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Florida Tax Review

Abstract

A zeitgeist's collective momentum is curious. The arm's length standard has been the touchstone of international transfer pricing and Code section 482 for the better part of a century, but its relevance is under scrutiny. As evidenced by the Organisation for Economic Co-operation and Development's (OECD's) Base Erosion & Profit Shifting policy proposals (BEPS), a growing consensus among the international community suggests the arm's length standard is no longer adequate to accurately and fairly tax the multinational enterprises (MNEs) that make up the modem global economy. Xilinx, Inc. & Subsidiaries v. Commissioner of Internal Revenue (Xilinx I), Xilinx, Inc. v. Commissioner of Internal Revenue (Xilinx II), and Xilinx, Inc. v. Commissioner of Internal Revenue (Xilinx III), which drastically narrowed the IRS's definition of the arm's length standard, foreshadowed these concerns.

In Xilinx III, the Ninth Circuit held that allocating "all costs" in a cost sharing arrangement is irreconcilable with the arm's length standard if unrelated parties would not agree to share these costs. In holding for the taxpayer, the court found this departure from the arm's length standard frustrated the purpose of "parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions." Thus, the court's ruling could potentially invalidate any regulations conflicting with the arm's length standard as contrary to the spirit of section 482. This possibility signifies a remarkable shift in the U.S. transfer pricing landscape.

My conclusion is that both the Ninth Circuit and the IRS are incorrect: the arm's length standard should function as a legal principle, with explicit exceptions, rather than as a legal rule. I propose that income within these explicit exceptions could be allocated using flexible or limited formulary apportionment, creating a hybrid formulary-arm's length system.

Part I provides a brief overview of transfer pricing and the evolution of the arm's length standard. Because transfer pricing is a legal fiction, it diverges significantly from economic reality. An increasing lack of comparable uncontrolled transactions exacerbates this discrepancy. Moreover, the arm's length standard is failing in its duty to ensure taxpayer parity because it neglects to adequately tax MNEs' residual income. Part II summarizes the Xilinx case history, beginning with the Tax Court's decision in 2005 and ending with the Ninth Circuit's 2010 reversal of its own 2009 holding. Part III discusses implications of the Ninth Circuit reversal. I then propose supplementing the existing transfer pricing framework with flexible or limited formulary apportionment in transactions particularly ill-suited to the arm's length standard. Finally, my conclusion argues the complexity of section 482's regulations promotes arbitrage and gamesmanship while forcing the IRS to maintain strained claims of regulatory consistency.

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