A three-judge panel of the Ninth Circuit Court of Appeals by a 2-1 vote has affirmed the opinion of the Tax Court in Xilinx, Inc. v. Commissioner that employee-stock-option (ESO) expenses should not be taken into account in the context of cost-sharing arrangements. The decision, which effectively reverses a prior withdrawn opinion by the same three-judge panel, stands as a reaffirmation of the arm’s-length standard and another example of transfer-pricing litigation being decided on the basis of evidence of actual arm’s-length dealings rather than economic theories. The government may petition for a rehearing by the same three-judge panel, for a rehearing en banc, or for Supreme Court review. The implications of the decision for post-2003 periods, which are governed by new regulations that explicitly provide the result the government was seeking, are unclear.
Xilinx, Inc. entered into a cost-sharing arrangement in 1995 with an Irish subsidiary pursuant to which each company agreed to share the costs of intangible property development and acquisition in exchange for an ownership interest in such property. Employees of each company engaged in the development activities were eligible for ESO programs and were granted ESOs. The costs associated with such ESOs were not included in the pool of costs shared under the arrangement. The IRS issued notices of deficiency for tax years 1997-1999 contending that ESO costs should have been included in the cost pool, and proposing penalties as well.
Tax Court Decision and Initial Ninth Circuit Review
The Tax Court decided in favor of the taxpayer on the basis of overwhelming evidence that parties at arm’s length in fact do not share ESO costs in similar co-development arrangements. The government appealed on narrow grounds; rather than challenging the Tax Court’s factual findings, the government argued that the sharing of all costs was required in the cost-sharing context to produce an arm’s-length result notwithstanding the behavior of parties at arm’s length in similar arrangements. Alternatively, the government argued that the regulatory requirement to include “all costs” in the cost pool was a specific application of the general arm’s-length standard in this specific case and therefore should govern.
On May 27, 2009, the Ninth Circuit held in favor of the government, reversing the Tax Court by a 2-1 vote. This initial Ninth Circuit opinion found the “all costs” regulatory requirement in conflict with the generally applicable arm’s-length standard (a finding neither party advocated), and applied the canon of statutory construction under which more specific rules govern over the general rules to conclude that the specific “all costs” requirement of Treas. Reg. 1.482-7(d)(1) trumped the arm’s-length standard of Treas. Reg. § 1.482-1(b)(1). It further noted that the government was within its discretion to provide that technical phrases, such as “arm’s length,” mean whatever the government wished. This opinion was heavily criticized by practitioners and commentators as it appeared to set aside the arm’s-length standard, a step that neither the taxpayer nor the government advocated and that could have drastic consequences if taken in other transfer-pricing contexts. The taxpayer’s petition for rehearing drew support from amicus groups who argued, among other things, that the arm’s-length standard was not simply a fundamental precept of the U.S. transfer-pricing regulations, but had become an international standard consistently promoted by the United States and followed by tax authorities worldwide. On January 13, 2010, the Ninth Circuit withdrew its opinion, setting the stage for a new decision.
New Ninth Circuit Analysis
The new Ninth Circuit opinion relies on the “dominant purpose” of the transfer-pricing regulations, which is to put commonly controlled taxpayers at “tax parity” with uncontrolled taxpayers, in order to resolve the ambiguity in the regulations in favor of the taxpayer. Judge Noonan’s majority opinion, which echoes his dissent to the withdrawn opinion, frames the regulatory ambiguity as follows: Treas. Reg. § 1.482-1(b)(1) provides that the true taxable income of taxpayers under common control is determined “in every case” based on how parties at arm’s length would behave, while Treas. Reg. § 1.482-7(d)(1) provides that parties to a cost-sharing arrangement must share “all costs.” Under these regulatory standards, it is not clear whether the phrase “all costs” should be interpreted to include costs that parties at arm’s length do not or would not share. Rather than rely on a canon of construction, the opinion relies on the dominant purpose of the regulations as a whole, and concludes that the purpose of achieving tax parity among controlled and uncontrolled taxpayers is best furthered by concluding that ESOs need not be shared.
Judge Fisher’s concurring opinion merits attention as well, particularly because he authored the withdrawn opinion, and it is his change of view that caused the Ninth Circuit’s about-face. Judge Fisher stated that he reconsidered his prior view partly because of the failure of the government to adopt the rationale of the withdrawn opinion that the specific cost-sharing regulation trumps the more general arm’s-length requirement. Although Judge Fisher found the taxpayer’s interpretation of the regulations more persuasive, he found the government’s interpretation of the regulations plausible. Rather than defer to the interpretation of the agency charged with administering the tax law, however, Judge Fisher rejected the government’s interpretation as overly theoretical and complex, and concluded that adopting this interpretation would be unfair as taxpayers did not have notice of how the regulations would affect them and therefore could not have been expected to comply. This echoes the sentiments expressed in the Tax Court opinion that the government appeared to be attempting retroactively to apply new regulatory standards to years not governed by the new regulations. In effect, rather than deferring to the government’s interpretation of ambiguous regulations, Judge Fisher concluded that the ambiguity should be resolved against the drafters.
Judge Reinhardt provided a strongly worded dissent. He expressed considerable doubt as to whether the taxpayer’s position can be characterized as reflecting arm’s-length behavior, although he acknowledged that the Tax Court decided this issue and that the government is not challenging that decision. He stated that neither regulation can be said to better advance the purpose of the statute or the regulatory regime in this case, and that therefore the specific regulation should trump the general regulation. He expressed sympathy for the taxpayer’s equitable arguments, but viewed such arguments as irrelevant to the legal question decided in the case.
Implications of the Decision
The significance of the Xilinx decision going forward is unclear. Viewed narrowly, the opinion arguably resolves only the ESO issue in the cost-sharing context for periods before the effective date of the 2003 cost-sharing regulations. The judges were careful to note that they were not addressing the 2003 regulations. That said, the decision could be useful to taxpayers that wish to challenge those regulations, which are consistent with the litigating position of the government in Xilinx.
The decision also may have implications in other transfer-pricing contexts. Once again a court has relied on evidence of actual arm’s-length dealings over theoretical assertions regarding what arm’s-length behavior should look like. The court seemed frustrated with the government’s theoretical arguments, implying that such arguments amounted to post hoc rationalizations rather than more straightforward interpretations of the regulations. The government has yet to persuade even one judge – either in the Tax Court or in the Ninth Circuit – of its primary theory that the arm’s-length standard required the inclusion of ESO costs notwithstanding evidence of arm’s-length behavior to the contrary. Finally, the Ninth Circuit’s reversing course could be read as an acknowledgement that the arm’s-length standard is not only the touchstone of section 482 and the regulations promulgated thereunder but that it has become the internationally recognized test for transfer-pricing disputes. The new opinion does not specifically reference the amicus briefs filed in support of the rehearing petition, but it is likely that the panel’s unusual willingness to reconsider and reverse course was attributable in part to the outpouring of concern from the international tax community over the original decision’s potential threat to the internationally recognized arm’s-length standard.
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