Tax Court Invalidates Final Rule on Cost-Sharing Arrangements

Farhad Asghar, Kevin G. Croke, Anne O'Brien Hintermeister, Allan Lang, Aaron T. Vaughan, and Mary E. Wynne, for respondent.

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.'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 performed on or after May 23, 1997. The R&D cost-sharing agreement was in effect from May 23, 1997, through 2007.

During each of petitioner's taxable years ending December 31, 2004, December 30, 2005, December 29, 2006, and December 28, 2007 (2004-07 taxable years), Altera U.S. granted stock options and other stock-based compensation to certain of its employees. Certain of the employees of Altera U.S. who performed research and development activities 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

                                          Cost-sharing payment

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:

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:

The conference report that accompanied the 1986 amendment to section 482 states, in relevant part, as follows:

C. Treasury's Position That the Commensurate-With-Income Standard Was Intended To Work Consistently With the Arm's-Length Standard

As the conference report suggested, Treasury and the Internal Revenue Service (IRS) conducted a comprehensive study of the regulations under section 482, the results of which they published in Notice 88-123, 1988-2 C.B. 458 (1988 White Paper).

The 1988 White Paper concluded that the arm's-length standard is the international norm for making transfer pricing adjustments. Id., 1988-2 C.B. at 475 ("The arm's length standard is embodied in all U.S. tax treaties; it is in each major model treaty, including the U.S. Model 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-with-income standard to work consistently with the arm's-length standard. See id. ("To allay fears that Congress intended the commensurate with income standard to be implemented in a manner inconsistent with international transfer pricing norms and U.S. treaty obligations, Treasury officials publicly stated that Congress intended no departure from the arm's length standard, and that the Treasury Department would so interpret the new law.").

The 1988 White Paper explained that the commensurate-with-income standard is consistent with the arm's-length standard because

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's-length standard, see id. at 56-58; and (4) unrelated parties would not share the exercise spread or grant date value⁴ of stock-based compensation, see id. at 58-62.

In concluding that unrelated parties would not share either the exercise spread or grant date value of stock-based 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 cost-sharing 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 taxpayers' expert who testified that unrelated parties would not agree to share spread-based cost because doing so would create perverse incentives for each party to diminish the stock price of the other, see id. at 61; and (7) we observed that during the years in issue the grant value of stock-based compensation was generally not treated as an expense for tax and financial accounting purposes, see id. at 61-62.

C. The Ninth Circuit Opinions in Xilinx

The U.S. Court of Appeals for the Ninth Circuit initially reversed our Opinion in Xilinx. The majority opinion by Judge Fisher reasoned that "[b]ecause the all costs requirement [of the 1995 cost-sharing regulations] is irreconcilable with the arm's length standard," the more specific all costs requirement controls. Xilinx Inc. v. Commissioner, 567 F.3d 482, 489 (9th Cir. 2009), rev'g and remanding 125 T.C. 37, withdrawn, 592 F.3d 1017 (9th Cir. 2010). The dissenting opinion by Judge Noonan agreed that the regulations were irreconcilable, see id. at 497 (Noonan, J., dissenting), but concluded that the all costs requirement should be construed as not applying to stock-based compensation because (1) the regulations should be interpreted in the light of the dominant purpose of the statute -- "parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions", id. at 498; (2) any inconsistencies in the regulations should be construed against the Government, see id.; and (3) Treasury's technical explanation of the income tax convention between the United States and Ireland confirms that the commensurate-with-income standard is meant to work consistently with the arm's-length standard, see id. at 498-500 ("'This article incorporates in the Convention the arm's[-]length principle reflected in the U.S. domestic transfer pricing provision, particularly Code section 482. * * * It is understood that the 'commensurate with income' standard for determining appropriate transfer prices for intangibles, added to Code section 482 by the Tax Reform Act of 1986, was designed to operate consistently with the arm's-length standard.'" (quoting Treasury Department Technical Explanation of the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains Signed at Dublin on July 28, 1997, and the Protocol Signed at Dublin on July 28, 1997 (1997 U.S.-Ir. Income Tax Convention and Protocol), U.S.-Ir., Tax Treaties (CCH) para. 4435, at 103,223)).

The Court of Appeals subsequently withdrew its opinion in Xilinx and issued a new opinion affirming our Opinion in Xilinx. The new opinion by Judge Noonan was in substance similar to his original dissenting opinion, with the exception that the new opinion did not rest its reasoning on the notion that inconsistencies in the regulations should be resolved against the Government. See Xilinx Inc. v. Commissioner, 598 F.3d at 1191-1197 (Noonan, J.).

Judge Fisher's concurring opinion first explained the parties' "dueling interpretations of the 'arm's length standard'". Id. at 1197 (Fisher, J., concurring). According to Judge Fisher, Xilinx contended that the arm's-length standard required "controlled parties * * * [to] share only those costs uncontrolled parties share." Id. By contrast, the Commissioner contended that

In July 2002 Treasury issued a notice of proposed rulemaking and notice of a public hearing (NPRM) with respect to proposed amendments to the 1995 cost-sharing regulations. The NPRM set a public hearing on the proposed amendments for November 20, 2002. See 67 Fed. Reg. 48997 (July 29, 2002). The preamble to the NPRM states that the proposed amendments to the 1995 cost-sharing regulations sought to clarify

B. Comments Submitted in Response to the Proposed Regulations

In response to the NPRM the following persons and organizations submitted written comments to Treasury: (1) American Electronics Association (AeA); (2) Baker & McKenzie, LLP, on behalf of the Software Finance and Tax Executives Council (SoFTEC); (3) Deloitte & Touche, LLP; (4) Ernst & Young LLP, on behalf of the Global Competitiveness Coalition (Global); (5) Fenwick & West, LLP (Fenwick); (6) Financial Executives International (FEI); (7) Information Technology Association of America; (8) Information Technology Industry Council; (9) KPMG, LLP; (10) PricewaterhouseCoopers, LLP (PwC); (11) Irish Office of the Revenue Commissioners; (12) Joseph A. Grundfest, W.A. Franke Professor of Law and Business, Stanford Law School; (13) Xilinx Inc. Additionally, the following four persons spoke at the November 20, 2002, public hearing: (1) Eric D. Ryan, of PwC; (2) Ron Schrotenboer, of Fenwick; (3) John M. Peterson, Jr., of Baker & McKenzie, LLP and on behalf of SoFTEC; and (4) Caroline Graves Hurley, of AeA.⁵

Several of the commentators informed Treasury that they knew of no transactions between unrelated parties, including any cost-sharing arrangement, service agreement, or other contract, that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation.

AeA provided to Treasury the results of a survey of its members. AeA member companies reviewed their arm's-length codevelopment and joint venture agreements and found none in which the parties shared stock-based compensation. For those agreements that did not explicitly address the treatment of stock-based compensation, the companies reviewed their accounting records and found none in which any costs associated with stock-based compensation were shared.

