Tax Court's Decision in Xilinx Affirmed by the Ninth Circuit Court of Appeals
In an en banc decision, the Ninth Circuit Court of Appeals, reversed its prior 2-1 panel decision, and affirmed the Tax Court's determination in Xilinx, 105 AFTR2d 2010-638 (3/22/ 2010), ruling that that under pre-2004 Regulations to section 482, employee stock options (ESOs) did not have to be included in the costs shared between related companies under a bona fide, cost-sharing arrangement (CSA).
The central issue in the case was whether, under the pre-2004 Regulations to section 482, related companies that engaged in a joint venture to develop intangible property must include the value of certain ESOs in the pool of costs to be shared under a CSA, regardless of whether companies operating at arm's length would fail to do so.
Xilinx, Inc., was engaged in researching, developing, manufacturing, marketing, and selling field programmable logic devices. During the tax years initially in issue (1996-1999) it was the parent corporation of a group of affiliated subsidiaries including Xilinx Ireland (XI). Xilinx and XI entered into a cost-sharing arrangement to develop intangibles. Each party was required to pay a percentage of the total research and development based on its respective anticipated benefits from the intangibles, and to share direct costs, which included salaries, bonuses and other payroll costs, indirect costs, and acquired intellectual property rights costs.
Under the plans, Xilinx offered incentive stock options (ISOs), nonstatutory stock options (NSOs), and employees stock purchase plans (ESPPs). All ISOs and NSOs were issued at prices that were at-the-money whereas ESPP purchase rights were issued with an exercise price equal to 85% of the stock's market price.The options generally were subject to a five-year vesting period.
In 1996, Xilinx and XI entered into an agreement permitting XI employees to acquire stock in Xilinx. The agreement required XI to pay Xilinx the cost associated with the exercise of the options. Cost equaled the stock's market price on the exercise date over the exercise price. During the years in issue, generally accepted accounting principles (Accounting Principles Board Opinion 25 (APB 25)), required that the issuing company not incur expense related to options granted at-the-money.
After auditing the group’s return, the IRS issued notices of deficiency under the cost-sharing regulations, i.e., Treas. Reg. 1.482-7(d) , that the spread (stock's market price over exercise price on exercise date), or the grant date value, relating to compensatory stock options, should have been included as a research and development cost. Under the Service’s approach, Xilinx’s taxable income was substantially increased.
The Tax Court Sides with the Petitioner
The Tax Court, 125 TC 37 (2005), rejected the IRS’s interpretation under Treas. Reg. §1.482-7(d) by holding that such analysis violated the arm’s length standard under Treas. Reg. §1.482-1(b) where it was uncontroverted that unrelated parties would not explicity share such amounts. The IRS was attempting to circumvent the arm's length standard, arguing that Treas. Reg. §1.482-7's application automatically produced the required arm's length result was in its view disingenuous and erroneous in light of Treas. Reg. §1.482-1(b)’s explicit language and history. Thus, the IRS's reallocation was arbitrary and capricious. In contrast, taxpayers' allocation, excluding any ESO-related costs from research and development expenses, satisfied the arm's length standard and was upheld. Accordingly, it held that IRS's allocations were arbitrary and capricious and that Xilinx's allocations met the arm's-length standard mandated by Treas. Reg. 1.482-1(b) .
The Ninth Circuit’s Panel Decision Reverses
In May 2009, the Ninth Circuit reversed the Tax Court, 2-1 (Judges Fisher and Reinhardt in the majority, Judge Noonan in dissent). However, Xilinx’s requesting for rehearing en banc was granted and the panel decision was withdrawn in January, 2010.
The en banc decision reversed the panel’s conclusion . In the March 2010 decision by a three-judge panel of the Ninth Circuit, Judge Raymond Fisher, who wrote the court's 2009 opinion, changed his mind. On the second try, Judge Fisher noted that while Xilinx viewed Treas. Regs. §§1.482-1(b)(1) and 1.482-7(d)(1) as irreconcilable, the IRS interpreted Treas.Reg. §1.482-7(d)(1) 's “all costs” requirement as consistent with Treas.Reg. §1.482-7(b)(1) 's arm's-length standard. In other words, the more narrowly drawn specifics contained in the CSA regulation should be controlling.
The Ninth Circuit disagreed and concluded that the taxpayer’s position that Treas. Reg. §1.482-1(b) was controlling where another part the of the regulations appeared to be in conflict. This was based on analyzing the legislative history of §482, the drafting history of the regulations, and authoritative comments under various tax treaties. Judge Noonan, who wrote the new opinion, held that where the two Regulations were "hopelessly ambiguous" and that the ambiguity should be resolved in light of the commonly held understanding of the arm's-length standard prior to the case's litigation. If the standard of arm's length is trumped by [Treas. Reg. §1.482-]7(d)(1), the Ninth Circuit opined that the purpose of the statute is frustrated." "If Xilinx cannot deduct all its stock option costs, Xilinx does not have tax parity with an independent taxpayer."
Noonan also noted that with respect to the Ireland-U.S. income tax treaty , "[i]t is enough that our foreign treaty partners and responsible negotiators in the Treasury thought that arm's length should function as the readily understandable international measure."
