Whether the Treasury Department's regulation is arbitrary and capricious and thus invalid under the Administrative Procedure Act

QUESTIONS PRESENTED For nearly a century, federal tax treatment of agreements between related companies (such as parents and subsidiaries) has depended on the “arm’slength” standard: If unrelated companies operating at arm’s length would share a cost, then related companies must share the cost as well. 26 U.S.C. 482; 26 C.F.R. 1.482-1(b)(1). The United States has incorporated the arm’s-length standard into many tax treaties, and all major developed nations now follow it. In 2003, the Treasury Department promulgated a regulation, purporting to follow the arm’s-length standard, in which it required related companies to share the cost of stock-based employee compensation. 26 C.F.R. 1.482-7(d)(2) (2003). In a 15-0 decision, the Tax Court invalidated the regulation as arbitrary and capricious. On appeal, the government abandoned the arm’s-length standard and proposed a new rationale never advanced during the rulemaking process. A divided panel of the Ninth Circuit upheld the regulation as “permissible” and therefore entitled to deference under Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). The questions presented are: 1. Whether the Treasury Department’s regulation is arbitrary and capricious and thus invalid under the Administrative Procedure Act, 5 U.S.C. 551 et seq. 2. Whether, under SEC v. Chenery Corp., 332 U.S. 194 (1947), the regulation may be upheld on a rationale the agency never advanced during rulemaking. 3. Whether a procedurally defective regulation may be upheld under Chevron on the ground that the agency has offered a “permissible” interpretation of the statute in litigation.