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

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").

A. 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.

B. 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 of the trial record and testimony was directed at issues and theories raised, argued and abandoned by the IRS. As Judge Hamblen noted, the record was inundated with "an inordinate amount of useless information while other important information is nowhere to be found."(16) Judge Hamblen then stated the type of evidence that the IRS should have introduced if the issues had been narrowed and properly joined.(17) If the trial had focused upon these items of proof, the scope of the trial and trial record would have been significantly reduced.

The Perkin-Elmer case, in contrast, is an example of a recent case where the court and the parties were able effectively to narrow and join the issues for trial. The facts are similar to Sundstrand I. PECC, a Puerto Rican subsidiary, manufactured scientific instruments under a license from its U.S. parent ("P-E"), using parts purchased from P-E. PECC then sold the completed instruments to P-E for resale worldwide. In the notice of deficiency and initially at trial, the IRS advanced a consignment contract manufacturer theory and allowed PECC a small profit markup only on labor and overhead. As a backup position, the IRS adopted a resale price approach for the sale of instruments, a comparable transaction approach for the royalty, and a putative cost-plus method for the parts sold to PECC. The taxpayer posited a resale price/comparable royalty/comparable uncontrolled transaction approach for the instruments, royalties, and parts. Prior to trial, the IRS abandoned its contract manufacturer approach. Further, the parties stipulated to a comparable royalty transaction, leaving only the resale price margin on instruments and the price of the parts in issue.

Because of the narrowing and joinder of issues, the actual trial in Perkin-Elmer proceeded far more quickly than anticipated by the parties, consuming only nine days of trial time over a three-week period. To further narrow and join the issues, Judge Tannenwald limited the parties to 150 cumulative pages for both the primary brief and the reply brief, which forced the parties to focus on the important facts and arguments. As noted earlier, the case proceeded through discovery to trial in less than two years. Final briefs were filed in June 1992, and a decision is still pending.

2. The Trend Toward Ambiguous Notices of Deficiency

In section 482 cases, the taxpayer carries a dual burden. First, the taxpayer must prove that the IRS's assessment was arbitrary, capricious, and unreasonable.(18) In other words, the taxpayer must first prove by a preponderance of the evidence that the IRS abused its discretion in determining the amount of the deficiency.(19) Second, even if a taxpayer can show that the IRS acted arbitrarily, capriciously and unreasonably, the taxpayer will still lose its case unless the taxpayer can also show affirmatively that its intercompany transactions were conducted at arm's length.(20) The taxpayer must establish the arm's-length nature of its prices and royalties by a preponderance of the evidence.

Despite the clear need to narrow and join the issues, the IRS' practice in issuing section 482 notices of deficiency appears to be to state the rationale for the adjustment as ambiguously as possible. The following description of the basis for multi-million dollar allocations of income is typical:(21)

During the taxable year, you engaged in transactions

with related entities. An income allocation of

$XXX million is being made pursuant to section

482.

The IRS takes the position that the determinations set forth in the notice of deficiency are not arbitrary and capricious so long as any theory advanced by it at any time justifies the amount of the deficiency. Further, the IRS avers that the inquiry into the Commissioner's actions should take into account only the notice of deficiency and not the underlying actions, factual findings, and reasoning of the agents upon audit.(22)

A full analysis of the propriety of the IRS position is beyond the scope of this article, but the IRS position can be thought of as the "Dart Board Theory of Section 482." Under the IRS view, the agent could throw a dart at a board of numbers and determine the income allocation based upon the number hit by the dart. According to the IRS, this method of determining the income allocation would not be arbitrary or capricious so long as an IRS counsel or an expert witness could later craft a theory supporting the income allocation originally determined by a throw of the dart.

Obviously, using a dart board to determine income allocations is arbitrary and capricious despite the fact that a later analysis suggests that the throw of the dart fortuitously picked the right number. What the IRS dart board approach fails to consider is the dual burdens carried by the taxpayer: the taxpayer must prove both (a) that the IRS abused its discretion, and (b) the amount of an arm's-length price or royalty. A supporting economic theory developed on the eve of trial is irrelevant to whether the agent's use of a dart board to determine the allocation was arbitrary. The IRS trial expert report is properly relevant, however, to the second proposition that must be proved by the taxpayer, the establishment of an arm's-length price or royalty.

