Opinion ID: 4404666
Heading Depth: 3
Heading Rank: 1

Heading: The Arm’s Length Standard

Text: “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). Indeed, the first sentence of § 482 states that, “[i]n any case of two or more organizations, trades, or businesses . . . owned or controlled directly or indirectly by the same interests, the Secretary may . . . allocate gross income . . . if he determines that such . . . allocation is necessary in order to prevent evasion of ALTERA CORP. V. CIR 53 taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” This sentence has always been viewed as requiring an arm’s length standard. See First Sec. Bank of Utah, 405 U.S. at 400; Barclays Bank PLC v. Franchise Tax Bd. of Cal., 512 U.S. 298, 305 (1994). 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) (emphasis added). 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 income and deductions. As far back as 1968, Treasury’s regulations also required that, “[i]n order for the sharing of costs and risks to be considered on an arm’s length basis, the terms and conditions must be comparable to those which would have been adopted by unrelated parties similarly situated had they entered into such an arrangement.” Allocation of Income and Deductions Among Taxpayers, 33 Fed. Reg. 5848, 5854 (April 16, 1968) (emphasis added). That same regulation provided that Treasury may not allocate income with respect to QCSAs involving the development of intangible property unless doing so would be consistent with the arm’s length standard. Id. (providing that, in “a bona fide cost sharing arrangement with respect to the development of intangible property, the district director shall not make allocations with respect to such acquisition except as may be appropriate to reflect each participant’s arm’s length share of the costs and risks of developing the property.”). Therefore, at the time Congress enacted the 1986 amendment, Treasury’s own regulations explicitly required a determination of what an arm’s length result would show and 54 ALTERA CORP. V. CIR required a comparability analysis to reach that result where comparable transactions exist. The majority attempts to water down the text of Treasury’s own regulations at the time. It contends that, “[a]lthough the Secretary adopted the arm’s length standard, courts did not hold related parties to the standard by exclusively requiring the examination of comparable transactions.” Op. 9. To support its position, the majority cites this court’s decision in Frank v. Int’l Canadian Corp., 308 F.2d 520, 528–29 (9th Cir. 1962), which disagreed that “‘arm’s length bargaining’ is the sole criterion for applying the statutory language of [§ 482] in determining what the ‘true net income’ is of each ‘controlled taxpayer.’” But, in Oil Base, Inc. v. Commissioner of Internal Revenue, 362 F.2d 212, 214 n.5 (9th Cir. 1966), this court clarified that the holding in Frank was an outlier, limited only to the peculiar facts of that case. Frank’s departure from the arm’s length analysis, the court held, was justified, in part, because “there was no evidence that arm’s-length bargaining upon the specific commodities sold had produced a higher return” and because “the complexity of the circumstances surrounding the services rendered by the subsidiary” made it “difficult for the court to hypothesize an arm’s-length transaction.” Id. Significantly, the parties in Frank had stipulated to applying a standard other than the arm’s length standard. Id. There really can be no doubt that, prior to the 1986 amendment, this Circuit believed that an arm’s length standard based on comparable transactions was the sole basis for allocating costs and income under the statute in all but the narrow circumstances outlined in Frank—including the presence of the stipulation therein. The majority’s attempt to breathe life back into Frank is, simply, unpersuasive. ALTERA CORP. V. CIR 55
The 1986 amendment passed against the backdrop of Treasury’s own longstanding practices did not change the obligation to employ an arm’s length standard. Indeed, Congress left the first sentence of § 482—the sentence that undisputedly incorporates the arm’s length standard—intact. It merely added a second sentence providing that, “[i]n 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 (1986) (codified as amended at 26 U.S.C. § 482). The plain text of the statute limits the application of the commensurate with income standard to only transfers or licenses of intangible property. This is consistent with the underlying purpose of the 1986 amendment. 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 specific 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 56 ALTERA CORP. V. CIR attributable to the intangible.” Id. at 425. Congress did not make any other findings regarding the use of the commensurate with income standard for any transactions other than transfers or licenses of intangible property. Thus, the statute—read in light of this legislative history—did not grant Treasury the flexibility to depart from a comparability analysis whenever it sees fit; rather, it permitted a departure in the limited context of “any transfer (or license) of intangible property” because it had found that comparable transactions in such cases are frequently unrealistic. Treasury reiterated the limited circumstances in which the commensurate with income standard applies in its 1988 “White Paper.” It stated there that, even in the context of transfers or licenses of intangible property, the “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, 1988-1 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” for transfers of intangible property 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 mandated the arm’s length principle, in all but this narrow category of intangible transfers. See Xilinx II, 598 F.3d at 1196–97 (citing tax treaty explanations); 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 ALTERA CORP. V. CIR 57 arm’s length standard as Congress’ intended touchstone for § 482”).1