                     FOR PUBLICATION

    UNITED STATES COURT OF APPEALS
         FOR THE NINTH CIRCUIT

 ALTERA CORPORATION &                            Nos. 16-70496
 SUBSIDIARIES,                                        16-70497
               Petitioner-Appellee,
                                                   Tax Ct. Nos.
                     v.                              6253-12
                                                     9963-12
 COMMISSIONER OF INTERNAL
 REVENUE,                                           OPINION
            Respondent-Appellant.

                 Appeal from a Decision of the
                   United States Tax Court

           Argued and Submitted October 11, 2017
                 San Francisco, California

                       Filed July 24, 2018

   Before: Sidney R. Thomas, Chief Judge, and Stephen
  Reinhardt* and Kathleen M. O’Malley** Circuit Judges.

               Opinion by Chief Judge Thomas;
                 Dissent by Judge O’Malley


    *
      Judge Reinhardt fully participated in this case and formally
concurred in the majority opinion prior to his death.
    **
      The Honorable Kathleen M. O’Malley, United States Circuit Judge
for the U.S. Court of Appeals for the Federal Circuit, sitting by
designation.
2                       ALTERA CORP. V. CIR

                            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 and thus avoid an IRS adjustment,
was invalid under the Administrative Procedure Act. The
panel reasoned that the Commissioner of Internal Revenue
did not exceed the authority delegated to him by Congress
under 26 U.S.C. § 482, that the Commissioner’s rule-making
authority complied with the Administrative Procedure Act,
and that therefore the regulation is entitled to deference under
Chevron, U.S.A., Inc. v. Natural Resources Defense Council,
Inc., 467 U.S. 837 (1984).

    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; Diana L. Erbsen, Deputy Assistant
Attorney General; Caroline D. Ciraolo, Acting Assistant
Attorney General; Tax Division, United States Department of
Justice, Washington, D.C.; for Respondent-Appellant.

    ***
        This summary constitutes no part of the opinion of the court. It has
been prepared by court staff for the convenience of the reader.
                  ALTERA CORP. V. CIR                   3

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, Harvard Law School, Cambridge,
Massachusetts; for Amici Curiae J. Richard Harvey, Leandra
Lederman, Ruth Mason, Susan Morse, Stephen Shay, 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 Avi-Yonah, 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.
4                 ALTERA CORP. V. CIR

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.
                      ALTERA CORP. V. CIR                             5

                             OPINION

THOMAS, Chief Judge:

    In this case, we consider the validity of 26 C.F.R. § 1.482-
7A(d)(2),1 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 (“QCSA”) and thus avoid an IRS adjustment.
We conclude that the regulations withstand scrutiny under
general administrative law principles, and we therefore
reverse the decision of the Tax Court.

                                   I

    Corporations often elect to conduct business through
international subsidiaries. Transactions between related
companies can provide opportunities for minimizing or
avoiding taxes, particularly when a foreign subsidiary is
located in a low tax jurisdiction. For example, a parent
company in a high tax jurisdiction can sell property to its
subsidiary in a low tax jurisdiction and have its subsidiary
sell the property for profit. The profits from those sales are
thus taxed in a lower tax jurisdiction, resulting in significant
tax savings for the parent. This practice, known as “transfer
pricing” can result in United States companies shifting profits
that would be subject to tax in America offshore to avoid tax.
Similarly, related companies can identify and shift costs


    1
      The 2003 amendments to Treasury’s cost-sharing regulations are at
issue. Although they are still in effect, the Code has been reorganized,
and what was § 1.482-7 in 2003 is now numbered § 1.482-7A. To
minimize confusion, our citations are to the current version of the
regulations unless otherwise specified.
6                  ALTERA CORP. V. CIR

between American and foreign jurisdictions to minimize tax
exposure. In recent years, United States corporations have
used these techniques to develop intangible property with
their foreign subsidiaries, and to share the cost of
development between the companies.              Under these
arrangements, a U.S. corporation might enter into a research
and development (“R&D”) cost-sharing agreement with its
foreign subsidiary located in a low tax jurisdiction and grant
the offshore company rights to exploit the property
internationally. The interplay of cost and income allocation
between the two companies in such a transaction can result in
significantly reduced taxes for the United States parent.

    To address the risk of multinational corporation tax
avoidance, Congress passed legislation granting the United
States Department of the Treasury the authority to allocate
income and costs between such related parties. 26 U.S.C.
§ 482. In turn, the Secretary of the Treasury promulgated
regulations authorizing the Commissioner of the Internal
Revenue Service to allocate income and costs among these
related entities. 26 C.F.R. §§ 1.482-0 through 1.482-9.

    At issue before us are employee stock options, the cost of
which the companies in this case elected not to share,
resulting in substantial tax savings for the parent—here, the
tax associated with over $80 million in income. The
Commissioner contends that allocation of stock compensation
costs between the companies is appropriate to reflect
economic reality; Altera Corporation (“Altera”) and its
subsidiaries contend that any cost allocation exceeds the
Commissioner’s authority.

   Fundamental to resolution of this dispute is an
understanding of the arm’s length standard, a tool that
                   ALTERA CORP. V. CIR                       7

Treasury developed in the mid-twentieth century to ensure
that controlled taxpayers were taxed similarly to uncontrolled
taxpayers. The arm’s length standard is results-oriented,
meaning that its goal is parity in taxable income rather than
parity in the method of allocation itself. 26 C.F.R. § 1.482-
1(b)(1) (“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).”). A traditional arm’s
length analysis looks to comparable transactions among non-
related parties to achieve an arm’s length result. The issue in
this case is whether Treasury can permissibly allocate
between related parties a cost that unrelated parties do not
agree to share.

    Altera asserts that the arm’s length standard always
demands a comparability analysis, meaning that the
Commissioner cannot allocate costs between related parties
in the absence of evidence that unrelated parties share the
same costs when dealing at arm’s length. Altera argues that,
because uncontrolled taxpayers do not share the cost of
employee stock options, the Commissioner cannot require
related parties to share that cost.