Logically, whether the original allocation of income was an abuse of discretion must turn upon the actions of the agents and the factual findings and reasoning employed in arriving at the notice of deficiency. In order to clarify the issues, the Tax Court should focus the issue of arbitrariness upon the facts, events, and knowledge in existence at the time of the notice of deficiency. As the courts in all of the more recent section 482 cases have recognized, this determination must, by definition, "go behind the notice of deficiency" in order be resolved.(23) Alternative litigating positions advocated by the IRS should properly be considered in determining whether the taxpayer has proved the arm's-length prices by a preponderance of the evidence.

3. The Need to Join the Issues As Early As Possible

Issues must be narrowed and joined in order for meaningful settlement discussions and efficient administration and trial of section 482 cases to occur. In most cases, however, the IRS has resisted disclosure of its position until immediately before trial on the basis that its trial expert has not yet told the IRS what its position should be.(24) The failure to narrow and join the issues has a number of bad effects upon the administration and trial of the case.

First, generic notices of deficiency are unlikely to promote settlement of section 482 cases either before or after docketing in Tax Court.

Second, the failure of the IRS to articulate a position precludes the taxpayer from effectively preparing a response to the IRS case. In a multi-million dollar case involving thousands of transactions and millions of documents, fundamental fairness requires that the taxpayer be given adequate notice of the IRS position and time to prepare its response.

Third, the failure to narrow the issues in dispute spawns unbridled discovery. As discussed in the next section, discovery in Tax Court litigation is almost entirely one-sided in favor of the IRS. The failure to narrow and join the issues licenses the IRS to use discovery as a fishing expedition.

Fourth, the failure to identify the parties' theory of the case results in over-inclusive stipulations of fact that are often full of essentially worthless materials. These stipulations become distended with this non-essential information and exhibits because (a) the IRS does not know what it wants or needs in the trial record to support its theory of the case, and (b) the taxpayer must protect itself against every possible position that could be taken by the IRS.

Under new IRS procedures, the government attorney who will try a section 482 case is the attorney who reviews the notice of deficiency. This procedure means that the attorney who will answer the petition has notice of the issues in the case and access to the administrative file at least five months before an answer is due. With the regular participation of District Counsel in section 482 audits, counsel has generally had the opportunity to sculpt the development of the case long before any notice of deficiency is ever issued. With this recognition, the Tax Court should require the IRS to state its theory of the case either at the time of the answer or shortly thereafter but prior to discovery.

The Federal Rules of Civil Procedure(25) encourage the use of a discovery conference under Federal Rule of Civil Procedure 26(f) to require identification of each party's theory of the case, to review each party's discovery plan, and to lay out the preliminary schedule for trial. The Tax Court should similarly take advantage of discovery conferences in order to force both sides to identify their respective theories of the case and to lay out their proposed discovery schedules.

C. Focusing Discovery

1. The Tremendous Cost of Discovery

Both the Federal Rules of Civil Procedure and the Tax Court Rules seek to give parties access to as much information and as many documents as possible as long as the information and documents might lead to the discovery of admissible evidence and are not privileged from disclosure. Thus, the basic presumption is that parties are entitled to any documents or information that they deem necessary.

Academics, trial lawyers, and judges have engaged in a continuing debate over the years on the wisdom, merits, and cost of this policy of "wide open" discovery. The debate, while outside the scope of this article, generally involves the proper balance to be drawn between the need for access to information in order to avoid "trial by ambush" and the costs and burden of discovery upon the responding party. Balancing the need for discovery against the burden on the responding party is left to the sound discretion of the trial judge. If necessary, the trial judge has the ability to issue protective orders to protect a party against excessive discovery requests.

