On March 22, 2010, a panel of the US Court of Appeals for the Ninth Circuit reversed its position on an issue of intense interest to multinational corporations that engage in research and development under cost sharing arrangements with their foreign affiliates. The new decision affirms the Tax Court’s 2005 determination that related companies in such arrangements need not allocate employee stock option expenses between them when companies dealing at arm’s length would not do so. Thus, Xilinx, Inc., need not share the stock option expenses of US employees under its cost sharing arrangement with its subsidiary, Xilinx Ireland.
In January 2010, the Ninth Circuit withdrew its May 27, 2009, decision in which it reversed the Tax Court. As we explained in a May 29, 2009, Client Alert (“Ninth Circuit Reverses Tax Court in Xilinx, Rules IRS Administrative Position Contrary to Arm’s Length Standard”), the Ninth Circuit’s previous decision was a victory for the IRS, but a problematic one. The decision sparked immediate international controversy because a 2-1 majority had held that IRS regulations could override the arm’s length standard, notwithstanding the US government’s insistence in treaty negotiations that all parties apply that standard to cross-border transactions. The new opinion, by contrast, unequivocally holds that any ambiguity in the regulations must be construed in favor of the arm’s length standard. That approach, the court held, is consistent with the purpose of section 482, the regulations thereunder, and the understanding of US treaty partners.
Both decisions started from the premise, not contested by the IRS, that unrelated parties in a similar transaction would not share the employee stock option costs in question. The panel’s previous opinion focused narrowly on the purported inconsistency between former Treas. Reg. § 1.482-7(d)(1), which specified that controlled participants in cost sharing arrangements must share “all costs,” and the general requirement in Treas. Reg. § 1.482-1(b)(1) that the arm’s length standard be applied in “every case.”
Applying the canon of statutory construction that a more specific statute or regulation “controls” a more general provision, the panel concluded that the “all costs” requirement of Treas. Reg. § 1.482-7(d)(1) trumped the arm’s length standard. The panel dismissed the arm’s length standard in the regulations and in U.S. tax treaties as a mere “regulatory gloss” on the statutory language of section 482. The decision prompted not only a petition for rehearing by Xilinx, but also drew criticism from senior officials at the Organization of Economic Cooperation and Development and tax officials at US treaty partner countries around the globe. Several trade associations, companies, and individuals filed amicus briefs in support of Xilinx’s position. (Mayer Brown was counsel on one of those amicus briefs.) The court withdrew its opinion on January 13, 2010, but did not issue a new decision until now.
The new opinion was authored by Judge Noonan, who had dissented from the 2009 decision. In the new opinion, Judge Noonan swiftly disposed of the former decision’s reliance on a canon of statutory construction analysis as “all too pat” and “untenable” in light of the “dominant purpose of the regulations” and the context of the tax treaties that incorporated an arm’s length standard.
The new majority opinion explicitly recognizes that the purpose of the regulations, as embodied in Treas. Reg. § 1.482-1(a)(1), is to maintain “parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions.” If the “all costs” requirement of Treas. Reg. § 1.482-7(d)(1) were applied to require allocation of option expenses between Xilinx, Inc. and Xilinx Ireland in this case, the purpose of section 482 would be frustrated because Xilinx would not have tax parity with a taxpayer engaging in a similar transaction with an independent counterparty.
With respect to the tax treaties, the opinion reflects some of the reasoning appearing in the amicus briefs. The arm’s length standard appears in the United States-Ireland Tax Treaty and in other international tax treaties negotiated by the US Treasury Department. Treasury’s interpretation of that standard, as expressed in its various Technical Explanations to these treaties, is “entitled to great weight.” The court found it unnecessary to decide whether the treaty obligations are directly enforceable in US courts. Rather, the court explained, “[i]t is enough that our foreign treaty partners and responsible negotiators in the Treasury thought that arm’s length should function as the readily understandable international measure.”
Judge Noonan was joined by Judge Fisher, the author of the majority opinion in the withdrawn decision. Judge Fisher wrote separately to explain the reason he changed his mind as to the outcome. He now agreed that simple application of a canon of statutory construction could not resolve the issue, in part because the IRS did not “fully endorse” the reasoning of the withdrawn opinion. Finding the regulations “hopelessly ambiguous,” Judge Fisher looked to “various interpretive tools” mentioned by the amici, including the plain language of the regulations, the legislative history of section 482, the drafting history of the regulations, authority from international tax treaties, and the general understanding of corporate taxpayers in similar circumstances. He now concluded that the ambiguity in the regulations “should be resolved in favor of what appears to have been the commonly held understanding of the meaning and purpose of the arm’s length standard prior to this litigation.”
Judge Reinhardt, the other member of the majority in the withdrawn opinion, dissented from the new decision. Like his colleagues, Judge Reinhardt rejected the IRS’s attempt to persuade the court to “find somehow that the arm’s length standard is met by way of the all costs requirement.” But he continued to believe that the canon of construction was the best tool to resolve the conflict between regulations, so that the more specific “all costs” regulation should displace the arm’s length standard. Judge Reinhardt admitted that he was “particularly troubled by the international tax consequences that [his preferred result] would apparently create.” But he would have left resolution of the issue to Congress and Treasury.
In sum, the new decision is significant for several reasons. Importantly, the taxpayer prevailed in a case that has received significant attention, both within the IRS and more broadly. In addition, the decision restores the primacy of the arm’s length standard, relieving the IRS of the need to explain an apparent departure from that standard in the regulations as the former panel decision construed and applied them.