AeA and PwC represented to Treasury that they conducted multiple searches of the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system⁶ and found no cost-sharing agreements between unrelated parties in which the parties agreed to share either the exercise spread or grant date value of stock-based compensation.

Several commentators identified arm's-length agreements in which stock-based compensation was not shared or reimbursed. For example, (1) AeA identified, and PwC provided, a 1997 collaboration agreement between Amylin Pharmaceuticals, Inc., and Hoechst Marion Roussel, Inc. (Amylin-HMR collaboration agreement), that did not include stock options in the pool of costs to be shared; (2) PwC identified a joint development agreement between the biotechnology company AgraQuest, Inc., and Rohm & Haas under which only "out-of-pocket costs" would be shared; (3) PwC identified a 1999 cost-sharing agreement between software companies Healtheon Corp. and Beech Street Corp. that expressly excluded stock options from the pool of expenses to be shared. Additionally, in written comments, and again at the November 20, 2002, hearing, Ms. Hurley offered to provide Treasury with more detailed information regarding several agreements involving AeA member companies, provided that the companies received adequate assurances that their proprietary information would not be disclosed.⁷

FEI submitted model accounting procedures from the Council of Petroleum Accountant Societies (COPAS) for sharing costs among joint operating agreement partners in the petroleum industry. FEI noted that COPAS recommends that joint operating agreements should not allow stock options to be charged against the joint account because they are difficult to accurately value.

AeA, SoFTEC, KPMG, and PwC cited the practice of the Federal Government, which regularly enters into cost-reimbursement contracts at arm's length. They noted that Federal acquisition regulations prohibit reimbursement of amounts attributable to stock-based compensation.⁸

AeA, Global, and PwC explained that, from an economic perspective, unrelated parties would not agree to share or reimburse amounts related to stock-based compensation because the value of stock-based compensation is speculative, potentially large, and completely outside the control of the parties. SoFTEC provided a detailed economic analysis from economists William Baumol and Burton Malkiel reaching the same conclusion.

Finally, the Baumol and Malkiel analysis concluded that there is no net economic cost to a corporation or its shareholders from the issuance of stock-based compensation. Similarly, Mr. Grundfest asserted that a company's "decision to grant options to employees * * * does not change its operating expenses" and does not factor into its pricing decisions.

C. Final Rule

The final rule provides two methods for measuring the value of stock-based compensation: a default method and an elective method. Under the default method, "the costs attributable to stock-based compensation generally are included as intangible development costs upon the exercise of the option and measured by the spread between the option strike price and the price of the underlying stock." Id., 2003-2 C.B. at 844. Under the elective method, "the costs attributable to stock options are taken into account in certain cases in accordance with the 'fair value' of the option, as reported for financial accounting purposes either as a charge against income or in footnoted disclosures." Id. The elective method, however, is available only with respect to options on stock that is publicly traded "on an established United States securities market and is issued by a company whose financial statements are prepared in accordance with United States generally accepted accounting principles for the taxable year." Sec. 1.482-7(d)(3)(iii)(B)(2), Income Tax Regs.

The preamble to the final rule responded to comments that asserted that stock-based compensation does not constitute an economic cost, or relevant economic cost, as follows:

The preamble to the final rule responded to comments that asserted that parties at arm's length would not share either the exercise spread or grant date value of stock-based compensation because they would produce results that are too speculative or not sufficiently related to the employee services that are compensated, as follows:

Finally, the preamble to the final rule states that "[i]t has also been determined that [APA] section 553(b) * * * does not apply to these regulations." Id., 2003-2 C.B. at 847.

Pursuant to APA sec. 553, in promulgating regulations through informal rulemaking an agency must (1) publish a notice of proposed rulemaking in the Federal Register,⁹see APA sec. 553(b); (2) provide "interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments with or without opportunity for oral presentation", id. subsec. (c); and (3) "[a]fter consideration of the relevant matter presented, * * * incorporate in the rules adopted a concise general statement of their basis and purpose", id. These requirements do not apply to interpretive rules,¹⁰see id. subsec. (b)(A), or when an agency for good cause finds -- and incorporates its findings in the rules issued -- that "notice and public procedure thereon are impracticable, unnecessary, or contrary to the public interest", id. para. (B).

Generally, interpretive rules merely explain preexisting substantive law. See Hemp Indus. Ass'n v. DEA, 333 F.3d 1082, 1087 (9th Cir. 2003). Substantive (or legislative) rules by contrast, "create rights, impose obligations, or effect a change in existing law". Id. Stated simply, "legislative rules, unlike interpretive rules, have the 'force of law.'" Id. (quoting Am. Mining Cong. v. Mine Safety & Health Admin., 995 F.2d 1106, 1109 (D.C. Cir. 1993)); see also Chrysler Corp. v. Brown, 441 U.S. 281, 301-302 (1979).

A rule has the force of law "only if Congress has delegated legislative power to the agency and if the agency intended to exercise that power in promulgating the rule." Am. Mining Cong., 995 F.2d at 1109 (citing Am. Postal Workers Union v. USPS, 707 F.2d 548, 558 (D.C. Cir. 1983)). The U.S. Court of Appeals for the Ninth Circuit, to which an appeal in these cases appears to lie absent a stipulation to the contrary, see sec. 7482(b)(1)(B), (2), has held that we can infer that an agency intends for a rule to have the force of law in any of the following circumstances: "(1) when, in the absence of the rule, there would not be an adequate legislative basis for enforcement action; (2) when the agency has explicitly invoked its general legislative authority; or (3) when the rule effectively amends a prior legislative rule," Hemp Indus., 333 F.3d at 1087 (citing Am. Mining Cong., 995 F.2d 1106), or "'effect[s] a change in existing law or policy'", D.H. Blattner & Sons, Inc. v. Sec'y of Labor, Mine Safety & Health Admin., 152 F. 3d 1102, 1109 (9th Cir. 1998) (alteration in original) (quoting Powderly v. Schweiker, 704 F.2d 1092, 1098 (9th Cir. 1983)). In determining whether a rule is interpretive or legislative we "need not accept the agency characterization at face value." Hemp Indus., 333 F.3d at 1087 (citing Gunderson v. Hood, 268 F.3d 1149, 1154 n.27 (9th Cir. 2001)).

The notice and comment requirements of APA sec. 553 "are intended to assist judicial review as well as to provide fair treatment for persons affected by a rule." Home Box Office, Inc. v. FCC, 567 F.2d 9, 35 (D.C. Cir. 1977). Accordingly, "there must be an exchange of views, information, and criticism between interested persons and the agency." Id. Additionally, because "the opportunity to comment is meaningless unless the agency responds to significant points raised by the public", an agency is required to respond to significant comments.¹¹Id. at 35-36. However, "'[t]he failure to respond to comments is significant only insofar as it demonstrates that the agency's decision was not based on a consideration of the relevant factors.'" Sherley v. Sebelius, 689 F.3d 776, 784 (D.C. Cir. 2012) (quoting Covad Commc'ns v. FCC, 450 F.3d 528, 550 (D.C. Cir. 2006)).