As a general matter, in complex commercial litigation there is a very straightforward set of informal checks and balances to protect against overly burdensome discovery: if one party issues a particularly burdensome set of requests, the receiving party is likely to respond in kind with a similar set of discovery requests. Even with this uneasy detente, the number and contentiousness of discovery disputes in commercial litigation are legion.

In section 482 litigation, this informal set of checks and balances is not present because the IRS has relatively little information that would be useful to the taxpayer. The overwhelming bulk of the relevant information is in the control of the taxpayer or, to a lesser degree, third parties. Thus, discovery in Tax Court section 482 cases is decidedly one-way in nature: the IRS does virtually all of the propounding of the discovery requests while the taxpayer takes virtually all of the pounding in receiving and responding to discovery requests.

Discovery is the single most expensive aspect of trying a section 482 case from the taxpayer's point of view. The costs attendant to discovery cannot be overstated either in terms of the explicit costs of lawyer time, outside accounting assistance, and other related expenses such as photocopying charges. In a large section 482 case, these explicit costs of discovery can easily exceed $1 million. As for the implicit costs of management time, effort, and distraction, discovery is without question the aspect of section 482 litigation that requires the most interaction by management. The taxpayer's costs of preparing and trying its own case pale by comparison to the costs of responding to IRS discovery requests.

2. Focusing Discovery by Narrowing and Joining Issues

Because of the fact-intensive nature of section 482 cases, the taxpayer's possession or control over most of the relevant facts, and the policy of wide open discovery embodied in the Tax Court Rules, it is a fact of life in section 482 cases that discovery will be a burdensome and expensive proposition for taxpayers. It is not unusual for IRS discovery requests to seek literally millions of pages of documentation scattered throughout the world from the taxpayer and for the IRS to issue a thousand or more detailed interrogatories seeking information from the taxpayer. In the first Sundstrand case, for example, the taxpayer produced over a million pages of documentation. In the second Sundstrand case, by the time discovery closed, the taxpayer had produced more than two million pages of documentation. In Perkin-Elmer, the taxpayer similarly produced roughly two million pages of documentation. The document productions in these cases were in addition to hundreds of pages of responses to IRS interrogatories and the totals do not take into account information and documents provided during the audit and at Appeals. Needless to say, only the tiniest fraction of these documents were actually ever reviewed by the IRS or used in the cases.(26)

The problem with discovery in section 482 cases is twofold. First, because the IRS has little information the taxpayer wants or needs, the IRS can issue burdensome discovery requests safe in the knowledge that the taxpayer cannot respond in kind. Thus, there is no "cost" to the IRS of issuing discovery requests. Second, unless the issues in the case are narrowed and joined, virtually every scrap of paper produced or received by the taxpayer is likely to meet the extremely low relevancy standard governing discovery. Every invoice of every sale by the taxpayer, for example, is potentially discoverable in a pricing case because it is either directly relevant or may lead to the discovery of admissible evidence. Similarly, all of the taxpayer's dealings with outside suppliers may be relevant to the case (e.g., all purchase orders, acknowledgements, contracts, requests for quotations, proposals, negotiation documents, invoices, shipping documents, quality records, and internal memoranda evaluating sources of supply) and therefore discoverable. All communications between the taxpayer and its customers are generally discoverable. All maternal memoranda, documents, and other communication relating to product development may be relevant to a royalty issue. Even such documents relating to products not developed may be relevant. Similar requests can be (and are regularly) made with respect to every aspect of the taxpayer's business and operations.

Even in cases where the issues are narrowed and joined, section 482 discovery is a massive undertaking. If the issues are not narrowed and joined prior to discovery, that undertaking will constitute a nightmarish fishing expedition by the IRS. The court can use discovery conferences early in the case to both narrow and join the issues and require parties to identify their proposed discovery schedules.

