Xilinx Inc. researches, develops, manufactures, and markets integrated circuit devices and related development software systems. With a view toward expanding its business in Europe, Xilinx established Xilinx Ireland (XI).
Xilinx and XI entered into a “cost and risk sharing agreement” that stated that all right, title, and interest in new technology developed by either would be jointly owned. The agreement required the parties to share direct costs, indirect costs, and costs incurred to acquire products or intellectual-property rights necessary to conduct research and development.
Xilinx offered employee stock options (ESOs) to its employees under two plans. In determining the R&D costs to be shared under the agreement, Xilinx did not include any amount related to ESOs. The Internal Revenue Service contended that ESOs issued to employees involved in or supporting R&D activities were costs that should be shared under the agreement. By sharing these costs with XI, Xilinx’s deductions would be reduced, thereby increasing its taxable income.
The U.S. Tax Court concluded that the IRS’s allocation was “arbitrary and capricious” because it included ESOs in the pool of costs to be shared under the agreement even though two unrelated corporations dealing with each other at arm’s length would not share those costs. On March 23, the Court of Appeals for the Ninth Circuit upheld the tax court’s decision, dealing the IRS another in a series of transfer-pricing blows.
Arm’s-Length Standard Is Controlling
Section 482 of the Internal Revenue Code provides that “…in any case of two or more organizations, trades, or businesses…owned or controlled by the same interests, the Secretary may…allocate gross income, deductions, credits, or allowances” between the organizations, if the Secretary determines that the allocation is necessary “to prevent evasion of taxes or clearly to reflect the income.”
“In determining the true taxable income, the standard to be applied, in every case, is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” — Robert Willens
The regulations provide that Section 482 places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer.1 In determining the true taxable income, the standard to be applied, in every case, is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.2
Another provision of the regulations provides that a controlled participant’s “costs of developing intangibles” mean all of the costs incurred by that participant related to the intangible-development area. Costs incurred related to the development of intangibles consist of operating expenses.3 For this purpose, operating expenses are defined as including all expenses (with certain exceptions not relevant here) not included in cost of goods sold. How do these provisions interact?
The court noted that the language of Regulation Section 1.482-1(b)(1) is unequivocal: the arm’s-length standard is to be applied in every case. By implication, costs that uncontrolled parties wouldn’t share need not be shared.
By contrast, Regulation Section 1.482-7(d)(1) specifies that controlled parties in a cost-sharing agreement must share all costs “related to the intangible development area,” and that phrase is defined to include virtually all expenses not included in cost of goods sold. Therefore, each provision’s plain language mandates a different result.
Indeed, the court noted that often the specific controls the general. That is, if the rule is applied in this case, Regulation Section 1.482-7(d)(1) would control. The court did not apply this canon of construction (to find in favor of the IRS) because to do so would give “controlling importance” to a single canon of construction. Instead, the court concluded, purpose is paramount.
The purpose of the regulations is parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions. The regulations, the court concluded, are not to be applied to stultify that purpose. If the standard of arm’s length is trumped by Regulation
Section 1.482-7(d)(1), the purpose of the statute is frustrated.
So if Xilinx cannot deduct all of its stock-option costs, the company does not have tax parity with an independent taxpayer. Accordingly, the judgment of the tax court was affirmed and the IRS’s attempt to allocate ESO costs proved unsuccessful.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See Regulation Section 1.482-1(a).
2 See Regulation Section 1.482-1(b)(1).
3 See Regulation Section 1.482-7(d)(1).