* Dispute centers on 'transfer pricing' and employee compensation
* Technology companies watching for possible tax savings
* Case retests 2010 Xilinx victory over IRS
WASHINGTON, July 24 (Reuters) - Altera Corp and the Internal Revenue Service are battling in U.S. Tax Court over the semiconductor maker's handling of employee stock-based compensation and a unit in the low-tax Cayman Islands.
The dispute centers on "transfer pricing," or how multinational companies allocate assets and money globally with the goal of reducing their tax bills. Other tech companies will be watching the Altera case, lawyers said.
The IRS, seeking $27 million in tax payments, contends that from 2004 through 2007 Altera wrongly booked expenses for employee stock-based compensation in the United States where the expenses were tax deductible, according to court records.
The agency says Altera should split its employee costs between its U.S. parent and its Cayman Islands unit. Under this treatment, Altera would lose the U.S. tax deductibility of employee costs allocated to the Caymans.
Altera is challenging IRS rules written in 2003 that require stock-based compensation to be shared between a U.S. company and a subsidiary. Altera says the 2003 rules are impossible to follow, according to court filings.
For now, most companies are following the 2003 rules and splitting employee costs with foreign subsidiaries, forgoing potential tax benefits, tax lawyers said.
But many companies have provisions in place that would trigger tax treatment changes if the 2003 rules are deemed invalid in court, said two sources familiar with companies' arrangements.
"This is a very important issue to a lot of companies, especially technology-oriented companies where research and development is critical," said Paul Dau, an international tax lawyer at the law firm of McDermott Will & Emery.
The IRS and San Jose, California-based Altera declined to comment on the pending litigation. No trial date has been scheduled in the case. Altera is expected to report quarterly earnings on Tuesday after the stock markets close.
The dispute replays a tax fight over transfer pricing that the IRS waged for years with Xilinx Inc, an Altera rival in the semiconductor market. Xilinx sued the IRS in January 2003 - before the IRS issued rules on transfer pricing - and won on appeal in March 2010, leading to one-time tax savings.
Now, Altera faces a tough slog to defeat the 2003 rules as the first company to challenge them in Tax Court, tax attorneys said.
"Altera has basically got to attack and overturn the explicit rule," said Eric Ryan, a partner with DLA Piper. "It will be a significantly harder road for them to take."
Multinationals constantly move goods, services and assets between units in different countries and payments follow. These "transfers" are internal but have to be accounted for in ways that reflect the separate legal status of foreign units.
By managing the pricing of these transfers, companies can shift profits to low-tax countries from high-tax ones and reduce their tax costs. Transfer pricing management is legal, but sometimes the IRS rules that practices cross the line.
International "arm's length" standards meant to prevent abuses largely focus on getting businesses to set transfer prices that resemble open market prices.
Technology companies are particularly attracted to transfer pricing strategies because patented programming codes and other intellectual property assets can easily be moved overseas.
The IRS lost the Xilinx case and a 2009 transfer pricing case involving Veritas Software, now part of Symantec Corp .
IRS Commissioner Doug Shulman made changes in mid-2010 that revamped the agency's transfer pricing operations. Samuel Maruca was hired last year to run the IRS transfer pricing division.
"I'd be interested to see if Maruca's presence or any of that makes a difference in how this (Altera) case is litigated," said David Rosenbloom, a lawyer with Caplin & Drysdale.
"The IRS did a very poor job litigating Xilinx," he said.