    The Commissioner argues that he may, consistent with
the arm’s length standard, apply a purely internal method of
allocation, distributing the costs of employee stock options in
proportion to the income enjoyed by each controlled
taxpayer. This “commensurate with income” method
analyzes the income generated by intangible property in
comparison with the amount paid (usually as royalty) to the
parent. In the Commissioner’s view, the commensurate with
income method is consistent with the arm’s length standard
8                   ALTERA CORP. V. CIR

because controlled cost-sharing arrangements have no
equivalent in uncontrolled arrangements, and Congress has
provided that the Commissioner may dispense with a
comparability analysis where comparable transactions do not
exist in order to achieve an arm’s length result.

    Because this case involves a challenge to regulations, the
ultimate issue is not what the arm’s length standard should
mean but rather whether Treasury may define the standard as
it has. We conclude that the challenged regulations are not
arbitrary and capricious but rather a reasonable execution of
the authority delegated by Congress to Treasury.

                               II

    At issue is Altera’s tax liability for the years 2004 through
2007. During the relevant period, Altera and its subsidiaries
designed, manufactured, marketed, and sold programmable
logic devices, electronic components that are used to build
circuits.

    In May of 1997, Altera entered into a cost-sharing
agreement with one of its 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
International paid royalties to Altera. The parties agreed to
pool their resources to share R&D costs in proportion to the
benefits anticipated from new technologies.

   Altera and the IRS agreed to an Advance Pricing
Agreement covering the 1997–2003 tax years. Pursuant to
                   ALTERA CORP. V. CIR                      9

this agreement, and consistent with the cost-sharing
regulations in effect at the time, Altera shared with Altera
International stock-based compensation costs as part of the
shared R&D costs. The Treasury regulations were amended
in 2003, and 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. v. Commissioner,
involving a challenge to the allocation of employee stock
compensation costs under 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 Stock-
Based 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[A](d)(2) (as amended
       by T.D. 9088), and (ii) the Parties’ inclusion
       of Stock-Based Compensation in R&D Costs
       pursuant to Amendment I would be contrary
       to the arm’s length standard.
10                 ALTERA CORP. V. CIR

    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

    The Altera group timely filed petitions in the Tax Court.
The parties filed cross-motions for partial summary
judgment, and the Tax Court granted Altera’s motion. Sitting
en banc, the court held that § 1.482-7A(d)(2) is invalid under
the Administrative Procedure Act (“APA”). Altera Corp. &
Subsidiaries v. Comm’r, 145 T.C. 91 (2015).

    The Tax Court unanimously determined that the
Commissioner’s allocation of income and expenses between
related entities must be consistent with the arm’s length
standard, and 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 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 court concluded that the
agency decision-making process was fundamentally flawed
because: (1) it rested on speculation rather than hard data and
expert opinions; and (2) it failed to respond to significant
public comments, particularly those identifying uncontrolled
                    ALTERA CORP. V. CIR                       11

cost-sharing arrangements in which the entities did not share
stock compensation costs. Altera, 145 T.C. at 122–31.

     The Tax Court’s decision rested largely on its own
opinion in Xilinx, in which it held that “the arm’s-length
standard always requires an analysis of what unrelated
entities do under comparable circumstances.” Id. at 118
(citing Xilinx, 125 T.C. at 53–55). In its decision in this case,
the Tax Court reinforced its conclusion that the
Commissioner cannot require related entities to share stock
compensation costs unless and until it locates uncontrolled
transactions in which these costs are shared. Id. at 118–19.

     The court reached five holdings: (1) that the 2003
amendments constitute a final legislative rule subject to the
requirements of the APA; (2) that Motor Vehicle
Manufacturers Association of the United States v. State Farm
Mutual Auto 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) that Treasury failed to
adequately support its decision to allocate the costs of
employee stock compensation between related parties;
(4) that Treasury’s failure was not harmless error; and (5) that
§ 1.482-7A(d)(2) is invalid under the APA. Id. at 115–33.

    On appeal, the Commissioner does not dispute the first
holding regarding the applicability of State Farm, although he
argues that the appropriate standard is more deferential and
less empirically minded than the standard actually applied by
the Tax Court. Nor does he claim that any error in the
decisionmaking process, if it existed, was harmless. The
challenged holdings—(2), (3), and (5)—are all part of the
12                     ALTERA CORP. V. CIR

same broader question: did Treasury exceed its authority in
requiring Altera’s cost-sharing arrangement to include a
particular distribution of employee stock compensation costs?

                                    III

    The Commissioner’s position is founded on 26 U.S.C.
§ 482. Because an understanding of § 482 and its history is
integral to resolution of each of the issues raised by the
parties, a brief overview of the statute and its history is
important.

    At the relevant time,2 26 U.S.C. § 482 appeared to provide
a nearly limitless grant of authority to Treasury to allocate
income between related parties:

         In any case of two or more organizations,
         trades, or businesses (whether or not
         incorporated, whether or not organized in the
         United States, and whether or not affiliated)


     2
      Section 482 was amended in December 2017 to include a third
sentence:

         For purposes of this section, the Secretary shall require
         the valuation of transfers of intangible property
         (including intangible property transferred with other
         property or services) on an aggregate basis or the
         valuation of such a transfer on the basis of the realistic
         alternatives to such a transfer, if the Secretary
         determines that such basis is the most reliable means of
         valuation of such transfers.

Tax Cuts and Jobs Act, Pub. L. No. 115-97, 131 Stat. 2054. Because the
amendment postdates the operative regulations, it does not affect our
analysis.
                   ALTERA CORP. V. CIR                    13

       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, 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. 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.

    The first sentence has remained substantively unchanged
since 1928, Revenue Act of 1928, ch. 852, § 45, 45 Stat. 791,
806 (1928), and it provides the statutory authority for the
arm’s length standard, which first appeared in the 1934 tax
regulations, Regulations 86, Art. 45-1(b) (1935). The second
sentence sets forth the commensurate with income standard,
and it was added to the statute in 1986. Tax Reform Act of
1986, Pub. L. No. 99-514, § 1231(e)(1), 100 Stat. 2085, 2562
(1986).

