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Xilinx: A Case Study in Judicial Activism By Charles Cope and Thomas Zollo KPMG, LLP, Washington, DC With the nomination of a Supreme Court justice pending, the news media now are filled with commentators of all political persuasions decrying the perils of “judicial activism” and extolling the benefits of “judicial restraint.” Historically, judicial restraint has been associated with determining the “plain meaning” of a statute.1 By contrast, judicial activism, as it is known in common parlance, typically involves interpreting a statute in a light that advances the judge's perception of legislative objectives.2 When interpreting Treasury regulations, some courts have exhibited a preference for a plain-meaning approach. The Tax Court's decision in Woods Investment v. Comr.3 is perhaps the preeminent example.4 Other courts have taken a more activist approach, utilizing the economic substance doctrine to resolve cases that might be handled otherwise.5 The Ninth Circuit's decision in Xilinx appears to be a case study in judicial activism in a regulatory context.6 We believe, for the reasons discussed below, that other more conservative circuits are unlikely to find its reasoning persuasive. Background The facts and law relevant to the Xilinx case are relatively simple. On April 2, 1995, Xilinx, Inc. (“Xilinx”), a domestic corporation, and its Irish affiliate, Xilinx Ireland (“XI”), entered into a cost-sharing arrangement (CSA). Under the CSA, Xilinx and XI agreed to share their total research and development costs based upon specified percentages. During the years at issue, based upon the cost-sharing regulations' definition of the pool of costs required to be shared and its method of accounting for employee stock options (ESOs) for financial accounting purposes, Xilinx did not include any cost for stock options in its cost pool. However, in computing its taxable income, as provided by §83(h),7 Xilinx deducted an amount equal to the income its employees recognized from the exercise of the ESOs, i.e., the spread, at the date of exercise, between the exercise price of its ESOs and the fair market value of its stock. The IRS, clearly dissatisfied with the results yielded by a literal reading of its own regulations, issued a deficiency notice to Xilinx, recomputing its income by including in its cost pool the difference between the fair market value of the stock covered by the ESOs on the date those options were exercised over the exercise price for the options. The 1995 Regulations Xilinx's CSA, in its 1997 through 1999 taxable years, was governed by regulations issued on December 19, 1995. Under these regulations, taxpayers were required to include in their cost-sharing pool all expenses related to the intangible development area. These expenses were defined to include “operating expenses … other than depreciation or amortization expense, plus … the charge for the use of any tangible property made available to the qualified cost-sharing arrangement.”8 The regulations contained two rules for accounting for costs. First, they provided that taxpayers must use a consistent method to measure costs and benefits.9 Second, they provided that taxpayers must maintain documentation to establish “[t]he accounting method used to determine the costs and benefits of the intangible development … and, to the extent that the method materially differs from U.S. generally accepted accounting principles, an explanation of such differences.”10 As the above italicized language requires that the cost pool be reconciled to U.S. GAAP, the implication is that the regulations considered U.S. GAAP to be an acceptable -- indeed, perhaps the presumptive -- method of accounting for costs. Financial Accounting Treatment of ESOs During the 1997 through 1999 taxable years at issue, Xilinx determined its compensation expense for ESOs for financial accounting purposes by applying Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under APB 25, the expense for stock options generally was measured based on their “intrinsic value” on the grant date. Hence, options that were issued with an exercise price at least equal to the stock's fair market value did not generate any expense. APB 25 was issued in 1972, and in April 1995 it was the primary standard for determining stock option expense under U.S. GAAP. In October 1995, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) [Editor's Note: Effective for financial statements issued for interim and annual periods ending after Sept. 15, 2009, under the FASB codification, FAS 123 is primarily FASB ASC 718]. Effective for fiscal years beginning after December 15, 1995, FAS 123 added the “fair value method” of valuing stock options as the “preferred method” for determining a company's stock option expense. As under APB 25, FAS 123 used the grant date, rather than