C.F.R. § 1.482-1(b)(1). The

An important, but secondary purpose was to avoid double taxation of multi-national corporations, which the United States effected through various tax treaties. See, e.g., Convention Concerning Double Taxation, Fr.-U.S., art. IV, Apr. 27, 1932, 49 Stat.

3145.

relevant regulation also noted: “However, because

identical transactions 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.” Id.

Although the Secretary adopted the arm’s length

standard, courts did not hold related parties to that

standard by exclusively requiring the examination of

comparable transactions. For example, in Seminole

Flavor Co. v. Commissioner, the Tax Court rejected a

strict application of the arm’s length standard in favor

of an inquiry into whether the allocation of income between related parties was “fair and reasonable.” 4

T.C. 1215, 1232 (1945); see also id. at 1233 (“Whether

any such business agreement would have been entered into by petitioner with total strangers is wholly

problematical.”); Grenada Indus., Inc. v. Comm’r, 17

T.C. 231, 260 (1951) (“We approve an allocation . . . to

the extent that such gross income in fact exceeded the

fair value of the services rendered . . . .”). And in

1962, we collected various allocation standards and

outright rejected the superiority of the arm’s length

bargaining analysis over all others:

[W]e do not agree . . . that “arm’s length bargaining” is the sole criterion for applying the statutory

language of [26 U.S.C. § 482] in determining what

the “true net income” is of each “controlled taxpayer.” Many decisions have been reached under

[§ 482] without reference to the phrase “arm’s

length bargaining” and without reference to Treasury Department Regulations and Rulings which

state that the talismanic combination of words –

“arm’s length” – is the “standard to be applied in

every case.”

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Frank v. Int’l Canadian Corp., 308 F.2d 520, 528-29

(9th Cir. 1962).

Frank noted that “it was not any less proper . . . to

use here the ‘reasonable return’ standard than it was

for other courts to use ‘full fair value,’ ‘fair price including a reasonable profit,’ ‘method which seems not

unreasonable,’ ‘fair consideration which reflects arm’s

length dealing,’ ‘fair and reasonable,’ ‘fair and reasonable’ or ‘fair and fairly arrived at,’ or ‘judged as to fairness,’ all used in interpreting [the statute].” Id. (footnotes omitted). We later limited Frank to situations

in which “it would have been difficult for the court to

hypothesize an arm’s-length transaction.” Oil Base,

Inc. v. Comm’r, 362 F.2d 212, 214 n.5 (9th Cir. 1966).

However, Frank’s central point remained: the arm’s

length standard based on comparable transactions

was not the sole basis of reallocating costs and income

under the statute.

In the 1960s, the problem of abusive transfer pricing practices created a new adherence to a stricter

arm’s length standard. In response to concerns about

the undertaxation of multinational business entities,

Congress considered reworking the Tax Code to resolve the difficulty posed by the application of the

arm’s length standard to related party transactions.

H.R. Rep. No. 87-1447, at 28-30 (1962). However, it

instead asked Treasury to “explore the possibility of

developing and promulgating regulations . . . which

would provide additional guidelines and formulas for

the allocation of income and deductions” under 26

U.S.C. § 482. H.R. Rep. No. 87-2508, at 19 (1962)

(Conf. Rep.), as reprinted in 1962 U.S.C.C.A.N. 3732,

3739. Legislators believed that § 482 authorized the

Secretary to employ a profit-split allocation method

without amendment. Id.; H.R. Rep. No. 87-1447, at

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28-29. In 1968, following Congress’s entreaty, Treasury finalized the first regulation tailored to the issue

of intangible property development in QCSAs.

26 C.F.R. § 1.482-2(d) (1968).

The 1968 regulations “constituted a radical and

unprecedented approach to the problem they addressed – notwithstanding their being couched in

terms of the ‘arm’s length standard,’ and notwithstanding that that standard had been the nominal

standard under the regulations for some 30 years.”

Stanley I. Langbein, The Unitary Method and the

Myth of Arm’s Length, 30 Tax Notes 625, 644 (1986).

In addition to three arm’s length pricing methods, the

1968 regulations included a “fourth method,” which

was essentially open-ended: “Where none of the three

methods of pricing . . . can reasonably be applied under the facts and circumstances as they exist in a particular case, some appropriate method of pricing other

than those described . . . , or variations on such methods, can be used.” 26 C.F.R. § 1.482-2(e)(1)(iii) (1968).

Following the promulgation of the 1968 regulation,

courts continued to employ a comparability analysis,

but not to the exclusion of other methodologies. Reuven S. Avi-Yonah, The Rise & Fall of Arm’s Length: A

Study in the Evolution of U.S. International Taxation,

15 Va. Tax Rev. 89, 108-29 (1995). Indeed, a study

determined that direct comparable transactions were

located and applied in only 3% of the Internal Revenue Service’s adjustments prior to the 1986 amendment. U.S. Gen. Accounting Office., GGD-81-81, IRS

Could Better Protect U.S. Tax Interests in Determining the Income of Multinational Corporations (1981).

The decades following the 1968 regulations involved

a gradual realization by all parties concerned, but

especially Congress and the IRS, that the [compa-

12a

rability method of meeting the arm’s length standard], firmly established . . . as the sole standard

under section 482, did not work in a large number

of cases, and in other cases its misguided application produced inappropriate results. The result

was a deliberate decision to retreat from the standard while still paying lip service to it.

Avi-Yonah, supra, at 112; see also James P. Fuller,

Section 482: Revisited Again, 45 Tax L. Rev. 421, 453

(1990) (“[T]he 1986 Act’s commensurate with income

standard is not really a new approach to § 482.”).

Ultimately, as controlled transactions increased in

frequency and complexity, particularly with respect to

intangible property, Congress determined that legislative action was necessary. The Tax Reform Act of

1986 reflected Congress’s view that strict adherence

to the comparability method of meeting the arm’s

length standard prevented tax parity. Thus, the Tax

Reform Act of 1986 added a sentence to § 482 that

largely forms the basis of the present dispute, providing that:

In the case of any transfer (or license) of intangible

property (within the meaning of section

936(h)(3)(B)), the income with respect to such

transfer or license shall be commensurate with the

income attributable to the intangible.

Tax Reform Act of 1986, 26 U.S.C. § 482 (1986) (as

amended 2018).

The House Ways and Means Committee recommended the addition of the commensurate with income clause because it was “concerned” that the current code and regulations “may not be operating to assure adequate allocations to the U.S. taxable entity of

income attributable to intangibles.” H.R. Rep. No. 99426, at 423 (1985). The clause was intended to correct

13a

a “recurrent problem” – “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.” Id. at 423-24.

The House Report makes clear that the committee

intended the commensurate with income standard to

displace a comparability analysis where comparable

transactions cannot be found:

A fundamental problem is the fact that the relationship between related parties is different from

that of unrelated parties. . . . [M]ultinational companies operate as an economic unit, and not “as if ”

they were unrelated to their foreign subsidiaries . . . .

....

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. While the committee is concerned that

such decisions may unduly emphasize the concept

of comparables even in situations involving highly

standardized commodities or services, it believes

that such an approach is sufficiently troublesome

where transfers of intangibles are concerned that

a statutory modification to the intercompany pricing rules regarding transfers of intangibles is necessary.

....

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. . . 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 . . . be commensurate with the income attributable to the intangible . . . .

....

. . . [T]he 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 intangible transfers. Where taxpayers transfer intangibles with a

high profit potential, the compensation for the intangibles should be greater than industry averages

or norms.

Id. at 424-25 (footnote and citation omitted).3

Treasury’s first response to the Tax Reform Act

was the “White Paper,” an intensive study published

in 1988. A Study of Intercompany Pricing Under Section 482 of the Code, I.R.S. Notice 88-123, 1988-2 C.B.

458 (“White Paper”). The White Paper confirmed that

The Conference Committee suggested only one change – to

broaden the sweep of the amendment so as to encompass domestic related-party transactions – in order to better serve the objective of the amendment, “that the division of income between related parties reasonably reflect the relative economic activity undertaken by each.” H.R. Rep. No. 99-841, at II-637 (1986) (Conf.

Rep.), as reprinted in 1986 U.S.C.C.A.N. 4075, 4725. The Report

also clarified that cost-sharing arrangements would not generally be subject to § 482 allocations – but only “if and to the extent . . . the income allocated among the parties reasonably reflect the actual economic activity undertaken by each.” Id. at II638.

15a

Treasury believed the commensurate with income

standard to be consistent with the arm’s length standard (and that Treasury understood Congress to share

that understanding). Id. at 475. Treasury wrote that

a comparability analysis must be performed where

possible, id. at 474, but it also suggested a “clear and

convincing evidence” standard for comparable transactions, indicating that a comparability analysis

would rarely be possible. Id. at 478.

The White Paper signaled a shift in the interpretation of the arm’s length standard as it had been defined following the 1968 regulations. Treasury advanced a new allocation method, the “basic arm’s

length return method,” White Paper at 488, that

would apply only in the absence of comparable transactions and would essentially split profits between the

related parties, id. at 490. Commentators understood

that, by attempting to synthesize the arm’s length

standard and the commensurate with income provision, Treasury was moving away from a view that the

arm’s length standard always requires a comparability analysis. Marc M. Levey, Stanley C. Ruchelman,

& William R. Seto, Transfer Pricing of Intangibles After the Section 482 White Paper, 71 J. Tax’n 38, 38

(1989); Josh O. Ungerman, Comment, The White Paper: The Stealth Bomber of the Section 482 Arsenal,

42 Sw. L.J. 1107, 1128-29 (1989).

In 1994 and 1995, Treasury issued new regulations that defined the arm’s length standard as resultoriented, meaning that the goal is parity in taxable income rather than parity in the method of allocation

itself. 26 C.F.R. § 1.482-1(b)(1) (1994) (“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

16a

same circumstances (arm’s length result).”). However, the arm’s length standard remained “the standard to be applied in every case.” Id.

The regulations also set forth methods by which

income could be allocated among related parties in a

manner consistent with the arm’s length standard.

Id. § 1.482-1(b)(2)(i) (1994). According to Treasury,

the 1994 regulations defined the arm’s length standard in terms of “the results that would have been realized if uncontrolled taxpayers had engaged in the

same transaction under the same circumstances.”

Compensatory Stock Options Under Section 482, 67

Fed. Reg. 48,997-01, 48,998 (proposed July 29, 2002).

The 1995 regulation provided that “[i]ntangible development costs” included “all of the costs incurred by

[a controlled] participant related to the intangible development area.” 26 C.F.R. § 1.482-7(d)(1) (1995). By

contrast to the 1994 regulation, the 1995 regulation –

consistent with the 1986 Conference Report – “implement[ed] the commensurate with income standard in

the context of cost sharing arrangements” by “requir[ing] that controlled participants in a [QCSA]

share all costs incurred that are related to the development of intangibles in proportion to their shares of

the reasonably anticipated benefits attributable to

that development.” Compensatory Stock Options Under Section 482, 67 Fed. Reg. at 48,998.

Neither the Tax Reform Act nor the implementing

regulations specifically addressed allocation of employee stock compensation, which is the issue in this

dispute. However, that omission was unsurprising

given that the practice did not develop on a major

scale until the 1990s. Zvi Bodie, Robert S. Kaplan, &

Robert C. Merton, For the Last Time: Stock Options

Are an Expense, Harv. Bus. Rev., Mar. 2003, at 62, 67.

Beginning in 1997, the Secretary interpreted the

17a

“all . . . costs” language to include stock-based compensation, meaning that controlled taxpayers had to

share the costs (and associated deductions) of providing employee stock compensation. Xilinx, Inc. v.

Comm’r, 598 F.3d 1191, 1193-94 (9th Cir. 2010).

In 2003, Treasury issued the cost-sharing regulations that are challenged in this case. Treasury intended for the 2003 amendments to clarify, rather

than to overhaul, the 1994 and 1995 regulations. The

clarifications were twofold. First, the amendments directly classified employee stock compensation as a

cost to be allocated between QCSA participants. Compensatory Stock Options Under Section 482 (Proposed), 67 Fed. Reg. at 48,998; 26 C.F.R. § 1.4827A(d)(2). Second, the “coordinating amendments”

clarified Treasury’s belief that the cost-sharing regulations, including § 1.482-7A(d)(2), operate to produce

an arm’s length result. Compensatory Stock Options

Under Section 482 (Proposed), 67 Fed. Reg. at 48,998;

26 C.F.R. § 1.482-7A(a)(3).

Specifically, § 1.482-7A provides that costs shared

by related parties to a QCSA are not subject to IRS

reallocation for tax purposes if each entity’s share of

the intangible property development costs equals each

entity’s reasonably anticipated benefits. Section

1.482-7A(a)(3) incorporates and coordinates with the

arm’s length standard:

A qualified cost sharing arrangement produces

results that are consistent with an arm’s length result . . . if, and only if, each controlled participant’s

share of the costs (as determined under paragraph

(d) of this section) of intangible development under

the qualified cost sharing arrangement equals its

share of reasonably anticipated benefits attributable to such development . . . .

18a

Section 1.482-7A(d)(2) provides that parties to a

QCSA must allocate stock-based compensation between themselves:

[In a QCSA], a controlled participant’s operating expenses include all costs attributable to compensation, including stock-based compensation.