                             A

    From the beginning, § 482’s precursor was designed to
give Treasury the flexibility it needed to prevent cost and
income shifting 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
14                 ALTERA CORP. V. CIR

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 is “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 Treas. Reg. § 1.482-1(b)(1) (1971)).
This parity is double-edged: as much as § 482 works to
ensure controlled taxpayers are not overtaxed, the concern
expressed on the face of § 482, even before the 1986
amendment, is preventing tax avoidance by controlled
taxpayers.

      After 1934, when the arm’s length standard appeared in
the regulations—in what is essentially its modern form—
courts did not hold related parties to the standard by looking
for 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 services rendered . . . .”). And in 1962, this
Court collected various allocation standards and outright
rejected the superiority of the arm’s length standard over all
others:
                       ALTERA CORP. V. CIR                              15

         [W]e do not agree . . . that “arm’s length
         bargaining” is the sole criterion for applying
         the statutory language of § 45 in determining
         what the “true net income” is of each
         “controlled taxpayer.” Many decisions have
         been reached under § 45 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.”

              For example, 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 § 45.

Frank v. Int’l Canadian Corp., 308 F.2d 520, 528–29 (9th
Cir. 1962) (footnotes omitted).3

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


    3
      The Court later took a hard turn from the flexibility it welcomed in
Frank, which it limited 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)
16                  ALTERA CORP. V. CIR

standard. In response to concerns about the undertaxation of
multinationals, Congress considered reworking the 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 28–29 (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 § 482. H.R. CONF. REP. NO. 87-2508, at
19 (1962), reprinted in 1962 U.S.C.C.A.N. 3732, 3739.
Legislators believed that § 482, at least in theory, authorized
the Secretary to employ a profit-split allocation method
without amendment. Id.; H.R. REP. No. 87-1447, at 28–29
(“This provision appears to give the Secretary the necessary
authority to allocate income between a domestic parent and
its foreign subsidiary.”).

    In 1968, following Congress’s entreaty, Treasury
finalized the first regulation tailored to the issue of intangible
property development in cost-sharing arrangements. Treas.
Reg. § 1.482-2(d) (1968). The novelty of the 1968
regulations was their focus on comparability. Compare
Treas. Reg. § 1.482-2(d)(2) (“An arm’s length consideration
shall be in a form which is consistent with the form which
would be adopted in transactions between unrelated parties in
the same circumstances.”) with Regulations 86, Art. 45-1(b)
(1935) (focusing on arm’s length results rather than arm’s
length form). 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).
                   ALTERA CORP. V. CIR                     17

    Despite the asserted focus on comparability, the arm’s
length standard has never been used to the exclusion of other,
more flexible approaches. Indeed, a study determined that
direct comparables were located and applied in only 3% of
IRS’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 29 (1981). The decades
following the 1968 regulations involved

       a gradual realization by all parties concerned,
       but especially Congress and the IRS, that 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.

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, 112 (1995); 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.”). The arm’s length
standard had proven to be similarly illusory in international
contexts. Langbein, supra, at 649.

                              B

   As controlled transactions increased in frequency and
complexity, Congress determined that legislative action was
necessary. The Tax Reform Act of 1986 reflected Congress’s
18                  ALTERA CORP. V. CIR

view that strict adherence to the arm’s length standard
prevented tax parity.

    The House Ways and Means Committee recommended
the addition of the commensurate with income clause because
it was “concerned” that the current statute 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. 99-426, at 423 (1985). The clause was
intended to correct 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.

    Congress 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
                   ALTERA CORP. V. CIR                    19

       harbor” for related party pricing
       arrangements, even though there are
       significant differences in the volume and risks
       involved, or in other factors. . . . [S]uch 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.

       ...

           . . . 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 423–25.
20                 ALTERA CORP. V. CIR

    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.
CONF. REP. NO. 99-841, at II-637 (1986), reprinted in 1986
U.S.C.C.A.N. 4075, 4725. It also clarified that cost-sharing
arrangements qualify as QCSAs only “if and the extent . . .
the income allocated among the parties reasonably reflect the
actual economic activity undertaken by each.” H.R. CONF.
REP. NO. 99-841, at II-638, 1986 U.S.C.C.A.N. at 4726.

                              C

    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 the Code, I.R.S. Notice 88-
123, 1988-C.B. 458 (“White Paper”). The White Paper
makes clear that Treasury initially understood 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 comparables, suggesting
that a comparability analysis would rarely suffice, id. at
477–78.

    Despite its use of the phrase “arm’s length standard,” the
White Paper signaled a dramatic shift from the standard as it
had been defined following the 1968 regulations. Treasury
advanced a new allocation method, the “basic arm’s length
return method,” id. at 488, which—contrary to its
                      ALTERA CORP. V. CIR                           21

name—would apply only in the absence of comparables and
would essentially split profits between the related parties, id.
at 490.4 The White Paper’s re-framing of the arm’s length
standard was not novel:

        [D]espite the Treasury’s affirmation of the
        traditional [arm’s length standard] in its 1988
        White Paper, this narrow conception . . . was
        already obsolete by 1988 in the large majority
        of cases, insofar as the United States’
        approach to international taxation was
        concerned.      Subsequent developments,
        especially the recently issued proposed,
        temporary and final regulations under section
        482 of the Code, merely strengthened the nails
        in its coffin.

Avi-Yonah, supra, at 94–95.

   The White Paper was silent regarding employee stock
compensation—unsurprisingly, as 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, 81 HARV. BUS. REV. 62, March
2003, at 63, 67 (March 2003).



    4
       Contemporary commentators understood that, by attempting
synthesis between the arm’s length and commensurate with income
provisions, Treasury was moving away from a view of the arm’s length
standard as grounded in comparability. Marc M. Levy, 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).
22                  ALTERA CORP. V. CIR

    In 1994 and 1995, Treasury issued the regulations
challenged in Xilinx. As in previous iterations, the
1994–1995 regulations defined the arm’s length standard as
results-oriented, meaning that the goal is parity in taxable
income rather than parity in the method of allocation itself.
Treas. Reg. § 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 same circumstances (arm’s length
result).”). The arm’s length standard remained “the standard
to be applied in every case.” § 1.482-1(b)(1) (1994).

