By Charles W. Cope and Thomas M. Zollo
KPMG LLP, Washington, DC, and Chicago, IL
The latest installment of Xilinx finds the Ninth Circuit holding that pre-2004 cost-sharing regulations do not require participants in cost-sharing arrangements to share the costs of stock-based compensation. This commentary outlines the opinions of the Tax Court and the Ninth Circuit and considers what the latest Ninth Circuit decision might mean for challenges to the validity of subsequently issued cost-sharing regulations that, unlike the earlier regulations, specifically require the sharing of stock-based compensation costs.
On March 22, a three-judge panel of the U.S. Court of Appeals for the Ninth Circuit issued an opinion holding that, under the pre-2004 cost-sharing regulations, stock-based compensation is not a "cost" that the parties to the arrangement must share. Thus, a U.S. taxpayer is not required to reduce its deduction for employee stock options (ESOs) by the portion of that compensation that otherwise would be shared with related parties under the cost-sharing arrangement.1 The decision affirms both the result and the logic of a decision of the Tax Court rendered in August 2005.2
The Ninth Circuit's decision is notable because many U.S. technology companies have entered into cost-sharing arrangements and have paid a sizable portion of their employees' compensation in the form of stock options (and other types of equity-based compensation). Thus, the amounts at stake for both taxpayers and the government are significant. The decision's logic also creates some doubt as to whether subsequently issued cost-sharing regulations, which require stock-based compensation to be shared, are valid.
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 Xilinx's method of accounting for ESOs for financial accounting purposes, Xilinx did not include any costs related to ESOs in its cost pool. However, in computing its taxable income, as provided by §83(h), Xilinx deducted an amount equal to the income its employees recognized from the exercise of the ESOs, i.e., generally the spread, at the date of exercise, between the exercise price of the ESOs and the fair market value of its stock. The IRS issued a deficiency notice to Xilinx where it recomputed Xilinx's income by including in the cost pool the difference between the fair market value of the stock covered by the ESOs on the date those options were exercised and the exercise price for the options. By including this amount in the cost pool, the IRS effectively reduced Xilinx's deduction for the portion of the ESO deductions allocable to XI.
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."3
The Tax Court's Decision
In its 2005 opinion, the Tax Court held that the arm's-length standard (and Regs. §1.482-1) applied to cost-sharing arrangements (as described in Regs. §1.482-7). The Tax Court, after considering the testimony of the experts proffered by Xilinx and the IRS, also found that unrelated parties would not share the cost of ESOs, whether measured by the spread at the date of exercise or the value of the ESO at the date of grant. (The IRS presented only one expert witness on this issue.) The Tax Court concluded, therefore, that the cost-sharing regulations' requirement that stock-based compensation be shared by the parties to the CSA was contrary to the overriding rule of §482 that related parties deal with each other on an arm's-length basis:Because unrelated parties would not share the spread or the grant date value, respondent's imposition of such a requirement is inconsistent with section 1.482-1…. Simply put, the regulations applicable to the years in issue did not authorize respondent to require taxpayers to share the spread or the grant date value relating to [employee stock options].
The Original Ninth Circuit's Decision
In May 2009, two of the three judges on a three-judge panel in the Ninth Circuit agreed with the IRS and issued an opinion reversing the Tax Court. The majority found that Regs. §1.482-7(d)(1)'s "all costs requirement" was irreconcilable with Regs. §1.482-1(b)(1)'s requirement that the arm's-length standard apply in every case. The majority then concluded that:
Because the all costs requirement is irreconcilable with the arm's-length standard, we hold §1.428-7(d)(1) controls, in light of the `elementary tenant of statutory construction that where there is no clear indication otherwise, a specific statute will not be controlled or nullified by a general one' Santiago Salgado v. Garcia, 384 F.3d 769, 774 (9th Cir. 2004) …
Xilinx petitioned the Ninth Circuit for a rehearing en banc. Its petition was supported by a number of briefs filed by interested parties (including several accounting firms) as amici curiarum. In January 2010, the three-judge panel withdrew its opinion, setting the stage for the panel's new opinion.