As used in this section, the term stock-based compensation means any compensation provided by a

controlled participant to an employee or independent contractor in the form of equity instruments,

options to acquire stock (stock options), or rights

with respect to (or determined by reference to) equity instruments or stock options, including but

not limited to property to which section 83 applies

and stock options to which section 421 applies, regardless of whether ultimately settled in the form

of cash, stock, or other property.

These regulations, and the procedure employed in

adopting them, form the basis of the present controversy.

At issue is Altera Corporation (“Altera”) & Subsidiaries’ tax liability for the years 2004 through 2006.

During the relevant period, Altera and its subsidiaries

designed, manufactured, marketed, and sold programmable logic devices, which are electronic components that are used to build circuits.

In May of 1997, Altera entered into a cost-sharing

agreement with one of its foreign subsidiaries, Altera

International, Inc., a Cayman Islands corporation

(“Altera International”), which had been incorporated

earlier that year. Altera granted to Altera International a license to use and exploit Altera’s preexisting

intangible property everywhere in the world except

the United States and Canada. In exchange, Altera

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International paid royalties to Altera. The parties

agreed to pool their resources to share research and

development (“R&D”) costs in proportion to the benefits anticipated from new technologies. The question

in this appeal is whether Treasury was permitted, for

tax liability purposes, to re-allocate the cost of employee stock-based compensation.

Altera and the IRS agreed to an Advance Pricing

Agreement covering the 1997-2003 tax years. Pursuant to this agreement, Altera shared with Altera International stock-based compensation costs as part of

the shared R&D costs. After the Treasury regulations

were amended in 2003, Altera and Altera International amended their cost-sharing agreement to comply with the modified regulations, continuing to share

employee stock compensation costs.

The agreement was amended again in 2005 following the Tax Court’s opinion in Xilinx Inc. & Consolidated Subsidiaries v. Commissioner, which involved a

challenge to the 1994-1995 cost-sharing regulations.

125 T.C. 37 (2005). The parties agreed to “suspend

the payment of any portion of [a] Cost Share . . . to the

extent such payment relates to the Inclusion of StockBased Compensation in R&D Costs” unless and until

a court upheld the validity of the 2003 cost-sharing

regulations. The following provision explains Altera’s

reasoning:

The Parties believe that it is more likely than

not that (i) the Tax Court’s conclusion in Xilinx v.

Commissioner, 125 T.C. [No.] 4 (2005), that the

arm’s length standard controls the determination

of costs to be shared by controlled participants in a

qualified cost sharing arrangement should also apply to Treas. Reg. § 1.482-7(d)(2) (as amended by

T.D. 9088), and (ii) the Parties’ inclusion of StockBased Compensation in R&D Costs pursuant to

20a

Amendment I would be contrary to the arm’s

length standard.

Altera and its U.S. subsidiaries did not account for

R&D-related stock-based compensation costs on their

consolidated 2004-2007 federal income tax returns.

The IRS issued two notices of deficiency to the group,

applying § 1.482-7(d)(2) to increase the group’s income

by the following amounts:

2004

$ 24,549,315

2005

$ 23,015,453

2006

$ 17,365,388

2007

$ 15,463,565

Altera timely filed petitions in the Tax Court. The

parties filed cross-motions for summary judgment,

and the Tax Court granted Altera’s motion. Sitting en

banc, the Tax Court held that § 1.482-7A(d)(2) is invalid under the Administrative Procedure Act (“APA”),

5 U.S.C. §§ 701-706. Altera Corp. & Subsidiaries v.

Comm’r, 145 T.C. 91 (2015).

The Tax Court unanimously determined: (1) that

the Commissioner’s allocation of income and expenses

between related entities must be consistent with the

arm’s length standard; and (2) that the arm’s length

standard is not met unless the Commissioner’s allocation can be compared to an actual transaction between

unrelated entities. The Tax Court reasoned that the

Commissioner could not require related parties to

share stock compensation costs, because the Commissioner had not considered any unrelated party transactions in which the parties shared such costs. The

Tax Court held that the agency’s decisionmaking process was fundamentally flawed because: (1) it rested

on speculation rather than on hard data and expert

21a

opinions; and (2) it failed to respond to significant public comments, particularly those pointing out uncontrolled cost-sharing arrangements in which the entities did not share stock compensation costs. Id. at

133-34.

The Tax Court’s decision rested largely on its own

opinion in Xilinx, in which it determined that the

arm’s length standard mandates a comparability

analysis. Id. at 118 (citing Xilinx, 125 T.C. at 53-55).

In its decision in this case, as well, the Tax Court suggested that the Commissioner cannot require related

entities to share stock compensation costs unless and

until the Commissioner locates uncontrolled transactions in which these costs are shared. Id. at 118-19.

The Tax Court reached five holdings: (1) the 2003

amendments constitute a final legislative rule subject

to the requirements of the APA; (2) Motor Vehicle

Manufacturers Ass’n of the United States, Inc. v. State

Farm Mutual Automobile Insurance Co., 463 U.S. 29

(1983), provides the appropriate standard of review

because the standard set forth in Chevron, U.S.A., Inc.

v. Natural Resources Defense Council, Inc., 467 U.S.

837 (1984), incorporates State Farm’s “reasoned decisionmaking” standard; (3) Treasury did not support

adequately its decision to allocate the costs of employee stock compensation between related parties;

(4) Treasury’s procedural regulatory deficiencies were

not harmless;4 and (5) § 1.482-7A(d)(2) is invalid under the APA.

On appeal, the Commissioner does not claim that any error in

the decisionmaking process, if it existed, was harmless. Thus,

we decline to address the issue.

22a

III

Our task in this appeal, then, is to determine

whether Treasury’s 2003 regulations are lawful. In

the context of the arguments made in this case, we

evaluate the validity of the agency’s regulations under

both Chevron and State Farm, which “provide for related but distinct standards for reviewing rules promulgated by administrative agencies.” Catskill Mountains Chapter of Trout Unlimited, Inc. v. EPA, 846

F.3d 492, 521 (2d Cir. 2017). “State Farm is used to

evaluate whether a rule is procedurally defective as a

result of flaws in the agency’s decisionmaking process.” Id. “Chevron, by contrast, is generally used to

evaluate whether the conclusion reached as a result of

that process – an agency’s interpretation of a statutory provision it administers – is reasonable.” Id.5 “A

litigant challenging a rule may challenge it under

State Farm, Chevron, or both.” Id. Altera challenges

both the procedural adequacy of the APA process and

the substance of the regulation.6

There are circumstances when the two analyses may overlap.

See, e.g., Confederated Tribes of Grand Ronde Cmty. of Or. v.

Jewell, 830 F.3d 552, 561 (D.C. Cir. 2016) (We are mindful that,

“[i]n [some] situations, what is ‘permissible’ under Chevron is

also reasonable under State Farm.” (quoting Arent v. Shalala, 70

F.3d 610, 616 n.6 (D.C. Cir. 1995))).

We afforded the parties the opportunity to file optional supplemental briefs on the question whether the six-year statute of limitations under 28 U.S.C. § 2401(a) – which generally applies to

procedural challenges to regulations under the APA – applies to

this case. The Commissioner responded that it had waived this

non-jurisdictional defense by failing to assert it to the Tax Court.

We agree with the parties that the Commissioner waived the defense. Day v. McDonough, 547 U.S. 198, 210 n.11 (2006)

(“[S]hould a State intelligently choose to waive a statute of limitations defense, a district court would not be at liberty to disregard that choice.”); Whidbee v. Pierce County, 857 F.3d 1019,

23a

We first turn to Chevron analysis.

Under Chevron, we first apply the traditional rules

of statutory construction to determine whether “Congress has directly spoken to the precise question at issue.” 467 U.S. at 842. We start with the plain statutory text and, “when deciding whether the language is

plain, we must read the words ‘in their context and

with a view to their place in the overall statutory

scheme.’ ” King v. Burwell, 135 S. Ct. 2480, 2489

(2015) (quoting FDA v. Brown & Williamson Tobacco

Corp., 529 U.S. 120, 133 (2000)).

In addition, we examine the legislative history, the

statutory structure, and “other traditional aids of

statutory interpretation” in order to ascertain congressional intent. Middlesex Cty. Sewerage Auth. v.

Nat’l Sea Clammers Ass’n, 453 U.S. 1, 13 (1981). If,

after conducting that Chevron step one examination,

we conclude that the statute is silent or ambiguous on

the issue, we then defer to the agency’s interpretation

so long as it “is based on a permissible construction of

the statute.” Chevron, 467 U.S. at 843. A permissible

construction is one that is not “arbitrary, capricious,

or manifestly contrary to the statute.” Id. at 844.

Ultimately, questions of deference boil down to

whether “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.” United States v. Mead Corp., 533 U.S. 218,

1024 (9th Cir. 2017) (“[E]ven if a claim has expired under a state

statute of limitations, a defendant can still waive this affirmative

defense.”). Therefore, we need not address it.

24a

226-27 (2001). “When Congress has ‘explicitly left a

gap for an agency to fill, there is an express delegation

of authority to the agency to elucidate a specific provision of the statute by regulation,’ and any ensuing regulation is binding in the courts unless procedurally

defective, arbitrary or capricious in substance, or

manifestly contrary to the statute.” Id. at 227 (quoting Chevron, 467 U.S. at 843-44).

Here, the resolution of our step one Chevron examination is straightforward. Section 482 does not speak

directly to whether the Commissioner may require

parties to a QCSA to share employee stock compensation costs in order to receive the tax benefits associated with entering into a QCSA. Thus, there is no

question that the statute remains ambiguous regarding the method by which Treasury is to make allocations based on stock-based compensation.

Altera argues that the statute, by its terms, cannot

apply to stock-based compensation. According to Altera, stock-based compensation is not “transferred”

between parties because only preexisting intangibles

can be transferred. Thus, for Altera, Treasury has exceeded the delegation of authority apparent from the

plain text of the statute.

We are not persuaded. When parties enter into a

QCSA, they are transferring future distribution rights

to intangibles, albeit intangibles that have yet to be

developed. Indeed, the present-day transfer of those

rights provides the main incentive for entering into a

QCSA. The right to distribute intangibles to be developed later is, itself, one right in the bundle of property

rights that exists at the time that parties enter into a

QCSA.

Moreover, even assuming that the crucial transfer

does not occur contemporaneously, § 482 applies “[i]n

25a

the case of any transfer . . . of intangible property”

that produces income. (Emphasis added.) That

phrasing is as broad as possible, and it cannot reasonably be read to exclude the transfers of expected intangible property. See, e.g., United States v. Gonzales,

520 U.S. 1, 5 (1997) (“Read naturally, the word ‘any’

has an expansive meaning . . . .”); see also Republic of

Iraq v. Beaty, 556 U.S. 848, 856 (2009) (“Of course the

word ‘any’ (in the phrase ‘any other provision of law’)

has an ‘expansive meaning, giving us no warrant to

limit the class of provisions of law [encompassed by

the statutory provision].” (citation omitted)). Additionally, the sentence necessarily is forward-looking

because the production of taxable income always follows the transfer.

In short, the text of the statute does not limit its

application to preexisting intangibles in the way Altera’s argument suggests. Because parties to a QCSA

transfer cost-shared intangibles – including stockbased compensation – they are subject to regulation

under 26 U.S.C. § 482.

Thus, we must move on to Chevron step two to consider whether Treasury’s interpretation of § 482 as to

allocation of employee stock option costs is permissible. An agency’s interpretation of statutory authority

is examined “in light of the statute’s text, structure

and purpose.” Miguel-Miguel v. Gonzales, 500 F.3d

941, 949 (9th Cir. 2007). The interpretation fails if it

is “unmoored from the purposes and concerns” of the

underlying statutory regime. Judulang v. Holder, 565

U.S. 42, 64 (2011). Thus, Congress’s purpose in enacting and amending § 482 in 1986 is key to resolution of

this issue.

26a

The congressional purpose in enacting § 482 was

to establish tax parity. First Sec. Bank of Utah, 405

U.S. at 400. In the 1986 amendments, Congress called

for an approach to allocation of costs and income that

would “reasonably reflect the actual economic activity

undertaken by each [party to a QCSA],” H.R. Rep. No.

99-841, at II-638 (1986) (Conf. Rep.). Put another

way, Congress’s objective in amending § 482 was to

ensure that income follows economic activity. Id. at

II-637. Although the 1986 amendment delegates to

Treasury the choice of a specific methodology to

achieve that end, it suggested: “In the case of any

transfer (or license) of intangible property . . . , the income with respect to such transfer or license shall be

commensurate with the income attributable to the intangible.” This standard is a purely internal one, that

is, internal to the entity being taxed, and evidence

supports Treasury’s belief that Congress intended it

to be. H.R. Rep. No. 99-426, at 423-35; H.R. Rep. No.

99-841, at II-637 (Conf. Rep.). In the QCSA context,

Congress did not want to interfere with controlled

cost-sharing arrangements, but only to the degree

that the allocation of costs and income “reasonably reflect[s] the actual economic activity undertaken by

each.” H.R. Rep. No. 99-841, at II-638 (Conf. Rep.). In

light of this history, Treasury’s decision to adopt a

methodology that followed actual economic activity

was reasonable.

So was Treasury’s determination that uncontrolled

cost-sharing arrangements do not provide helpful

guidance regarding allocations of employee stock compensation. When it amended § 482 in 1986, Congress

bemoaned the difficulties associated with finding and

using data involving high-profit intangibles. See H.R.

