By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
As regular readers of these commentaries know, we find what passes for excitement and drama among us international tax nerds where we can, international tax law being a generally dry and humorless subject. The recent Ninth Circuit opinion in Xilinx Inc. v. Comr.rates fairly high on this relatively low excitement and drama scale, both as a legal matter and for what appears between the lines in a footnote in the dissent about the reasons for a change in the vote of Judge Fisher, a change that reversed the outcome from the original Ninth Circuit decision.
In Xilinx, the IRS contended that stock-based compensation related to a cost-sharing arrangement during the 1997, 1998, and 1999 taxable years had to be shared. In August 2005, Judge Foley, writing for the Tax Court, held that stock-based compensation costs did not need to be shared, because parties acting at arm's length would not share such costs. The IRS appealed, and in May 2009, the Ninth Circuit issued its first decision in the case, reversing the Tax Court and holding that Xilinx and its Irish subsidiary were required to share stock-based compensation costs under the pre-2003 cost-sharing regulations. In January 2010, the Ninth Circuit withdrew its first decision without explanation.
Original Ninth Circuit Opinion
The original Ninth Circuit opinion written by Judge Fisher (in which Judge Reinhardt joined) held that Regs. §1.482-1(b), which provides that the arm's-length standard should apply "in every case," was irreconcilable with Regs. §1.482-7(d)(1), which provides that "all costs" are to be shared in a cost-sharing agreement. Applying the canon of statutory construction that the specific controls the general, the original opinion held that Regs. §1.482-7(d)(1) should prevail. This was mildly earth-shaking, in transfer pricing and treaty circles, as it unhooked the cost-sharing regulation from the arm's-length standard. In his dissent, Judge Noonan asserted that the canon relied on by the majority was but one of many available and that, in deciding between the two provisions, the overall purpose of the statute (parity with unrelated taxpayers) and the Treasury Department's practice in applying §482, particularly in the context of income tax treaties, should prevail.
New Ninth Circuit Opinion
Between the time of issuance of the original and the new Ninth Circuit opinions, Judge Fisher changed his vote. While, as a signatory of/contributor to one of the amici briefs, I'd be pleased to claim some small credit for Judge Fisher's change of heart (see footnote 2 to his concurring opinion), it appears from footnote 3 to his concurrence, as well as footnote 2 to Judge Reinhardt's dissent, among other things, that there may have been something more at work.
First, some context. In the new Ninth Circuit opinion, Judges Reinhardt and Noonan essentially retain their respective positions, with Judge Noonan, now writing for the court, focusing on the overall purpose and treaty interpretation, and Judge Reinhardt, now in dissent, focusing on the canon of the specific over the general, as well as Regs. §1.482-1(a)(1)'s "clear reflection of income … to prevent the avoidance of taxes" mandate. Only Judge Fisher has a different view than that which he expressed as author of the original opinion.
In writing his concurring opinion, Judge Fisher reiterated his (and the other judges') belief that the regulations are "hopelessly ambiguous." Judge Fisher concluded, however, contrary to his earlier opinion, that:the ambiguity should be resolved in favor of what appears to be the commonly held understanding of the meaning and purpose of the arm's length standard prior to this litigation.
In reaching this conclusion, Judge Fisher writes that he: thoroughly considered not only the plain language of the regulations, but also various interpretive tools the parties and amici have brought before us, including the legislative history of §482, the drafting history of the regulations, persuasive authority from international tax treaties,[1 ] and what appears to be the understanding of corporate taxpayers in similar circumstances and of others.[2 ]
Most interestingly, Judge Fisher also seems to have been annoyed with the government's unwillingness to endorse the reasoning of his prior opinion and the dissenting opinion's having made note of his sensitivity to that fact.3 In footnote 3 to his concurring opinion, Judge Fisher writes: "The dissent invokes the prior, withdrawn majority opinion. [Citations omitted.] In writing that opinion, I was persuaded that the arm's length standard and the all costs regulation were in conflict, and that the more specific of the two should control. [Citation omitted.] I no longer share Judge Reinhardt's confidence in that resolution because the Commissioner's response to Xilinx's petition for rehearing declined to fully endorse its reasoning. Instead, the thrust of the Commissioner's response was that our resultwas correct, even though our reasoning was not." [Emphasis in the original.]
This sort of thing passes for drama in the arid world of international tax: one Circuit Court judge accusing another of being too sensitive—of changing his mind, and the result in a case, because he thinks the government failed to give proper respect to his reasoning—in essence, punishing the government for failing to appreciate what he did for them in the first opinion.
So, did the government lose because it was insufficiently respectful of Judge Fisher's reasoning? Not really. First, the government was in a tight spot. Had it endorsed his reasoning, it would have contradicted years of defending the §482 regulations to myriad foreign governments as entirely consistent with, and subservient to, the arm's-length standard. Second, to be fair, Judge Fisher appears to have been ultimately persuaded by the difficulty (convolutedness?) with which the IRS sought to justify its position. Judge Fisher states that: the Commissioner's attempts to square the "all costs" regulations with the arm's length standard have only succeeded in demonstrating that the regulations are at best ambiguous.
To those ends, Judge Fisher notes that he was:troubled by the complex, theoretical nature of many of the Commissioner's arguments trying to reconcile the two regulations. Not only does this make it difficult for the court to navigate the regulatory framework, it shows that taxpayers have not been given clear, fair notice of how the regulations will affect them.
Thus, Judge Fisher concludes: "Xilinx's understanding of the regulations is the more reasonable even if the Commissioner's current interpretation may be theoretically plausible."
For many years, there has been a bit of a square peg in a round hole exercise with claiming that §482 and the §482 regulations are wholly consistent with the arm's-length principle. The commensurate-with-income language of the statute, together with its implementation through various iterations of the comparable profits method under the regulations, is one thing. The justification of including stock-based compensation costs in the cost-sharing regulations is quite another. The Ninth Circuit appears to recognize this. But given the long history and international importance of the arm's-length standard, it is now unwilling to disengage the regulations from that principle when, instead, it can find a reading (albeit contrary to the IRS's) that is consistent with it.
What is most portentous for the IRS, however, is not that it lost this case. More important is footnote 4 to Judge Fisher's concurring opinion:It is an open question whether these flaws have been addressed in the new regulations Treasury issued after the tax years at issue in this case. See26 C.F.R. §1.482-7T(a) and (d)(1)(iii) (2009) (stating explicitly that ESOs are costs that must be shared and that the all costs requirement is an arm's length result).
If this becomes an official view of the Ninth Circuit (and, given this footnote and the dollars involved with respect to many Ninth Circuit taxpayers, there may well be an opportunity for that to happen as a result of new litigation), the government may wish it had been more circumspect in what it had to say about Judge Fisher's reasoning in the original Ninth Circuit opinion after all.
This commentary also will appear in the June 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Warner, 887 T.M., Transfer Pricing: The Code and Regulations, Meyer, 888 T.M., Transfer Pricing: Judicial Strategy and Outcomes, Levey, 890 T.M., Transfer Pricing: Alternative Practical Strategies, and in Tax Practice Series, see ¶7110, U.S. International Taxation—General Principles.
3 In footnote 2 to the dissenting opinion, Judge Reinhardt writes, "I guess I am just not as sensitive as Judge Fisher. Simply because the Commissioner advanced an argument that we reject, but then argued that if we reject it, we should apply the rule that we held applicable in our opinion is hardly a reason for abandoning the rule that we believed to be correct. We can't expect anyone, let alone the Commissioner of Internal Revenue, to agree completely with everything we say."
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