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Is Treasury Bound by the Arm’s-Length Standard?

Posted on Apr. 1, 2024
Reuven S. Avi-Yonah
Reuven S. Avi-Yonah

Reuven S. Avi-Yonah ( is the Irwin I. Cohn Professor of Law at the University of Michigan Law School. He thanks Ryan Finley and Jeffery M. Kadet for their helpful comments.

In this installment of Reflections With Reuven Avi-Yonah, Avi-Yonah examines the history of the arm’s-length standard and considers whether Treasury can deviate from it if it is necessary to clearly reflect related taxpayers’ income.

In December 2023 Abbott Laboratories petitioned the Tax Court to reverse $417 million in section 482 deficiencies.1 The petition addresses many issues, but as Tax Notes contributing editor Ryan Finley pointed out in his excellent recent article, the most important one relates to the issue of whether stock-based compensation should be included in the pool of costs covered by a cost-sharing arrangement.2 This is the same issue that taxpayers have litigated repeatedly, with the most recent case, Altera, resulting in an IRS victory in the Ninth Circuit.3 If Abbott wins, the case is appealable to the Seventh Circuit, potentially setting up a circuit split that (given the amount of revenue involved) could ultimately end up in the Supreme Court.

Formally, like the previous cases, Abbott Labs is a challenge to a regulation that explicitly requires taxpayers to include the cost of stock-based compensation in the pool of costs to be shared under a cost-sharing arrangement.4 But the underlying issue is whether Treasury is always bound by the arm’s-length standard in reg. section 1.482-1 or whether it can deviate from the arm’s-length standard if that is necessary to clearly reflect the related taxpayers’ income. The basic problem is that stock-based compensation is one of the largest costs incurred by multinationals that rely heavily on intellectual property, but if the parent and the subsidiary were unrelated, the subsidiary would not agree to share in the cost of stock-based compensation that depends on the performance of an unrelated entity. This is a classic case in which the arm’s-length standard cannot be applied because the position of related parties is inherently not comparable with that of unrelated parties.

Finley explains that this issue is the decisive one:

This raises the question whether the arm’s-length standard’s legal basis is statutory, regulatory, or both. Statutory authority and regulatory consistency are two distinct questions, but they inevitably blend if one assumes that the same interpretation of the arm’s-length standard underlies both the statute and the regulations. All four of the court opinions (excluding two withdrawn opinions) issued in Altera and Xilinx made this assumption, but only the Ninth Circuit’s Altera opinion made even a partial attempt to corroborate it. The Ninth Circuit held in Altera that the challenged regulation and the preexisting regulations all implemented the statute as amended by the Tax Reform Act of 1986, which codified the commensurate with income standard in a newly added second sentence of section 482.

But even in Altera, the Ninth Circuit’s analysis of potentially distinct statutory and regulatory standards lacks ideal clarity and detail. An important unanswered question is whether the 1986 commensurate with income amendment, which features prominently in the Altera opinion’s Chevron and State Farm analyses, was strictly necessary to align the statutory and regulatory standards.

After Abbott’s petition, the question isn’t just theoretical. The company isn’t just challenging the validity of reg. section 1.482-7(d)(1)(iii), which forms part of the cost-sharing regulations’ definition of intangible development costs and represents the modern counterpart to the regulation challenged in Altera. Abbott also challenges reg. section 1.482-9(j), which includes stock-based compensation in the definition of total services costs. The services regulations were the product of a separate rulemaking procedure and, more importantly, aren’t subject to the 1986 amendment.5

Thus, the key question is, to what extent is Treasury bound by the arm’s-length standard?

