IRS Acquiesces in Xilinx Decision but only for Pre-2003 Cases: IRS Acquiesces in the Result (but Not the Reasoning) of Ninth Circuit Holding that Employee Stock Option Expenses Need Not Be Shared Among Related Parties Under Pre-2003 US Transfer Pricing Rules

Sullivan & Cromwell LLP - August 2, 2010

In an "action on decision" (IRS AOD 2010-03) (the “AOD”) issued on July 28, 2010, the IRS acquiesced in the result (but not the reasoning) of Xilinx, Inc. et al. v. Commissioner, 598 F.3d 1191 (9th Cir. 2010) (“Xilinx”) for taxable years beginning prior to August 26, 2003. In Xilinx, the US Court of Appeals for the Ninth Circuit, reversing its earlier decision, upheld the supremacy of the arm’s-length standard for transfer pricing by holding that employee stock option (“ESO”) expenses in cost-sharing agreements related to developing intangible property are not subject to reallocation under then applicable US transfer pricing rules, because unrelated parties jointly developing intangibles and transacting on an arm’s-length basis would not include ESO expenses in such a cost-sharing agreement. For a fuller discussion of the Court of Appeals decisions, please see our prior publications, entitled “Court Addresses Employee Stock Option Expenses for Transfer Pricing Purposes,” and “Court Addresses (Again!) Employee Stock Option Expenses for Transfer Pricing Purposes.”

The Xilinx decision applies to a prior version of the Treasury Regulations (“pre-2003 Regulations”) that were amended in 2003. The post-amendment Treasury Regulations (“post-2003 Regulations”) explicitly require inclusion of stock-based compensation expenses in a cost-sharing agreement while the pre-2003 Regulations did not. Even though the direct impact of Xilinx and the AOD is on companies involved in ongoing transfer pricing disputes with the IRS for taxable years beginning prior to August 26, 2003, Xilinx has potentially significant impact beyond such taxable years because the decision is based on the principle that the arm’s-length standard trumps transfer pricing requirements that are inconsistent with the arm’s-length standard. Accordingly, the decision could be read to invalidate any transfer pricing requirement that is perceived to be inconsistent with the arm’s-length standard, and under such a reading, it is possible that the post-amendment Treasury Regulations would be invalidated as they require related parties to share stock-based compensation costs even where such costs are not shared by unrelated parties transacting on arm’s-length terms. Indeed, the concurring opinion in Xilinx noted that it is an “open question” as to whether the current Treasury Regulations adequately address the perceived ambiguity of the rules and the inconsistency between the arm’s-length standard and the all-costs-sharing requirement.

Perhaps in order to quell such speculation, the IRS issued the AOD stating that the IRS “believes that the Ninth Circuit opinion is erroneous” but that the IRS accepts the result of the Ninth Circuit decision while rejecting the court’s reasoning. The IRS explains that it accepts the result only because the amendment of the Treasury Regulations moots the impact of the Ninth Circuit decision. The amended rules explicitly require ESO expenses and other stock-based compensation be included in cost-sharing agreements for developing intangibles. The IRS also reaffirms its prior litigating position that the arm’s-length standard is consistent with the requirement that “all” costs of developing intangibles be shared under a cost-sharing agreement, even where parties transacting on arm’s-length terms may not share such expenses.