In Xilinx Inc. v Commissioner, 125 T.C. No. 4, August 30, 2005, the tax court held that the value of stock-based compensation should not be included in cost-sharing allocations under the arm’s length standard of Treas. Reg. §1.482-1. The Xilinx holding is generally limited to stock-based compensation expenses in taxable years beginning on or after January 1, 1996 through August 25, 2003 (applicable years). All stock-based compensation granted in taxable years beginning on or after August 26, 2003 is covered under the current regulations.

The Xilinx decision will become final at the end of November unless the IRS decides to appeal. In the meantime, taxpayers should consider taking appropriate steps to preserve their rights as a result of Xilinx.

The Xilinx Case

Xilinx entered a cost sharing agreement (CSA) with an Irish subsidiary in April of 1995. At the time, Xilinx offered three types of stock-based compensation to employees: incentive stock options, nonstatutory stock options, and an employee stock purchase plan. Xilinx did not include any stock option costs in its cost-sharing allocations.

The IRS argued that Xilinx was required to include the spread at exercise in its cost sharing allocations, equivalent to its corresponding federal income tax deduction. The IRS argued that Xilinx was alternatively required to include the grant date value.1

Court Says Arm’s Length Standard is Rule for Allocation of Costs

The court held that under the Treasury Regulations in effect for the applicable years, the standard for the allocation of costs was purely the arm’s length standard of §1.482-1. The court found no evidence that unrelated parties would share the spread at exercise or the grant date value in a cost-sharing arrangement. In fact, the court found evidence that unrelated parties would not share such expenses due to the high degree of uncertainty relating to these types of costs. It was therefore held that the imposition of such a requirement on related parties by the IRS was inconsistent with the arm’s length standard.

This result directly conflicts with the IRS position2 concerning the sharing of stock-based compensation costs. In view of this conflict, we discuss below the potential actions available to taxpayers who followed the IRS position and who are now seeking to protect their rights in view of the Xilinx decision.

Xilinx Decision Introduces Contradiction

For the applicable years of the Xilinx holding, the regulations required that a taxpayer’s cost sharing allocations meet the arm’s length standard and the commensurate-with-income standard, but did not specifically mandate the inclusion of stock-based compensation. Amended regulations were finalized in 1995 corresponding to the IRS’ litigating position and policy regarding the inclusion of stock-based compensation.

Current Treas. Reg. §1.482-7 specifies that all stock-based compensation relating to the development of intangibles under a qualified CSA must be allocated between the participants. Stock options are required to be valued under one of the two methods argued by the IRS in Xilinx: the spread (equivalent to the taxpayer’s allowable Federal income tax deduction), or alternatively the fair value for public companies (grant date value for fiscal years after June 15, 2005). The arm’s length standard of §1.482-1(b)(1) continues to govern cost sharing arrangements; however, the IRS regulations now state that inclusion of stock-based compensation in the cost sharing pool is required to produce an arm’s length result. Accordingly, the ultimate issue to be determined (assuming Xilinx is correctly decided) is whether the IRS may define what constitutes an "arm’s lengths method" under Section 482 even if the evidence demonstrates that such "method" does not reflect how unrelated parties would act.

Since the current regulations dictate that §1.482-7 provides the specific method for determining whether a CSA is consistent with the arm’s length standard, it follows that, under these regulations, CSA allocations that do not include stock-based compensation fail the arm’s length standard. In contrast, under Xilinx, CSA allocations that do include stock-based compensation fail the arm’s length standard.

Taxpayers Should Consider Protective Actions

Xilinx is just one decision, has not been reviewed by the full Tax Court, and is not yet final. The IRS may appeal the decision in the Ninth Circuit. The IRS may also choose to relitigate the issue with a different taxpayer; this time presenting stronger evidence that the inclusion of stock-based compensation expenses fall within the arm’s length standard. The Xilinx holding also calls into question the current regulations. It is possible, however, that the IRS may argue that defining its allocation methods as "arm’s length" under the commensurate-with-income standard leaves the taxpayer without recourse to object. Regardless of potential IRS actions or positions, taxpayers are advised to consider their own protective actions as a result of the Xilinx decision.

For Taxpayers with Cost Sharing of Stock-Based Compensation Granted in Taxable Years Beginning on or Before August 25, 2003

Claims for Refund

Taxpayers with shared stock-based compensation expenses in the applicable years may wish to file protective claims for refund based on the Xilinx decision. Treas. Reg. §1.482-1(a)(3) restricts the filing of amended returns based on adjustments with respect to controlled transactions. However, a claim for refund based upon the current Xilinx decision may fall outside of this restriction. Xilinx, assuming it becomes final in its current form, is a rejection of the stated IRS position concerning the treatment of option expenses for the applicable years. Some taxpayers may have based their allocations on the IRS’ stated interpretation of the Treas. Regs. then in effect in order to avoid litigation similar to that faced by Xilinx. If taxpayers now bring refund claims as a result of Xilinx, it may be possible to argue this is outside the scope of adjustments contemplated and restricted by Treas. Reg. §1.482-1(a)(3). Such refund claims may also be raised in the context of an audit.

Setoffs

Taxpayers with any applicable years under audit, or which come under audit, may also be able to claim Xilinx Setoffs under Treas. Reg. §1.482-1(g)(4) and Revenue Procedure 2005-46, if the IRS proposes inbound allocations under IRC §482 associated with the taxpayer’s cost sharing partner. Setoff claims must be made within 30 days of notification of proposed adjustments by the IRS or issuance of deficiency notice, whichever is earlier.

True-ups

Taxpayers should also review the terms of cost sharing agreements covering the applicable years with regards to the treatment of arm’s length adjustments. The terms of the cost sharing agreement may allow for a current year true-up between participants to account for non-arm’s length transactions associated with prior periods. If so, it may be appropriate to make an associated current year true-up. However, it is possible that the IRS may contest such true-ups as violative of the policy underlying Treas. Reg. §1.482-1(a)(3).

For Taxpayers with Stock-Based Compensation Granted in Taxable Years Beginning on or after August 26, 2003

Pending a final determination of Xilinx and the clear resolution of this issue, taxpayers should review and amend their cost sharing agreements as necessary to allow for current adjustments in the event of changes in the treatment of stock-based compensation expenses.3 The cost sharing agreement should clearly specify the method of adjustment between the parties and should allow for changes to both scope of included compensation and valuation methodologies.

If the IRS acquiesces in Xilinx, it is recommended that the IRS confirm that taxpayers have specific refund rights and/or the right to current year true-up adjustments to comply with the arm’s length standard.

Footnotes

[1] Under the current regulations, taxpayers are required to use one of these two methods to value options for cost sharing allocations. Because the grant date value method was raised late, the IRS had the burden of proof.

[2] IRS Internal Industry Directives Dated January 25, 2002 and January 12, 2004; Field Service Advice (FSA) 200003010; FSA 200103024

[3] Under the current regulations, stock-based compensation includes equity instruments, stock options, or rights with respect to equity instruments or stock options, including Section 83 property and Section 421 stock options, regardless of whether ultimately settled in the form of cash, stock, or other property.

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