Statute and Regs

The statutory text of section 482 dates back to section 45 of the Revenue Act of 1928, which contains the first sentence of the current section 482.6 It contains no reference to the arm’s-length standard because that standard had not been invented yet. The arm’s-length standard derives from the work of Mitchell B. Carroll, who first included it in the France-U.S. treaty of 19327 and then in Treasury regulations issued in 1935 interpreting section 45.8 Carroll also was the principal U.S. adviser to the League of Nations and inserted the arm’s-length standard into article 9 of the league and OECD model tax treaties, rejecting the formulary apportionment alternative that was practiced at the state level in the United States and approved in the four economists’ report to the league in 1923.9

As the Ninth Circuit pointed out in Altera, the arm’s-length standard is subject to the commensurate with income amendment to the statutory text of section 482, which was added in 1986. Congress intended the commensurate with income standard to apply regardless of whether it was consistent with the arm’s-length standard.10 But even if that position persuades the Tax Court to disregard its own reviewed precedent in Altera (which it is not required to do when the case is appealable to a different circuit), Abbott Labs also involves a challenge to a regulation that applies to services, not intangibles, which is therefore not subject to the commensurate with income standard.11

Thus, Abbott Labs directly raises the question of whether Treasury is bound by the arm’s-length standard when issuing its regulations. The answer is different in treaty and non-treaty situations.

Customary International Tax Law

Every U.S. tax treaty includes the arm’s-length standard in article 9, and despite the contrary position taken in the conduit financing regulations, there is no basis to overriding a treaty by regulation.12 Thus, if a treaty applies, Treasury is bound by the arm’s-length standard.

But Abbott Labs involves in part an affiliate in Singapore, and Altera involved an affiliate in the Cayman Islands. The United States does not have a treaty with either country, and therefore Treasury is not bound by the arm’s-length standard in those cases unless the standard represents customary international tax law.13

The existence of customary international tax law is disputed, but one of the more convincing potential examples of it is the arm’s-length standard.14 Although the arm’s-length standard is found in every treaty, what is hard to prove is that countries consider themselves bound by the arm’s-length standard in the absence of a treaty, which is required for the arm’s-length standard to be considered customary international tax law. But the behavior of Treasury in Altera suggests that it considered the arm’s-length standard to be binding customary international tax law even without a treaty.

The previous IRS loss in Xilinx involved a cost-sharing agreement with Xilinx’s subsidiary in Ireland so that the Ireland-U.S. tax treaty applied. Thus, when confronted with the result in Xilinx, Treasury could have distinguished it as a treaty case and amended reg. section 1.482-7, the cost-sharing regulation, any way it wanted for non-treaty cases. Treasury could have relied on the legislative history of the commensurate with income standard of section 482, which states that this standard applies regardless of the arm’s-length standard.15 Thus, Treasury could have just said that the inclusion of the cost of stock options in the cost-sharing pool between related parties is an exception to the arm’s-length standard because there are no realistic comparables: Unrelated parties would not have agreed to share the cost of stock options because the value of the options depends on the performance of an entity that by definition they do not control (that is, an unrelated party). The Xilinx outcome, after all, warned Treasury that to not address the arm’s-length standard risks losing the case.

Instead, in a non-treaty context, in which Treasury was not bound by the arm’s-length standard (which is, for domestic law purposes, only a regulatory requirement because it is not in section 482), Treasury chose to stick with the arm’s-length standard and risk the consequences. The implication is that Treasury believes itself bound by the arm’s-length standard even when there is no formal treaty-based or statutory requirement to be so bound (that is, when there is no treaty), and that is the essence of customary international tax law. Thus, Treasury’s behavior in Altera indicated that it believes the arm’s-length standard is part of customary international tax law and hence that customary international tax law exists.

What Next?