Rep. No. 99-426, at 425 (“There are extreme difficul-

27a

ties in determining whether the arm’s length transfers between unrelated parties are comparable. . . .

[I]t is appropriate to require that the payment made

on a transfer of intangibles to a related foreign corporation be commensurate with the income attributable

to the intangible.”); see also Compensatory Stock Options Under Section 482, 68 Fed. Reg. 51,171-02,

51,173 (Aug. 26, 2003) (citing H.R. Rep. No. 99-426, at

423-25) (“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.”).7 It follows that Congress granted Treasury authority to develop methods that did not rely on

analysis of these problematic comparable transactions. Indeed, Treasury echoed Congress’s rationale

for amending § 482 in the first place when it published

Although the 2017 amendment to § 482 has no bearing on our

analysis, we note that Congress has not changed its mind:

The transfer pricing rules of section 482 and the accompanying Treasury regulations are intended to preserve the U.S.

tax base by ensuring that taxpayers do not shift income

properly attributable to the United States to a related foreign

company through pricing that does not reflect an arm’slength result . . . . The arm’s-length standard is difficult to

administer in situations in which no unrelated party market

prices exist for transactions between related parties . . . .

. . . For income from intangible property, section 482 provides “in the case of any transfer (or license) of intangible

property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.”

By requiring inclusion in income of amounts commensurate

with the income attributable to the intangible, Congress was

responding to concerns regarding the effectiveness of the

arm’s-length standard with respect to intangible property –

including, in particular, high-profit-potential intangibles.

H. Rep. No. 115-466, at 574-75 (2017).

28a

the final rule. Id. at 51,173 (“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.”).

What is more, although Altera suggests there can

be only one understanding of the methodology required by the arm’s length standard, historically the

definition of the arm’s length standard has been a

more fluid one. Indeed, as we have discussed, for most

of the twentieth century the arm’s length standard explicitly permitted the use of flexible methodology in

order to achieve an arm’s length result. See also H.R.

Rep. No. 87-2508, at 18-19 (1962) (Conf. Rep.) (noting

that, in 1962, Congress stated that Treasury should

“provide additional guidelines and formulas” to

achieve arm’s length results). It is true that, more recently, an understanding that the primary means of

reaching an arm’s length result suggested the analysis of comparable transactions. But, in the lead-up to

the 1986 amendments, Congress voiced numerous

concerns regarding reliance on this methodology.

Further, as we have discussed, courts for more than

half a century have held that a comparable transaction analysis was not the exclusive methodology to be

employed under the statute. In light of the historic

versatility of methodology, it is reasonable that Treasury would understand that Congress intended for it to

depart from analysis of comparable transactions as

the exclusive means of achieving an arm’s length result.

In addition, Treasury reasonably concluded that

doing away with analysis of comparable transactions

was an efficient means of ensuring that § 482 would

“operat[e] to assure adequate allocations to the U.S.

29a

taxable entity of income attributable to intangibles in

[QCSAs].” H.R. Rep. No. 99-426, at 423. Congress expressed numerous concerns that pre-1986 allocation

methods permitted entities to undervalue their tax liability by placing undue emphasis on “the concept of

comparables” and basing allocations on industry

norms, rather than on actual economic activity. Id. at

424-25. Doing away with analysis of comparable

transactions, and instead requiring an internal

method of allocation, proves a reasonable method of

alleviating these concerns.

In sum, Treasury reasonably understood § 482 as

an authorization to require internal allocation methods in the QCSA context, provided that the costs and

income allocated are proportionate to the economic activity of the related parties. These internal allocation

methods are reasonable methods for reaching the

arm’s length results required by statute. While interpreting the statute to do away with reliance on comparables may not have been “the only possible interpretation” of Congress’s intent, it proves a reasonable

one. Entergy Corp. v. Riverkeeper, Inc., 556 U.S. 208,

218 (2009). Thus, Treasury’s interpretation is not “arbitrary, capricious, or manifestly contrary to the statute,” and it is therefore permissible under Chevron.

467 U.S. at 844.

Altera contends that the Commissioner misreads

§ 482 and its history, arguing that the addition of the

commensurate with income standard to § 482 did

nothing to change the meaning and operation of the

arm’s length standard, thus rendering Treasury’s interpretation unreasonable. Altera supports its argument with a canon of construction: “Amendments by

30a

implication, like repeals by implication, are not favored.” United States v. Welden, 377 U.S. 95, 103 n.12

(1964). That canon does not apply here. It operates

to prevent courts from attributing unspoken motives

to legislators, not to force courts to ignore legislative

action and express legislative history. In addition,

cases invoking the maxim typically refer to a later-enacted, separate statute or provision amending a previous statute or provision; most cases do not involve

changes to the same statute or provision.8 It is illogical to argue that amending a singular statute does not

alter its meaning.

Altera’s interpretation of the 1986 amendment

would render the commensurate with income clause

meaningless except in two circumstances: (1) to allow

the Commissioner periodically to adjust prices initially assigned following a comparability analysis; and

(2) to reflect a party’s contribution of existing intangible property or “buy-in” to a cost-sharing arrangement. This narrow reading of § 482 is not supported

by the text or history of the 1986 amendment.

The Commissioner’s allocation of employee stock

compensation costs between related parties is necessary for Treasury to fulfill its obligation under § 482.

Congress did not intend to interfere with qualified

cost-sharing arrangements when those arrangements

provided for the allocation of income consistent with

See, e.g., Nat’l Ass’n of Home Builders v. Defs. of Wildlife, 551

U.S. 644, 650-52, 664 n.8 (2007) (considering whether a later-enacted provision of the Endangered Species Act could amend a

provision of the Clean Water Act); Blanchette v. Conn. Gen. Ins.

Corps., 419 U.S. 102, 134 (1974) (considering whether the Rail

Act amended a remedy provided by the Tucker Act); United

States v. Dahl, 314 F.3d 976, 977-78 (9th Cir. 2002) (considering

whether a provision codified as a separate note to an existing

statute amended the statute).

31a

the commensurate with income provision. H.R. Rep.

No. 99-841, at II-638 (Conf. Rep.).

Altera makes much of the United States’s treaty

obligations with other countries, asserting that a

purely internal standard is inconsistent with the

standards agreed to therein and is therefore unreasonable. However, there is no evidence that our treaty

obligations bind us to the analysis of comparable

transactions. As demonstrated by nearly a century of

interpreting § 482 and its precursor, the arm’s length

standard is not necessarily confined to one methodology. It reflects neither how related parties behave nor

how they are taxed. Moreover, our most recent treaties incorporate not only the arm’s length standard,

but also the 2003 regulations. See, e.g., U.S. Dep’t of

Treasury, Technical Explanation of the Convention

Between the United States and Poland for the Avoidance of Double Taxation 31 (2013) (“It is understood

that the Code section 482 ‘commensurate with income’

standard for determining appropriate transfer prices

for intangibles operates consistently with the arm’slength standard. The implementation of this standard in the regulations under Code section 482 is in accordance with the general principles of paragraph 1 of

Article 9 of the Convention . . . .”).

Though Treasury’s interpretation of its statutory

grant of authority was reasonable, we also must examine whether the procedures used in its promulgation prove defective under the APA. Catskill Mountains, 846 F.3d at 522 (“[I]f an interpretive rule was

promulgated in a procedurally defective manner, it

will be set aside regardless of whether its interpretation of the statute is reasonable.”). After reviewing

32a

the administrative record, we conclude that Treasury

complied with the procedural requirements of the

APA and, therefore, the regulations survive State

Farm scrutiny.

Section 706 of the APA directs courts to “decide all

relevant questions of law, interpret constitutional and

statutory provisions, and determine the meaning or

applicability of the terms of an agency action.” 5

U.S.C. § 706 (flush language). Agencies may not act

in ways that are “arbitrary, capricious, an abuse of

discretion, or otherwise not in accordance with law.”

Id. § 706(2)(A).

The APA “sets forth the full extent of judicial authority to review executive agency action for procedural correctness.” FCC v. Fox Television Stations,

Inc., 556 U.S. 502, 513 (2009). It “prescribes a threestep procedure for so-called ‘notice-and-comment rulemaking.’ ” Perez v. Mortg. Bankers Ass’n, 135 S. Ct.

1199, 1203 (2015) (citing 5 U.S.C. § 553). First, a

“[g]eneral notice of proposed rule making” must ordinarily be published in the Federal Register. 5 U.S.C.

§ 553(b). Second, provided that “notice [is] required,”

the agency must “give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments.”

Id. § 553(c). “An agency must consider and respond to

significant comments received during the period for

public comment.” Perez, 135 S. Ct. at 1203. Third, the

agency must incorporate in the final rule “a concise

general statement of [its] basis and purpose.” 5 U.S.C.

§ 553(c).

Altera does not dispute that Treasury satisfied the

first step by giving notice of the 2003 regulations. Id.

Nor does there appear to be a controversy as to

whether Treasury included in the final rule “a concise

general statement of [its] basis and purpose.” Id.;

33a

5 U.S.C. § 553. Rather, Altera argues that the regulations fail on the second step, asserting that: (1)

Treasury improperly rejected comments submitted in

opposition to the proposed rule, (2) Treasury’s current

litigation position is inconsistent with statements

made during the rulemaking process, (3) Treasury did

not adequately support its position that employee

stock compensation is a cost, and (4) a more searching

review is required under Fox, because the agency altered its position. We address each in turn.

Under State Farm, the touchstone of “arbitrary

and capricious” review under the APA is “reasoned decisionmaking.” State Farm, 463 U.S. at 52. “[T]he

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.’ ” Id. at 43 (quoting Burlington Truck

Lines, Inc. v. United States, 371 U.S. 156, 168 (1962)).

“[A]gency action is lawful only if it rests ‘on a consideration of the relevant factors.’ ” Michigan v. EPA,

135 S. Ct. 2699, 2706 (2015) (quoting State Farm, 463

U.S. at 43). However, we may not set aside agency

action simply because the rulemaking process could

have been improved; rather, we must determine

whether the agency’s “path may reasonably be discerned.” State Farm, 463 U.S. at 43 (quoting Bowman

Transp., Inc. v. Ark.-Best Freight Sys., Inc., 419 U.S.

281, 286 (1974)).

In considering and responding to comments, “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.’ ” Id. (quoting Burlington Truck Lines,

371 U.S. at 168). “[A]n agency need only respond to

34a

‘significant’ comments, i.e., those which raise relevant

points and which, if adopted, would require a change

in the agency’s proposed rule.” Am. Mining Congress

v. EPA, 965 F.2d 759, 771 (9th Cir. 1992) (quoting

Home Box Office v. FCC, 567 F.2d 9, 35 & n.58 (D.C.

Cir. 1977) (per curiam)). If the comments ignored by

the agency would not bear on the agency’s “consideration of the relevant factors,” we may not reverse the

agency’s decision. Id.

Treasury published its notice of proposed rulemaking in 2002. Compensatory Stock Options Under Section 482 (Proposed), 67 Fed. Reg. 48,997-01. In its notice, Treasury made clear that it was relying on the

commensurate with income provision. Id. at 48,998.

To support its position, Treasury drew from the legislative history of the 1986 amendment, explaining that

Congress intended a party to a QCSA to “bear its portion of all research and development costs.” Id. (quoting H.R. Rep. No. 99-841, at II-638 (Conf. Rep.)). It

also informed interested parties of its intent to coordinate the new regulations with the arm’s length standard, suggesting that it was attempting to synthesize

the potentially disparate standards found within

§ 482 itself. Id. at 48,998, 49,000-01.

Commenters responded by attacking the proposed

regulations as inconsistent with the traditional arm’s

length standard because the methodology did not involve analysis of comparable transactions. To support

their position, they primarily discussed arm’s length

agreements in which unrelated parties did not mention employee stock options. They explained that unrelated parties do not share stock compensation costs

because it is difficult to value stock-based compensation, and there can be a great deal of expense and risk

involved.

35a

In the preamble to the final rule, Treasury dismissed the comments (and, relatedly, the behavior of

controlled taxpayers):

Treasury and the IRS continue to believe that requiring stock-based compensation to be taken into

account for purposes of QCSAs is consistent with

the legislative intent underlying section 482 and

with the arm’s length standard (and therefore with

the obligations of the United States under its income tax treaties . . .). The legislative history of

the Tax Reform Act of 1986 expressed Congress’s

intent to respect cost sharing arrangements as consistent with the commensurate with income standard, and therefore consistent 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. No. 99-481, at II-638 (1986). . . . [I]n 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 context.

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. . . .

The uncontrolled

transactions cited by commentators do not share

36a

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.

Compensatory Stock Options under Section 482 (Preamble to Final Rule), 68 Fed. Reg. 51,171-02, 51,17273 (Aug. 26, 2003).

Treasury added:

Treasury and the IRS believe that if a significant

element of [the costs shared by unrelated parties]

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.

Id. at 51,173.

By submitting the cited transactions between unrelated parties, the commentators apparently assumed that Treasury would employ analysis of comparable transactions. This assumption, however,

overlooks Treasury’s decision to do away with analysis of comparable transactions in the first place – a

decision that was made clear enough by citations to

legislative history in the notice of proposed rulemaking and in the preamble to the final rule. As discussed

in our Chevron analysis, Treasury’s conclusion that it

could require parties to a QCSA to share all costs was

a reasonable one. Thus, “significant” comments that

required a response would have spoken to why this interpretation was not, in fact, reasonable, so that

adopting the comments would require Treasury to

change the regulation. Am. Mining Congress, 965

F.2d at 771. As an example, Treasury would have

been required to respond to comments demonstrating

that doing away with analysis of comparables did not,

37a

in fact, serve the purposes of parity set out in the statute.