Routinely, the IRS argues that it cannot identify its theory of the case until discovery is completed. This IRS position is nothing more than a request for a license to fish at the taxpayer's expense and turns the discovery and trial process on its head. Large section 482 cases generally get to the Tax Court only after the IRS has had an opportunity through the audit process to use its administrative discovery tools to gather information and to develop its position. Presumably, this position -- developed after reasonable factual and legal inquiry -- forms the basis for the statutory notice. If, as the IRS often asserts, it has no position until after discovery in Tax Court is concluded, then the IRS position in the notice must, by definition, be arbitrary. Moreover, if the IRS cannot state its current rationale (if different from the notice of deficiency) for being in court, then the expense and burden of the litigation should not be forced upon either the taxpayer or the Tax Court.

The simple fact of the matter is that case analysis and the development of a party's theory of the case is a difficult, time-consuming, and wrenching process. The discipline required by such a case analysis, however, forces a party to consider early on its reason for being in court, its theory of the case, the facts it must prove at trial to prevail, the method of proof that it must use, the types of information and documents needed, the witnesses (or type of witnesses) that it must call, the stipulations that it would like prior to trial, and -- importantly for this discussion -- the discovery that it must seek from the other party in order to prepare its case. This is precisely the type of mental process the Tax Court should require the IRS and the taxpayer to perform before discovery ever begins. See, e.g., Federal Rule of Civil Procedure 26(f) (requiring parties to provide detailed information in early discovery conference on theory of case, discovery required, and timetable for discovery).

Even if the Tax Court narrows and joins the issues and thereby focuses discovery, discovery in section 482 cases will remain burdensome and expensive to taxpayers. At a minimum, fundamental fairness and the need to conserve both judicial and taxpayer resources mandate that the IRS be forced to think through its case, to disclose its position, and to give advance notice of the discovery that it will seek.

3. Other Discovery Suggestions

In its discovery requests, the IRS routinely asks for what Judge Tannenwald termed in Perkin-Elmer "kitchen-sink discovery." That is to say, the IRS will ask for "each and every" and "any and all" of everything available in the broadest manner possible. Inevitably, the IRS requests overlap to the point that any given document may be responsive to numerous discovery requests. Moreover, owing to the broad wording of the request, the taxpayer is forced to attempt to ascertain what IRS counsel meant or thought when propounding the request.

Good practice dictates that discovery requests be drafted to leave no doubt about what documents are being sought. Unfortunately, the IRS is not generally willing to narrow its requests, presumably because counsel is afraid that the taxpayer will take advantage of the narrower request to avoid producing a smoking gun. When the taxpayer refuses to comply with the over-broad request until narrowed, the IRS seeks to compel discovery. Typically, the IRS narrows its requests only on the courthouse steps (or literally in one of the Tax Court conference rooms to which the judge banishes the parties until agreement on the scope of the request is reached).

The Tax Court should make it clear to both parties that over-broad requests will not be enforced. This position would require parties to think through their discovery requests before issuance. Further, the Tax Court should encourage parties to get the court involved sooner rather than later in discovery disputes. Often a timely word from the judge can head off a discovery impasse that would otherwise result in lengthy motions, briefs, and court hearings over detailed and voluminous discovery requests.

Under Federal Rule of Civil Procedure 34(a)(1) and Tax Court Rule 72(a)(1), a responding party's obligation in response to a production request is to make the document available for inspection and copying or to produce a copy of the document. Under these rules, each party was intended to bear its own discovery costs. Thus, the requesting party must arrange to copy the documents at its own expense. Alternatively, the producing party can provide the copies at the requesting party's expense. This practice of making the requesting party bear copying costs is standard in the federal district courts. In the Tax Court, however, the production costs are imposed upon the producing party (i.e., the taxpayer). Given the one-way nature of Tax Court discovery, imposition of copying costs upon the IRS is both fair and a potential, albeit limited, means of causing the IRS to consider carefully the scope of its discovery requests. This practice was adopted recently by Chief Judge Hamblen in the strand II litigation.

D. The Use of Experts

1. The Proper Role of Expert Testimony 

As in other types of complex litigation, th experts in section 482 cases has expanded dramatically. It is not unusual for the parties to present the testimony of five or more experts, and in some cases the number has been far higher. In the Seagate case, the IRS alone used a dozen expert witnesses. In the Yamaha case (which was scheduled for trial in January 1993), the IRS identified 11 expert witnesses and the taxpayer identified 6 expert witnesses.

