A panel of the U.S. Court of Appeals for the Ninth Circuit held that employee stock option (ESO) costs incurred by one company participating with related companies in a cost-sharing agreement (CSA) in the late 1990s must be allocated among the research and development (R&D) costs of all the participants under former Treas. Reg. [section] 1.482-7 (which applied because the transactions occurred before 2003, when the regulations were amended). This decision reversed a Tax Court holding that because unrelated parties in a cost-sharing agreement did not have to share ESO costs, related parties also did not have to share these costs. Semiconductor company Xilinx Inc., and Xilinx Ireland, a subsidiary, entered into a joint venture CSA that required them to share R&D costs of developing new technology. The parties agreed to share all direct and indirect costs and those of acquiring intellectual property rights. The agreement did not specifically address ESOs, and they were not shared for tax years 1997. 1998 and 1999.

The IRS contended that ESO costs for employees working on the R&D project should have been shared between the related parties and assessed substantial deficiencies and accuracy-related penalties.

The court extensively analyzed which regulation section governed the sharing of ESO costs. Former Treas. Reg. [section] 1.482-1 required controlled transactions to be analyzed by an arms-length standard "in every case," that is, whether the results were consistent with those of uncontrolled taxpayers engaging in the same transaction. The court rejected the IRS" attempt to harmonize thai standard with the more specific former Treas. Reg. [section] 1.482- 7, which provided that all "costs . . . related to the intangible development area" must be shared by the related parties regardless of whether unrelated parties would do so. The court found the two provisions irreconcilable but noted that in keeping with an "elementary tenet of statutory construction," the general standard did not nullify the specific requirement. Therefore, the court concluded that former Treas. Reg. [section] 1.4827, which contained a specific "bright line mie" that all costs must be shared, including ESO costs, should be followed instead of the general rule in former Treas. Reg. [section] 1.482-1.

The court could not conclusively determine the accuracy of the IRS' allocation of ESO costs to the joint venture and remanded the case to the Tax Court to make this calculation. Also, because of the irreconcilable regulations, the Ninth Circuit expressed concern about the imposition of accuracy-related penalties totaling more than $16.2 million for 1997 through 1999 and asked the Tax Court to consider any defenses Xilinx might raise. On Aug. 12, Xilinx petitioned for a rehearing by the Ninth Circuit en banc.

Note: The Treasury Department amended the regulations effective August 2003 to specifically include ESOs in the costs to be shared under Temp. Treas. Reg. [section] 1.482-7?. The Ninth Circuits decision, however, may affect similarly situaied taxpayers that have pre-2003 open tax years with the IRS.

* Xilinx, Inc. v. Commissioner, docket nos. 06-74246 and 06- 74269 (9th Cir.)

Copyright American Institute of Certified Public Accountants Oct 2009

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