Indeed, the cited transactions actually reinforced

the original justification for adopting a purely internal

methodology – the lack of transactions comparable to

those occurring between parties to a QCSA. Specifically, as Treasury remarked, the submitted transactions did not “share enough characteristics of QCSAs

involving the development of high-profit intangibles”

to provide grounds for accurate comparison. Because

of this lack of similar transactions, Treasury justifiably chose to employ methodology that did not depend

on non-existent comparables to satisfy the commensurate with income test and achieve tax parity. In this

way, the comments reinforced Treasury’s premise for

adopting the purely internal methodology, but were

irrelevant to the underlying choice of methodology.

Treasury did not err in refusing to examine them more

rigorously.

In sum, we cannot find a failure in Treasury’s refusal to consider comments that proved irrelevant to

its decisionmaking process. Here, Treasury gave sufficient notice of what it intended to do and why, and

the submitted comments were irrelevant to the issues

Treasury was considering. Because the comments

had no bearing on “relevant factors” to the rulemaking, nor any bearing on the final rule, there was no

APA violation. Am. Mining Congress, 965 F.2d at 771.

Treasury’s current litigation position is not inconsistent with the statements it made to support the

2003 regulations at the time of the rulemaking. Altera argues that its position is justified by SEC v.

Chenery Corp., 332 U.S. 194 (1947). “[A] reviewing

court . . . must judge the propriety of [agency] action

38a

solely by the grounds invoked by the agency.” Id. at

196. “If those grounds are inadequate or improper,

the court is powerless to affirm the administrative action by substituting what it considers to be a more adequate or proper basis.” Id.

Altera argues that the Commissioner cannot now

claim that “Treasury reasonably determined that it

was statutorily authorized to dispense with comparability analysis” because “[n]owhere in the regulatory

history did the Secretary suggest that he ‘was statutorily authorized to dispense with comparability analysis.’ ” But these arguments misunderstand the rulemaking requirements imposed by Chenery. Chenery

does not require us to adopt Altera’s position as to how

the arm’s length standard operates. Instead, we must

“defer to an interpretation which was a necessary presupposition of [the agency’s] decision,” if reasonable,

even when alternative interpretations are available.

Nat’l R.R. Passenger Corp. v. Boston & Maine Corp.,

503 U.S. 407, 419-20 (1992).

Treasury reasonably interpreted congressional intent in the 1986 amendments as permitting it to dispense with a comparable transaction analysis in the

absence of actual comparable transactions. Its interpretation was all the more reasonable given, as we

have discussed, that the arm’s length standard has

historically been understood as more fluid than Altera

suggests. Because Chenery does not require agencies

to provide “exhaustive, contemporaneous legal arguments to preemptively defend its action,” its references to the 1986 amendments provide an adequate

ground for its determination. Nat’l Elec. Mfrs. Ass’n

v. U.S. Dep’t of Energy, 654 F.3d 496, 515 (4th Cir.

2011).

Altera contends further that the Commissioner’s

position is incompatible with Treasury’s statements

39a

during the rulemaking process, when the Secretary

claimed that the cost-sharing regulations were consistent with the arm’s length standard (as well as the

commensurate with income standard). This argument misinterprets Treasury’s position. Treasury asserted then, and still asserts in this litigation, that using an internal method of reallocation is consistent

with the arm’s length standard because it attempts to

bring parity to the tax treatment of controlled and uncontrolled taxpayers, as does comparison of comparable transactions when they exist. Treasury’s position

was also consistent with its White Paper,9 and Treasury’s interpretation in the 1994 regulation of the

arm’s length standard as result-oriented, rather than

method-oriented, with the goal of achieving tax parity.

26 C.F.R. § 1.482-1(b)(1) (1994).

Altera’s argument is founded on its belief that an

arm’s length analysis always must be method-oriented, and rooted in actual transactional analysis.

But the question before us is not which view is superior; it is whether Treasury’s position in 2003 was incompatible with its prior position in promulgating the

1994 and 1995 regulations. As we have discussed, it

was clear in 1994 and 1995 that, in implementing the

commensurate with income amendment, Treasury

was moving away from a purely method-based, comparable-transaction view of the arm’s length standard

in attempting to achieve tax parity. Treasury’s citation to the amendment, and its legislative history,

Altera argues that a passage in the White Paper, in which

Treasury wrote that “intangible income must be allocated on the

basis of comparable transactions if comparables exist,” demonstrates inconsistency. However, that statement is entirely consistent with Treasury’s view that a different methodology must

be applied when comparable transactions do not exist.

40a

demonstrates that its position was not inconsistent,

and there is no basis under Chenery to invalidate it.

Altera also argues that Treasury did not adequately support its position that employee stock compensation is a cost, asserting that Treasury wrongfully ignored evidence that companies do not factor

stock-based compensation into their pricing decisions.

As an accounting matter in the past, this issue may

have been disputed. Indeed, at one point, “[t]he debate on accounting for stock-based compensation . . .

became so divisive that it threatened the [Financial

Accounting Standards] Board’s future working relationship with some of its constituents.” Financial Accounting Standards Board, Financial Accounting

Foundation, Accounting for Stock-Based Compensation: Statement of Financial Accounting Standards

No. 123, at 25 (1995). However, as we will discuss, it

is uncontroversial today. Since 1995, the Financial

Accounting Standards Board has supported treating

stock options as costs. Id.

Treasury’s rulemaking process was sufficient.

Treasury articulated why treating stock-based compensation as a cost led to arm’s length results. It first

noted that stock-based compensation is a “critical element” of R&D costs for parties to a QCSA and noted

that such compensation is “clearly related to the intangible development area.” Compensatory Stock Options Under Section 482 (Preamble to Final Rule), 68

Fed. Reg. at 51,173. Logic supports these conclusions.

Parties dealing at arm’s length, as Treasury explained, would not “ignore” stock-based compensation

if such compensation were a “significant element” of

the compensation costs one party incurs and another

party agrees to reimburse when developing high-

41a

profit intangibles. Id. Rather, “through bargaining,”

each party would ensure that the cost-sharing agreement is in its best interest, meaning that the parties

will consider the internal costs of stock compensation

without requiring the other party to recognize those

costs. Id.

Though commentators presented evidence of some

transactions in which stock-based compensation was

not a cost, this evidence provided little guidance because it did not concern parties to a QCSA developing

high-profit intangibles. This out-of-context data did

not require a different decision. In the absence of applicable evidence, Treasury’s analysis provides a logical explanation of how treating stock-based compensation as a cost leads to arm’s length results.

In addition, as we have noted, generally accepted

accounting principles supported Treasury’s conclusion, and Treasury cited generally to “tax and other

accounting principles” for its determination that there

is a “cost associated with stock-based compensation.”

Compensatory Stock Options Under Section 482 (Proposed), 67 Fed. Reg. at 48,999. One such principle is

that a distinction exists between the economic costs of

stock compensation – which are debatable – versus

the accounting costs – which are not. Because entities

account for the cost of providing employee stock options, it is reasonable for Treasury to allocate that

cost. In light of these fundamental understandings,

Treasury’s reference to “tax and other accounting

principles” provides a solid foundation for the Commissioner’s interpretation.10

10 See, e.g., Andrew Barry, How Much Do Silicon Valley Firms

Really Earn?, Barron’s (June 27, 2015), http://www.barrons.com/articles/how-much-do-silicon-valley-firms-really-earn1435372718)) (noting that numerous companies, including

42a

Most notably, the Tax Code classifies stock-based

compensation as a trade or business “expense.”

26 U.S.C. § 162(a). And the challenged regulation

cites the provision providing that this expense is a deductible expense. 26 C.F.R. § 1.482-7A(d)(2)(iii)(A)

(“[T]he operating expense attributable to stock-based

compensation is equal to the amount allowable . . . as

a deduction for Federal income tax purposes . . . (for

example, under [26 U.S.C. § 83(h)]).”). The reference

to the Tax Code’s classifications in the regulation itself serves as yet another articulation of Treasury’s

reasoning, the reasonableness of which is made clear

by the Tax Code’s treatment of stock-based compensation as a cost.

Though it could have been more specific, Treasury

“articulated a rational connection” between its decision and these industry standards. County of Amador

v. U.S. Dep’t of Interior, 872 F.3d 1012, 1027 (9th Cir.

2017) (internal quotation marks omitted), cert. denied,

139 S. Ct. 64 (2018). Presuming that Treasury was

authorized to dispense with a comparability analysis,

making the economic behavior of uncontrolled taxpayers irrelevant, Altera does not offer any compelling argument against the reasonableness of Treasury’s determination.

Finally, in addition to its general State Farm argument, Altera asks for a more searching review under

Fox. Altera claims that the cost-sharing amendments

present a major shift in administrative policy such

that Treasury could not issue the regulations without

carefully considering and broadcasting its decision.

Google and Qualcomm, reported stock compensation “total[ling]

five percent or more of revenue in recent years”).

43a

Altera argues that “[t]he assertion that the commensurate with income clause supplants the arm’s-length

standard with a ‘purely internal’ analysis is a sharp –

but unacknowledged – reversal from Treasury’s longstanding prior policy.”

“Agencies are free to change their existing policies

as long as they provide a reasoned explanation for the

change.” Encino Motorcars, LLC v. Navarro, 136 S.

Ct. 2117, 2125 (2016). Indeed, “[w]hen an agency

changes its existing position, it ‘need not always provide a more detailed justification than what would

suffice for a new policy created on a blank slate.’ ” Id.

at 2125-26 (quoting Fox, 556 U.S. at 515). However,

an agency may not “depart from a prior policy sub silentio or simply disregard rules that are still on the

books.” Fox, 556 U.S. at 515.

[A] policy change complies with the APA if the

agency

(1) displays “awareness that it is changing position,”

(2) shows that “the new policy is permissible under

the statute,”

(3) “believes” the new policy is better, and

(4) provides “good reasons” for the new policy,

which, if the “new policy rests upon factual findings that contradict those which underlay its prior

policy,” must include “a reasoned explanation . . .

for disregarding facts and circumstances that underlay or were engendered by the prior policy.”

Organized Vill. of Kake v. U.S. Dep’t of Agric., 795

F.3d 956, 966 (9th Cir. 2015) (en banc) (format altered) (quoting Fox, 556 U.S. at 515-16).

44a

At its core, this argument is not meaningfully different from Altera’s general APA argument. If the

arm’s length standard allows the Commissioner to allocate costs between related parties without a comparability analysis, there is no policy change, merely a

clarification of the same policy. Further, as we have

discussed, the policy change was occasioned by the

congressional addition of the “commensurate with income” sentence in the Tax Reform Act of 1984 and the

1994 and 1995 implementing regulations. Those

changes occurred well before 2003. The 2003 regulations clarified, rather than altered, prior policy. And

the enactment of a statutory amendment obviously

makes a concomitant regulatory amendment appropriate.

Thus, the 2003 regulations are not arbitrary and

capricious under the standard of review imposed by

the APA. Treasury’s regulatory path may be reasonably discerned. Treasury understood § 482 to authorize it to employ a purely internal, commensurate with

income approach in dealing with related companies.

It provided adequate notice of its intent and adequately considered the objections. Its conclusion that

stock based compensation should be treated as a cost

was adequately supported in the record, and its position did not represent a policy change under Fox.

Altera also argues that the outcome of this case is

controlled by our court’s decision in Xilinx. We disagree. Although the Xilinx panel could have reached a

holding that would foreclose the Commissioner’s current position, it did not.

In Xilinx, we considered the 1994 and 1995 costsharing regulations. The case involved a matter of

45a

regulatory interpretation, not executive authority.

Xilinx, Inc., another maker of programmable logic devices, challenged the Commissioner’s allocation of employee stock options between Xilinx and its Irish subsidiary. 598 F.3d at 1192. As framed by the panel,

the issue was whether § 1.482-1 (1994) – which sets

forth the arm’s length standard – could be reconciled

with § 1.482-7(d)(1) (1995) – under which parties to a

QCSA were required to share “all . . . costs” incurred

in developing intangibles. Id. at 1195.

Xilinx does not govern here. First, the parties in

Xilinx were not debating administrative authority,

and we did not consider the “commensurate with income” standard, which Congress itself did not see as

inconsistent with the arm’s length standard. Second,

and more significantly, the Xilinx panel was faced

with a conflict between two rules. If the rules were

conceptually distinguishable, they were also in direct

conflict. The arm’s length rule, § 1.482-1(b)(1) (1994),

listed specific methods for calculating an arm’s length

result. The all-costs provision was not one of those

methods, as the first Xilinx majority noted. 567 F.3d

at 491. Treasury issued the coordinating amendment

in 2003, after the tax years at issue in Xilinx, and the

arm’s length regulation now expressly references the

cost-sharing provision that Altera challenges. The

Xilinx panel did not address the “open question” of

whether the 2003 regulations remedied the error

identified in that decision. 598 F.3d at 1198 n.4

(Fisher, J., concurring). Today, there is no conflict in

the regulations, and Altera does not challenge the regulations on the ground that a conflict exists.