B. Judicial Review of Agency Decisionmaking -- State Farm Review

Pursuant to APA sec. 706(2)(A), a court must "hold unlawful and set aside agency action, findings, and conclusions" that the court finds to be "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law". A court's review under this "standard is narrow and a court is not to substitute its judgment for that of the agency." Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983); see also Judulang v. Holder, 565 U.S. ____, _____, 132 S. Ct. 476, 483 (2011); Citizens to Pres. Overton Park, Inc. v. Volpe, 401 U.S. 402, 416 (1971), abrogated on other grounds by Califano v. Sanders, 430 U.S. 99 (1977). However, a reviewing court must ensure that the agency "engaged in reasoned decisionmaking." Judulang, 565 U.S. at _____, 132 S. Ct. at 484. To engage in reasoned decisionmaking, "the agency must examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.'" State Farm, 463 U.S. at 43 (quoting Burlington Truck Lines v. United States, 371 U.S. 156, 168 (1962)).

In reviewing an agency action a court must determine "'whether the decision was based on a consideration of the relevant factors and whether there has been a clear error of judgment.'" Id. (quoting Bowman Transp., Inc. v. Arkansas-Best Freight Sys., Inc., 419 U.S. 281, 285 (1974)); see also Judulang, 565 U.S. at _____, 132 S. Ct. at 484. "Normally, an agency rule would be arbitrary and capricious if the agency has relied on factors which Congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation for its decision that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise." State Farm, 463 U.S. at 43.

In providing a reasoned explanation for agency action that departs from an agency's prior position the agency must "display awareness that it is changing position." FCC v. Fox Television Stations, Inc., 556 U.S. 502, 515 (2009) (citing United States v. Nixon, 418 U.S. 683, 696 (1974)). However, the agency need not demonstrate "that the reasons for the new policy are better than the reasons for the old one". Id.

In examining an agency's explanation for issuing a rule a reviewing court "'may not supply a reasoned basis for the agency's action that the agency itself has not given.'" State Farm, 463 U.S. at 43 (quoting SEC v. Chenery Corp., 332 U.S. 194, 196 (1947)); see also Carpenter Family Invs., LLC v. Commissioner, 136 T.C. 373, 380, 396 n.30 (2011). Similarly, when an agency "relie[s] on multiple rationales (and has not done so in the alternative), and * * * [a reviewing court] conclude[s] that at least one of the rationales is deficient," Nat'l Fuel Gas Supply Corp. v. FERC, 468 F.3d 831, 839 (D.C. Cir. 2006) (citing Allied-Signal, Inc. v. U.S. Nuclear Regulatory Comm'n, 988 F.2d 146, 150-151 (D.C. Cir. 1993), and Consol. Edison Co. of N.Y. v. FERC, 823 F.2d 630, 641-642 (D.C. Cir. 1987)), the court cannot sustain the agency action on the basis of the sufficient rationale unless the court is certain that the agency would have taken the same action "even absent the flawed rationale", id. However, the reviewing court must "'uphold a decision of less than ideal clarity if the agency's path may reasonably be discerned.'" State Farm, 463 U.S. at 43 (quoting Bowman Transp., 419 U.S. at 286).

C. Judicial Review of Agency Statutory Construction -- Chevron Review

A court reviews an agency's authoritative construction of a statute under the two-step test first articulated in Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 842 (1984). See Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, 55-58 (2011). In Mayo, the Supreme Court clarified that both specific authority regulations and general authority regulations are to be accorded Chevron deference.¹²See id.

Under Chevron step 1, "applying the ordinary tools of statutory construction," City of Arlington v. FCC, 569 U.S. ____, _____, 133 S. Ct. 1863, 1868 (2013), a court must determine "whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress." Chevron, 467 U.S. at 842-843. Under Chevron step 2, a court must defer to the agency's authoritative interpretation of an ambiguous statute "unless it is 'arbitrary or capricious in substance, or manifestly contrary to the statute.'" Mayo Found., 562 U.S. at 53 (quoting Household Credit Servs., Inc. v. Pfennig, 541 U.S. 232, 242 (2004)); see also Judulang, 565 U.S. at _____, 132 S. Ct. at 483 n.7.

Chevron deference applies even where an agency adopts a construction that conflicts with a prior judicial construction of the statute. See Nat'l Cable & Telecomms. Ass'n v. Brand X Internet Servs., 545 U.S. 967, 982-983 (2005). However, if a precedential case holds that a statute unambiguously expresses a congressional intent that is contrary to the agency's construction of the statute, the prior judicial construction controls. See id.; see also United States v. Home Concrete & Supply, LLC, 566 U.S. _____, _____, 132 S. Ct. 1836, 1844 (2012).

D. Harmless Error

APA sec. 706 instructs reviewing courts to take "due account * * * of the rule of prejudicial error." See also Nat'l Ass'n of Home Builders v. Defenders of Wildlife, 551 U.S. 644, 659-660 (2007) ("'In administrative law, as in federal civil and criminal litigation, there is a harmless error rule[.]'" (quoting PDK Labs. Inc. v. DEA, 362 F.3d 786, 799 (D.C. Cir. 2004)). This rule reflects the notion that "[i]f the agency's mistake did not affect the outcome, if it did not prejudice the petitioner, it would be senseless to vacate" the agency action. PDK Labs., 362 F.3d at 799.

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

Petitioner contends that the final rule is a legislative rule under APA sec. 553(b) and is therefore subject to the notice and comment requirements of APA sec. 553 because, if valid, it would have the force of law. Alternatively, petitioner contends that if the final rule were an interpretive rule, it would "not have the force and effect of law", Shalala v. Guernsey Mem'l Hosp., 514 U.S. 87, 99 (1995), and therefore the final rule would not be binding on this Court. Respondent agrees that the final rule has the force of law but disagrees with petitioner's contention that it is a legislative rule. However, respondent declined to argue this issue on brief or at oral argument.

Instead, respondent contends that we need not decide this issue because Treasury complied with the notice and comment requirements. However, petitioner contends that Treasury failed to adequately explain the basis of the final rule, and Treasury's obligation to explain the basis of the final rule depends, at least in part, on its being a legislative rule subject to the notice and comment requirements of APA sec. 553. See APA sec. 553(c); cf. Internal Revenue Manual pt. 32.1.5.4.7.5.1(2) (Sept. 30, 2011) ("[M]ost IRS/Treasury regulations will be interpretative regulations because they fill gaps in legislation or have a prior existence in the law."); id. pt. 32.1.5.4.7.3(1) ("In the Explanation of Provisions section, the drafting team should describe the substantive provisions of the regulation in clear, concise, plain language * * *. It is not necessary to justify the rules that are being proposed or adopted or alternatives that were considered.").¹³ Petitioner also contends that Treasury failed to respond to significant comments, and Treasury's obligation to respond to significant comments is derived, at least in part, from the notice and comment requirements of APA sec. 553. See Home Box Office, 567 F.2d at 35-36. Moreover, we cannot avoid this issue because petitioner alternatively contends that the final rule would not bind this Court if it were an interpretive rule. Consequently, we will decide this issue.