    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. § 1.482-1(b)(2)(i)
(1994). Absent from the list of approved methods was the
method outlined in the singular cost-sharing regulation
separately issued in 1995, § 1.482-7. The 1995 regulation
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) (1995). Beginning in 1997, the Secretary interpreted
the “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 v. Comm’r, 598 F.3d 1191,
1193–94 (9th Cir. 2010).

   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 transactions under the same circumstances.”
Compensatory Stock Options Under Section 482 (Proposed),
                    ALTERA CORP. V. CIR                      23

67 Fed. Reg. 48,997, 48,998 (July 29, 2002). On the other
hand, the 1995 regulation, consistent with the 1986
Conference Report excerpted above, “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.” Id. Recognizing the potential for
conflict between the 1994 and 1995 regulations (also
discussed by this Court in Xilinx, as described below),
Treasury later issued new cost-sharing regulations, the 2003
regulations that Altera now challenges.

                              IV

    We turn then, to the disputed 2003 amendments to the
regulations, which Treasury intended to clarify rather than
overhaul the 1994 and 1995 regulations. The clarifications
were two-fold. First, the amendments expressly 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; Treas.
Reg. § 1.482-7A(d)(2).         Second, the “coordinating”
amendments clarified Treasury’s understanding 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 49,000; Treas.
Reg. § 1.482-7A(a)(3).

    Altera challenges two regulations. It squarely challenges
26 C.F.R. § 1.482-7A(d)(2). It also objects to § 1.482-
7A(a)(3), but only insofar as it incorporates § 1.482-7A(d)(2)
by reference.
24                 ALTERA CORP. V. CIR

    Broadly, § 1.482-7A provides that costs are shared by
parties to a QCSA, a controlled cost-sharing arrangement that
meets the standards of the cost-sharing regulations and thus
enables the participants to avoid an IRS adjustment. Section
1.482-7A(a)(3) incorporates and attempts synthesis 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 . . . .

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
                       ALTERA CORP. V. CIR                             25

         whether ultimately settled in the form of cash,
         stock, or other property.

Altera does not challenge the allocation of other intangible
development costs under § 1.482-7A(d).

    In determining whether Treasury’s regulation is
permissible, we are faced with two questions: whether
Treasury’s “decreed result [is] within the scope of its lawful
authority,” and whether “the process by which it reache[d]
that result [was] logical and rational.” Michigan v. EPA,
135 S. Ct. 2699, 2706 (2015) (quoting State Farm, 463 U.S.
at 43). Consideration of these issues requires examination of
the APA and Chevron deference.

    The Tax Court correctly held that the APA applies to
Treasury in the context of the present controversy. See Mayo
Found. for Med. Ed. & Res. v. United States, 562 U.S. 44, 55
(2011) (“In the absence of [any] justification, we are not
inclined to carve out an approach to administrative review
good for tax law only.”).5

   Under the APA, we must “hold unlawful and set aside
agency action, findings, and conclusions found to be . . .


    5
      Because the Commissioner does not contest the applicability of the
APA or Chevron in this context, this case does not require us to decide the
broader questions of the precise contours of the application of APA to the
Commissioner’s administration of the tax system or the continued vitality
of the theory of tax exceptionalism. See generally, e.g., Stephanie Hoffer
and Christopher J. Walker, The Death of Tax Court Exceptionalism,
99 MINN. L. REV. 221 (2014); Kristin E. Hickman, Coloring Outside the
Lines: Examining Treasury’s (Lack of) Compliance with Administrative
Procedure Act Rulemaking Requirements, 82 NOTRE DAME L. REV. 1727
(2007).
26                     ALTERA CORP. V. CIR

arbitrary, capricious, an abuse of discretion, or otherwise not
in accordance with law,” “in excess of statutory jurisdiction,”
or “without observance of procedure required by law.”
5 U.S.C. § 706(2)(A), (C)–(D). However, “[t]he scope of
review under the ‘arbitrary and capricious’ standard is narrow
and a court is not to substitute its judgment for that of the
agency.” State Farm, 463 U.S. at 43.

     If we conclude that Treasury complied with the APA in
its rulemaking, we apply the familiar Chevron standard in
examining the agency’s interpretation of the statute that
defines the scope of its authority. Chevron, 467 U.S. at 843.

                                    A

    Accordingly, our first task is to determine whether
Treasury complied with the APA in the first instance. Only
if Treasury complied with the APA may we defer to its
interpretation of § 482 under Chevron. Encino Motorcars,
LLC v. Navarro, 136 S.Ct. 2117, 2125 (2016).6



     6
       We note that the procedural posture of this case—following
enforcement— differs from that of a typical case challenging a regulation
under the APA. Generally, strict APA-based challenges arise in the pre-
enforcement context, which is less disruptive to the agency and which
allows plaintiffs to avoid the six-year statute of limitations applicable to
APA-based challenges. See 28 U.S.C. § 2401. By contrast, post-
enforcement challenges, often brought after the six-year statute of
limitations, are rarely brought under the APA, even if the APA proves
relevant. Rather, courts are generally called on to address the degree of
deference to which the agency is entitled. In these typical post-
enforcement challenges, the ultimate question is not whether the agency
action was procedurally defective but rather whether it was a permissible
exercise of executive authority. The court focuses not on the APA but on
the statute as it is implemented by the agency.
                    ALTERA CORP. V. CIR                        27

      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 three-step procedure for so-
called ‘notice-and-comment rulemaking.’”               Perez v.
Mortgage 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 . . . .”
§ 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.” § 553(c).

                                1

    Altera does not dispute that Treasury satisfied the first
step by giving notice of the 2003 regulations. Altera, 14 T.C.
at 103. 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.” 5 U.S.C. § 553.
Rather, Altera argues that the regulations fail on the second
step, asserting that although Treasury solicited public
comments, it did not adequately consider and respond to
those responses, rendering the regulations arbitrary and
capricious under State Farm. Altera, 14 T.C. at 120–31. We
disagree.