Xilinx did not involve the question of statutory interpretation, the Commissioner’s authority, or the

regulation at issue in this appeal:

26 C.F.R.

46a

§ 1.482-7A(d)(2). Accordingly, it does not assist Altera.

The 1986 amendment focused specifically on intangibles, and it gave Treasury the ability to respond

to rapid changes in the high tech industry. “The broad

language of [§ 482] reflects an intentional effort to

confer the flexibility necessary to forestall . . . obsolescence.” Massachusetts v. EPA, 549 U.S. 497, 532

(2007). In the modern economy, employee stock options are integral to R&D arrangements. In fact, in

Altera’s 2015 annual report, its stock-based compensation cost equaled nearly five percent of total revenue. Altera Corp., Annual Report for the Fiscal Year

Ended Dec. 31, 2014 (Form 10-K). Simply speaking,

the rise in employee stock compensation is an economic development that Treasury cannot ignore without rejecting its obligations under § 482.

In sum, we disagree with the Tax Court that the

2003 regulations are arbitrary and capricious under

the standard of review imposed by the APA. While

the rulemaking process was less than ideal, the APA

does not require perfection. We are able to reasonably

discern Treasury’s path – Treasury understood § 482

to authorize it to employ a purely internal, commensurate with income approach where comparable

transactions are not comparable.

In light of the statute’s plain text and the legislative history, Treasury also reasonably concluded that

Congress intended to hone the definition of the arm’s

length standard so that it could work to achieve an

arm’s length result, instead of forcing application of a

particular comparability method. Given the long history of the application of other methods, and the text

and legislative history of the Tax Reform Act of 1984,

47a

Treasury’s understanding of its power to use methodologies other than a pure transactional comparability

analysis was reasonable, and we defer to its interpretation under Chevron. The Commissioner did not exceed the authority delegated to him by Congress in issuing the regulations.

REVERSED.

O’MALLEY, Circuit Judge, dissenting:

“[T]he foundational principle of administrative law

[is] that a court may uphold agency action only on the

grounds that the agency invoked when it took the action.” Michigan v. EPA, 135 S. Ct. 2699, 2710 (2015)

(citing SEC v. Chenery Corp. (“Chenery I ”), 318 U.S.

80, 87 (1943)).

Prior to promulgating Treas.

Reg. § 1.482-7A(d)(2), whose validity we consider

here, Treasury repeatedly recognized that 26 U.S.C.

§ 482 requires application of an arm’s length standard

when determining the true taxable income of a controlled taxpayer – i.e., it requires Treasury to assess

what a taxpayer dealing with an uncontrolled taxpayer would do in the same circumstances. And,

Treasury just as consistently asserted that a comparability analysis is the only way to determine the

arm’s length standard; indeed, Treasury made clear

that a comparability analysis is the cornerstone of the

arm’s length standard. Despite these consistent practices and declarations, in its preamble to § 1.4827A(d)(2), Treasury stated, for the first time and with

no explanation, that it may, instead, employ the “commensurate with income” standard to reach the required arm’s length result.

48a

Today, the majority justifies Treasury’s about-face

in three steps: (1) it finds that, by citing to the legislative history surrounding the enactment of the Tax

Reform Act of 1986 in the preamble to § 1.4827A(d)(2), Treasury implicitly communicated its understanding that Congress “permitt[ed] it to dispense

with a comparable transaction analysis,” Op. 40-41;

(2) it finds that, by including that same cryptic citation to legislative history in its proposed notice of rulemaking, Treasury made it “clear enough” to interested

parties that Treasury was changing its longstanding

practice of applying a comparability analysis, Op. 3839; and (3) it justifies Treasury’s resort to the commensurate with income standard by invoking the second sentence of § 482 to conclude that Treasury may

jettison the arm’s length standard altogether – a justification Treasury never provided and one which does

not withstand careful scrutiny.

The majority, thus, “suppl[ies] a reasoned basis for

the agency’s action that the agency itself has not

given,” Motor Vehicle Mfrs. Ass’n of U.S., Inc. v. State

Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983) (citing SEC v. Chenery Corp. (“Chenery II ”), 332 U.S. 194,

196 (1947)), encourages “executive agencies’ penchant

for changing their views about the law’s meaning almost as often as they change administrations,” BNSF

Ry. Co. v. Loos, 586 U.S. ___, No. 17-1042, slip op. at

9 (2019) (Gorsuch, J., dissenting), and endorses a

practice of requiring interested parties to engage in a

scavenger hunt to understand an agency’s rulemaking

proposals. That practice is inconsistent with another

fundamental Administrative Procedure Act (“APA”)

principle: that a notice of proposed rulemaking

“should be sufficiently descriptive of the ‘subjects and

issues involved’ so that interested parties may offer

informed criticism and comments.” Am. Mining Cong.

49a

v. U.S. EPA, 965 F.2d 759, 770 (9th Cir. 1992) (quoting Ethyl Corp. v. EPA, 541 F.2d 1, 48 (D.C. Cir. 1976)

(en banc)). In so doing, the majority stretches “highly

deferential” review, Providence Yakima Med. Ctr. v.

Sebelius, 611 F.3d 1181, 1190 (9th Cir. 2010) (quoting

J & G Sales Ltd. v. Truscott, 473 F.3d 1043, 1051 (9th

Cir. 2007)), beyond its breaking point.

I would instead find, as the Tax Court did, that

Treasury’s explanation of its rule (to the extent any

was provided) failed to satisfy the State Farm standard, that Treasury did not provide adequate notice of

its intent to change its longstanding practice of employing the arm’s length standard and using a comparability analysis to get there, and that its new rule is

invalid as arbitrary and capricious. I would also hold

that this court’s previous decision in Xilinx, Inc. v.

Commissioner of Internal Revenue (“Xilinx II ”), 598

F.3d 1191 (9th Cir. 2010), controls and mandates an

order affirming the Tax Court’s decision. I therefore

would affirm the judgment of the Tax Court that expenses related to stock-based compensation are not

among the costs to be shared in qualified cost sharing

arrangements (“QCSAs”) under Treas. Reg. § 1.4827(d)(1) (as amended in 2013). See Altera Corp. v.

Comm’r, 145 T.C. 91, 92 (2015). For these reasons, I

respectfully dissent.

I. Background

A. The Arm’s Length Standard

1. Before 1986

“The 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.”

Comm’r v. First Sec. Bank of Utah, 405 U.S. 394, 400

50a

(1972) (quoting Treas. Reg. § 1.482-1(b)(1) (1971)).

The “touchstone” of this tax parity inquiry is the arm’s

length standard. Xilinx II, 598 F.3d at 1198 n.1

(Fisher, J., concurring). Indeed, the first sentence of

§ 482 states that, “[i]n any case of two or more organizations, trades, or businesses . . . owned or controlled

directly or indirectly by the same interests, the Secretary may . . . allocate gross income . . . if he determines that such . . . allocation is necessary in order to

prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” This sentence has always been viewed as requiring an arm’s length standard. See First Sec. Bank

of Utah, 405 U.S. at 400; Barclays Bank PLC v. Franchise Tax Bd. of Cal., 512 U.S. 298, 305 (1994).

Since the 1930s, Treasury regulations consistently

have explained 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.” Treas.

Reg. § 1.482-1(b)(1) (2003) (emphasis added). That is,

income and deductions are to be allocated among related companies in the same way that unrelated companies negotiating at arm’s length would allocate income and deductions. As far back as 1968, Treasury’s

regulations also required that, “[i]n order for the sharing of costs and risks to be considered on an arm’s

length basis, the terms and conditions must be comparable to those which would have been adopted by unrelated parties similarly situated had they entered

into such an arrangement.” Allocation of Income and

Deductions Among Taxpayers, 33 Fed. Reg. 5848,

5854 (April 16, 1968) (emphasis added). That same

regulation provided that Treasury may not allocate

income with respect to QCSAs involving the development of intangible property unless doing so would be

51a

consistent with the arm’s length standard. Id.

(providing that, in “a bona fide cost sharing arrangement with respect to the development of intangible

property, the district director shall not make allocations with respect to such acquisition except as may

be appropriate to reflect each participant’s arm’s

length share of the costs and risks of developing the

property.”). Therefore, at the time Congress enacted

the 1986 amendment, Treasury’s own regulations explicitly required a determination of what an arm’s

length result would show and required a comparability analysis to reach that result where comparable

transactions exist.

The majority attempts to water down the text of

Treasury’s own regulations at the time. It contends

that, “[a]lthough the Secretary adopted the arm’s

length standard, courts did not hold related parties to

the standard by exclusively requiring the examination

of comparable transactions.” Op. 9. To support its position, the majority cites this court’s decision in Frank

v. Int’l Canadian Corp., 308 F.2d 520, 528-29 (9th Cir.

1962), which disagreed that “ ‘arm’s length bargaining’ is the sole criterion for applying the statutory language of [§ 482] in determining what the ‘true net income’ is of each ‘controlled taxpayer.’ ” But, in Oil

Base, Inc. v. Commissioner of Internal Revenue, 362

F.2d 212, 214 n.5 (9th Cir. 1966), this court clarified

that the holding in Frank was an outlier, limited only

to the peculiar facts of that case. Frank’s departure

from the arm’s length analysis, the court held, was

justified, in part, because “there was no evidence that

arm’s-length bargaining upon the specific commodities sold had produced a higher return” and because

“the complexity of the circumstances surrounding the

services rendered by the subsidiary” made it “difficult

52a

for the court to hypothesize an arm’s-length transaction.” Id. Significantly, the parties in Frank had stipulated to applying a standard other than the arm’s

length standard. Id.

There really can be no doubt that, prior to the 1986

amendment, this Circuit believed that an arm’s length

standard based on comparable transactions was the

sole basis for allocating costs and income under the

statute in all but the narrow circumstances outlined

in Frank – including the presence of the stipulation

therein. The majority’s attempt to breathe life back

into Frank is, simply, unpersuasive.

2. The 1986 Amendment

The 1986 amendment passed against the backdrop

of Treasury’s own longstanding practices did not

change the obligation to employ an arm’s length

standard. Indeed, Congress left the first sentence of

§ 482 – the sentence that undisputedly incorporates

the arm’s length standard – intact. It merely added a

second sentence providing that, “[i]n the case of any

transfer (or license) of intangible property . . . , the income with respect to such transfer or license shall be

commensurate with the income attributable to the intangible.” Tax Reform Act of 1986, Pub. L. No. 99-514,

§ 1231(e)(1), 100 Stat. 2085, 2562 (1986) (codified as

amended at 26 U.S.C. § 482). The plain text of the

statute limits the application of the commensurate

with income standard to only transfers or licenses of

intangible property.

This is consistent with the underlying purpose of

the 1986 amendment. Congress explained in the committee report that it was introducing the commensurate with income standard to address a “recurrent

problem” with transfers of highly valuable intangible

property: “the absence of comparable arm’s length

53a

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

length concept in the absence of comparables.” H.R.

Rep. No. 99-426, at 423-24 (1985). Congress noted

that “[i]ndustry norms for transfers to unrelated parties of less profitable intangibles frequently are not realistic comparables in these cases,” and that “[t]here

are extreme difficulties in determining whether the

arm’s length transfers between unrelated parties are

comparable.” Id. at 424-25. To address this specific

gap, Congress found it “appropriate to require that the

payment made on a transfer of intangibles to a related

foreign corporation . . . be commensurate with the income attributable to the intangible.” Id. at 425. Congress did not make any other findings regarding the

use of the commensurate with income standard for

any transactions other than transfers or licenses of intangible property. Thus, the statute – read in light of

this legislative history – did not grant Treasury the

flexibility to depart from a comparability analysis

whenever it sees fit; rather, it permitted a departure

in the limited context of “any transfer (or license) of

intangible property” because it had found that comparable transactions in such cases are frequently unrealistic.

Treasury reiterated the limited circumstances in

which the commensurate with income standard applies in its 1988 “White Paper.” It stated there that,

even in the context of transfers or licenses of intangible property, the “intangible income must be allocated

on the basis of comparable transactions if comparables exist.” A Study of Intercompany Pricing under

Section 482 of the Code (“White Paper”), I.R.S. Notice

88-123, 1988-1 C.B. 458, 474; see also id. at 473 (noting that, where “there is a true comparable for” the

licensing of a “high profit potential intangible,” the

54a

royalty rate for the license “must be set on the basis of

the comparable because that remains the best measure of how third parties would allocate intangible income”). Only “in situations in which comparables do

not exist” for transfers of intangible property would

the commensurate with income standard apply. Id. at

474. Indeed, the United States continued to insist in

tax treaties, and in documents that Treasury issued

to explain these treaties, that § 482 mandated the

arm’s length principle, in all but this narrow category

of intangible transfers. See Xilinx II, 598 F.3d at

1196-97 (citing tax treaty explanations); see also id. at

1198 n.1 (Fisher, J., concurring) (noting that “the 1997

United States-Ireland Tax Treaty, . . . and others like

it, reinforce the arm’s length standard as Congress’ intended touchstone for § 482”).1

B. Treatment of Stock-Based Compensation

In the early 1990s, related companies began to

compensate certain employees who performed research and development activities pursuant to QCSAs

by granting stock options and other stock-based compensation. See id. at 1192-93. This manner of compensation allowed companies to avoid the income reallocation mechanisms available under § 482 by including only the employees’ cash compensation in the

cost pool under the agreement, but not their stockbased compensation.

