Resolution of international tax disputes in and out of court: section 482 from the trial lawyer's view.

• Author: Haderlein, Thomas M.

The number, complexity, and contentiousness of section 482 cases have increased dramatically. The purpose of this article is to stimulate debate on ways to cope with the flood of section 482 disputes and to improve the administration of section 482 cases. See, e.g., Tax Court Rule 1(b) ("These Rules shall be construed to effect the just, speedy, and inexpensive determination of every case").

1. The Explosion in Section 482 Cases

   During the past decade, section 482 litigation has mush-roomed from disputes over a little-known tax law provision to the stuff of front page Wall Street Journal stories.(1**) Along the way, perspectives on section 482 cases have ranged from that of Judge Nichols who, in a concurring opinion affirming the trial court in the DuPont case, observed that the procedural hurdles facing taxpayers practically ensured IRS victory in all section 482 cases,(2) Congress's view a decade later in enacting the 1990 amendments to section 6038A that the Tax Court judges had been biased in favor of taxpayers and had not impartially given the IRS's trial positions the deference they deserved.(3)

   Since the IRS victory in the DuPont case and Judge Nichols's prediction that only the "rare" taxpayer would prevail in section 482 cases, the momentum seems to have shifted in favor of taxpayers. Although the courts have not always completely embraced the taxpayer's interpretation of the proper arm's-length price or royalty, the courts have consistently held the IRS determinations to be arbitrary, capricious, and unreasonable.(4)

   Unsuccessful in the courts, the IRS instead focused its attention on Congress and lobbied for a change in the controlling law in order to enhance its litigating position.(5) The IRS also lobbied for tough new penalties, advantageous procedural rules, and wide-sweeping changes in the types of documentation that firms must keep or create.(6) The IRS also adopted procedures to use District Counsel and outside experts aggressively in section 482 audits.(7) In its first two attempts to revise the current section 482 regulations, the IRS proposed regulations that, among other things, adopted its litigating positions in the prior cases.(8)

   As a result of all these changes, more and more taxpayers are facing significant section 482 allocations. Not surprisingly, many of these taxpayers have challenged the proposed IRS adjustments, spawning a virtual flood of new section 482 cases at both the administrative Appeals level and in the Tax Court. The Tax Court has approximately 85 docketed section 482 cases, involving $17 billion in disputed amounts.9 Moreover, the cases currently docketed in Tax Court appear to be only the tip of the iceberg: approximately twice as many cases are currently undocketed and under consideration in Appeals.(10)

   This flood of section 482 litigation threatens to swamp the Tax Court's ability to manage its docket. Although the number of general docketed cases has declined, the remaining cases contain an increasing number of the so-called jumbo cases. According to Chief Judge Hamblen, the Tax Court's jumbo cases represent asserted deficiencies of approximately $34 billion. Fewer than 90 of the jumbo cases are section 482 cases, but approximately one-half of the dollar volume of the jumbo case inventory -- $17 billion -- is represented by section 482 disputes.(11) The size and complexity of these jumbo section 482 cases are staggering.

   The amount of judicial resources consumed by the section 482 cases is, at the risk of being trite, truly commensurate with the income allocations in dispute. Complex pleadings, constant

   procedural posturing, protracted and contentious discovery, voluminous stipulations, month-long trials, thousands of pages of trial transcripts, hundreds of trial exhibits, post-trial briefs measured by pounds rather than pages, and complex factual and economic issues consume judicial resources with a ravenous hunger. These jumbo section 482 cases take years to work their way from petition through discovery to trial, although the Tax Court recently has adopted procedures that dramatically shorten the amount of time prior to trial.(12) Even after trial, many of the Tax Court's major section 482 opinions have literally taken years to issue owing to the complexity of the issues and the sheer size of the trial record.(13)

   Section 482 cases also consume huge amounts of taxpayer resources both in terms of the explicit costs of litigation and the implicit costs of management time, effort, and distraction. The explicit costs of litigation -- the costs of the lawyers, the experts and related expenses -- can run into the millions of dollars. The drain on management time, while not measured as easily, may well exceed the explicit costs as taxpayers' top corporate officers are taken away from running their businesses to participate in and manage the litigation.

