Xilinx AOD Straightforward but Finds the IRS Still Intent on Redefining the Arm’s Length Standard

On July 28, 2010, the IRS released AOD 2010-33; 2010-33 IRB 1.  The AOD acquiesces in the result but not the reasoning of Xilinx, Inc. v. Comm’r, 598 F.3d 1191, 1196 (9th Cir. 2010) which held that stock option costs are not required to be shared as “costs” for purposes of cost sharing agreements under old Treas. Reg. §1.482-7.  For prior analysis of Xilinx see this.  The AOD in and of itself is relatively unsurprising.  New regulations (some might say “litigating regulations”) have been issued that explicitly address the issue, and those regulations will test the question of whether Treasury has the authority to require the inclusion of such costs.  The IRS surely realized that from an administrative perspective it was smart to let this one go.  The best move for most taxpayers is likely to grab a bucket of popcorn and watch the fireworks as a few brave souls test Treasury’s mettle by challenging the validity of the new regulations.  Including a provision in your cost sharing agreements that allow adjustments in the event of a future invalidation of the regulations might go well with the popcorn.

The only really interesting item in the AOD is the gratuitous bootstrap of the Cost Sharing Buy-In Regs “realistic alternatives principle.”  The still warm “realistic alternatives principle” – the IRS assertion that an uncontrolled taxpayer will not choose an alternative that is less economically rewarding than another available alternative – “applies not to restructure the actual transaction in which controlled taxpayers engage, but to adjust pricing to an arm’s length result.”  AOD, 2010 TNT 145-18, pp.4-5.  That assertion appears to ignore that “arm’s length” is not some obscure term of art cooked up by the IRS, but rather an established concept that lies at the heart of most countries’ approach to international taxation.

Still clinging to the withdrawn Ninth Circuit opinion, the AOD offers in support of this premise that “the Secretary of the Treasury is authorized to define terms adopted in regulations, especially when they are neither present nor compelled in statutory language (such as the arm’s length standard), that might differ from the definition others would place on those terms.”  Xilinx, Inc. v. Comm’r, 567 F.3d 482, 491 (9th Cir. 2009).

In short, the IRS appears to have dusted off the rule book of the King in Alice and Wonderland:

The King: “Rule Forty-two. All persons more than a mile high to leave the court.”

“I’m not a mile high,” said Alice.

“You are,” said the King.

“Nearly two miles high,” added the Queen.

“Well, I shan’t go, at any rate,” said Alice: “besides, that’s not a regular rule: you invented it just now.”

“It’s the oldest rule in the book,” said the King.

“Then it ought to be Number One,” said Alice.

Alice’s Adventures in Wonderland at 125 (Giunti Classics ed. 2002).  The IRS has often been disappointed with the real rule Number One (the arm’s length principle) when the results of real-world transactions do not coincide with the results the IRS desires.   Now the IRS looks to magically transform that rule into one that replaces those real-world transactions with the IRS’s revenue-maximizing vision.  Tax Wonderland is getting curiouser and curiouser.