At the same time that the parties are increasing the number of experts used, the Tax Court's willingness to accept the testimony of experts has declined, perhaps because of the court's concerns over the credibility of expert witnesses. See, e.g., Sundstrand I, 96 T.C. at 371.

The explosion in the use and reliance upon experts in section 482 litigation has had several important consequences. First, the increased use of experts has had the tendency to abstract the issues away from the ascertainable facts and circumstances and toward a more complex, theoretical hypothesis of how income should be distributed between related parties. This abstraction of the issues away from a common-sense approach to the arm's-length standard may not be entirely helpful to the court but rather may serve to confuse and cloud the issues. See, e.g., Federal Rule of Evidence 702 (standard for admissibility of expert testimony is whether the testimony will be helpful to the trier of fact). This is not to say that experts are not necessary and useful -- they clearly are when used for narrow and defined roles.

Second, experts are being used in lieu of (or in spite of) the actual facts of the individual cases. Rather, experts should be used to interpret or explain the facts of the case. As in building a house, the facts serve as the bricks whereas expert testimony serves as mortar to fill in the gaps and to hold the facts together.

Third, even more disturbing, some IRS attorneys have seemingly abdicated their roles as trial lawyers in terms of case development and theory of the case. Rather than hiring experts to satisfy a specific need in its theory of the case, the IRS appears to hire experts to develop the theory of the case. Having done this, the IRS attorneys resist discovery of the IRS theory of the case until expert reports have been issued 30 days prior to trial. This late disclosure precludes discovery by the taxpayer and makes meaningful development of a rebuttal case all but impossible.

In the Yamaha litigation, Judge Cohen faced this very situation when the IRS adopted a new theory in its expert reports. The Yamaha case had been docketed for nearly four and a half years before the IRS's new theory of the case was unveiled. Judge Cohen allowed the IRS to amend its answer to conform to the new theory, but shifted the burden of proof to the IRS on all allegations set forth in the amended Answer. Judge Cohen explained her ruling:

Taken together, these two rules permit the Court to

make appropriate orders determining the burden of

proof and conditioning leave to amend in an appropriate

manner consistent with the interest of justice.

A major consideration in acting on motions for

leave to amend is prejudice to the opposing party.

Another consideration is undue burden on the

Court. Although petitioners do not directly allege 

that they would be prejudiced if respondent's motion

were granted, petitioners' recitation of the history

of contentions and pleadings in this case compels

agreement with their conclusion that "Respondent

should not be permitted to continually redefine 

the scope of Petitioners' burden of proof by

forcing Petitioners to shoot at a constantly moving

(and often unidentifiable) target." That conclusion

identifies the prejudice to petitioners as well as the

result that the Court has continuously tried to avoid

over the last several years. Yamaha Motor Corp., USA & Subsidiaries v. Commissioner, Tax Ct. Dkt. No. 2674-88 (Oct. 29, 1992) (order granting leave to file Second Amended Answer and shifting the burden of proof) (citations omitted). Although the new IRS theory of the case did change some of the amounts in dispute, Judge Cohen made it clear that her ruling was based upon a new theory of the case and not a change in the amount in dispute:

In this instance, it is the analytical approach and

not the dollar change that is significant in determining

fairness in allocating the burden of proof

and justice in allowing a Second Amendment to

Answer.

This ruling by Judge Cohen may be a harbinger of things to come. Judge Cohen's ruling reflects the court's recognition that it must take steps to bring about the joinder of issue in these complex factual cases. Shifting the burden of proof under these circumstances may cause the IRS to focus its position at an earlier time or to run the risk of bearing the burden of proof. Subsequent to Judge Cohen's ruling, the trial of the Yamaha case was postponed and the matter was referred to competent authority for resolution.

