29 May 2009
On May 27, 2009, the US Court of Appeals for the Ninth Circuit reversed the Tax Court’s 2005 ruling in Xilinx, Inc. v. Commissioner (No. 06-74269, slip op. (9th Cir.)), holding instead that the cost sharing regulations in existence from 1997 through 1999 required that stock options costs be included among the costs that must be shared by participants in cost sharing arrangements. While the IRS secured a victory in its long-running effort to force participants to share stock option costs, it did so at the expense of an express conclusion by the Ninth Circuit that the IRS’s administrative position is contrary to the arm’s length standard.
The court’s decision hinges on what it cites as an “elementary tenet of statutory construction” to be followed in the face of what the Ninth Circuit thought to be irreconcilable regulatory guidance. The general provisions of Treas. Reg. § 1.482-1(b)(1) specify that the arm’s length standard is to be applied “in every case” in order to determine the true taxable income of controlled parties. This implies that controlled parties share only those costs that uncontrolled parties would share, and that controlled parties do not have to share costs that uncontrolled parties would not share. At trial, the taxpayer presented extensive evidence, which the Tax Court credited, and which was uncontested on appeal, that unrelated parties engage in transactions that are comparable to cost sharing arrangements and that such unrelated parties never share stock option costs.
Although the command of Treas. Reg. § 1.482-1(b)(1) seemed clear, former Treas. Reg. § 1.482-7(d)(1) (in effect during the years at issue) specified that controlled parties in a cost sharing arrangement share “all of the costs incurred by [the participants] that are related to the intangible development area.” Relying upon this regulation, the IRS argued that the term “all…costs” encompasses stock option costs. The Ninth Circuit believed that “[e]ach provision’s plain language mandates a different result,” thereby leaving “distinct and irreconcilable standards for determining which costs must be shared between parties in cost sharing arrangements….”
The court broke what it believed to be a stalemate by holding that this “all costs” requirement under former Treas. Reg. § 1.482-7(d)(1) wins out over the arm’s length standard of Treas. Reg. § 1.482-1(b)(1) by virtue of the “elementary tenet of statutory construction that where there is no clear indication otherwise, a specific statute will not be controlled or nullified by a general one.”
The court also ruled that the United States-Ireland income tax treaty in effect during the period at issue did not preempt the “all costs” requirement of former Treas. Reg. § 1.482-7(d)(1). Although noting that the Department of the Treasury’s explanation confirms that the language in the treaty is “identical to” the arm’s length standard of Treas. Reg. § 1.482-1(b)(1), the court cited the treaty’s express provision allowing a contracting state to apply its domestic laws to its own citizens, even when those laws conflict with the treaty. Thus, the provisions of former Treas. Reg. § 1.482-7(d)(1) could be applied to Xilinx without violating the treaty, even if the “all costs” requirement were inconsistent with the arm’s length standard.
The most significant aspect of the Ninth Circuit’s analysis concerns the extent to which the IRS is bound by the arm’s length standard. In the litigation, the IRS had strenuously and repeatedly argued that its position with respect to stock options costs was entirely consistent with the arm’s length standard, which it conceded to be controlling. Based upon the trial record, the court forcefully rejected the IRS's position that it had acted consistently with the arm's length standard: “[T]he Commissioner has presented no evidence that any companies operating at arm’s length share [stock options] costs and does not challenge the tax court’s finding that unrelated parties would not do so. If unrelated parties operating at arm’s length would not share [stock options] costs, requiring controlled parties to share [them] is simply not an arm’s length result.”
This conclusion might have seemed fatal to the IRS’s position, but the court went on to hold that the IRS is not required to follow the arm’s length standard with respect to the definition of costs that must be shared pursuant to the cost-sharing regulations. In this context, the Ninth Circuit characterized the arm’s length standard as “regulatory gloss.” Hence, in the court’s view, the IRS was free to write cost sharing regulations that were inconsistent with the arm’s length standard, as set forth in Treas. Reg. § 1.482-1(b)(1).
In a strong dissent, Judge Noonan agreed that the “all…costs” language of Treas. Reg. § 1.482-7(d)(1) was irreconcilable with Treas. Reg. § 1.482-1(b)(1)’s requirement that the arm’s length standard be applied “in every case.” However, he criticized the majority’s reliance on the canon that a more specific regulatory provision controls a general one. In his view, Xilinx should not have had to include stock options costs on three grounds. First, the general purpose of the section 482 regulatory regime — tax parity between controlled and uncontrolled taxpayers — should control the interpretation and application of the cost sharing regulations. Second, based on an equally venerable canon of construction, regulatory ambiguities should be construed against the government and in favor of the taxpayer. Finally, the Treasury Department interpreted the United States-Ireland tax treaty as incorporating the arm’s length standard, without any exception for stock options costs. This must inform the interpretation of the related tax regulations, likewise issued by the Treasury. The treaty and its interpretation, “act as guides. They tell us what the Treasury has had in mind in the regulations at issue.”
While the IRS prevailed in Xilinx, there is undeniable irony in the result. Ever since the IRS first took its position with respect to the stock option issue, it has insisted to taxpayers and treaty partners alike that its position on the options issue was in strict compliance with the arm’s length standard. The Ninth Circuit’s opinion puts that claim to rest. Indeed, the opinion indicates that the IRS’s 2003 cost sharing regulations, which expressly require the sharing of stock-based compensation, and which the IRS has insisted are fully consistent with the arm’s length standard, in fact are contrary to the arm’s length standard. In this respect, the court offered the view that government bodies “may adopt a technical definition of a term that is distinct from its plain meaning.”
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