    Section 706 of the APA directs courts to “decide all
relevant questions of law, interpret constitutional and
28                  ALTERA CORP. V. CIR

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.” 5 U.S.C. § 706(2)(A).
Following 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 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,
135 S. Ct. at 2706 (quoting State Farm, 463 U.S. at 43).
However, courts 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. Arkansas-Best Freight Sys,
419 U.S. 281, 286 (1974)).

    Altera argues that Treasury’s rulemaking process does not
sufficiently support the regulations, which Altera understands
to be a significant departure from Treasury’s earlier
regulations implementing § 482. This argument is premised
on: (1) Treasury’s rejection of the comments submitted in
opposition to the proposed rule, and (2) Altera’s claim that
Treasury’s current litigation position is inconsistent with
statements made during the rulemaking process.

    “[A]n agency need only respond to ‘significant’
comments, i.e., those which raise relevant points and which,
if adopted, would require a change in the agency’s proposed
                   ALTERA CORP. V. CIR                      29

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)). If the comments to which the
agency did not respond would not bear on the agency’s
“consideration of the relevant factors,” the court 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. 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. CONF. REP. NO. 99-841, at II-638).
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. 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.

    In the preamble to the final rule, Treasury dismissed the
comments (and, relatedly, the behavior of controlled
taxpayers) as irrelevant:
30              ALTERA CORP. V. CIR

          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
                   ALTERA CORP. V. CIR                      31

       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 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, 51,172–73 (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.

    With its references to legislative history, Treasury
communicated its understanding that Congress had called
upon it to move away from the traditional arm’s length
standard.

    In short, the objectors were arguing that the evidence they
cited—showing that unrelated parties do not share employee
32                  ALTERA CORP. V. CIR

stock compensation costs—proved that Treasury’s
commensurate with income analysis did not comport with the
arm’s length standard. Thus, the thrust of the objection was
that Treasury misinterpreted § 482. But that is a separate
question—one properly addressed in the Chevron analysis.
That commenters disagreed with Treasury’s interpretation of
the law does not make the rulemaking process defective.

    Under the APA, the issue is whether Treasury’s
references to legislative history gave interested parties notice
of its proposal and an opportunity to respond to it. Here,
Treasury’s “path may reasonably be discerned.” State Farm,
463 U.S. at 43. Treasury’s citations to legislative history in
the notice of proposed rulemaking and the preamble to the
final rule make clear enough why Treasury believed it could
require related parties to share all costs—including employee
stock compensation—in proportion to the income enjoyed by
each. Treasury set forth its understanding that it should not
examine comparable transactions when they do not in fact
exist and should instead focus on a fair and reasonable
allocation of costs and income. Compensatory Stock Options
Under Section 482 (Proposed), 67 Fed. Reg. at 48,998
(quoting H.R. Conf. Rep. No. 99-841, at II-638); accord
Compensatory Stock Options under Section 482 (Preamble to
Final Rule), 68 Fed. Reg. at 51,172. Treasury relied on
Congressional rejection of primacy of the traditional arm’s
length standard. None of the comments at issue address why
Treasury was mistaken in its understanding that it was
authorized to use a method that did not include comparables.

    Thus, Treasury’s refusal to credit oppositional comments
is not fatal to a holding that it complied with the APA.
Treasury gave sufficient notice of what it intended to do and
why; it considered the comments, but it rejected them.
                   ALTERA CORP. V. CIR                      33

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.

    Further, 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 solely by the grounds invoked by
the agency.” Chenery, 332 U.S. 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.’” This argument twists Chenery,
which protects judicial deference by strengthening
administrative processes, into excessive proceduralism. See
Nat’l Elec. Mfrs. Ass’n v. U.S. Dept. of Energy, 654 F.3d 496,
515 (4th Cir. 2011) (“[Chenery] does not oblige the agency to
provide exhaustive, contemporaneous legal arguments to
preemptively defend its action.”). But it is also inconsistent
with the record, given Treasury’s citation to legislative
history.

                              2

   Altera also argues that Treasury did not adequately
support its position that employee stock compensation is a
34                  ALTERA CORP. V. CIR

cost. Treasury cites 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. Treasury classifies stock compensation as a “critical
element” of R&D costs and notes that it is “clearly related to
the intangible development area.” Compensatory Stock
Options under Section 482 (Preamble to Final Rule), 68 Fed.
Reg. at 51,173.

    The rulemaking record is sufficient to survive an APA
challenge because Treasury’s position is supported by logic
and by industry norms. Treasury wrote that parties 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. Id. at
51,173. Treasury’s determination is reasonable because
parties dealing at arm’s length certainly would not grant stock
options to each other’s employees without mentioning the
arrangement in the cost-sharing agreement. In other words,
parties dealing at arm’s length simply do not share these
costs, but related parties, whose stock is commonly owned,
do. “[T]hrough bargaining,” each unrelated party ensures 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.

    A distinction exists between the economic costs of stock
compensation—which are debatable—and the accounting
costs—which are not. Because entities account for the cost
of providing employee stock options, it is reasonable for
Treasury to allocate the costs, and it is irrelevant how much
the same entity ultimately pays to provide the options.
                    ALTERA CORP. V. CIR                      35

Further, as the Commissioner noted, “tax and other
accounting principles” provide a strong foundation for the
Commissioner’s interpretation.

    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 to the provision
providing that the expense is deductible. Treas. Reg. § 1.482-
7A(d)(2)(iii)(A) (citing 26 U.S.C. § 83(h)) (“[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 83(h)) . . . .”). Indeed,
the dispute here is not truly whether stock-based
compensation is a cost but whether Altera— rather than the
Commissioner—may decide how to apportion that cost
between related entities.

                               3

    Finally, in addition to its general State Farm argument,
Altera asks for a more searching review under FCC v. Fox
Television Stations, Inc., 556 U.S. 502. 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. 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 long-standing
prior policy.” Red Br. 47.

   “Agencies are free to change their existing policies as
long as they provide a reasoned explanation for the change.”
Encino Motorcars, 136 S.Ct. at 2125. Indeed, “[w]hen an
36                 ALTERA CORP. V. CIR

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. USDA, 795 F.3d 956, 966 (9th Cir.
2015) (en banc) (ellipses in original) (quoting Fox, 556 U.S.
at 515–16).