As the majority observes, more recent tax treaty explanations

have also cited the alternative commensurate with income standard. Op. 32-33 (citing Technical Explanation of the US-Poland

Tax Treaty, at 31 (Feb. 13, 2013)). Even these explanations, however, emphasize the primacy of the arm’s length standard, and

they assure the reader that the commensurate with income

standard “operates consistently with the arm’s-length standard.”

Technical Explanation of the US-Poland Tax Treaty, at 30-31

(Feb. 13, 2013).

55a

To address this loophole, Treasury promulgated

new regulations governing the tax treatment of controlled transactions in 1994 and 1995. These regulations affirmed that “the standard to be applied in

every case” was the arm’s length standard and that

“an arm’s length result generally will be determined

by reference to the results of comparable transactions”

because “identical transactions can rarely be located.”

Treas. Reg. § 1.482-1(b)(1) (as amended in 1994).

They also provided that intangible development costs

included “all of the costs incurred by . . . [an uncontrolled] participant related to the intangible development area.” Treas. Reg. § 1.482-7(d)(1) (as amended

in 1995). The IRS interpreted this latter “all costs”

provision to include stock-based compensation, so that

related companies in cost-sharing agreements would

have to share costs of providing such compensation.

Xilinx II, 598 F.3d at 1193-94.

When Xilinx, Inc. (“Xilinx”) challenged the IRS’s

interpretation, the Tax Court decided that the

agency’s interpretation was inconsistent with Treas.

Reg. § 1.482-1 because the IRS had not adduced evidence sufficient to show that unrelated parties transacting at arm’s length would, in fact, share expenses

related to stock-based compensation. Xilinx v. Commissioner (“Xilinx I ”), 125 T.C. 37, 53 (2005). The

Commissioner did not appeal this underlying factual

finding and, instead, argued on appeal to this court

that Treas. Reg. § 1.482-7 superseded the arm’s length

requirement of Treas. Reg. § 1.482-1. All three members of the divided panel therefore assumed that sharing expenses related to stock-based compensation

would be inconsistent with the arm’s length standard.

Xilinx II, 598 F.3d at 1194 (“The Commissioner does

not dispute the tax court’s factual finding that unrelated parties would not share [employee stock options]

56a

as a cost.”); id. at 1199 (Reinhardt, J., dissenting) (assuming that the Tax Court “correctly resolved” the issue of whether sharing stock-based compensation

costs would constitute an arm’s length result). The

panel also assumed that Treas. Reg. § 1.482-7 required stock-based compensation expenses to be

shared. Id. at 1196 (majority opinion) (noting that the

“all costs” provision “does not permit any exceptions,

even for costs that unrelated parties would not

share”); id. at 1199 (Reinhardt, J., dissenting) (assuming that the “all costs” provision includes “employee

stock option costs”). But a majority of the panel ultimately held that the arm’s length standard, which it

described as the fundamental “purpose” of the regulations, trumped Treas. Reg. § 1.482-7, and that stockbased compensation expenses could not be shared in

the absence of evidence that unrelated parties would

share such costs. Id. at 1196 (majority opinion); see

also id. at 1198 n.1 (Fisher, J., concurring) (finding

“the arm’s length standard” to be “Congress’ intended

touchstone for § 482”). On that ground, this court affirmed the Tax Court’s judgment in favor of Xilinx. Id.

at 1196 (majority opinion).

C. The Regulations at Issue

While Xilinx II was pending before this court,

Treasury promulgated the regulations at issue here.

Compensatory Stock Options Under Section 482, 68

Fed. Reg. 51,171, 51,172 (Aug. 26, 2003) (codified at

26 C.F.R. pts. 1 and 602). The amended regulations

sought to reconcile the apparent contradiction between the arm’s length standard in Treas.

Reg. § 1.482-1 and the requirement that stock-based

compensation expenses be shared under Treas.

Reg. § 1.482-7. The former provision now specifies

that § 1.482-7 “provides the specific methods to be

used to evaluate whether a [QCSA] produces results

57a

consistent with an arm’s length result.” Treas.

Reg. § 1.482-1(b)(2)(i) (2003). And § 1.482-7, in turn,

now provides that a QCSA produces an arm’s length

result “if, and only if,” the participants share all of the

costs of intangible development – explicitly including

costs associated with stock-based compensation – in

proportion to their shares of reasonably anticipated

benefits attributable to such development. Treas.

Reg. § 1.482-7(d)(2) (2003).

Altera Corp. (“Altera U.S.”), a Delaware corporation, and its subsidiary Altera International, a Cayman Islands corporation, (collectively “Altera”) entered into a technology research and development

cost-sharing agreement under which the related participants “agreed to pool their respective resources to

conduct research and development using the pre-costsharing intangible property” and “to share the risks

and costs of research and development activities they

performed on or after May 23, 1997.” Altera, 145 T.C.

at 93. This agreement was effective from May 23,

1997 through 2007. Id. During the 2004-2007 taxable

years, Altera U.S. granted stock options and other

stock-based compensation to certain employees who

performed research and development activities pursuant to the agreement. Id. The employees’ cash compensation was included in the cost pool under the

agreement, but their stock-based compensation was

not. Id.

Altera timely filed an income tax return for its

2004-2007 taxable years. Id. at 94. Treasury responded by mailing notices of deficiency for those

years, allocating income from Altera International to

Altera U.S. by increasing Altera International’s costsharing payments. Id. Treasury claimed its costsharing adjustments were for the purpose of bringing

Altera in compliance with § 1.482-7(d)(2), now

58a

§ 1.482-7A(d)(2). Id. Altera challenged the validity of

§ 1.482-7A(d)(2) in Tax Court, arguing that the new

rule is arbitrary and capricious. Id. at 92. The Tax

Court unanimously held, as discussed in more detail

below, that the explanation Treasury offered in the

preamble accompanying the new regulations was insufficient to justify those regulations under State

Farm. Id. at 120-33. The Commissioner appeals that

decision.

II. Discussion

The Tax Court considered and rejected Treasury’s

plainly stated explanation for its regulation – that

Treasury applied the commensurate with income test

because it could find no transactions comparable to

the QCSAs at issue and that Treasury’s analysis was

actually consistent with the arm’s length standard.

The Commissioner now argues on appeal, however –

and the majority accepts its new claim – that what

Treasury was actually saying is that § 482 no longer

requires a comparability analysis when Treasury concludes that any comparable transactions are imperfect and that the methodology for arriving at an arm’s

length result is, and always has been, fluid. I disagree. Specifically, as explained below, I believe that:

(1) Treasury’s rule is procedurally invalid and the majority’s attempt to recreate the record surrounding its

adoption cannot cure that flaw; (2) Treasury’s purported interpretation of § 482 is wrong; and (3) related

companies may not be required to share the cost of

stock-based compensation under current law because

comparable uncontrolled taxpayers would not do so.

A. The New Rule is Procedurally Invalid

Under the Administrative Procedure Act, we must

“hold unlawful and set aside agency action . . . found

to be . . . arbitrary, capricious, an abuse of discretion,

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or otherwise not in accordance with law.” 5 U.S.C.

§ 706(2)(A). Our review of an agency regulation is

“highly deferential, presuming the agency action to be

valid and affirming the agency action if a reasonable

basis exists for its decision.” Crickon v. Thomas, 579

F.3d 978, 982 (9th Cir. 2009) (quoting Nw. Ecosystem

All. v. U.S. Fish & Wildlife Serv., 475 F.3d 1136, 1140

(9th Cir. 2007)). But “an agency’s action must be upheld, if at all, on the basis articulated by the agency

itself.” State Farm, 463 U.S. at 50 (citing Burlington

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

(1962)). For that reason, “[w]e may not supply a reasoned basis for the agency’s action that the agency itself has not given.” Id. at 43 (quoting Chenery II, 332

U.S. at 196).

I start, therefore, with what Treasury said when it

promulgated the regulation at issue. In Treasury’s

notice of proposed rulemaking, the agency explained

the origins of the commensurate with income standard and discussed the White Paper. Compensatory

Stock Options Under Section 482, 67 Fed. Reg. 48,997,

48,998 (proposed July 29, 2002) (to be codified at

26 C.F.R. pt. 1). Treasury noted, in particular, the

White Paper’s observation “that Congress intended

that Treasury and the IRS apply and interpret the

commensurate with income standard consistently

with the arm’s length standard.” Id. (citing White Paper, 1988-1 C.B. at 458, 477).

Treasury then detailed how the proposed rules

would function, including that the new rules required

stock-based compensation costs to be included among

the costs shared in a QCSA to produce “results consistent with an arm’s length result.” Id. at 49,000-01.

It acknowledged that “[t]he Tax Reform Act of

1986 . . . amended section 482 to require that consid-

60a

eration for intangible property transferred in a controlled transaction be commensurate with the income

attributable to the intangible” property. Id. at 48,998

(emphasis added). But it then conclusively stated,

based on a vague reference to the “legislative history

of the Act,” that parties may continue to enter into

bona fide research and development cost sharing arrangements so long as “the income allocated among

the parties reasonably reflect actual economic activity

undertaken by each” – i.e., so long as these agreements to develop intangible property survive the commensurate with income standard. Id. (emphasis

added). Not once did Treasury justify its application

of the commensurate with income standard by stating

that QCSAs of this kind constitute “transfers” of intangible property under the Tax Reform Act. And,

while it generally cited to the legislative history of the

1986 amendments to § 482 – a fact on which the majority places great weight – it did not explain what

portions of the legislative history it found pertinent or

how any of that history factored into its thinking.

Treasury expanded on its reasoning in the preamble to the final rule. It explained that the tax treatment of stock-based compensation in QCSAs would

have to be consistent “with the arm’s length standard

(and therefore with the obligations of the United

States under its income tax treaties and with the

OECD transfer pricing guidelines).” 68 Fed. Reg. at

51,172. Treasury observed, however, that the legislative history of the 1986 amendment to § 482 “expressed Congress’s intent to respect cost sharing arrangements as consistent with the commensurate

with income standard, and therefore consistent with

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

participants’ shares of income ‘reasonably reflect the

actual economic activity undertaken by each.’ ” Id.

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(quoting H.R. Rep. No. 99-481, at II-638 (1986) (Conf.

Rep.)). Again, Treasury never explained why QCSAs

in which controlled parties share costs to develop intangibles would constitute “transfers” of intangibles

sufficient to trigger the commensurate with income

standard in the first place. Instead, it simply declared

that, “in order for a QCSA to reach an arm’s length

result consistent with legislative intent,” the QCSA

must include stock-based compensation among the

costs shared. Id.

Throughout the preamble, Treasury repeatedly

emphasized that it was continuing to apply the arm’s

length standard. Treasury explained, for example,

that “[t]he 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.” Id. (emphasis added). Treasury determined that “[p]arties dealing at arm’s length

in [a cost-sharing] arrangement based on the sharing

of costs and benefits generally would not distinguish

between stock-based compensation and other forms of

compensation.” Id. (emphasis added). And Treasury

concluded that “[t]he 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.” Id. (emphasis added).

Yet, Treasury failed to consider comparable transactions submitted by commentators demonstrating

that unrelated companies would never share the cost

of stock-based compensation. Treasury responded to

these comments invoking the arm’s length standard.

See id. (rejecting “comments that assert that taking

stock-based compensation into account in the QCSA

context would be inconsistent with the arm’s length

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standard in the absence of evidence that parties at

arm’s length take stock-based compensation into account in similar circumstances”). Treasury acknowledged that these comparable arm’s-length transactions are typically relevant, but it determined that

there were no comparable transactions available for

QCSAs for the development of high-profit intangibles:

While the results actually realized in similar

transactions under similar circumstances 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. 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.

Id. at 51,172-73 (internal citation omitted).

The Tax Court held that Treasury’s explanation

for its regulation was insufficient under State Farm.

Altera, 145 T.C. at 120-33. It found that Treasury

“failed to provide a reasoned basis” for its “belief that

unrelated parties entering into QCSAs would generally share stock-based compensation costs.” Id. at

123. The court acknowledged that agencies need not

gather empirical evidence for some policy-based propositions, but it held that “the belief that unrelated parties would share stock-based compensation costs in

the context of a QCSA” was not such a proposition. Id.

In reaching this conclusion, the court observed that

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commentators submitted significant evidence during

the rulemaking process indicating that unrelated parties would not share stock-based compensation costs

in QCSAs; that the Tax Court itself had made a factual determination on that issue in Xilinx I – concluding they would not; and, that Treasury was required

at least to attempt to gather empirical evidence before

declaring that no such evidence was available. Id. at

123-24.

The Tax Court then detailed why Treasury’s explanation for the regulations was insufficient. The court

noted that only some QCSAs involved high-profit intangibles or included stock-based compensation as a

significant element of compensation, yet Treasury

failed to distinguish between QCSAs with and without those characteristics. Id. at 125-27. And the court

found that Treasury responded only in conclusory

fashion to a number of comments identifying comparable transactions or explaining why unrelated parties would not share stock-based compensation costs

in QCSAs. Id. at 127-30. On these grounds, the Tax

Court struck down the regulation. Id. at 133-34.