The Ninth Circuit's Second Decision
On March 22, 2010, the same three-judge panel that issued the original Ninth Circuit opinion reversed itself, when one of the judges who had been in the majority joined the original dissenting judge, and affirmed the judgment of the Tax Court. The second opinion, written by the dissenting judge in the first opinion, adopts much of the reasoning of that dissent. One of the judges who had been in the majority in the first decision (Judge Fisher) wrote a concurring opinion, and the other judge in the original majority, now alone, wrote a dissenting opinion.
The new majority opinion frames the issue as a choice between two alternatives: either applying a rule of thumb (i.e., one of the canons of statutory construction) or resolving the internal contradiction in the regulations by considering the dominant purpose of the regulations.
The majority opinion first notes that the canons of construction are not mandatory rules and they can be overcome by other circumstances manifesting the legislature's intent. The majority opinion further states:
Purpose is paramount. The purpose of the regulations is parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions. The regulations are not to be construed to stultify that purpose. If the standard of arm's length is trumped by 7(d)(1), 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.
The concurring opinion by Judge Fisher is notable because of the judge's criticism of the government's regulations. Judge Fisher, referring to the regulations in effect for the years at issue, states that the taxpayer is not given "clear fair notice of how the regulations will affect them." In an accompanying footnote, Judge Fisher goes on to say "[i]t is an open question whether these flaws have been addressed in the new regulations Treasury issued after the taxable years at issue in this case."
The Validity of the Post-2003 Cost-Sharing Regulations
We understand that at least one taxpayer currently is challenging the validity of the post-2003 regulations as to the inclusion of stock-based compensation in the pool of costs to be shared, and others may be encouraged by this recent decision to initiate a challenge, especially in light of the dictum of Judge Fisher. In case of such challenge, however, the issue that a court would have to decide would be different from the issue decided in Xilinx. The regulations at issue in Xilinx were not specific as to whether stock-based compensation should be included in the cost pool. For years after 2003, the regulations specifically treat stock-based compensation as a cost to be shared. In other words, the amendments specifically requiring that ESO expenses be included in the pool of costs to be shared have removed any ambiguity regarding what the regulations themselves require.
Thus, a taxpayer challenging the post-2003 regulations would have to argue that the regulations are invalid because they are contrary to the statute (§482). Generally, when reviewing the validity of regulations, a court will defer to an agency's interpretation of the statute. The degree of deference a court will extend to an agency's interpretation of a statute depends on the type of regulation, i.e., whether it is "legislative" or "interpretative." The §482 regulations, like most income tax regulations, were issued under the authority of §7805(a). The IRS historically has taken the position that regulations issued under the authority of §7805(a) are interpretative.4 Interpretative regulations are entitled to judicial deference, provided a court finds that the agency's interpretation of the statute is reasonable.5 Accordingly, a taxpayer challenging the validity of the regulations in effect after 2003 has a higher hurdle to overcome in the courts than did the taxpayer in Xilinx.6
While experience shows that it is risky to predict how a court will decide a case, there are several reasons why a court could find the post-2003 regulations to be valid. First, §482, which is the foundation for U.S. transfer pricing rules, does not explicitly refer to the arm's-length standard. The standards in §482 are "clear reflection of income" and "tax avoidance." Under the less stringent "clear reflection" standard, a court could find the post-2003 regulations to be valid based upon the theory that limiting a U.S. taxpayer's deduction for ESOs under §83 to its proportion of the cost pool most clearly reflects its income. This theory could be viewed as consistent with the view that cost-sharing is, by definition, the sharing of costs by participants, as opposed to one participant charging a related party for property or services. Arguably, while the determination of a charge for property or services is limited by the arm's-length standard, the clear reflection of income standard may permit the IRS to limit a U.S. participant's deductible expenses to its proportionate share of the deductible pool costs under U.S. tax accounting principles. Second, even if a court were to find the arm's-length standard implicit in the statute, for example, as a result of many years of IRS practice, the IRS arguably reconciled Regs. §§1.482-1 and -7 when it amended the latter regulation in 2003 and added the following new paragraph (a)(3):7
Coordination with §1.482-1. A qualified cost sharing arrangement produces results that are consistent with an arm's length result within the meaning of Sec. 1.482-1(b)(1) if, and only if, each controlled participant's share of the costs (as determined under paragraph (d) of this section) of intangible development under the qualified cost sharing arrangement equals its share of reasonably anticipated benefits attributable to such development (as required by paragraph (a)(2) of this section) and all other requirements of this section are satisfied.