Finally, if meaningful settlement is to occur, both parties must understand the merits of both parties' positions. The IRS development of its theory of the case on the eve of trial in its expert reports delays meaningful settlement to a point where the case may have developed an inertia of its own that precludes settlement. Although use of an expert in a consulting role to develop a theory of the case is certainly defensible, that step should be taken and a theory developed at the very outset of the litigation. Unless the issues are narrowed and joined before discovery, the trial and administration of section 482 cases cannot be efficiently handled.

2. Timing of Expert Report Disclosure and Discovery

Unless the judge orders to the contrary, expert reports are not required to be filed under Tax Court Rule 143(f) until 30 days prior to trial. This disclosure date occurs after discovery has ended and provides little time to prepare an effective rebuttal. Although Tax Court Rule 76 has been liberalized to provide for expert depositions in complex cases such as section 482 cases, Tax Court Rule 76(c) provides for the expert deposition to be taken within the time for completion of discovery. If the report is not issued until 30 days prior to trial, then as a technical matter the time for discovery will have closed and as a pragmatic matter the ability to depose the expert will be greatly diminished owing to the exigencies of trial preparation. Alternatively, the expert deposition would have to be taken during the discovery period prior to the issuance of the expert report -- clearly an unsatisfactory option.

In the current Yamaha litigation, Judge Cohen has adopted a common-sense approach to the timing of expert reports and expert depositions. In that case, expert reports were required to be filed in August 1992, five months prior to trial. Expert depositions were taken in early fall. Rebuttal expert reports were due in November 1992, two months prior to trial.

As Judge Cohen has done in Yamaha, the Tax Court should require expert reports to be issued well in advance of trial. Depositions and other expert discovery should then occur, with rebuttal reports required at least two months prior to trial. Rebuttal expert depositions should then be available prior to trial. Although expert depositions require a court order under Tax Court Rule 76, the Tax Court should adopt a practice of freely allowing expert depositions. By granting this expert discovery, the Tax Court will cause the issues to be more effectively joined, eliminate surprise at trial, allow the parties to better prepare for the expert testimony, and prevent experts from waffling at trial.

3. Resisting the Temptation to Second-Guess Expert Testimony

In the typical section 482 case, if the court finds the notice of deficiency to be arbitrary, the court then reviews the parties' positions to determine an arm's-length price or royalty. In most cases, the court has rejected the specific arm's-length price advocated by each party in favor of its own analysis. Without question, the Tax Court has this authority to substitute its own judgment for that of the parties before it.

In so substituting the court's judgment, however, the Tax Court has inadvertently given the impression to taxpayers and the IRS that whatever positions they take, the court will split the baby in a Solomonic judgment. This perception of the court's tendency to split the difference gives the parties the incentive to take the most extreme supportable positions they can muster in order to get the best possible result when the difference is split. In turn, by taking more extreme positions, the parties reduce the likelihood of settlement prior to trial. Further, because the parties may have taken extreme positions, the Tax Court then has good grounds to feel that a middle position is more appropriate. This splitting of the difference reinforces the parties' perceptions and the cycle repeats itself.

If, in contrast, the Tax Court made it clear to the parties that it would not second-guess the expert testimony or the parties' positions but rather would adopt the more reasonable position, the Tax Court could create a significant incentive to the parties to take the most reasonable position possible.(27) The taking of more reasonable positions, in turn, would narrow the issues and the amount in dispute and promote settlement in advance of trial. Further, if the parties take more reasonable positions at trial, those positions should ease the court's task of deciding the case far easier and make the court more comfortable with adopting one of the parties' positions rather than undertaking its own analysis. Adoption by the court of one party's position would then reinforce the incentive for future parties to take reasonable positions.

The cost of implementing such an approach is that the Tax Court may feel that a "perfect" result will not be achieved in any given case. Because of the nature of the arm's-length standard, however, it is unlikely that a "perfect" result ever truly exists. Further, adoption of one party's position is entirely consistent with our adversary system of litigation. The litigants can hardly complain if the Tax Court refuses to bail them out of an unreasonable position. The benefits to the administration and trial of the section 482 cases generally would appear substantially to outweigh the loss of precision in any particular section 482 result.