On appeal, the Commissioner does not meaningfully dispute the Tax Court’s determination that

Treasury’s analysis under the arm’s length standard

was inadequate and unsupported. In its opening

brief, it contends, instead, “that, in the context of a

QCSA, the arm’s-length standard does not require an

analysis of what unrelated entities do under comparable circumstances.” Appellant’s Br. 57 (internal quotation marks omitted). In the Commissioner’s view,

Treasury’s detailed explanations regarding its comparability analysis were merely “extraneous observations” – “since Treasury reasonably determined that

it was statutorily authorized to dispense with comparability analysis in this narrow context, there was no

64a

need for it to establish that the uncontrolled transactions cited by commentators were insufficiently comparable.” Appellant’s Br. 64.

In its supplemental brief, the Commissioner reiterates that – despite its own earlier machinations to

the contrary – one should not conflate comparability

analysis with the arm’s length standard. Appellant’s

Suppl. Br. 29-31. It also argues for the first time that

Treasury’s passing reference to the legislative history

of § 482 not only justified its departure from a comparability analysis, but also explained that QCSAs to develop intangibles constitute transfers of intangibles

under the second sentence of § 482.

The majority accepts the latest of the Commissioner’s ever-evolving post-hoc rationalizations and

then, amazingly, goes even further to justify what

Treasury did here. First, it accepts the Commissioner’s new explanation that the taxpayer’s agreement to “divide beneficial ownership of any Developed

Technology” constitutes a transfer of intangibles.

E.R. 145. Second, it holds that Treasury’s reference

to the legislative history communicated its understanding that, when Congress enacted the 1986

amendment, it “delegate[d] to Treasury the choice of

a specific methodology to” “ensure that income follows

economic activity.” Op. 27. The majority finds that

Treasury implicitly communicated its understanding

that Congress called upon it to move away from a comparability analysis and “to develop methods that [d]o

not rely on analysis of ” what it deems “problematic

comparable transactions” when it sees fit. Op. 28-29.

The majority finds that Treasury was therefore entitled to ignore the comparable transactions submitted

by commentators because they purportedly did not

“bear[] on ‘relevant factors’ to the rulemaking.” Op.

39-40 (quoting Am. Mining Cong., 965 F.2d at 771).

65a

As to Altera’s rejoinder that Treasury never suggested

that it had the authority to “dispense with” the comparability analysis entirely, Appellee’s Br. 43, the majority dismisses this argument, stating that, “historically[,] the definition of the arm’s length standard has

been a more fluid one.” Op. 29. Finally, the majority

concludes that the second sentence of § 482 not only

allowed Treasury to dispense with a comparability

analysis but also allowed it to ignore the arm’s length

test altogether.

I do not share the majority’s views. Treasury may

well have thought – incorrectly, I believe – that

QCSAs involving the development of high-profit intangibles constitute transfers of intellectual property

under the second sentence of § 482. It may also have

believed that, given the fundamental characteristics

of stock-based compensation in QCSAs and what the

majority here calls the “fluid” definition of the arm’s

length standard, it could dispense with a comparability analysis entirely, regardless of whether QCSAs

constitute transfers. Cf. Xilinx II, 598 F.3d at 1197

(Fisher, J., concurring) (hypothesizing why unrelated

companies may not share stock-based compensation

costs). It may – despite never taking this position before rehearing in this appeal – have even believed that

the arm’s length standard was not required at all in

these circumstances by virtue of the second sentence

of § 482. But the APA required Treasury to say that

it was taking these positions, which depart starkly

from Treasury’s previous regulations. See FCC v. Fox

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

(“[T]he requirement that an agency provide reasoned

explanation for its action would ordinarily demand

that it display awareness that it is changing position.”).

66a

The APA’s safeguards ensure that those regulated

do not have to guess at the regulator’s reasoning; just

as importantly, they afford regulated parties a meaningful opportunity to respond to that reasoning.

Treasury’s notice of proposed rulemaking ran afoul of

these safeguards by failing to put the relevant public

on notice of its intention to depart from a traditional

arm’s length analysis.2 See CSX Transp., Inc. v. Surface Transp. Bd., 584 F.3d 1076, 1080 (D.C. Cir. 2009)

(holding that a final rule “violates the APA’s notice requirement where ‘interested parties would have had

to divine [the agency’s] unspoken thoughts’ ” (alteration in original) (quoting Int’l Union, United Mine

Workers of Am. v. Mine Safety & Health Admin., 407

F.3d 1250, 1259-60 (D.C. Cir. 2005))). Asking Treasury to show its work in the preamble to its final rule

– that is, to set forth when and why the agency believed that a comparability analysis is not required or

even why an arm’s length analysis can be eschewed –

does not, as the majority states, “require agencies to

provide ‘exhaustive, contemporaneous legal arguments to preemptively defend its action.’ ” Op. 41

(quoting Nat’l Elec. Mfrs. Ass’n v. U.S. Dep’t of Energy,

654 F.3d 496, 515 (4th Cir. 2011)). It is the essence of

the review that the APA demands.

When the Tax Court conducted that review, it considered the explanation that Treasury offered, and it

The majority also glosses over the Tax Court’s criticism that

the final rule applied to all QCSAs but was based only on Treasury’s beliefs about the subset of QCSAs involving “high-profit intangibles” where stock-based compensation is a “significant element” of compensation. Altera, 145 T.C. at 125-26 (quoting Compensatory Stock Options Under Section 482, 68 Fed. Reg. at

51,173). Treasury’s failure to explain this leap and the Commissioner’s failure to defend it provide another reason that Treasury

failed to comply with the APA.

67a

found that Treasury “failed to provide a reasoned basis” for its “belief that unrelated parties entering into

QCSAs would generally share stock-based compensation costs.” Altera, 145 T.C. at 123. The Tax Court set

forth in detail why Treasury’s explanation for the regulations was insufficient. Id. at 125-30. Treasury offers no response to these findings; it simply invites

this court to recreate the record and interpret § 482 in

a way it never asked the Tax Court to do in order to

supply a post-hoc justification for its decisionmaking.

I would hold, as the Tax Court did, that Treasury’s

belated arguments are insufficient to justify the 2003

regulations and that those regulations are, thus, are

procedurally invalid.

B. Chevron Does Not Save Treasury’s Flawed

Interpretation of Section 482

Even if Treasury did not err procedurally, I would

still find that the regulations are impermissible under

Chevron. The Commissioner does not argue that its

interpretation of § 482 is compelled by the unambiguous text of the statute at step one of Chevron. Rather,

he contends that § 482 does not directly resolve the

question of whether Treasury may allocate the cost of

stock-based compensation between related parties.

The majority similarly reasons that “[§] 482 does not

concludes that “there is no question that the statute

remains ambiguous regarding the method by which

Treasury is to make allocations based on stock-based

compensation.” Op. 25.

While I agree with the majority and the Commissioner that the statute is silent as to the precise question of whether the Commissioner may require parties

68a

to a QCSA to share the cost of stock-based compensation, I believe that the statute unambiguously communicates the types of cases in which each methodology applies. Specifically, § 482 dictates that the status quo – i.e, the arm’s length standard – controls in

“any case of two or more organizations, trades, or businesses owned or controlled directly or indirectly by the

same interests.” It also allows Treasury to employ the

commensurate with income standard, but only “[i]n

the case of any transfer (or license) of intangible property.” Accordingly, the precise gap left by Congress in

this case is the question of whether QCSAs constitute

a “transfer” of “intangible property” under the second

sentence of the statute. If yes, then Treasury may employ the commensurate with income standard to determine if related parties to a QCSAs would share the

cost of stock-based compensation. If no, then Treasury must make that determination by employing a

comparability analysis to reach an arm’s length result. Because the statute does not expressly state that

QCSAs for the development intangibles constitute

“transfers” of intangibles, I would proceed to step two

of Chevron.

At step two, we consider whether Treasury’s interpretation is “arbitrary or capricious in substance, or

manifestly contrary to the statute.” Mayo Found. for

Med. Educ. & Research v. United States, 562 U.S. 44,

53 (2011) (internal citations omitted). The agency’s

interpretation is not arbitrary and capricious if it is

“rationally related to the goals of the Act.” AT&T

Corp. v. Iowa Utils. Bd., 525 U.S. 366, 388 (1999). “If

the [agency]’s interpretation is permissible in light of

the statute’s text, structure and purpose, we must defer under Chevron.” Miguel-Miguel v. Gonzales, 500

F.3d 941, 949 (9th Cir. 2007). Accordingly, I begin

with the text of the statute.

69a

The statutory text provides in relevant part:

In any case of two or more organizations, trades,

or businesses . . . owned or controlled directly or

indirectly by the same interests, the Secretary may

distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among

such organizations . . . 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. In the case of any transfer

(or license) of intangible property (within the meaning of section 367(d)(4)), the income with respect to

such transfer or license shall be commensurate

with the income attributable to the intangible.

Section 482 (emphases added). It is undisputed that

the first sentence of the statute requires an arm’s

length analysis; even the majority agrees with that

longstanding principle. As previously explained,

moreover, at the time Congress amended § 482, the

arm’s length standard was understood to require a

comparability analysis. But, because transfers of intangible property oftentimes lacked comparable

transactions, Congress added a second sentence to the

statute. This sentence allows the Secretary to apply

the commensurate with income standard to reach an

arm’s length result in the case of any transfer of intangible property.

The Commissioner contends, based on Treasury’s

purported belief that QCSAs are transfers of intangible property, that Treasury correctly interpreted § 482

to require that controlled companies share the cost of

stock-based compensation. But, as noted above,

Treasury never made, much less supported, a finding

70a

that QCSAs constitute transfers of intangible property. We cannot and should not conclude that the

Commissioner’s post-hoc interpretation would be permissible when Treasury never articulated such an interpretation. Even if it had, Treasury’s own characterization of QCSAs as arrangements “for the development of high-profit intangibles” contradicts any conclusion that QCSAs constitute transfers of already

existing intangible property. 68 Fed. Reg. at 51,173

(emphasis added). No rights are transferred when

parties enter into an agreement to develop intangibles; this is because the rights to later-developed intangible property would spring ab initio to the parties

who shared the development costs without any need

to transfer the property. And, there is no guarantee

when the cost-sharing arrangements are entered into

that any intangible will, in fact, be developed. In such

circumstances, Treasury should not have employed

the commensurate with income standard.

The majority attempts to justify Treasury’s departure from the comparability analysis in these circumstances by stating it was reasonable for Treasury to

“determin[e] that uncontrolled cost-sharing arrangements,” such as those submitted by the commentators, “do not provide helpful guidance regarding allocations of employee stock compensation.” Op. 28. According to the majority, the legislative history “makes

clear” that Congress “intended the commensurate

with income standard to displace a comparability

analysis where comparable transactions cannot be

found.” Op. 13. This reasoning fails for several reasons.

As noted, the text of the statute provides that

Treasury may employ the commensurate with income

standard only in the case of a transfer or license of intangible property – not whenever Treasury finds that

71a

uncontrolled transactions fail to provide helpful guidance. Congress did not leave a gap in the statute allowing Treasury to choose when one methodology displaces the other. Rather, it made its own findings regarding the relative helpfulness of comparable uncontrolled transactions in the case of a transfer or license

of intangible property. It then amended § 482 to allow

for the use of the commensurate with income methodology in those specific cases, but not in others. Congress’s findings in the legislative history do not invite

Treasury to make its own determinations regarding

the helpfulness of other uncontrolled transactions.

Nor do they allow Treasury to expand the category of

cases in which the commensurate with income standard would apply when the statutory text states otherwise. Here, Treasury’s only justification for eschewing the comparability analysis was its insistence that

the legislative history allows it to disregard comparable transactions that it deems imperfect. This rationale is inconsistent with the plain text of the statute and thus, is impermissible under Chevron.

Even if Treasury could dispense with a comparability analysis whenever it believed no comparables

exist, that interpretation would still fail step two of

Chevron because uncontrolled comparable transactions do exist here. Even the majority acknowledges

Treasury’s view that a different methodology may

only be applied “when comparable transactions do not

exist.” Op. 41 n.9 (emphasis added). Treasury itself

explained, in effect, that a precondition for the applicability of the commensurate with income standard

is the lack of real-world comparable transactions with

which to make an arm’s length comparison. Such

transactions, as Treasury admitted, would “ordinarily

provide significant evidence in determining whether a

72a

controlled transaction meets the arm’s length standard.” 68 Fed. Reg. at 51,173. According to the majority, however, imperfect comparables are tantamount

to the absence of comparables.

But the arm’s length standard of § 482 does not require perfectly identical transactions – only comparable ones. As Altera notes, the Commissioner cannot

“avoid the statutory limits on his ability to reallocate

income by asserting that a related-party transaction

is fundamentally different from all similar transactions between unrelated parties by virtue of the very

fact that the parties are related.” Appellee’s Suppl.

Br. 33. Such an interpretation would allow Treasury

to dispense with the comparability analysis altogether

because related parties, by virtue of common ownership, are always positioned differently than unrelated

parties. Legislative history can only do so much – if

any – work, and it certainly cannot set out an exception that swallows a rule codified by statute.

Even if Treasury were correct that no comparable

transactions exist, Treasury’s reasoning would still

fail. Treasury concluded that it could allocate costs

because there were no transactions in which parties

at arm’s length would even consider taking stock options into account in the context of an arrangement

similar to a QCSA. See 68 Fed. Reg. at 51,173. But

the absence of evidence is not evidence of absence. Indeed, the absence of any comparable transactions

could itself mean that uncontrolled taxpayers would

not share the costs of stock-based compensation.

