Court Addresses (Again!) Employee Stock Option Expenses for Transfer Pricing Purposes: Ninth Circuit Reverses Itself and Holds that the Arm’s-Length Standard Controls in Determining if Employee Stock Option Expenses Must Be Shared Among Related Parties Under Pre-2003 US Transfer Pricing Rules

Sullivan & Cromwell LLP - March 24, 2010
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In a major taxpayer victory, the US Court of Appeals for the Ninth Circuit, in Xilinx, Inc. v. Comm’r (2010 U.S. App. LEXIS 5795 (March 22, 2010)), reversed its earlier decision and affirmed the Tax Court’s decision that the arm’s-length standard controls in determining whether employee stock option (“ESO”) expenses in cost sharing agreements related to developing intangibles are subject to transfer pricing. The Court of Appeals upheld the Tax Court’s determination that unrelated parties jointly developing intangibles and transacting on an arm’s-length basis would not include ESO expenses in a cost sharing agreement, and therefore such expenses are not subject to reallocation under pre-2003 US transfer pricing rules. The new decision is a dramatic reversal of the Ninth Circuit’s prior decision in May 2009 (which decision had been withdrawn on January 13, 2010) that related companies sharing expenses of developing intangibles (such as intellectual property) must share costs attributable to ESOs (and thus, must share any deductions associated with such costs) even if such sharing would be inconsistent with the arm’s-length standard that generally governs transfer pricing rules under US tax law and under US international tax treaties. A discussion of the earlier Court of Appeals decision can be found in our prior publication, entitled “Court Addresses Employee Stock Option Expenses for Transfer Pricing Purposes,” available at http://sullcrom.com/publications or by following the instructions at the end of the publication.

The new decision by the Court of Appeals is particularly significant for multinational taxpayers, especially those taxpayers involved in high technology or similar businesses that have substantial operations conducted through foreign subsidiaries. Many businesses, as a matter of practice, did not allocate to non-US subsidiaries the costs of stock-based compensation issued by a US parent on the basis that unrelated parties transacting on an arm’s-length standard would not share such costs. Instead, the US parent would claim the full amount of stock-based compensation costs as deductible business expenses on its US tax returns. Reallocation of a portion of these expenses to a foreign subsidiary, as would have been required under the withdrawn Court of Appeals decision, would have effectively reduced the amount of deductible and creditable business expenses available to the US parent and deferred the benefit of those deductions until such time as the related income was repatriated from the foreign subsidiary to the US through a distribution or otherwise.

As a technical matter, the Xilinx decision applies to a prior version of the Treasury Regulations that were amended in 2003. The post-2003 Treasury Regulations explicitly require reallocation of stock-based compensation expenses to offshore subsidiaries. However, the Xilinx decision will have direct impact on many companies involved in ongoing transfer pricing disputes with the IRS for pre-2003 taxable years. Indeed, the Xilinx case has been of great interest to the business community and tax practitioners, several of whom expressed their concerns through amicus briefs, which appear to have been given serious consideration by the Court of Appeals.

Beyond the impact on pre-2003 taxable years, the Xilinx decision has significant ramifications because it upholds the supremacy of the arm’s-length standard as the principal standard for transfer pricing determinations. The Court of Appeals 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, because the primary purpose and intent of the US transfer pricing rules is to put related parties on tax parity with unrelated parties, or, in other words, to conform related party transactions to the arm’s-length standard. The fact that the US Treasury Department has espoused the primacy of the arm’s-length standard in its Technical Explanations of US international tax treaties was also given serious weight by the court.

An interesting question that remains unanswered is to what extent the Court of Appeals decision calls into question current US Treasury Regulations that require cost sharing even where the costs are not shared by unrelated parties transacting on arm’s-length terms. The concurring opinion notes that it is an “open question” as to whether current Treasury Regulations (amended in 2003) adequately address the ambiguity and inconsistency at the heart of the Xilinx case.