   In addition to growing in number and in terms of the amount at issue, the section 482 cases have been growing in terms of contentiousness. This increase in contentiousness appears to be the result of (a) the huge dollar amounts in dispute; (b) the highly burdensome discovery sought by the IRS; (c) the IRS's refusal to identify its position in these cases until the issuance of its expert reports 30 days prior to trial; and (d) the perception that the IRS's positions may be extreme. As the contentiousness level rises, the Tax Court becomes inundated with discovery and procedural motions, thereby exacerbating the drain on judicial and taxpayer resources.

2. Narrowing and Joining Issues

   1. The Need to Narrow and Join the Issues

   In any section 482 case, the common goal of the taxpayer, the IRS, and the court should be to resolve the case short of litigation. Not all cases will be settled, but the cases that go to trial should involve a question of fact,(14) that is critical to a trial lawyer's valuation of the case. If the fact in dispute fundamentally changes the value of the case, settlement is possible only if opposing counsel's respective valuations of the case overlap. If counsel's valuations of the case do overlap, then settlement should occur somewhere in the region of overlap.

   In order to settle cases, counsel must know and understand both his or her own case and opposing counsel's case. Without adequate notice of opposing counsel's case, the chances of settlement are greatly diminished because counsel cannot value his or her case. Thus, identification of both the facts in dispute and the opposing side's theory of the case is critical to settlement. This identification of the items in dispute between the parties is known as "joinder of issue."

   Even if a case does not settle prior to trial, joinder of issue is critical for effective and efficient management of cases and section 482 cases in particular. Virtually any fact related to the taxpayer, its markets, or its products is potentially relevant to a section 482 case. Without some identification of or limit on what the parties are attempting to prove and why, the trial and trial record of a section 482 case can balloon to immense proportions. Put differently, if a party does not know what its theory is, virtually any fact can potentially support it.

   If a case comes to trial without proper joinder of issue, the resulting trial is likely to resemble two ships passing in the night. At the end of the trial, the court will be left with a morass of documents and testimony that it will be forced to pick through to identify for itself the issues and facts properly in dispute. In contrast, a trial in which the issues have been properly narrowed and joined will provide the court with a road map through the record. Proper joinder of issue will both allow the parties to keep extraneous documents and testimony out of the record and enable the court to review the salient portions of the record and write its opinion more efficiently.

   The Lilly and Searle trials provide good examples of trials in which the issues could have been more effectively narrowed and joined. The parties in those two cases were unable to resolve their disputes because of fundamentally opposed views on an interpretation of law: both cases involved the question whether the IRS could use section 482 to disregard an otherwise bona fide transfer of intangibles under section 351. Because of the taxpayers' and the IRS's different view of the facts in dispute, issues were never properly joined and the proof proffered by the parties failed to meet head on. In Searle, the taxpayer, believing the transfer of intangibles to be valid, introduced evidence on the proper marketing fee for pharmaceuticals while the IRS ignored the transfer of intangibles and presented evidence on the amounts contract manufacturers should earn. Similarly, the taxpayer in Lilly presented evidence of arm's-length distribution prices and margins for Darvon while the IRS again pursued a contract manufacturer approach. If the Tax Court had made the key legal ruling prior to trial -- that is to say, whether section 482 allows the IRS to override seetion 351 transfers -- the issues, one way or another, would have been joined.(15) Trial could then have proceeded on a much smaller, more focused basis.

   Although the Lilly and Searle cases involved a legal issue that prevented joinder, the Sundstrand I case lacked joinder of issue owing to the IRS's failure to adopt and stick with a theory of the case. In that case, the IRS all but abandoned the contract manufacturer theory espoused in the notice of deficiency in favor of four distinct theories presented by its expert at trial. Each of these theories viewed the case as involving the provision of services by the offshore subsidiary, SunPac, or the sale of tangible goods by SunPac as a contract manufacturer with no intangibles. On brief, the IRS abandoned these theories in favor of a services theory under which the U.S. parent provided valuable services to SunPac. Not surprisingly, much...