Pursuant to section 7805(a) the Secretary is authorized to "prescribe all needful rules and regulations for the enforcement of" the Code. Such regulations carry the force of law, and the Code imposes penalties for failing to follow them. See, e.g., sec. 6662(b)(1). We therefore conclude that "Congress has delegated legislative power to" Treasury. Am. Mining Cong., 995 F.2d at 1109.

We further conclude that Treasury intended for the final rule to have the force of law for the following reasons: (1) the parties stipulated -- and we agree, see Xilinx Inc. v. Commissioner, 125 T.C. 37 -- that the adjustments to petitioner's income can be sustained only on the basis of the final rule, see Hemp Indus., 333 F.3d at 1087, and (2) in promulgating the final rule Treasury invoked its general legislative rulemaking authority under section 7805(a), see id. The final rule is therefore a legislative rule. See Am. Mining Cong., 995 F.2d at 1109.

Because it is a legislative rule and Treasury did not find for good cause that notice and comment were impracticable, unnecessary, or contrary to the public interest, see APA sec. 553(b)(A) and (B), APA sec. 553 applies to the final rule. We must therefore also consider whether Treasury satisfied its obligations under APA sec. 553(b) and (c) in issuing the final rule.

B. The Final Rule Must Satisfy State Farm's Reasoned Decisionmaking Standard.

Petitioner contends that we should review the final rule under State Farm. Respondent contends that we should review the final rule under Chevron. For the reasons that follow, we conclude that -- regardless of the ultimate standard of review -- the final rule must satisfy State Farm's reasoned decisionmaking standard.

Respondent contends that State Farm review is not appropriate because the interpretation and implementation of section 482 do not require empirical analysis. Similarly, respondent repeatedly argues that section 482 does not require allocations to be made with reference to uncontrolled party conduct. But "'[t]he purpose of section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining according to the standard of an uncontrolled taxpayer, the true taxable income from the property and business of a controlled taxpayer. * * * The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.'" Commissioner v. First Sec. Bank of Utah, 405 U.S. 394, 400 (1972) (quoting section 1.482-1(b)(1) (1971), Income Tax Regs.); accord sec. 1.482-1(a)(1), (b)(1), Income Tax Regs.; Treasury Department Technical Explanation of the 2001 U.S.-U.K. Income Tax Convention, art. 9; Treasury Department Technical Explanation of the 1997 U.S.-Ir. Income Tax Convention and Protocol, art. 9, Tax Treaties (CCH) para. 4435, at 103,223; Treasury Department Technical Explanation of the 2006 U.S. Model Income Tax Convention, art. 9. For these reasons we have previously stated that "the determination under section 482 is essentially and intensely factual". Procacci v. Commissioner, 94 T.C. 397, 412 (1990).

Section 1.482-1(b)(1), Income Tax Regs., provides that "[i]n determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer." In Xilinx Inc. v. Commissioner, 125 T.C. at 53-55, we held that the arm's-length standard always requires an analysis of what unrelated entities do under comparable circumstances. Similarly, in promulgating the final rule Treasury explicitly considered whether unrelated parties would share stock-based compensation costs in the context of a QCSA. See T.D. 9088, 2003-2 C.B. at 843 ("Treasury and the IRS believe that if a significant element of that compensation consists of stock-based compensation, the party committing employees to the arrangement generally would not agree to do so on terms that ignore the stock-based compensation."). Treasury necessarily decided an empirical question when it concluded that the final rule was consistent with the arm's-length standard.

Respondent counters that Treasury should be permitted to issue regulations modifying -- or even abandoning -- the arm's-length standard. But the preamble to the final rule does not justify the final rule on the basis of any modification or abandonment of the arm's-length standard,¹⁴ and respondent concedes that the purpose of section 482 is to achieve tax parity.¹⁵ The preamble also did not dismiss any of the evidence submitted by commentators regarding unrelated party conduct as addressing an irrelevant or inconsequential factor. See id., 2003-2 C.B. at 842-843. We therefore need not decide whether, under Brand X, 545 U.S. at 982-983, Treasury would be free to modify or abandon the arm's-length standard because it has not done so here. See Chenery Corp., 332 U.S. at 196; Carpenter Family Invs., LLC v. Commissioner, 136 T.C. at 380, 396 n.30.

The validity of the final rule therefore turns on whether Treasury reasonably concluded, see State Farm, 463 U.S. at 43, that it is consistent with the arm's-length standard, and that is necessarily an empirical determination. The reasonableness of Treasury's conclusion in no way depends on its interpretation of section 482 or any other statute. As the Supreme Court recently articulated, State Farm review is "the more apt analytic framework" where the challenged regulation does not rely on an agency's interpretation of a statute. Judulang, 565 U.S. at _____ n.7, 132 S. Ct. at 483.

Nevertheless, respondent contends that we should not review the final rule under State Farm because the Supreme Court has never, and this Court has rarely, reviewed Treasury regulations under State Farm. However, respondent concedes that Treasury is subject to the APA, and respondent has not advanced any justification for exempting Treasury regulations from State Farm review. The Supreme Court has stated that "[i]n the absence of such justification, we are not inclined to carve out an approach to administrative review good for tax law only. To the contrary, we have expressly '[r]ecogniz[ed] the importance of maintaining a uniform approach to judicial review of administrative action.'" Mayo Found., 562 U.S. at 55 (quoting Dickinson v. Zurko, 527 U.S. 150, 154 (1999) (alteration in original)); see also Dominion Res., Inc. v. United States, 681 F.3d 1313, 1319 (Fed. Cir. 2012) (invalidating the associated-property rule in section 1.263A-11(e)(1)(ii)(B), Income Tax Regs., under State Farm).

Ultimately, however, whether State Farm or Chevron supplies the standard of review is immaterial because Chevron step 2¹⁶ incorporates the reasoned decisionmaking standard of State Farm. See Judulang, 565 U.S. at _____ n.7, 132 S. Ct. at 483 (stating that, under either standard, the "analysis would be the same, because under Chevron step two, we ask whether an agency interpretation is 'arbitrary or capricious in substance'" (quoting Mayo Found., 562 U.S. at 53)); Torres-Valdivias v. Holder, 766 F.3d 1106, 1114 n.5 (9th Cir. 2014) (citing Judulang, 565 U.S. at _____ n.7, 132 S. Ct. at 483); Agape Church, Inc. v. FCC, 738 F.3d 397, 410 (D.C. Cir. 2013) (citing Judulang, 565 U.S. at _____ n.7, 132 S. Ct. at 483). Because the validity of the final rule turns on whether Treasury reasonably concluded that it is consistent with the arm's-length standard, the final rule must -- in any event -- satisfy State Farm's reasoned decisionmaking standard. Accordingly, we will examine whether the final rule satisfies that standard without deciding whether Chevron or State Farm provides the ultimate standard of review.

