The Tax Lawyer
Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.

From General to Specific: The Arm’s-Length Standard’s Evolution and Its Relevancy in Determining Costs to Be Shared in Cost-Sharing Agreements

Edward B. Dix

I. Introduction
The various opinions issued by the U.S. Court of Appeals for the Ninth Circuit in Xilinx, Inc. v. Commissioner are illustrative of the confusion surrounding the arm’s-length standard and its application to cost-sharing agreements (CSAs). In May 2009, the court delivered its opinion, reversing the holding of the Tax Court. Eight months later, however, the court withdrew its opinion and, in March 2010, reversed its holding from the previous May.

At issue in Xilinx was over $100 million in deficiencies claimed by the Service for the taxpayer’s failure to include in the CSA—to which it and Xilinx Ireland (XI), its wholly owned Irish subsidiary, were parties—costs associated with the grant and exercise of employee stock options (ESOs). In May 2009, the Ninth Circuit issued an opinion holding that the regulations promulgated under section 482 required inclusion of ESO-related expenses in CSAs. The court based its decision on the traditional rule of statutory construction that “a specific statute will not be controlled or nullified by a general one.” While acknowledging the general applicability of the arm’s-length standard in matters related to transfer pricing, the court found that the more specific regulations of section 1.482-7—pertaining to CSAs and requiring that “all costs” be shared—superseded the general arm’s-length requirement set forth in Regulation section 1.482-1.

In January 2010, the court withdrew its May 2009 opinion and, two months later, issued a new opinion decrying its earlier application of the canon of construction as too simplistic a method. As Judge Noonan writing for the court explained, “[the] simple solution is all too pat.” The court, instead, held that the underlying purpose of the transfer pricing regulations should control. According to the court, the intent of the regulations is to ensure that related-party transactions resemble those between unrelated parties. The court held that the Xilinx–XI CSA effected an arm’s-length result and that, therefore, the taxpayer’s income and expense allocation was to be upheld.

Though different in outcome, the two opinions rely on the same fundamental assumption: the Xilinx CSA satisfied the arm’s-length standard. In both opinions, however, the Ninth Circuit failed to address the question of what exactly the arm’s-length standard is. In its simplest form, the standard requires related parties to structure transactions in the same manner as transactions between similarly situated unrelated parties. When comparable uncontrolled transactions do not exist, however, the concept of the arm’s-length standard becomes airy and elusive.

This Note argues that the Ninth Circuit’s May 2009 decision correctly gave effect to the Service’s allocations, but did so by employing an inappropriate rationale. The court held that the all-costs and arm’s-length standards are irreconcilable; they are not. In finding arm’s-length in conflict with all-costs, the court relied on mid-century notions of “arm’s-length” and failed to view the standard in light of the clear intent apparent in the legislative and regulatory histories of the arm’s-length standard.

This Note proposes that a more appropriate basis for the Ninth Circuit’s holding of May 2009 would take notice of the evolution of the arm’s-length standard and recognize that, as it has developed, the standard has come to comprise an enumerated set of specific, formulary methods. Moreover, such a holding would be conscious of the legislative and regulatory intent to curb overreliance on comparable transactions in determining arm’s-length results. As embodied in the 1994 final regulations, the arm’s-length standard simply cannot be applied to CSAs; that is, questions concerning which costs parties must share are not susceptible to arm’s-length analysis. Accordingly, Part II provides background concerning the statutory and regulatory frameworks that govern in matters related to intercompany pricing. Part III analyzes the Ninth Circuit’s rationale in concluding that the arm’s-length standard is irreconcilable with the all-costs requirement. Part IV parses the legislative and regulatory histories, and provides a critical analysis of the Ninth Circuit’s finding.

Published by
Section of Taxation,
American Bar Association
in Collaboration with the
Georgetown University Law Center

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