The court also could find that the United States had no obligation under §894 and U.S. income tax treaties to follow the arm's-length standard. The saving clause that is found in Article 1 of U.S. income tax treaties carves out the arm's-length standard in paragraph 1 of Article 9 (Associated Enterprises).8
Despite these possible arguments, the outcome of such a case is not free from doubt. We believe that the courts could follow the dictum of Judge Fisher and find the regulation invalid for several reasons. First, the arm's-length standard has been in the regulations under §482 for decades, and taxpayers should reasonably be allowed to rely on that standard because the IRS has never articulated the clear reflection standard to mean more than that. Also, the language that was added to Regs. §1.482-7 arguably does not reconcile that regulation with the arm's-length standard in light of the Tax Court's factual finding in Xilinx. If an uncontrolled cost-sharing participant would not charge a third party for ESOs, it effectively would keep its entire deduction under §83(h). Hence, the consequence of requiring a controlled cost-sharing participant to charge for ESOs would produce a tax disparity between controlled and uncontrolled taxpayers, contrary to the intent of §482. Furthermore, although the IRS has departed from the arm's-length standard in the regulations under §482 in the context of "safe harbors," the cost-sharing regulations are not crafted as such.
A court also might consider that cost-sharing arrangements ordinarily occur in a cross-border context and, notwithstanding the saving clause found in U.S. income tax treaties, U.S. taxpayers and U.S. treaty partners rely on that standard on a daily basis when setting intercompany prices. The Competent Authorities also employ that standard when resolving transfer pricing disputes. Thus, while Xilinx appears to be resolved (unless the IRS petitions the Ninth Circuit for en banc review of the court's most recent decision), we expect additional drama until the validity of the post-2003 regulations is resolved by the courts.
This commentary also will appear in the June 2010 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, Avi-Yonah, 888 T.M., Transfer Pricing: Judicial Strategy and Outcomes (Chapter 3, "Analysis of Judicial Decisions Interpreting §482"), Levi, 890 T.M., Transfer Pricing: Alternative Practical Strategies (Chapter 9, "Cost Sharing Arrangements"), and in Tax Practice Series, see ¶7110, U.S. International Taxation — General Principles.
4 The IRS takes this position because of concerns that all tax regulations, including temporary regulations, would be subject to the Administrative Procedure Act's notice and comment requirements if they were not "interpretative.'' The Justice Department, which would defend a refund claim challenging the validity of the post-2003 regulations, has not always agreed with this position, however. Whether regulations issued under §7805(a) are "interpretative" regulations within the meaning of the Administrative Procedure Act is analyzed in the concurring opinion of Judges Halpern and Holmes in Intermountain Insurance Service of Vail v. CIR, 134 T.C. No. 11 (5/6/10).
6 While we believe a court would likely apply the reasonableness standard in reviewing the post-2003 regulations, the matter is not free from doubt. First, the Justice Department may argue, and persuade a court, that the §482 regulations are legislative. Also, some recent judicial decisions have raised questions as to the standard to be applied by a court in reviewing the validity of an income tax regulation. For a discussion of the current state of the law, see"Judicial Deference to Tax Regulations: A Reconsideration in Light of National Cable, Swallows Holding and Other Developments," 61 Tax Law. 481 (Winter 2008).
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