The Even More Curious Case of Xilinx, Inc. v. Commissioner and the Future of Transfer Pricing

Editor's Note: The Ninth Circuit's revised opinion of March 22, 2010 agrees with the Tax Court's finding that the cost of employee stock options should not be included as a shared cost in a transaction governed by arm's length principles.  Previously, the court's decision of May 27, 2009 (Xilinx, Inc. v. Comm'r, 567 F.3d 482 (9th Cir. 2009)had been withdrawn by the court without comment. Xilinx, Inc. v. Comm'r, 2010 U.S. App. LEXIS 778 (9th Cir. Cal. Jan. 13, 2010). The Commissioner had contended that employee stock options issued to employees involved in research and development activities were costs that should have been shared between the taxpayer and its foreign subsidiary.  

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On May 27, 2009, the Ninth Circuit issued its original opinion in Xilinx, Inc. v. Comm'r (567 F3d 382 (9th Cir 2009), reversing the Tax Court. On January 13, 2010, the court withdrew the opinion. The other shoe dropped on March 22, 2010, when the court issued its revised opinion (2010 U.S. App. LEXIS 5795), this time affirming the Tax Court's conclusion that the Service had acted arbitrarily.

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Arm's Length Concept. [T]he arm's length standard... requires all related taxpayers that engage in commercial activity with one another to do so using an arm's length approach. Thus, the U.S. multinational corporation that has a foreign manufacturing subsidiary from which the parent buys inventory for resale is required to pay that subsidiary an arm's length price for the inventory...

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The Background of Xilinx. Xilinx is in the computer software business.. [with major] research and development... expenditures... Xilinx created an Irish subsidiary to conduct a good deal of that R&D. The parent and its subsidiary entered into a cost sharing agreement, applying Treas. Reg. Section 1.482-7(a)(2), under which the parties are to share the benefits of the R&D in proportion to their respective costs...

Xilinx did not treat... ESOs [employee stock options given to employees working in R&D] as a "cost" for purposes of the cost sharing agreement. The Internal Revenue Service challenged that position, claiming that the Irish subsidiary should have shared in the costs of ESOs granted to both the parent and the subsidiary's employees who worked on R&D matters...

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The Law. Both IRC Section 482 and Treas. Reg. Section 1.482-1(b)(1) apply the arm's length standard, the latter stating: “. . . the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer.” (italics added)

Contrast that regulation with the regulation dealing with cost sharing agreements (Treas. Reg. Section 1.482-7A(d)(1)) which provides that participants in a cost sharing arrangement are to allocate all costs of developing the intangible.

The Problem. The parties agreed (and the Tax Court found as a fact) that unrelated persons entering into a cost sharing arrangement would not include the cost of employee stock options as a “cost.” Since the arm's length principle would require related parties to only share costs that unrelated parties would share, that principle dictates that ESOs should not be included as a shared cost.

Comment on the 2010 Decision. The two regulations are certainly irreconcilable. Given that, one does wonder why the government did not meet that conflict between the two regulations head on and state that the "all cost" regulation is a divergence from the general arm's length standard, but that Treasury is authorized to take that action. That position may not have carried the day, but it woud have been far more difficult for the panel to hold that Treasury is not authorized to make small in-roads on the arm's length principle than to try to convince the court that an obvious conflict really did not exist.

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Is Transfer Pricing Dead? The answer is no, but it is headed for significant limitation, if not oblivion. The reason is that transfer pricing does not work. In addition to not working, transfer pricing policy imposes significant costs on both the business community and the governments that attempt to enforce that policy throughout the first world and does not carry any commensurate benefit.

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Is there a better way? Well, certainly there is another way—a way that, in our view, is a better way. That way falls under the heading of “unitary pricing”. Although that form of intercompany pricing has a number of iterations, unitary pricing is generally built on the concept that the separate existence of corporate related parties should be disregarded. The idea is not all that different than if Congress mandated that all subsidiary corporations would be treated as filing a consolidated return with their parents.

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The unitary approach disregards the corporate existence and attempts to allocate income and deductions based on commercial reality. That, alone, makes it a better approach to the problem.

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Comments

packy1196
  • 12-18-2010

Thank