Treasury believes, however, that uncontrolled taxpayers would not enter into such transactions, and, rather than find the absence of such transactions meaningful to a comparison, believes it is justified in using

different methodologies to assess income. But the fact

73a

that evidence of the absence of comparable transactions might support more favorable tax treatment

does not mean that no comparison can be made.

Finally, while Treasury’s interpretation of § 482 is

“entitled to no less deference . . . simply because it has

changed over time, . . . the agency must nevertheless

engage in reasoned analysis sufficient to command

our deference.” Good Fortune Shipping SA v. Comm’r

of Internal Rev. Serv., 897 F.3d 256, 263 (D.C. Cir.

2018) (internal quotations and citations omitted); Judalang v. Holder, 132 S. Ct. 476, 483 n.7 (2011) (clarifying that the court’s analysis of whether an agency

provided a reasoned explanation under State Farm

and its analysis of whether an agency’s interpretation

is permissible under Chevron step two is “the same,

because under Chevron step two, we ask whether an

agency interpretation is ‘arbitrary or capricious in

substance’ ”). Such a reasoned explanation, at a minimum, requires Treasury to “display awareness that

it is changing position.” Good Fortune Shipping, 897

F.3d at 263 (quoting Fox, 556 U.S. at 515). “An agency

may not, for example, depart from a prior policy sub

silentio or simply disregard rules that are still on the

books.” Fox, 556 U.S. at 515. And an agency may need

to “provide a more detailed justification than what

would suffice for a new policy created on a blank

slate . . . when, for example, . . . its prior policy has engendered serious reliance interests that must be

taken into account.” Id. (citing Smiley v. Citibank

(S.D.), N.A., 517 U.S. 736, 742 (1996)). “ ‘Unexplained

inconsistency’ between agency actions is ‘a reason for

holding an interpretation to be an arbitrary and capricious change.’ ” Organized Vill. of Kake v. USDA, 795

F.3d 956, 966 (9th Cir. 2015) (en banc) (quoting Nat’l

Cable & Telecomms. Ass’n v. Brand X Internet Servs.,

545 U.S. 967, 981 (2005)).

74a

As this court held in Xilinx II, the previous regulations preserved the primacy of the arm’s length standard and its requirement of comparability analysis.

See Xilinx II, 598 F.3d at 1195-96 (explaining the

then-operative version of Treas. Reg. § 1.482-1). In

amending those regulations, however, Treasury never

indicated – either in the notice of proposed rulemaking or in the preamble accompanying the final rule –

any awareness that it was changing course. Treasury

instead repeated its previous policy that it need not

conduct a comparability analysis where no comparable transactions can be found. See 68 Fed. Reg. at

51,172-73. It then ignored existing comparable transactions to reach what it claimed was “an arm’s length

result.” Id.

The majority contends that this does not constitute

a change because, “historically[,] the definition of the

arm’s length standard has been a more fluid one.” Op.

29. But, as explained above, the comparability analysis has always been a defining aspect of the arm’s

length standard. The mere fact that Treasury may

have been inconsistent in the way it has applied the

arm’s length standard, as the majority contends, does

not mean that the statute permits a fluid definition of

the standard. City of Arlington v. FCC, 569 U.S. 290,

327 (2013) (Roberts, C.J., dissenting) (“We do not

leave it to the agency to decide when it is in charge.”).

Because Treasury departed from the comparability

analysis and failed to provide a reasoned explanation

for why the commensurate with income standard is

permissible under the statute, I would find that

Treasury’s regulations constitute an impermissible

interpretation of the statute at Chevron step two.

75a

C. Stock-Based Compensation Is Not A Shared

Cost Under Section 482

Because I would find that Treasury’s regulations

are procedurally and substantively defective, I would

interpret the statute in the first instance, without deference. Encino Motorcars, LLC v. Navarro, 136 S. Ct.

2117, 2125 (2016) (“Chevron deference is not warranted where the regulation is procedurally defective

– that is, where the agency errs by failing to follow the

correct procedures in issuing the regulation.” (internal quotations and citations omitted)); Util. Air Regulatory Grp. v. EPA, 573 U.S. 302, 321 (2014) (“[A]n

agency interpretation that is inconsistent with the design and structure of the statute as a whole does not

merit deference.” (internal citations and quotations

omitted)).

Because I would find the 2003 regulations were invalid, I believe that this court’s decision in Xilinx II

controls, and that the Tax Court properly entered

judgment in favor of Altera. Altera, 145 T.C. at 134.

Even if Xilinx II did not control, I would hold that related parties in QCSAs need not share costs associated with stock-based compensation.

I agree with the majority that § 482 does not address this issue expressly. But I agree with amicus

curiae Cisco Systems, Inc. (“Cisco”), that, under the

best reading of § 482, QCSAs are not subject to the

commensurate with income standard. As Cisco points

out, the commensurate with income standard applies

only to a “transfer (or license) of intangible property,”

§ 482, which is distinct from a cost sharing agreement

for the joint development of intangibles, see White Paper, 1988-1 C.B. at 474 (noting that “bona fide research and development cost sharing arrangements”

provide a way to “avoid[] section 482 transfer pricing

76a

issues related to the licensing or other transfer of intangibles”). The plain meaning of “transfer” indicates

shifting ownership of an existing right from one party

to another. But under a cost-sharing arrangement,

parties agree to develop intangibles together. Because the intangible does not exist at the time the cost

sharing arrangement is entered into, there can be no

transfer either.

The majority contends that Congress’s choice to

use the word “any” is significant. It reasons that, because “§ 482 applies ‘[i]n the case of any transfer . . .

of intangible property,’ ” the statute “cannot reasonably be read to exclude the transfers of expected intangible property.” Op. 26. But, while “any” can be a

broadening modifier, it must be read in the context of

its surrounding text. Cf. United States v. Gonzales,

520 U.S. 1, 5 (1997) (finding that use of “any” modifies

the term it precedes.); see Ali v. Fed. Bureau of Prisons, 552 U.S. 214, 226 (2008) (narrowing the effect of

“any” based on the context in which it appears because

“a word is known by the company it keeps.” (internal

citations and quotations omitted)).

Here, “any” does not modify “intangible property.”

Rather, it precedes and thus, applies only to “transfer.” This indicates that, while the statutory text may

cover any kind of transfer, including expected transfers, it does not cover any kind of intangible property

– say, for example, intangible property that does not

yet exist. Indeed, § 482 expressly defines the term “intangible property” by referencing the definition provided in § 367(d)(4). See § 482 (“. . . any transfer (or

license) of intangible property (within the meaning of

section 367(d)(4)).” (emphasis added)). We need not

guess at whether Congress intended a broad reading

of the term because § 367(d)(4) enumerates specific

categories of intangible property covered under the

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statute, and none of those categories contemplates the

mere possibility that intangible property may someday exist.

While “any” may modify “transfer,” moreover,

QCSAs do not provide for future transfers; rather, as

noted above, rights to later-developed intangible property – if ever developed – would spring ab initio to the

parties who shared the development costs and would

thereby dispense with any need to transfer those

rights at some time in the future. I would conclude,

absent additional evidence to conclude otherwise, that

QCSAs are not transfers subject to the commensurate

with income standard under § 482.

Rather, I would find that QCSAs are governed under the first sentence of § 482 and that Treasury may

only allocate the cost of stock-based compensation

among related companies if unrelated companies

dealing at arm’s length would do so under comparable

circumstances. The evidence of comparable transactions submitted by commentators demonstrates that

unrelated companies do not and would not share such

costs. Thus, I would hold that an arm’s length result

is one in which related parties in QCSAs do not share

costs associated with stock-based compensation.

The Commissioner contends that the backdrop

against which Congress enacted the 1986 amendment

demonstrates that Congress intended § 482 to require

related companies to share stock-based compensation.

But, as the majority admits, “[n]either the Tax Reform

Act nor the implementing regulations specifically addressed allocation of employee stock compensation.”

Op. 17. This is because the practice of providing stockbased compensation did not develop on a major scale

until the 1990s – after Congress passed the 1986

amendment. Therefore, Congress could not have been

legislating against the backdrop of this particular

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type of tax avoidance. While it may choose to address

this practice now, it cannot be deemed to have done so

then.

Not all forms of tax avoidance amount to illegal tax

evasion. The very definition of a loophole is a gap in

the law or a set of rules. While Treasury may promulgate regulations to close such gaps, it must do so in

a manner consistent with its statutory authority under the Tax Reform Act and with the procedures outlined in the APA. When it fails to comply with those

requirements, its actions cannot be justified by the

mere existence of the loophole. In other words, an

arm’s length result is not simply any result that maximizes one’s tax obligations. For these reasons, I dissent.

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APPENDIX B

UNITED STATES TAX COURT

Altera Corporation and Subsidiaries,

Petitioner

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 operating at arm’s length

would not do so. In 2003 Treasury issued sec. 1.4827(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 subsidiary 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)

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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 legislative power to’’ Treasury, id., and Treasury ‘‘intended

to exercise that power’’ when it issued the final rule,

id. Held, further, 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. ___, ___, 132 S. Ct. 476, 483 n.7

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

Treasury reasonably concluded that the final rule is

consistent 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 administrative 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). Additionally, Treasury’s ‘‘explanation for its decision * * * runs 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 inconsistent with the arm’s-length

standard. Held, further, the final rule fails to satisfy

State Farm’s reasoned decisionmaking standard and

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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 judgment 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 stockbased 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

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 references are to the Administrative

Procedure Act (APA), 5 U.S.C. secs. 551-559, 701-706 (2012).

82a

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

was in California.

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 activities they per-

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formed 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 stockbased compensation to certain of its employees. Certain of the employees of Altera U.S. who performed

research and development activities subject 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 compensation was not included.

Pursuant to the R&D cost-sharing agreement, Altera International 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 deficiency allocated, pursuant to section

482, income from Altera International to Altera U.S.

by increasing Altera International’s cost-sharing payments for 2004-07 by the following amounts:

84a

Year

Cost-sharing payment

adjustment

2004 ..............................

$24,549,315

2005 ..............................

23,015,453

17,365,388

2006 ..............................

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 Secretary2

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.

***

The term ‘‘Secretary’’ means the Secretary of the Treasury or

his delegate. Sec. 7701(a)(11)(B).

85a

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

purpose 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 avoidance

of taxes with respect to such transactions. Section

482 places a controlled 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 consistent with the

results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length

result). However, because identical transactions

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

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

taxpayers 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.

86a

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 principle reflected in

the U.S. domestic transfer pricing provisions, 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 relevant 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 commensurate 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.

87a

* * * * * * *

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, taxpayers 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 profitpotential 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 intangibles frequently are not realistic comparables in these

cases.

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

88a

payment made on a transfer of intangibles to a related foreign corporation or possessions corporation be commensurate with the income attributable to the intangible. * * *

* * * * * * *

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 safeharbor 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 averages or norms. * * *

* * * * * * *

In requiring that payments be commensurate

with the income stream, the bill does not intend to

mandate the use of the ‘‘contract manufacturer’’ 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 transferee 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

89a

by, such related parties’ marketing efforts. However, the profit or income stream generated by or

associated with intangible property is to be given

primary weight.

[H.R. Rept. No. 99-426, at 423-426 (1985), 19863 C.B. (Vol. 2) 1, 423-426.]

The conference report that accompanied the 1986

amendment to section 482 states, in relevant part, as

follows:

In view of the fact that the objective of these provisions – that the division of income between related

parties reasonably reflect the relative economic activity undertaken by each – applies equally to inbound transfers, the conferees concluded that it

would be appropriate for these principles 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

believe that a comprehensive study of intercompany pricing rules by the Internal Revenue Service

should be conducted and that careful consideration

should be given to whether the existing regulations could be modified in any respect.

In revising section 482, the conferees do not intend to preclude the use of certain bona fide research and development cost-sharing arrangements as an appropriate method of allocating income attributable to intangibles among related

parties, if and to the extent such agreements are

consistent with the purposes of this provision that

the income allocated among the parties reasonably

90a

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 proportionate 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, 637638.]

C. Treasury’s Position That the Commensurate-With-Income Standard Was Intended

To Work Consistently With the Arm’sLength 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).

91a

The 1988 White Paper concluded that the arm’slength 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 Convention; 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 themselves to

transfer pricing issues; and virtually every major industrial nation takes the arm’s length standard as its

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

omitted.)). The 1988 White Paper further concluded

that Congress intended for the commensurate-withincome standard to work consistently with the arm’slength 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., 19882 C.B. at 472.]

92a

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’slength 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 ‘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.’’); Treasury Department Technical Explanation of the 2006 U.S. Model Income Tax Convention, art. 9, Tax Treaties (CCH) para. 215, at 10,64010,641 (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. Commissioner, 125 T.C. 37 (2005), aff’d, 598

F.3d 1191 (9th Cir. 2010), we addressed the treatment

of stock-based compensation 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.

93a

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 development’’.

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 determination 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 regulations, 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 entities would

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

standard was never intended to supplant the arm’slength standard, see id. at 56-58; and (4) unrelated

94a

parties would not share the exercise spread or grant

date value4 of stock-based compensation, see id. at 5862.

In concluding that unrelated parties would not

share either the exercise spread or grant date value of

stock-based compensation, (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 compensation 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 unrelated

parties do not share either the exercise spread or

grant date value of stock-based compensation in costsharing agreements, 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

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.

95a

to share spread-based cost because doing so would create perverse incentives for each party to diminish t

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