Good luck with that (meant seriously, not as snark)

A bit over four months ago, I posted a blog entry on the Altera case, in which a unanimous 15-0 Tax Court struck down the Treasury's cost-sharing regulations (within the transfer pricing regulations) and handed a huge victory to the taxpayer, which wanted to ensure that its overseas profits from work it actually did in the U.S. would never, at least in the foreseeable future, face tax liability anywhere.  Here's part of it:

"Altera ... concerned a regulatory election, under which U.S. taxpayers with foreign affiliates can opt to use an approach called "cost-sharing" for purposes of determining the applicable transfer prices within the group. In the typical case, a U.S. company with U.S. employees who live, say, in California or the Pacific Northwest is creating what it hopes will be valuable intellectual property (IP) that can be profitably exploited worldwide.  Cost-sharing is a device that they use to shunt as much of the overall profits as possible to tax haven subsidiaries in, say, the Cayman Islands.

"Now, in the real world of transactions between unrelated parties there sometimes are actual "cost-sharing" agreements. For example, two companies with complementary skill sets might agree to collaborate on something that they hope will make them both a lot of money.  In such a case, they may agree that the ultimate profit split will be affected by how much $$ each of them has expended in the development process.

"Then there is fake cost-sharing between affiliates, the topic of interest here. Back to our U.S. company. It has all the employees and all of the relevant skills for developing particular IP. But it creates a Caymans affiliate that, in substance, contributes nothing to the process. But the Caymans affiliate does indeed observably purport to contribute cash to help pay for developing the IP. Where did it get the cash?  Easy, the U.S. parent will typically have given it the cash, in exchange for all of its equity, so that the affiliate could hand the cash right back to the U.S. parent via the pretense of paying for a portion of the development costs. The Caymans affiliate may then get, say, 100% of the upside with regard to profits from selling the IP in all countries outside the U.S.

"In short, the typical deal is like (one suspects) almost no actual cost-sharing arrangement in the history of arm's length transactions.  One party (the U.S. parent) contributes everything, while the second party (the Caymans sub) contributes nothing, except for giving back cash that the first party had placed in its bank account 5 minutes earlier.

"It is already giving these transactions too much credit to say that the Caymans affiliate has effectively gotten the entire foreign "upside" in exchange for nothing. Its getting this upside (and thereby "bearing risk" regarding how great this will actually be) is completely meaningless, given common ownership. But in fact no party to a true arm's length cost-sharing arrangement would get the opportunity to make this sort of a deal. You don't get a piece of the upside without bringing something real to the table. So it's fundamentally ludicrous to look at actual arm's length cost-sharing deals for evidence of how a particular item within the broader deal ought to be treated in related-party arrangements.

"Giving away all the foreign upside in exchange for nothing is already a nice feature of supposed cost-sharing arrangements between commonly owned affiliates. But it's better still if, contrary to the supposed logic of section 482 cost-sharing, you can also give disproportionate deductions to the U.S. affiliate. This further increases the proportion of taxable income that can be treated as arising in a tax haven, rather than in the U.S."

I argued that the taxpayer's victory - it not only won the case, but got the regulations under which it would have lost thrown out as an abuse of discretion ((for requiring that incentive compensation be counted in cost-sharing formulas as between affiliates) -not only exposed the farcical nature of applying fictitious "arm's length" standards to related party transactions, but appeared to reflect a decade or more of careful litigation planning by the industry.  Basically, they flooded the regulatory process with lots of content that was probably less designed to persuade the government than to set the stage for litigation in which they could claim abuse of discretion. You put in lots of evidence that you know they think is irrelevant, then when they too swiftly dismiss it you say they have failed to act in a reasoned manner.  The upshot may be that an underfunded Treasury and IRS must henceforth treat the statements they publish explaining new regulations as litigating documents, meant not just to inform taxpayers but to discourage the courts from overruling them.  At a minimum, this might greatly slow down the process of regulatory issuance.

All this is not (necessarily) to say the Tax Court was to blame.  It hung its hat on the Treasury's refusal, to date, to amend the statement in the transfer pricing regulations to the effect that, "in all cases," the standard is arm's length.  So the fact that private parties making true cost-sharing arrangements generally ignore incentive compensation for purposes of the formula - the key issue here - appeared telling even though it has zero economic relevance to the related-party setting.  But in any event, the Tax Court's reliance on the "in all cases" language is what prevented its decision from being as clearly indefensible legally as it is substantively.

Also, I don't dispute that the Treasury generally ought to take seriously the evidence that taxpayers adduce in the reg process - it was just that here, given the absurd nature of the arm's length standard as applied to related party transactions, the evidence offered truly was substantively immaterial.  (There were also some apparently idiotic claims in the record from the regulatory process that the Tax Court repeated unquestioningly - for example, that incentive compensation costs the shareholders zero.  In that case, please let me have some for five cents.)

Anyway, the government has now filed notice of its intention to appeal Altera to the Ninth Circuit.

Tactically speaking, I certainly hope they know what they're doing.  Appealing such a vehement and unanimous Tax Court opinion is not going to be the easiest road imaginable.