01/15/2010 02:31:14 PM EST
An Uncertain Landscape: Xilinx, Stock Options, Cost Sharing, and the Arm's Length Standard
In a surprise move, the U.S. Court of Appeals for the Ninth Circuit has withdrawn the panel opinion it originally issued last May in Xilinx, Inc. v. Comm'r, 567 F.3d 482 (9th Cir. 2009). See Xilinx, Inc. v. Comm'r, 2010 U.S. App. LEXIS 778 (9th Cir. Jan. 13, 2010).
At issue in the case are a series of tax deficiencies assessed against Xilinx for Xilinx’ claim of business expense deductions for the exercise of stock options issued to its employees engaged in research and development activities by the IRS. The Service contended that, under Section 1.482-7 of the Income Tax Regulations, the company was obligated to share the cost of these employee stock options with its foreign subsidiary, Xilinx Ireland. By the terms of a cost sharing agreement entered into by parent and subsidiary, each party had agreed to pay a certain percentage of the total research and development costs, based on its respective anticipated benefits from the intangibles.
However, on first impression the Tax Court overruled the IRS: The Tax Court found that, in an arm's-length situation, unrelated parties would not allocate employee stock option costs in the manner determined by the Service. In a troubling 2-1 decision, the Ninth Circuit reversed, finding that, pursuant to the cost sharing regulations, as they existed, from 1997 through 1999, stock option costs must be included in those shared by participants in cost sharing arrangements. The court thoroughly rejected the IRS's position that it had acted consistently with the arm's-length standard. Nevertheless, the court held that the IRS is not required to follow the arm’s-length standard when defining costs that must be shared pursuant to the cost-sharing regulations.
In dissent, Judge Noonan correctly argued that Xilinx should not be required to include its stock options costs for three reasons:
At issue in the case are a series of tax deficiencies assessed against Xilinx for Xilinx’ claim of business expense deductions for the exercise of stock options issued to its employees engaged in research and development activities by the IRS. The Service contended that, under Section 1.482-7 of the Income Tax Regulations, the company was obligated to share the cost of these employee stock options with its foreign subsidiary, Xilinx Ireland. By the terms of a cost sharing agreement entered into by parent and subsidiary, each party had agreed to pay a certain percentage of the total research and development costs, based on its respective anticipated benefits from the intangibles. However, on first impression the Tax Court overruled the IRS: The Tax Court found that, in an arm's-length situation, unrelated parties would not allocate employee stock option costs in the manner determined by the Service. In a troubling 2-1 decision, the Ninth Circuit reversed, finding that, pursuant to the cost sharing regulations, as they existed, from 1997 through 1999, stock option costs must be included in those shared by participants in cost sharing arrangements. The court thoroughly rejected the IRS's position that it had acted consistently with the arm's-length standard. Nevertheless, the court held that the IRS is not required to follow the arm’s-length standard when defining costs that must be shared pursuant to the cost-sharing regulations. In dissent, Judge Noonan correctly argued that Xilinx should not be required to include its stock options costs for three reasons:
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First, the general purpose of the section 482 regulatory regime, tax parity between controlled and uncontrolled taxpayers, ought to control the interpretation and application of the cost sharing regulations.
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Second, and true to time-tested canons of statutory construction, regulatory ambiguities should be construed against the government and in favor of the taxpayer.
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Finally, the fact that the Treasury Department has interpreted the United States-Ireland tax treaty as having incorporated the arm’s-length standard, without any exception for stock options costs, must likewise inform the interpretation of the related tax regulations, which were also issued by Treasury.
Let’s hope the Ninth Circuit’s ambiguous actions yesterday, which have thrust the IRS and Xilinx into a state of uncertainty regarding the future of this important case, portends a future en banc hearing and the implementation of the dissent’s position. To do otherwise risks a significant departure from domestic tax law, international treaty obligations, and the settled expectations of U.S. companies and their foreign subsidiaries.