the exercise date, as the appropriate date for measuring stock option expense. Moreover, while FAS 123 preferred the use of the fair value method for valuing stock options, it continued to permit companies to use the intrinsic value method of APB 25, albeit requiring pro forma disclosure of the difference between the two valuation methods. As an empirical matter, substantially all SEC reporting companies, including Xilinx, continued to determine stock option expenses using APB 25's intrinsic value method throughout the years at issue. The measurement of cost that the IRS used in its notice of deficiency did not correspond, in either timing or amount, to the measure of cost used in APB 25, FAS 123, or indeed any other measure of cost recognized by any accounting standard board. The History of §83 The legislative history to §83 indicates that Congress was not concerned with measuring an employer's stock-based compensation “costs,” but rather with when and how to tax employees who received ESOs.11 The legislative judgment may have been that the difficulties of accurately measuring of the employee's income prior to exercise (particularly in the context of private companies) and the employee's limited access to liquid assets with which to pay his tax before exercise justified the deferral of taxation until the date of exercise. The timing and amount of the employer's deductions simply represent a matching of the employer's deduction with the employee's income. Nothing in the legislative history to §83 indicates that Congress considered the employer's deduction to be an appropriate measure of cost. The Issue Before the Court Based on these facts, the issue for the court's consideration was straightforward: Did the IRS abuse its discretion in requiring Xilinx to compute its cost-sharing pool by including the §83 valuation of stock options? The answer to this issue should have been “yes.” As described above, the regulations contained a fairly clear statement that taxpayers were entitled to determine their cost pool based on U.S. GAAP, consistently applied, with two adjustments: taxpayers were required to reduce costs for depreciation and amortization and to increase costs by an amount equal to an arm's-length charge for the use of tangible property made available to the CSA. The drafter's inclusion of these two specific adjustments in the regulations, if anything, should be interpreted to mean that no other adjustments were required. The use of the U.S. GAAP rules for measuring stock option expenses can be reconciled with the arm's-length standard, whereas the use of the §83 valuation amount cannot. Two uncontrolled cost-sharing participants presumably would agree to share the cost of employing their R&D workforce. To the extent that a workforce is compensated entirely in cash, that cost would be the employees' cash compensation. To the extent that an employer is able to induce employees to accept ESOs in lieu of cash compensation, both the employer and the employees necessarily measure the value of the options at the time of grant, as neither party knows whether the options ultimately will prove worthless or valuable. From the standpoint of a third-party cost-sharing participant effectively purchasing a pro rata portion of the employees' work product, the employer and employees' agreement over the mix of the employees' compensation between cash, ESOs, and other non-cash items would not matter; the third party would expect simply to pay its share of the cash-equivalent value of the employees' services. The Reasoning of the Ninth Circuit In a 2-1 decision, the Ninth Circuit concludes that Regs. §1.482-7(d)’s requirement that participants to a CSA share “all” costs was incompatible with the arm's-length standard. However, the majority opinion also concludes that when a specific provision (the “all costs” standard) conflicts with the more general standard (the arm's-length standard), the more specific provision controls. Having concluded that the regulations required Xilinx to include “all costs” in its cost-sharing pool, the majority makes a critical assertion concerning the appropriate measure of costs in order to reach the tax policy result it desires: that Xilinx not be allowed a deduction for XI's “share” of the compensation for the employees' services. The court's majority criticizes the use of APB 25's intrinsic value measurement of stock option expenses in comparison to the FAS 123 fair value measurement by noting that the FASB had referred to the fair value approach as the “preferred” approach. The majority then concludes that the IRS's use of the exercise-date spread was the appropriate measure of costs. Thus, the majority rejects both the arm's-length standard of §482 and a literal reading of the regulations in order, in its view, to clearly reflect Xilinx's income for the years at issue. Shortcomings of the Majority’s