A. The Final Rule Lacks a Basis in Fact.

Petitioner contends that the final rule lacks a basis in fact because Treasury issued the final rule without any evidence that unrelated parties would ever agree to share stock-based compensation costs. Respondent contends that (1) Treasury did not rely solely on its belief that unrelated parties entering into QCSAs would generally share stock-based compensation costs but also on the commensurate-with-income standard and (2) Treasury was sufficiently experienced with cost-sharing agreements to conclude that unrelated parties entering into QCSAs would generally share stock-based compensation costs.

Moreover, because Treasury did not rely exclusively on the commensurate-with-income standard, we cannot sustain the final rule solely on that basis if we decide that Treasury's reliance on the arm's-length standard in issuing the final rule was unreasonable. See Chenery Corp., 332 U.S. at 196; Nat'l Fuel Gas Supply, 468 F.3d at 839 (citing Allied-Signal, 988 F.2d at 150-151, and Consol. Edison, 823 F.2d at 641-642). Accordingly, the commensurate-with-income standard, as interpreted by Treasury, cannot provide a sufficient basis for the final rule.

Respondent concedes that (1) in adopting the final rule, Treasury took the position that it was not obligated to engage in fact finding or to follow evidence gathering procedures; (2) the files maintained by Treasury relating to the final rule did not contain any empirical or other evidence supporting Treasury's belief that unrelated parties entering into QCSAs would generally share stock-based compensation costs; (3) the files maintained by Treasury relating to the final rule did not have any record that Treasury searched any database that could have contained agreements between unrelated parties; and (4) Treasury was unaware of any written agreement -- or of any transaction -- between unrelated parties that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation.²⁰

The preamble to the final rule offered only Treasury's belief that unrelated parties entering into QCSAs would generally share stock-based compensation costs. Specifically, the preamble to the final rule states that, in the context of a hypothetical QCSA between unrelated parties to develop patentable pharmaceutical products, "Treasury and the IRS believe that if a significant element of that compensation consists of stock-based compensation, the party committing employees to the arrangement generally would not agree to do so on terms that ignore the stock-based compensation." T.D. 9088, 2003-2 C.B. at 843. Treasury, however, failed to provide a reasoned basis for reaching this conclusion from any evidence in the administrative record. See Tripoli Rocketry, 437 F.3d at 83. Indeed, "every indication in the record points the other way", State Farm, 463 U.S. at 57 (internal quotation omitted). See infra part IV.C.

Respondent defends Treasury's failure to provide a reasoned basis for its conclusion from any evidence in the administrative record on the notion that "[t]here are some propositions for which scant empirical evidence can be marshaled". See Fox Television, 556 U.S. at 519. This may be true regarding certain propositions, see id. ("the harmful effect of broadcast profanity on children is one of them"), but we do not agree that the belief that unrelated parties would share stock-based compensation costs in the context of a QCSA is one of them. First, commentators submitted significant evidence regarding this proposition. See infra part IV.C. Second, we were able to reach a definitive factual determination on the basis of significant evidence regarding this very proposition in Xilinx. See Xilinx Inc. v. Commissioner, 125 T.C. at 58-62. Third, Treasury could not have rationally concluded that this is a proposition "for which scant empirical evidence can be marshaled", see Fox Television, 556 U.S. at 519, without attempting to marshal empirical evidence in the first instance, which respondent concedes it did not do.

Relying on Peck v. Thomas, 697 F.3d 767 (9th Cir. 2012), respondent further contends that we must defer to Treasury's expertise with respect to whether the parties operating at arm's length would share stock-based compensation. At issue in Peck was a regulation issued by the Bureau of Prisons that denied early release to inmates with a felony conviction for certain enumerated offenses. In issuing the regulation the Bureau of Prisons expressly relied on its "'correctional experience'" in determining which offenses warrant preclusion from early release but did not disclose any statistical studies to support its conclusions. See id. at 773 (quoting 74 Fed. Reg. 1895 (Jan. 14, 2009)). The U.S. Court of Appeals for the Ninth Circuit rejected an inmate's argument that the Bureau of Prisons violated the APA in issuing this regulation because it did not develop statistical evidence to support its conclusions. See id. at 775-776. The Court of Appeals reasoned that the Bureau of Prisons was entitled to rely on its experience and the APA did not require it to develop statistical evidence to support its conclusions. See id. (citing Sacora v. Thomas, 628 F.3d 1059, 1067, 1069 (9th Cir. 2010)).

Respondent's reliance on Peck is misplaced. First, in Peck, the Bureau of Prisons relied on its extensive correctional experience in determining which offenses warrant preclusion from early release. Here, by contrast, Treasury admits that it had no knowledge of any transactions in which parties operating at arm's length shared stock-based compensation.

Second, the preamble to the regulation at issue in Peck expressly relied on the Bureau of Prisons' extensive, hands-on correctional experience. Here, by contrast, the preamble to the final rule does not rely on Treasury's experience as a party to arm's-length cost-sharing agreements -- or even on any experience Treasury may have had in examining the arm's-length cost-sharing agreements of taxpayers it regulates. Indeed, the preamble to the final rule all but disclaimed Treasury's reliance on any such experience.

Third, the administrative record for the regulation at issue in Peck contained no evidence contradicting the Bureau of Prisons' correctional experience. Here, by contrast, commentators introduced significant evidence showing that parties operating at arm's length would not share stock-based compensation. See infra part IV.C. Peck does not support the contention that an agency can rely on unsupported assertions in the face of significant contrary evidence in the administrative record.

We conclude that (1) by failing to engage in any fact finding, Treasury failed to "examine the relevant data", State Farm, 463 U.S. at 43, and (2) Treasury failed to support its belief that unrelated parties would share stock-based compensation costs in the context of a QCSA with any evidence in the record. Accordingly, the final rule lacks a basis in fact.

B. Treasury Failed To Rationally Connect the Choice It Made With the Facts It Found.

Petitioner contends that the preamble to the final rule fails to rationally connect the choice that Treasury made in issuing a uniform final rule with the facts on which it purported to rely. See id. The preamble to the final rule indicates that Treasury relied on its belief that unrelated parties entering into QCSAs to develop "high-profit intangibles" would share stock-based compensation if the stock-based compensation was a "significant element" of the compensation. T.D. 9088, 2003-2 C.B. at 842-843. However, petitioner alleges, and respondent does not dispute, that (1) many QCSAs do not deal with "high-profit intangibles" and (2) stock-based compensation is often not a "significant element" of the compensation of the employees of taxpayers that enter into QCSAs. Yet the final rule does not distinguish between QCSAs to develop "high-profit intangibles" in which stock-based compensation was a "significant element" of the compensation and QCSAs in which these elements are not present. Petitioner contends -- and we agree -- that the preamble's explanation for Treasury's decision is therefore inadequate. See State Farm, 463 U.S. at 43.