The court's recent decision in Westreco may be a step in this direction. In Westreco, Inc. v. Commissioner, 64 T.C.M. (CCH) 849 (September 23, 1992), Westreco performed research and development services in the United States for Nestec, its Swiss parent corporation, in return for a fee equal to Westreco's costs plus a markup of 3.5 percent to 7.5 percent. The IRS allocated additional service fee income to Westreco from Nestec under section 482 by increasing the service fees to three times Westreco's total salaries. At trial, the IRS expert reports supported a new analysis based on the financial performance of 15 "comparable" companies that was apparently based on the "comparable profit method" under the proposed section 482 regulations. The court rejected both IRS approaches and refused to uphold any portion of the income allocations. Westreco thus stands as an example of a very recent case in which the court refused to split the difference.

E. Conclusion

In order for the parties and the Tax Court to cope effectively with the flood of section 482 litigation, the parties and the court must work together to narrow and join the issues early in the case. Effective joinder of issue will permit discovery to be better focused, thus conserving judicial and taxpayer resources. If issues are joined early and discovery is focused, expert reports can be issued earlier in the trial process, allowing the issues to be further narrowed. This process of narrowing and joining the issues should substantially reduce the number of contested section 482 cases.

Notes

(1) E.g., Wall Street Journal, Sept. 30, 1992, at Al, col. 5 (reporting Westreco decision); Wall Street Journal, Feb. 27, 1991, at Al, col. 5 (reporting Sundstrand I decision). (2) DuPont de Nemours & Co. v. Commissioner, 608 F.2d 445, 462 (Ct. Cl. 1979) (Nichols, J., concurring), cert. denied, 445 U.S. 962 (1980). (3) H.R. Rep. No. 101-881, 101st Cong., 2d Sess. 315 (1990). (4) United States Steel Corp. u. Commissioner, 617 F.2d 942 (2d Cir. 1980); Eli Lilly & Co. v. Commissioner, 856 F.2d 855 (7th Cir. 1988), aff'g in part, rev'g in part, and rem'g in part, 84 T.C. 996 (1985); G.D. Searle & Co. v. Commissioner, 88 T.C. 252 (1987); Ciba-Geigy Corp. v. Commissioner, 85 T.C. 172 (1985), action on decision, CC-1987-021 (Oct. 26, 1987); Nissho-Iwai American Corp. v. Commissioner, 50 T.C.M. (CCH) 1483 (1985); Bausch & Lomb, Inc. v. Commissioner, 933 F.2d 1084 (2d Cir. 1991); Sundstrand Corp. v. Commissioner, 96 T.C. 226 (1991) (Sundstrand I); Westreco, Inc. u. Commissioner, 64 T.C.M. (CCH) 849 (1992). (5) The 1986 Act amended section 482 to adopt the commensurate with income standard for the transfer of intangible assets. Pub. L. No. 99-54, SS 1231(e)(1), 100 Stat. 2085, 2562-63 (Oct. 22, 1986). (6) See I.R.C. SS 6503(k) (designated summons and ability to extend the statute of limitations unilaterally); SS 6662 (accuracy-related penalties for valuation misstatements in section 482 cases); SSSS 603 A and 6038C (substantial record maintenance and creation requirements and severe penalties for non-compliance). (7) In addition, the IRS greatly expanded the number of international special trial counsel available to assist in these audits and ultimately in the resulting litigation. (8) Treasury Department White Paper on Section 482 (Oct. 18, 1988); Proposed Regulations Under Section 482 (Jan. 30, 1992). (9) These caseload statistics are based on remarks by Tax Court Chief Judge Lapsley W Hamblen, Jr. and IRS Chief Counsel Abraham N. M. Shashy at the American Bar Association Annual Meeting in San Francisco on August 7, 1992. Chief Judge Hamblen and Chief Counsel Shashy commented during a panel discussion with the authors on the administration and trial of section 482 cases. ABA Tax Section, Affiliated and Related Corporations Committee, Trial and Administration of Section 482 Cases in the Nineties: Perspectives of the Bench and Bar (Aug. 9, 1992). (10) Id. Currently, there are 249 section 482 