Analysis The majority's line of reasoning arguably has several shortcomings. First, while FAS 123 does indicate a preference for the fair value measurement approach over the intrinsic value approach, FAS 123 permitted companies to use either approach. Second, substantially all companies, in fact, continued to use the intrinsic value approach during the years at issue. Hence, the intrinsic value measurement approach certainly was a “generally accepted” accounting principle and not, as the court implies, a “nonstandard one” adopted at the whim of Xilinx. As discussed above, because the regulations indicated that costs could be measured in accordance with U.S. GAAP, Xilinx's reliance on APB 25 appears to have fully complied with the regulations. Third, even if one accepted the court's assertion that U.S. GAAP required companies to use the fair value method under FAS 123, the IRS did not make its adjustment by applying the fair value method. Rather, the IRS used the §83 amount that Xilinx deducted with respect to the ESOs. In upholding this approach, the court did not acknowledge the distinction between a deduction (granted as a matter of legislative grace) and a cost (an economic measure of burden), and permitted the IRS to make an adjustment based on a measure that the FASB never accepted as the appropriate measure of cost.12 The Arm’s-Length Standard in U.S. Income Tax Treaties In reaching its decision, the majority also concludes that its reading of the regulations, which repudiates the arm's-length standard in this instance, does not conflict with the United States' obligations under the 1997 U.S.-Ireland Income Tax Treaty (the “Irish Treaty”). The court reasons that there is no conflict because the saving clause in paragraph 4 of Article 1 of the Irish Treaty permits the United States to apply its domestic law (apart from the Irish Treaty) to determine the tax liability of U.S. citizens and residents (including U.S. corporations). Although there are a few exceptions, U.S. income tax treaties generally do not provide U.S. tax benefits to U.S. residents, in part because of concerns about the Constitutional authority to do so.13 Thus, the arm's-length standard in paragraph 1 of Article 9 of the 2006 U.S. Model Income Tax Treaty (“U.S. Model Treaty”) offers no specific relief to U.S. corporations that are subject to the Ninth Circuit's reading of Regs. §1.482-7(d)(1).14 U.S. income tax treaties do require the United States to follow the arm's-length standard when determining the U.S. tax liability of qualified residents of the treaty partner.15 More important, the correlative adjustment provision in paragraph 2 of Article 9 of the U.S. Model Treaty (also included in the Irish Treaty) is a stated exception to the saving clause.16 Thus, the United States is required to make a correlative adjustment to the income or expense of a U.S. corporation when the tax treaty partner makes an adjustment to the income of a controlled resident of that state in order to reflect arm's-length pricing of a transaction between the two companies and the United States “agrees” that the other state's adjustment is arm's-length. The majority's opinion states that the “Commissioner did not dispute the [T]ax [C]ourt's finding that unrelated parties would not share ESOs as a cost.” The majority also finds that Regs. §1.482-1(a)(1) and Regs. §1.482-7(d) are “irreconcilable standards.” Does that mean that, should a foreign tax authority reject, as it very likely would, a deduction for a charge of the §83 amount of the ESOs of employees of a related U.S. company, the U.S. company may seek relief in a U.S. court, relying on Xilinx (stating that Regs. §1.482-7(d) does not reflect the arm's-length standard) and the applicable income tax treaty, to force the IRS to not include that amount in its income? The IRS very likely would not argue. We are not certain how a court would read the Irish Treaty in this case, and the majority does not address the issue. The term “agrees” in this context historically has meant that the U.S. Competent Authority (“USCA”) must agree that the foreign tax authority's primary adjustment is arm's-length. The USCA may still argue in a Mutual Agreement Procedure that unrelated parties would share the cost of ESOs measured as the spread between the stock price and the ESOs' exercise price. In fact, the USCA typically will not take a position contrary to Chief Counsel's litigating position. Nevertheless, given the language of the majority's decision, arguing that the other state's primary adjustment is not arm's-length would seem to be an uphill battle for the USCA. In light of the government's position on this issue, and the reality that Competent Authorities need not reach agreement, a treaty with a mandatory arbitration provision may prove useful to a U.S. taxpayer in this situation. One must wonder how the majority would have