Indeed, respondent does not directly refute petitioner's contention. Instead, respondent defends the final rule's inflexibility by arguing that the final rule is reasonable because it eases administrative burdens.²¹

Improving administrability can be a reasonable basis for agency action. See Mayo Found., 562 U.S. at 59 ("[Treasury] reasonably concluded that its full-time employee rule would 'improve administrability[.]'" (quoting T.D. 9167, 2005-1 C.B. 261, 262)). However, Treasury failed to give this -- or any other -- explanation for treating all QCSAs identically in the preamble to the final rule,²²cf. id., and we cannot reasonably discern, see State Farm, 463 U.S. at 43, that this was Treasury's rationale for adopting a uniform final rule because the administrative benefits of a uniform final rule are entirely speculative.²³

Moreover, even if we could discern that this was Treasury's intent, we would be unable to sustain the final rule on that basis because Treasury did not disclose its factual findings and we would therefore be unable to evaluate whether Treasury reasonably concluded that the purported administrative benefits of a uniform final rule can justify erroneously allocating income in some of those cases. We therefore conclude that, by treating all QCSAs identically, Treasury failed to articulate a "'rational connection between the facts found and the choice made,'" State Farm, 463 U.S. at 43 (quoting Burlington Truck Lines, 371 U.S. at 168).

C. Treasury Failed To Respond to Significant Comments.

Petitioner contends that Treasury failed to respond to significant comments submitted by commentators. Respondent contends that Treasury was not persuaded by the submitted comments.

Several commentators informed Treasury that they knew of no evidence of any transaction between unrelated parties that required one party to reimburse the other party for amounts attributable to stock-based compensation. Additionally, AeA informed Treasury that a survey of its member companies' arm's-length codevelopment and joint venture agreements found none in which the parties agreed to share stock-based compensation costs. We found similar evidence to be relevant in Xilinx. See Xilinx Inc. v. Commissioner, 125 T.C. at 59. Treasury never directly responded to this evidence. Instead, Treasury reasoned that the final rule would not be inconsistent with the arm's-length standard in the absence of evidence that unrelated parties share stock-based compensation costs because relevant data may not be available. See T.D. 9088, 2003-2 C.B. at 842. Treasury's response, however, in no way refutes the commentators' evidence that unrelated parties never share such compensation.

AeA and PwC further represented to Treasury that they conducted multiple searches of the EDGAR system and found no cost-sharing agreements between unrelated parties in which the parties agreed to share either the exercise spread or grant date value of stock-based compensation. Treasury never responded to this evidence.

Several commentators identified arm's-length agreements in which stock-based compensation was not shared or reimbursed. Treasury responded to these comments by stating that "[t]he uncontrolled transactions cited by 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. In particular, Treasury stated that

FEI provided model accounting procedures from COPAS that recommended against sharing stock-based compensation because it is difficult to value. Treasury never responded to this evidence.

AeA, SoFTEC, KPMG, and PwC cited regulations that prohibit contractors from charging the Federal Government for stock-based compensation. Treasury responded to this evidence by stating that "[g]overnment contractors that are entitled to reimbursement for services on a cost-plus basis under government procurement law assume substantially less entrepreneurial risk than that assumed by service providers that participate in QCSAs". See T.D. 9088, 2003-2 C.B. at 842. However, this distinction rings hollow in the face of other evidence submitted by commentators that showed that even parties to agreements in which the parties assume considerable entrepreneurial risk do not share stock-based compensation costs.

AeA, Global, and PwC explained that, from an economic perspective, unrelated parties would be unwilling to share stock-based compensation costs because the value of stock-based compensation is speculative, potentially large, and completely outside the control of the parties. SoFTEC submitted Baumol and Malkiel's detailed economic analysis reaching the same conclusion. We found similar evidence to be relevant in Xilinx. See Xilinx Inc. v. Commissioner, 125 T.C. at 61. Treasury never directly responded to this evidence. Instead, Treasury construed these comments as objections to Treasury's selection of the exercise spread method and the grant date method as the only available valuation methods. See T.D. 9088, 2003-2 C.B. at 844. Treasury responded that these methods are consistent with the arm's-length standard and are administrable. See id. Treasury, however, never explained how these methods could be consistent with the arm's-length standard if unrelated parties would not share them or why unrelated parties would share stock-based compensation costs in any other way.

The Baumol and Malkiel analysis also concluded that there is no net economic cost to a corporation or its shareholders from the issuance of stock-based compensation. Treasury identified this evidence in the preamble to the final rule but did not directly respond to it. See id., 2003-2 C.B. at 843. Instead, the preamble states that "[t]he final regulations 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. Treasury, however, never explained why unrelated parties would share stock-based compensation costs -- or how the commensurate-with-income standard could justify the final rule -- if stock-based compensation is not an economic cost to the issuing corporation or its shareholders.²⁶

Mr. Grundfest informed Treasury that companies do not factor stock-based compensation into their pricing decisions. We found similar evidence to be relevant in Xilinx. See Xilinx Inc. v. Commissioner, 125 T.C. at 59. Treasury never responded to this evidence.

Indeed, Treasury failed to respond directly to any of the evidence that unrelated parties would not share stock-based compensation costs, other than by asserting that the transactions cited by the commentators did not "share enough characteristics of QCSAs involving the development of high-profit intangibles" to be relevant. T.D. 9088, 2003-2 C.B. at 842. This was a mere assertion; Treasury offered no analysis addressing the extent of the supposed differences or explaining why any differences make the cited transactions irrelevant or unpersuasive. By contrast, in Xilinx we examined a broad array of evidence to determine whether unrelated parties would share such costs. See Xilinx Inc. v. Commissioner, 125 T.C. at 58-62. Tellingly, respondent does not even attempt to explain why Treasury failed to address similar evidence in the preamble to the final rule.

Although Treasury's failure to respond to an isolated comment or two would probably not be fatal to the final rule, Treasury's failure to meaningfully respond to numerous relevant and significant comments certainly is. See Home Box Office, 567 F.2d at 35-36. Meaningful judicial review and fair treatment of affected persons require "an exchange of views, information, and criticism between interested persons and the agency." Id. at 35. Treasury's failure to adequately respond to commentators frustrates our review of the final rule and was prejudicial to affected entities.

D. The Final Rule Is Contrary to the Evidence Before Treasury.

Petitioner contends that the final rule is contrary to the evidence before Treasury when it issued the final rule. We agree.

We have already discussed Treasury's failure to cite any evidence supporting its belief that unrelated parties to QCSAs would share stock-based compensation costs, see supra part IV.A; the significant evidence submitted by commentators showing that unrelated parties to QCSAs would not share stock-based compensation costs, see supra part IV.C; and Treasury's failure to respond to much of the submitted evidence, see id.