But is the arm’s-length standard still customary international tax law? This is a harder question because in the October 2021 agreement on reforming the international tax regime, more than 140 countries, including the United States, agreed to abandon the arm’s-length standard for amount A of pillar 1. It can therefore be argued that even if the arm’s-length standard were part of customary international tax law before 2021, that is no longer the case. Even if, as expected, the multilateral tax convention embodying the abandonment of the arm’s-length standard does not come into effect because of U.S. opposition, it is plausible that many countries (such as India and EU countries) would adopt it unilaterally.16

I would therefore suggest that Treasury revise the cost-sharing arrangement regulations to state explicitly that the inclusion of the cost of stock options in the cost-sharing pool between related parties is an exception to the arm’s-length standard. This would not help it in Abbott Labs because that case involves previous versions of the regulations, but it may deter future attempts to reverse the IRS victory in Altera.


1 Abbott Laboratories v. Commissioner, No. 20227-23.

2 Finley, “Abbott Labs Revives Fight Over Stock Options in Transfer Pricing,” Tax Notes Int’l, Feb. 12, 2024, p. 863.

3 See Xilinx Inc. v. Commissioner, 598 F.3d 1191 (9th Cir. 2010), aff’g 125 T.C. No. 4 (2005); and Altera Corp. v. Commissioner, 926 F.3d 1061 (9th Cir. 2019), rev’g 145 T.C. 91 (2015).

5 Finley, supra note 2.

6 Revenue Act of 1928, ch. 852, section 45:

In any case of two or more trades or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion, or allocate gross income or deductions between or among such trades or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such trades or businesses.

7 Art. IV, 1932 France-U.S. treaty, ratified in 1935:

When an American enterprise, by reason of its participation in the management or capital of a French enterprise, makes or imposes on the latter, in their commercial or financial relations, conditions different from those which would be made with a third enterprise, any profits which should normally have appeared in the balance sheet of the French enterprise, but which have been, in this manner, diverted to the American enterprise, are, subject to the measures of appeal applicable in the case of the tax on industrial and commercial profits, incorporated in the taxable profits of the French enterprise.

For more on this treaty, see Reuven S. Avi-Yonah, “The First US Tax Treaty and Its Influence,” 52(1) Intertax 5 (2024).

8 Reg. 86, article 45-1(c) (1935).

9 League of Nations, “Report on Double Taxation Submitted to the Financial Committee,” Doc. E.F.S. 73. F.19 (1923); see also Avi-Yonah, “The 1923 Report and the International Tax Revolution,” 51(5) Intertax 427 (2023).

10 H.R. Rep. No. 99-841, at II-638 (1986); see Avi-Yonah, “The Rise and Fall of Arm’s Length: A Study in the Evolution of U.S. International Taxation,” 15 Va. Tax Rev. 89 (1995); Avi-Yonah et al., “Commensurate With Income: IRS Nonenforcement Has Cost $1 Trillion,” Tax Notes Int’l, May 22, 2023, p. 1017.

12 Reg. section 1.881-3 (allowing the IRS to disregard conduit financing arrangements regardless of tax treaties). Treaty overrides are based on a Supreme Court interpretation of the supremacy clause, which does not apply to regulations. See Avi-Yonah, “Tax Treaty Overrides: A Qualified Defence of U.S. Practice” in Tax Treaties and Domestic Law 65 (2006); Avi-Yonah, “Pacta Sunt Servanda? The Problem of Tax Treaty Overrides,” 2022(1) Brit. Tax Rev. 25 (2022).

13 The following is based on Avi-Yonah, “Altera, the Arm’s Length Standard, and Customary International Tax Law,” 38 Mich. J. Int’l Law Opinio Juris 1 (2017).

14 Chantal Thomas, “Customary International Law and State Taxation of Corporate Income: The Case for the Separate Accounting Method,” 14(1) Berkeley J. Int’l L. 99 (1996); Avi-Yonah, “Does Customary International Tax Law Exist?” in Research Handbook on International Taxation 2 (2020).

15 H.R. Rep. No. 99-841, at II-638; see Avi-Yonah, “The Rise and Fall of Arm’s Length: A Study in the Evolution of U.S. International Taxation,” supra note 10.

16 Avi-Yonah, “After Pillar One,” 2023(3) Brit. Tax Rev. 243 (2023).


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