balanced the arm's-length standard in Regs. §1.482-1 with the all-costs rule in Regs. §1.482-7(d)(2) if it also had considered the United States' obligations under the correlative adjustment mechanism in U.S. income tax treaties. Would the tax policy result have seemed as compelling when weighed against a treaty obligation? Conclusion For the reasons stated above, we have considerable doubt that other more conservative circuits will follow the reasoning of the Ninth Circuit. Taxpayers facing this issue outside the Ninth Circuit17 will have to carefully weigh the strengths of the various arguments made by the four judges who have considered this issue to date when determining their tax reserves for financial accounting purposes. In addition, taxpayers, including those in the Ninth Circuit, should evaluate their opportunity to achieve relief under an income tax treaty in their particular circumstances. This commentary also will appear in the August 2009, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Warner and McCawley, 887 T.M., Transfer Pricing: The Code and Regulations, and Levi, 890 T.M., Transfer Pricing: Alternative Practical Strategies (Chapter 9, Cost Sharing Arrangements), and in Tax Practice Series, see ¶3600, Section 482 -- Allocations of Income and Deductions Between Related Taxpayers, and ¶7110, Foreign Income Taxation -- General Principles. 1 See Oliver Wendell Holmes, Jr., “The Theory of Legal Interpretation,” 12 Harv. L. Rev. 417 (1899) and more recently Antonin Scalia, “The Rule of Law as a Law of Rules,” 56 U. Chi. L. Rev. 1175 (1989). 2 This lawmaking ability of judges has been explained and justified by various legal scholars over time. One of the more influential texts has been Henry Melvin Hart & Albert M. Sacks, The Legal Process: Basic Problems in the Making and Application of Law (tent. ed. 1958). 3 85 T.C. 274 (1985). 4 “This Court will apply these regulations and the statute as written.” 85 T.C. at 282. 5 See Stobie Creek Investments, LLC v. U.S., 82 Fed. Cl. 636 (2008) (the Court of Federal Claims rejected the IRS's anti-abuse regulation in favor of applying the economic substance doctrine in order to rule for the government); Charles I. Kingson, “Coltec: Thin Gruel,” 117 Tax Notes 1294 (12/24/07). 6 Xilinx, Inc. v. Comr., No. 06-74269, slip op. (9th Cir. May 27, 2009), 2009 U.S. App. LEXIS 11118, reversing Xilinx, Inc. v. Comr., 125 T.C. 37 (2005). 7 All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated. 8 Regs. §1.482-7(d)(1) before its amendment by T.D. 9088 (8/25/03). All the references herein to Regs. §1.482-7 are to the regulation as in effect during the years at issue. 9 Regs. §1.482-7(i). 10 Regs. §1.482-7(j)(2)(i)(D) (emphasis added). 11 See S. Rep. No. 91-552 at 119-24 (1969); H.R. Report No. 91-413, pt. 1, at 86-89 (1969). 12 To illustrate the potentially distortive consequences of the court's reasoning, suppose a company granted a stock option with a strike price of $100x to an employee on a date when the value of the option stock was $100x. Under APB 25's intrinsic value approach, the company's cost would be zero, while under FAS 123's fair value approach the cost might be $30x or $40x. However, the IRS's approach leaves the cost measurement open until exercise, when the value could be zero or could be $1,000x or $1,000,000x. Through its timing and valuation approach, the IRS therefore would achieve results inconsistent with those to which uncontrolled parties would agree, inconsistent with what the FASB has ever recognized as appropriate, and, most important, inconsistent with what the regulations required. 13 The U.S. Constitution requires tax laws to originate in the House of Representatives. U.S. Constitution, Article I, Section 7. Tax treaties are reviewed by the Senate. U.S. Constitution, Article II, Section 2. The Senate Foreign Relations Committee has been reluctant to approve a treaty that provided a U.S. tax benefit to U.S. citizens or residents not found in the Code. See Joint Committee on Taxation, Staff's Explanation of Proposed Income Tax Treaty and Proposed Protocol between the U.S. and Mexico, JCS-16-93 (10/26/93) (discussing expansion of the U.S. charitable contribution deduction by treaty). 14 Query whether as a matter of treaty policy it should, given that the arm's-length standard has long been a central element of §482. The most likely reason is that §482 has long been considered a sword in the hands of the government. See Regs. §1.482-1(a)(3). 15 U.S. Model Treaty, Article 9(1). Thus, the United States may impose a tax at source on only an arm's-length amount of income, such as business profits. 16 U.S. Model Treaty, Article 1(5)(a). 17 The Tax Court must follow the decision of the Ninth Circuit with respect to litigation arising within that circuit. See Golsen v. Comr., 54 T.C. 742 (1970).

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