    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,
                   ALTERA CORP. V. CIR                    37

merely a clarification of the same policy. Moreover, even if
the policy changed, it changed well before 2003, as Xilinx
demonstrates. And if so, it changed as a result of the 1986
amendment to § 482, in which case the question is, again,
whether the cost-sharing regulations are allowable under
Chevron.

                             4

    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.

                             B

    Having determined that Treasury adequately satisfied the
State Farm requirements, we turn to Chevron.

                             1

    Under Chevron, we first apply the traditional rules of
statutory construction to determine whether “Congress has
directly spoken to the precise question at issue.” Chevron,
467 U.S. at 842. We start with the plain statutory words, 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, __ U.S. __,
38                  ALTERA CORP. V. CIR

__, 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, 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 (internal citation and
footnote omitted) (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.
Further, as the text of the statute and its legislative history
                   ALTERA CORP. V. CIR                      39

indicate, Congress intended to provide Treasury with the
flexibility it needed to prevent improper cost and income
allocation between related parties for the purpose of defeating
tax liability.

    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,
565 U.S. at 64. Thus, Congress’s purpose in enacting and
amending § 482 in 1986 is key to resolution of this issue.
That purpose is parity. First Sec. Bank of Utah, 405 U.S. at
400. The 1986 amendment reflected Congress’s recognition
that the traditional arm’s length standard did not serve the
purpose of § 482.

    The 1986 amendment to § 482 provides that: “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 is a purely internal standard, and evidence supports
Treasury’s belief that Congress intended it to be. H.R. REP.
NO. 99-426, at 423–35; H.R. CONF. REP. NO. 99-841, at II-
637. Indeed, Congress’s objective in amending § 482 was to
ensure that income follows economic activity. H.R. CONF.
REP. No. 99-841, at II-637. Further, legislative history
supports Treasury’s application of the commensurate with
income standard 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
40                  ALTERA CORP. V. CIR

“reasonably reflect[s] the actual economic activity undertaken
by each.” H.R. CONF. REP. No. 99-841, at II-638. Treasury’s
decision to dispense with a comparability analysis was
reasonable.

    So was Treasury’s determination that uncontrolled cost-
sharing arrangements do not provide helpful guidance
regarding allocations of employee stock compensation. As
discussed above, Treasury discounted the relevance of
comments demonstrating that parties at arm’s length do not
share employee stock compensation costs, writing: “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.”
Compensatory Stock Options under Section 482 (Preamble to
Final Rule), 68 Fed. Reg. at 51,173.

    Treasury’s conclusion is entirely consistent with
Congress’s rationale for amending § 482 in the first place.
See id. (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.”); see also H.R. REP. NO.
99-426, at 425 (“There are extreme difficulties 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.”).7

    7
      Although the 2017 amendment to § 482 has no bearing on our
opinion, we note that Congress has not changed its mind:
                      ALTERA CORP. V. CIR                             41

    As Congress noted, the goal of parity is not served by a
constant search for comparable transactions. H.R. REP. NO.
99-426, at 423. That is why, in 1986, it acted by adding the
commensurate with income standard to § 482, synthesizing
the long-standing arm’s length standard with the new
provision; without an internal approach to allocation, related
parties had been able to escape paying the taxes that would be
paid by parties dealing at arm’s length. In other words, the
amendment was intended to hone the definition of the arm’s
length standard so that it could work to achieve arm’s length
results instead of forcing application of arm’s length methods.



        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’s length 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 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).
42                  ALTERA CORP. V. CIR

    Thus, the 2003 regulations are not “arbitrary and
capricious in substance.” Mayo Found., 562 U.S. at 53
(quoting Household Credit Servs., Inc. v. Pfennig, 541 U.S.
232, 242 (2004)). 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. 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.

                               2

    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. Altera
supports its argument with a canon of construction:
“Amendments by implication, like repeals by implication, are
not favored.” United States v. Welden, 377 U.S. 95, 102 n.12
(1964). The canon does not apply here. It operates to prevent
courts from attributing unspoken motives to legislators, not
to force courts to ignore legislative action. It is illogical to
argue that an amendment does not change the meaning of the
statute that is amended. Moreover, Altera’s conclusion, that
the commensurate with income standard is one method of
satisfying the arm’s length standard, is one with which the
Commissioner agrees.

    Altera’s interpretation of the 1986 amendment would
render the commensurate with income clause meaningless
except in two circumstances: (1) to allow the Commissioner
to periodically adjust prices initially assigned following a
comparability analysis; and (2) to reflect a party’s
                   ALTERA CORP. V. CIR                      43

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 the commensurate with
income provision. H.R. CONF. REP. NO. 99-841, at II-638.

                              3

    Altera makes much of the United States’s treaty
obligations with other countries. However, there is no
evidence that the unworkable empiricism for which Altera
argues is also incorporated into our treaty obligations. As
demonstrated by nearly a century of interpreting § 482 and its
precursor, the arm’s length standard is aspirational, not
descriptive. 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., Technical Explanation of the US-
Poland Tax Treaty, at 31 (Feb. 13, 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’s-length
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 . . . .”).
44                  ALTERA CORP. V. CIR

    The 1986 amendment focused specifically on intangibles,
and it gives 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.

                                4

    Altera also argues that the outcome of this case is
controlled by our Court’s decision in Xilinx. We disagree.
While the Xilinx panel could have reached a holding that
would foreclose the Commissioner’s current position, it did
not.

    In Xilinx, this Court considered the 1994 and 1995 cost-
sharing regulations. The case involved a matter of 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.
                    ALTERA CORP. V. CIR                      45

    Initially the panel, in a 2–1 decision, voted to reverse the
Tax Court, which had unanimously struck the 1995 cost-
sharing regulations. Xilinx, Inc. v. Comm’r, 567 F.3d 482
(9th Cir. 2009), withdrawn 592 F.3d 1017 (9th Cir. 2010).
However, the panel withdrew its first opinion after
reconsideration, and the panel—over Judge Reinhardt’s
dissent—ultimately affirmed the Tax Court in striking the
regulations. Xilinx, 598 F.3d 1191. As framed by all three
judges in both the withdrawn and final opinions, the issue
came down to whether the arm’s length standard and all costs
provision could be synthesized. All three judges determined
that synthesis was impossible, and the conflict was therefore
whether the arm’s length standard, versus the all costs
provision, had priority .