cases in Appeals, of which 74 are docketed and 175 are undocketed. (11) These figures are also based upon Chief Judge Hamblen's remarks at the ABA Annual Meeting in August 1992. See note 9 supra. Chief Counsel Shashy estimated the section 482 inventory at $13.1 billion. (12) For example, Lilly involved the 1971-73 taxable years, was tried in 1981, was decided by the Tax Court in 1985, was reversed in part, affirmed in part and remanded in part by the Seventh Circuit in 1988, and was finally settled prior to re-trial on remand to the Tax Court in 1989. Similarly, Sundstrand I involved the 1977-78 taxable years, was tried in 1987, and was decided in 1991. The Tax Court has recently adopted internal procedures that are designed to expedite the trial of its caseload, including section 482 cases. These procedures appear to be working: The Perkin-Elmer Corp. v. Commissioner, Tax Ct. Dkt. No. 28860-89 (tried Aug. 19, 1991 through Sept. 4, 1991), although involving the 1975-1981 taxable years, was docketed with the Tax Court in November 1989 and was tried in August 1991, within 20 months of docketing. A decision in the Perkin-Elmer case is still pending. (13) For example, the Lilly opinion was issued by the Tax Court four years after trial; the Searle opinion was issued by the Tax Court five years after trial; and the Sundstrand I opinion was issued more than three years after trial. (14) All legal questions, unless dependent upon issues of fact, should be resolved prior to trial. In other words, the parties should understand what the court's decision will be if certain facts are proved to be true and, conversely, what the court's decision will be if those facts are not ultimately proven. (15) Moreover, if the Tax Court thought that there was a significant likelihood that its ruling would be challenged on appeal, the court could have certified its interlocutory ruling for immediate appeal under Tax Court Rule 193(a). (16) Sundstrand I, 96 T.C. at 374-75. (17) Id. at 375. (18) E.g., Sundstrand I, 96 T.C. at 353. (19) Id. (20) Id. at 354. (21) The IRS approach of issuing ambiguous section 482 notices is not new: the notice in Lufkin Foundry & Mach. Co. u. Commissioner, 468 F.2d 805 (5th Cir.), reh'g denied per curiam, 72-2 U.S. Tax Cas. (CCH) [paragraph] 9744 (5th Cir. 1972), stated that the adjustments were proposed "under the internal revenue laws of the United States." (21) The IRS generally supports this contention by reference to Greenberg's Express, Inc. v. Commissioner, 62 T.C. 324, 327-28 (1974). (23) E.g., Sundstrand I, 96 T.C. at 355-58. (24) E.g., Sundstrand 1; Perkin-Elmer; Yamaha Motor Corp. U.S.A. v. Commissioner, Tax Ct. Dkt. No. 2674-88 (trial scheduled Jan. 19, 1992). The IRS's use of experts in this manner is discussed in the section on the use of experts. (25) The Tax Court Rules incorporate and draw upon the Federal Rules of Civil Procedure to the extent that the Federal Rules are "suitably adaptable" to Tax Court proceedings. Tax Court Rule 1(a). (26) In a recent case, cartons of documents produced in discovery were returned unopened to the taxpayer after the case was settled. (27) This mode of outcome determination is similar to "baseball style" arbitration in which the arbitrator is required to adopt one of the parties' positions, which in turn provides a significant incentive for the parties to narrow their differences and settle their disputes. Baseball-style arbitration was adopted by the parties in the current Apple arbitration. (*) This article is based upon materials prepared for a panel presentation entitled "Resolution of International Tax Disputes In and Out of Court" at Tax Executives Institute's 47th Annual Conference, which was held in San Diego in November 1992. The authors gratefully acknowledge the wisdom and insights of Tax Court Senior Judge Arthur L. Nims, Jr., who participated on the panel. Any errors or omissions are solely the responsiblity of the authors. (**) Footnotes are printed on page 43.