Significantly, Treasury never said that it found any of the submitted evidence incredible. Treasury also seemed to accept the commentators' economic analyses, which concluded that -- and explained why -- unrelated parties to a QCSA would be unwilling to share the exercise spread or grant date value of stock-based compensation. Finally, respondent has not identified any evidence in the administrative record that supports Treasury's belief that unrelated parties to QCSAs would generally share stock-based compensation costs.

Although we are mindful that "a court is not to substitute its judgment for that of the agency", State Farm, 463 U.S. at 43, we conclude that Treasury's "explanation for its decision * * * runs counter to the evidence before" it, see id.

A. Alternative Reasons for Adopting the Final Rule

Although the preamble refers to the commensurate-with-income standard, we have already concluded that Treasury never indicated that it was prepared to independently rely on the commensurate-with-income standard -- or any other reason -- as a basis for adopting the final rule. See supra parts III.B and IV.A.1. Moreover, because the arm's-length standard is incorporated into numerous income tax treaties, see, e.g., 2001 U.S.-U.K. Income Tax Convention, art. 9; 2006 U.S. Model Income Tax Convention, art. 9; Treasury Department Technical Explanation of the 2001 U.S.-U.K. Income Tax Convention, art. 9, Tax Treaties (CCH) para. 10,911, at 201,306-201,307; Treasury Department Technical Explanation of the 2006 U.S. Model Income Tax Convention, art. 9; Tax Treaties (CCH) para. 215, at 10,640-10,641, respondent cannot reasonably contend that Treasury would have clearly adopted the final rule had it concluded that the final rule conflicted with that standard. See PDK Labs., 362 F.3d at 799.

B. Settled Policy

Respondent's argument that the policy debate underlying the final rule has long been settled is irrelevant and misapprehends the role of this Court under State Farm. It is irrelevant because Treasury expressly disavowed reliance on financial reporting standards when it issued the final rule, see T.D. 9088, 2003-2 C.B. at 843 ("Treasury and the IRS agree that the disposition of financial reporting issues does not mandate a particular result under these regulations."), and the policy positions to which respondent refers did not exist and were therefore unavailable to Treasury when it issued the final rule, see Chenery Corp., 332 U.S. at 196; Carpenter Family Invs., LLC v. Commissioner, 136 T.C. at 380, 396 n.30. Respondent's argument misapprehends the role of this Court because, under State Farm, our role is not to decide whether the final rule is good policy -- it is simply to "ensur[e] that * * * [Treasury] engaged in reasoned decisionmaking." Judulang, 565 U.S. at _____, 132 S. Ct. at 483-484.

Because it is not clear that Treasury would have adopted the final rule had it concluded that the final rule is inconsistent with the arm's-length standard, the harmless error rule is inapplicable.

By reason of the above respondent erred in making the section 482 allocations at issue, and petitioner is therefore entitled to partial summary judgment. We will grant petitioner's motion and deny respondent's motion.

We have considered the parties' remaining arguments, and to the extent not discussed above, conclude those arguments are irrelevant, moot, or without merit.

To reflect the foregoing,

An appropriate order will be issued.

Reviewed by the Court.

THORNTON, COLVIN, HALPERN, FOLEY, VASQUEZ, GALE, GOEKE, HOLMES, PARIS, KERRIGAN, BUCH, LAUBER, NEGA, and ASHFORD, JJ., agree with this opinion of the Court.

MORRISON and PUGH, JJ., did not participate in the consideration of this opinion.

² The term "Secretary" means the Secretary of the Treasury or his delegate. Sec. 7701(a)(11)(B).

³ 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.

⁴ The exercise spread value is the spread between the option strike price and the price of the underlying stock when the option is exercised. See Xilinx Inc. v. Commissioner, 125 T.C. 37, 47 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010). The grant date value is the fair market value of the option on its grant date. See id. at 50.

⁵ Tax Analysts prepared a written transcript of the November 20, 2002, hearing. Treasury did not request or pay for the transcript and did not identify it as an "official" transcript.

⁶ EDGAR is maintained by the Securities and Exchange Commission (SEC) and is a public and searchable database that provides users with free access to registration statements, periodic reports, and other forms filed by companies, including "material contracts" that are required by law to be attached as exhibits to certain SEC forms.

⁷ Respondent admits that Treasury never had any discussions with the AeA member companies regarding the arm's-length cost-sharing agreements that the AeA member companies offered to discuss.

⁸ Federal acquisition regulations prohibit contractors from charging the Government for stock-based compensation. See 48 C.F.R. sec. 31.205-6(i) (2013).

⁹ The notice of proposed rulemaking must include "(1) a statement of the time, place, and nature of public rule making proceedings; (2) reference to the legal authority under which the rule is proposed; and (3) either the terms or substance of the proposed rule or a description of the subjects and issues involved." APA sec. 553(b).

¹⁰ We have previously referred to regulations issued pursuant to specific grants of rulemaking authority as legislative regulations and regulations issued pursuant to Treasury's general rulemaking authority, under sec. 7805(a), as interpretive regulations. See, e.g., Tutor-Saliba Corp. v. Commissioner, 115 T.C. 1, 7 (2000). Because the terms "legislative" and "interpretive" have different meanings in the administrative law context, see Hemp Indus. Ass'n v. DEA, 333 F.3d 1082, 1087 (9th Cir. 2003), we will refer to regulations issued pursuant to specific grants of rulemaking authority as specific authority regulations and regulations issued pursuant to Treasury's general rulemaking authority, under sec. 7805(a), as general authority regulations.

¹¹ "[O]nly comments which, if true, raise points relevant to the agency's decision and which, if adopted, would require a change in an agency's proposed rule cast doubt on the reasonableness of a position taken by the agency. Moreover, comments which themselves are purely speculative and do not disclose the factual or policy basis on which they rest require no response." Home Box Office, Inc. v. FCC, 567 F.2d 9, 35 n.58 (D.C. Cir. 1977); see also Am. Mining Cong. v. EPA, 965 F.2d 759, 771 (9th Cir. 1992) (citing Home Box Office, 567 F.2d at 35 & n.58).

¹² The Supreme Court explained that "Chevron deference is app ropriate 'when it appears that Congress delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of that authority.'" Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, 57 (2011) (quoting United States v. Mead Corp., 533 U.S. 218, 226-227 (2001)). The Supreme Court concluded that when Treasury issues general authority regulations after full notice and comment procedures, these conditions are met and those regulations are therefore entitled to Chevron deference. See id. at 56-57.

¹³ The current version of Internal Revenue Manuel pt. 32.1.5.4.7.3(1) (Oct. 20, 2014) omits the second sentence.