    Xilinx does not control for two reasons. First, the parties
in Xilinx were not debating administrative authority, and the
Court 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
46                 ALTERA CORP. V. CIR

no conflict in the regulations, and Altera does not challenge
the regulations on the ground that a conflict exists.

                              V

   In sum, we conclude that the Commissioner did not
exceed the authority delegated to him by Congress. The
Commissioner’s rule-making complied with the APA, and its
regulation is entitled to Chevron deference.

     REVERSED.



O’MALLEY, Circuit Judge, dissenting:

    A “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)). In promulgating
the rule we consider here, Treasury repeatedly insisted that it
was applying the traditional arm’s length standard and that
the resulting rule was consistent with that standard. Today,
however, the majority holds that Treasury’s citation to the
legislative history surrounding the enactment of the Tax
Reform Act of 1986 “communicated its understanding that
Congress had called upon it to move away from the historical
arm’s length standard.” Op. 31. And the majority finds that,
despite Treasury’s own statements to the contrary, that same
citation to legislative history sufficed to “make it clear
enough” to interested parties that Treasury was changing its
longstanding practice of applying the arm’s length standard
in all but the narrowest of circumstances. Op. 32.
                    ALTERA CORP. V. CIR                      47

    The majority, in effect, “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)). It also
endorses a practice of requiring interested parties to engage
in a scavenger hunt to understand an agency’s rulemaking
proposals. That 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. v. U.S. EPA, 965 F.2d 759,
770 (9th Cir. 1991) (quoting Ethyl Corp. v. EPA, 541 F.2d 1,
48 (D.C. Cir. 1976) (en banc)). In doing both of these things,
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 instead would find, as the Tax Court did, that Treasury’s
explanation of its rule did not 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 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. § 1.482-7(d)(1) (as amended in
48                     ALTERA CORP. V. CIR

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

    “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 (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). 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). 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 the same income and deductions.

   The 1986 amendment that introduced the commensurate
with income standard did not dislodge the arm’s length test.1


     1
      This amendment added a second sentence to § 482 that provided:
“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, § 1231(e)(1), 100 Stat. 2085, 2562 (codified as
amended at 26 U.S.C. § 482).
                   ALTERA CORP. V. CIR                      49

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 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 potential 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.

     Treasury reiterated in its 1988 “White Paper” that
“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, 1988-2 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
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” 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 reflected the arm’s length principle. See
Xilinx, 598 F.3d at 1196–97 (citing tax treaty explanations);
50                    ALTERA CORP. V. CIR

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”).2

         B. Treatment of Stock-Based Compensation

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

     2
      As the majority observes, more recent tax treaty explanations have
also cited the alternative commensurate with income standard. Op. 42–43
(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).
                   ALTERA CORP. V. CIR                      51

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] 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).
We 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 was the
fundamental “purpose” of the regulations, trumped Treas.
Reg. § 1.482-7, and therefore that stock-based 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,
we affirmed the Tax Court’s judgment in favor of Xilinx. Id.
at 1196 (majority opinion).
52                  ALTERA CORP. V. CIR

                 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 method to be used to evaluate whether
a [QCSA] produces results 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 several cost-
sharing agreements in 1997, under which Altera U.S. licensed
various forms of intangible property to Altera International,
and Altera International paid royalties to Altera U.S. Altera,
145 T.C. at 92–93. During the 2004 to 2007 taxable years,
Altera U.S. granted stock options and other stock-based
compensation to certain of its employees, but costs related to
that compensation were not included in the cost pool under
the operative cost-sharing agreements. Id. at 93.
                    ALTERA CORP. V. CIR                      53

    Each year from 2004 to 2007, the IRS notified Altera that
the cost-sharing payments did not satisfy the new regulations.
Id. at 94. But when Altera challenged these regulations, 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 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. But the Commissioner now argues on
appeal, and the majority accepts, that what Treasury was
actually saying is that § 482 no longer requires an arm’s
length analysis. I disagree.

      A. The New Rule Is Invalid Under State Farm

    Under the Administrative Procedure Act, we must “hold
unlawful and set aside agency action . . . found to be . . .
arbitrary, capricious, an abuse of discretion, or otherwise not
in accordance with law.” 5 U.S.C. § 706(2). To satisfy this
standard, “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)).
“That is, an agency must ‘cogently explain why it has
exercised its discretion in a given manner,’ and ‘[i]n
54                  ALTERA CORP. V. CIR

reviewing that explanation, we must “consider whether the
decision was based on a consideration of the relevant factors
and whether there has been a clear error of judgment.”’” Nw.
Envtl. Def. Ctr. v. Bonneville Power Admin., 477 F.3d 668,
687 (9th Cir. 2007) (alteration in original) (quoting State
Farm, 463 U.S. at 43, 48).

    Although an agency action is not subject to “more
searching review” simply because it represents a change in
position, “the requirement that an agency provide reasoned
explanation for its action would ordinarily demand that it
display awareness that it is changing position.” FCC v. Fox
Television Stations, Inc., 556 U.S. 502, 514–15 (2009). “An
agency may not, for example, depart from a prior policy sub
silentio or simply disregard rules that are still on the books.”
Id. 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)).

    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
                    ALTERA CORP. V. CIR                      55

agency itself.” State Farm, 463 U.S. at 50 (citing Burlington
Truck Lines, 371 U.S. at 168). For that reason, “we may not
supply a reasoned basis for the agency’s action that the
agency itself has not given.” Id. at 43 (citing 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, 1988-2 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.

    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).” Compensatory Stock
Options Under Section 482, 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
56                 ALTERA CORP. V. CIR

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. (quoting H.R.
Conf. Rep. No. 99-481, at II-638 (1986)). Applying this
standard, Treasury 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 applying 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).

