Court Addresses Employee Stock Option Expenses for Transfer Pricing Purposes: Ninth Circuit Overturns Tax Court and Holds That Expenses Attributable to Employee Stock Options Are “Costs” of Developing Intangibles for Transfer Pricing Purposes

Sullivan & Cromwell LLP - May 29, 2009

In a landmark transfer pricing decision, the U.S. Court of Appeals for the Ninth Circuit held, in Xilinx, Inc. v. Comm’r (2009 WL 1459501 (C.A.9)) (“Xilinx”) in a two-to-one decision, that related companies sharing expenses of developing intangibles (such as intellectual property) must share expenses of developing intangibles (and thus, must share any deductions associated with such costs) attributable to employee stock options (“ESOs”) even if such sharing would be inconsistent with the arm’s-length standard that generally governs transfer pricing rules under U.S. tax law and under U.S. international tax treaties. This decision is a major victory for the Internal Revenue Service as it has significant ramifications for multinational taxpayers, especially those taxpayers involved in high technology or similar businesses that have substantial operations conducted through foreign subsidiaries.

Related companies are required to allocate certain costs and income among themselves for U.S. federal income tax purposes. The general test is that costs and income needed to be allocated consistent with an arm’s-length standard—in other words, costs and income are to be shared among related parties in a manner consistent with how independent, unrelated parties would have shared such costs and income. With respect to the development of intellectual property, many businesses, as a matter of practice, did not allocate to non-U.S. subsidiaries the costs of stock-based compensation issued by a U.S. parent, based on the view that independent, unrelated parties generally do not share such costs. Instead, the U.S. parent would claim the full amount of stock-based compensation costs as deductible business expenses on its U.S. tax returns. Reallocation of a portion of these expenses to a foreign subsidiary would reduce the amount of deductible and creditable business expenses available to the U.S. parent, thereby increasing the U.S. parent’s taxable income in the U.S. While the deductions would be allocable to the foreign subsidiary, any benefit from these deductions would generally be deferred until the related income is repatriated to the U.S. through a distribution or otherwise. Although the applicable regulations were amended in 2003 to require reallocation of stock-based compensation expenses to offshore subsidiaries on a prospective basis, many companies are involved in ongoing transfer pricing disputes with the Internal Revenue Service for pre-2003 tax years and the Xilinx opinion would appear to have a direct impact on their disputes.

Xilinx has potentially a far-reaching impact as the decision upholds the Internal Revenue Service’s broad discretion to issue transfer pricing regulations deviating from the “arm’s-length standard,” a standard that had generally been thought by practitioners to be the principal standard for the application of Code Section 482 (see below for a description of Code Section 482). Moreover, the “arm’s-length standard” is the international standard for transfer pricing adjustments, and thus Xilinx essentially rejects the international standard for transfer pricing adjustments in favor of a purely domestic U.S. standard, at least insofar as intellectual property is concerned and at least insofar as it affects domestic U.S. taxpayers and others that cannot avail themselves of protection against U.S. taxation under the terms of an applicable U.S. tax treaty.