¹⁴ For example, the preamble does not say that controlled transactions can never be comparable to uncontrolled transactions because related and unrelated parties always occupy materially different circumstances. Cf. Xilinx Inc. v. Commissioner, 598 F.3d at 1197 (Fisher, J., concurring) ("The Commissioner * * * contends that analyzing comparable transactions is unhelpful in situations where related and unrelated parties always occupy materially different circumstances.").

¹⁵ The preamble states that "Treasury and the IRS do not agree with the comments that assert that taking stock-based compensation into account in the QCSA context would be inconsistent with the arm's length standard in the absence of evidence that parties at arm's length take stock-based compensation into account in similar circumstances." T.D. 9088, 2003-2 C.B. 841, 842. However, the preamble never suggests that the final rule could be consistent with the arm's-length standard if evidence showed that unrelated parties would not share stock-based compensation costs or that an evidentiary inquiry was unnecessary. See id., 2003-2 C.B. at 842-843.

¹⁶ The parties agree that sec. 482 is ambiguous. These cases would therefore be resolved at Chevron step 2.

¹⁷ In its response to comments asserting that stock-based compensation does not constitute an economic cost to the issuing corporation, Treasury appears to have relied exclusively on the arm's-length standard. See T.D. 9088, 2003-2 C.B. at 843 ("Treasury and the IRS continue to believe that requiring stock-based compensation to be taken into account in the context of QCSAs is appropriate. The final regulations provide that stock-based compensation must be taken into account in the context of QCSAs because such a result is consistent with the arm's length standard.").

¹⁸ "A tax treaty is negotiated by the United States with the active participation of the Treasury. The Treasury's reading of the treaty is 'entitled to great weight.'" Xilinx Inc. v. Commissioner, 598 F.3d at 1196-1197 (Noonan, J.) (quoting United States v. Stuart, 489 U.S. 353, 369 (1989) (internal quotation omitted)), aff'g 125 T.C. 37 (2005). Therefore, "[e]ven if the treaty and the Technical Explanation should be held not to operate as law trumping the hapless * * * [final rule], treaty and explanation act as guides. They tell us what the Treasury * * * had in mind", Xilinx Inc. v. Commissioner, 567 F.3d 482, 500-501 (9th Cir. 2009) (Noonan, J., dissenting), rev'g and remanding 125 T.C. 37, withdrawn, 592 F.3d 1017 (9th Cir. 2010), in issuing the final rule.

¹⁹ Even were we to conclude that Treasury intended to adopt a more expansive understanding of the commensurate-with-income standard, we would be unable to sustain the final rule on that basis because Treasury never acknowledged that it was changing its position. See FCC v. Fox Television Stations, Inc., 556 U.S. 502, 515 (2009) (citing United States v. Nixon, 418 U.S. 683, 696 (1974)).

²⁰ Treasury's failure to conduct any factfinding before issuing the final rule is also evident in the preamble to the final rule. See T.D. 9088, 2003-2 C.B. at 842 ("While the results actually realized in similar transactions under similar circumstances ordinarily provide significant evidence in determining whether a controlled transaction meets the arm's length standard, in the case of QCSAs such data may not be available." (Emphasis added.)).

²¹ Respondent also argues that petitioner cannot complain if the final rule sometimes produces results that are inconsistent with the arm's-length standard because the QCSA regime provides an "elective assured treatment". However, Treasury rejected commentators' suggestion to issue the final rule as a safe harbor, see T.D. 9088, 2003-2 C.B. at 843-844, and we conclude that petitioner has not forfeited its right to challenge the validity of the final rule because it chose to structure the R&D cost-sharing agreement as a QCSA.

²² The preamble to the final rule discusses administrability only with respect to Treasury's selection of the exercise spread method and the elective grant date method as the only available valuation methods. See T.D. 9088, 2003-2 C.B. at 844.

²³ We also note that unlike the statutory provision at issue in Mayo Found., sec. 482 purports only to empower the Secretary to allocate income among controlled entities but not to directly govern taxpayer conduct. See sec. 1.482-1(a)(3), Income Tax Regs. ("If necessary to reflect an arm's length result, a controlled taxpayer may report * * * the results of its controlled transactions based upon prices different from those actually charged." (Emphasis added.)). It is accordingly unclear whether administrability concerns are relevant in the context of sec. 482. However, because we cannot reasonably discern that Treasury relied on administrability concerns here, we need not resolve this question.

²⁴ The Amylin-HMR collaboration agreement also would permit the sharing of stock-based compensation based on the intrinsic value method, under which options issued in-the-money would be recognized as an expense. However, the treatment of in-the-money stock options is not at issue here, and the final rule explicitly rejected the use of the intrinsic value method. See T.D. 9088, 2003-2 C.B. at 844.

²⁵ Treasury appears to require a similar approach in analyzing comparability under the sec. 482 regulations. See sec. 1.482-1(d), Income Tax Regs.

²⁶ Respondent contends that the final rule is consistent with the commensurate-with-income standard because stock-based compensation is economic activity even if it is not an economic cost. However, Treasury never made this distinction in the preamble to the final rule, see SEC v. Chenery Corp., 332 U.S. 194, 196 (1947); Carpenter Family Invs., LLC v. Commissioner, 136 T.C. 373, 380, 396 n.30 (2011), and it did not explain why unrelated parties would share items that are not economic costs.

²⁷ In 2004 the OECD published a report on the impact of employee stock options on transfer pricing that "start[ed] with the premise that employee stock options are remuneration." OECD, Employee Stock Option Plans: Impact on Transfer Pricing 1. In 2005, however, the OECD published a policy study that again started with the same premise but recognized that the arm's-length standard required more analysis. See OECD, The Taxation of Employee Stock Options, Tax Policy Studies No. 11, at 165 ("Of course, whether in-kind remuneration, including stock options, should be taken into account in any particular case depends on a determination of what independent parties acting at arm's length would do in the facts and circumstances of that case.").

²⁸ Each of the policy positions that respondent now contends support the 2003 final rule was published after Treasury promulgated the final rule. See, e.g., Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (revised 2004), Share-Based Payment; International Financial Reporting Standard No. 2, Share-based Payment, February 2004; OECD, Employee Stock Option Plans: Impact on Transfer Pricing; see also OECD, the Taxation of Employee Stock Options, OECD Tax Policy Studies No. 11.

²⁹ Because we conclude that the final rule fails to satisfy State Farm's reasoned decisionmaking standard, the final rule would be invalid even if we were to conclude that Chevron supplies the ultimate standard of review. See supra part III.B. The analysis under Chevron would proceed as follows: The parties agree that sec. 482 is ambiguous. We would therefore proceed to Chevron step 2. Under Chevron step 2, we would conclude the final rule is invalid because it is "'arbitrary or capricious in substance'", Judulang v. Holder, 565 U.S. _____, _____ n.7, 132 S. Ct. 476, 483 (2011) (quoting Mayo Found., 562 U.S. at 53), and therefore cannot be justified as being a reasonable interpretation of what sec. 482 requires.