    Treasury also responded to 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 standard
in the absence of evidence that parties at arm’s length take
stock-based compensation into account in similar
circumstances”). Treasury acknowledged that comparable
arm’s-length transactions may have been relevant, but it
                    ALTERA CORP. V. CIR                       57

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. Treasury further detailed why it believed
that certain comparable transactions proposed by
commentators were not in fact comparable. Id. at 51,173.

    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
58                 ALTERA CORP. V. CIR

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 commentators submitted
significant evidence about whether unrelated parties would
share stock-based compensation costs in QCSAs; that the Tax
Court itself had made a factual determination on that issue in
Xilinx I; 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.

    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. The
Commissioner now 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
                    ALTERA CORP. V. CIR                       59

comparability analysis in this narrow context, there was no
need for it to establish that the uncontrolled transactions cited
by commentators were insufficiently comparable.”
Appellant’s Br. 64.

      The majority accepts Treasury’s rationalization. “With its
references to legislative history,” the majority holds, Treasury
adequately “communicated its understanding that Congress
had called upon it to move away from the historical arm’s
length standard.” Op. 31. The majority finds that Treasury
was therefore entitled to ignore the comments opposing the
final rule because they did not “bear on the agency’s
‘consideration of the relevant factors.’” Op. 28–29 (quoting
Am. Mining Congress v. EPA, 965 F.2d 759, 771 (9th Cir.
1992)). As to Altera’s rejoinder that Treasury never
suggested that it had the authority to “dispense with”
comparability analysis entirely, Appellee’s Br. 43, the
majority dismisses these arguments as “twist[ing] Chenery
. . . into excessive proceduralism,” Op. 33.

    I do not share the majority’s view. Treasury may well
have believed that, given the fundamental characteristics of
stock-based compensation in QCSAs, it could dispense with
arm’s length analysis entirely. Cf. Xilinx II, 598 F.3d at 1197
(Fisher, J., concurring) (hypothesizing why unrelated
companies may not share stock-based compensation costs).
But the APA required Treasury to say that it was taking this
position, which departed starkly from Treasury’s previous
regulations. See Fox, 556 U.S. at 515 (“[T]he requirement
that an agency provide reasoned explanation for its action
would ordinarily demand that it display awareness that it is
changing position.”). As we held in Xilinx, the previous
regulations preserved the primacy of the arm’s length
standard and its requirement of comparability analysis. See
60                  ALTERA CORP. V. CIR

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
said—either in the notice of proposed rulemaking or in the
preamble accompanying the final rule—that the nature of
stock compensation in the QCSA context rendered arm’s
length analysis irrelevant. Treasury instead explained only
that it could not conduct an arm’s length analysis because
comparable transactions could not be found.                See
Compensatory Stock Options Under Section 482, 68 Fed.
Reg. at 51,172–73 (“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 the
majority acknowledges, in fact, “Treasury set forth its
understanding that it should not examine comparable
transactions when they do not in fact exist and should instead
focus on a fair and reasonable allocation of costs and
income.” Op. 32 (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. The comments
submitted were relevant to the issue of whether “similar
transactions under similar circumstances” existed. Any such
transactions, as Treasury originally admitted, would
“ordinarily provide significant evidence in determining
whether a controlled transaction meets the arm’s length
standard.” Compensatory Stock Options Under Section 482,
                       ALTERA CORP. V. CIR                           61

68 Fed. Reg. at 51,172.3 If Treasury felt that these comments
were irrelevant, it presumably would have said so.
Treasury’s decision to respond to the comments on their
merits underscores that Treasury’s only justification for
eschewing comparability analysis was its belief that no
comparable transactions could be found. The fact that
evidence of comparable transactions might support more
favorable tax treatment does not mean such comparables do
not exist.4

    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
traditional arm’s length analysis. 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


    3
      The majority points to no language in the notice of proposed
rulemaking that contradicts this understanding.
    4
       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 the regulation does not satisfy the State Farm standard.
62                 ALTERA CORP. V. CIR

(D.C. Cir. 2005))). And 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 arm’s length analysis was not
required—is not, as the majority suggests, “excessive
proceduralism.” Op. 33. It is the essence of the review that
State Farm demands.

    When the Tax Court conducted that review, it considered
the explanation that Treasury offered, and 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.” 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 in order to
justify its decisionmaking. I therefore would hold, as the Tax
Court did, that the 2003 regulations are invalid under State
Farm.

B. Section 482 Does Not Require Sharing of Stock-Based
                 Compensation Costs

     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.
“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.” Encino Motorcars, LLC v. Navarro, 136 S. Ct.
2117, 2125 (2016) (quoting United States v. Mead Corp.,
                   ALTERA CORP. V. CIR                      63

533 U.S. 218, 227 (2001)). I therefore would interpret the
statute in the first instance, without deference.

    I agree with the majority that § 482 does not address this
issue directly. Op. 38–39. 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. See generally Amicus Curiae Br.
Supporting Appellee and Affirmance on Behalf of Cisco
Systems, Inc. As Cisco points out, the commensurate with
income standard applies only to a “transfer (or license) of
intangible property,” 26 U.S.C. § 482, which is distinct from
a cost sharing agreement for joint development of intangibles.
See White Paper, 1988-2 C.B. at 474 (noting that “bona fide
research and development cost sharing arrangements”
provided a way to “avoid[] section 482 transfer pricing issues
related to the licensing or other transfer of intangibles”).

    QCSAs fall neatly into the latter category. See Treas.
Reg. § 1.482-7(a)(1) (2003) (defining a QCSA as “an
agreement under which the parties agree to share the costs of
development of one or more intangibles in proportion to their
shares of reasonably anticipated benefits”).               The
Commissioner’s argument that the commensurate with
income standard applies to “intangible transactions in
general, and cost sharing arrangements in particular,”
Appellant’s Br. 57, is inconsistent with the plain language of
the statute. Under the only reasonable interpretation of § 482,
therefore, the commensurate with income standard does not
apply to QCSAs. For at least this reason, I also disagree with
the majority’s conclusion that Treasury’s reading of § 482
satisfies the second step of the Chevron test. Op. 39–46.
