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IRS Responds To Altera Ruling On Cost Sharing Arrangements

by Mike Godfrey,, Washington

08 August 2019

On July 31, 2019, the United States Internal Revenue Service issued a memorandum for all Large Business and International Division employees informing them of the withdrawal of a directive regarding cost sharing arrangements in the light of the recent Court of Appeals ruling in the Altera case.

According to the memorandum, the purpose of the document is to formally withdraw Directive LB&I-04-0118-005 (Cost Sharing Arrangement (CSA) Stock Based Compensation (SBC) Directive), dated January 12, 2018, which provided instructions for examiners on transfer pricing issue selection related to SBC in CSAs.


US taxpayers that are cost sharing participants are required to include SBC as intangible development costs (IDCs), under Treasury Regulation Section 1.482-7A(d)(2) and 1.482-7(d)(3), if such costs are directly identified with, or reasonably allocable to, the intangible development activity of the CSA.

However, in Altera Corp. v. Commissioner, the Tax Court invalidated Section 1.482-7A(d)(2). The IRS subsequently appealed this ruling and issued a directive on January 12, 2018, directing examiners to stop opening new examinations for issues related to SBC included in CSA IDCs until the outcome of the Altera appeal.

On June 7, 2019, the United States Court of Appeals for the Ninth Circuit reversed the US Tax Court's opinion in Altera. Among other things, the ruling agreed with the IRS Commissioner that the Treasury Department had acted lawfully under the Administrative Procedure Act when issuing regulations that provided for a "purely internal" method of allocating costs among related parties (and specifically among cost-sharing groups) for transfer pricing purposes.

The decision was expected to empower the IRS to make adjustments to taxpayers' transfer pricing dealings in circumstances where unrelated parties do not enter into the same transactions – where a comparability analysis is impossible.

It marks a shift away from the arm's-length standard and towards a commensurate-with-income standard for assessing groups' compliance with US transfer pricing law, with the US Tax Court earlier holding in the Xilinx case that the IRS is unable to enforce a transfer pricing adjustment in the absence of comparable transactions.

The Ninth Circuit Court instead said Treasury had authority to issue regulations to compel cost-sharing groups to share the cost of employee stock-based compensation in proportion to the income enjoyed by each controlled taxpayer, even though unrelated parties do not do the same. It said Treasury was empowered to do so, as in amending Section 482 of the IRC in 1986, Congress had indicated its intention to reject primacy of the arm's-length standard and, where necessary to prevent base erosion and profit shifting, enforce a commensurate-with-income standard.

Withdrawal of Directive

In the memorandum, Douglas W. O'Donnell, Commissioner, Large Business and International Division, stated that based on the Ninth Circuit's decision in Altera (now part of the Intel Group), he was formally withdrawing Directive LB&I-04-0118-005. The memorandum goes on to state:

"With the issuance of this Withdrawal, examiners should continue applying Section 1.482-7A(d)(2) and 1.482-7(d)(3), including opening new examinations of CSA SBC issues when appropriate. These issues may be factually intensive, and transfer pricing teams should develop the facts to support their analyses and conclusions."

"Where appropriate, Issue Teams should consider consulting the Practice Network and Counsel for support in developing the most reliable analyses of this issue. We will continue to monitor any further developments related to the Ninth Circuit's decision."

The effective date of the withdrawal of the directive is July 31, 2019. The memorandum states that this withdrawal is not an official pronouncement of law and cannot be used, cited, or relied upon as such.

TAGS: compliance | tax | law | employees | transfer pricing | United States | regulation | Tax | BEPS

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