Xilinx Inc. v. Comm'r of Internal Revenue, s. 4142–01
| Citation | 125 T.C. No. 4,125 T.C. 37 |
| Decision Date | 30 August 2005 |
| Docket Number | Nos. 4142–01,702–03.,s. 4142–01 |
| Parties | XILINX INC. AND CONSOLIDATED SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | United States Tax Court |
OPINION TEXT STARTS HERE
P entered into a cost-sharing agreement to develop intangibles with S, its foreign subsidiary. Each party was required to pay a percentage of the total research and development costs based on its respective anticipated benefits from the intangibles. P issued stock options to its employees performing research and development. In determining the allocation of costs pursuant to the agreement, P did not include in research and development costs any amount related to the issuance of stock options to, or exercise of stock options by, its employees. R, in his notices of deficiency, determined that for cost-sharing purposes, pursuant to sec. 1.482–7(d), Income Tax Regs., the spread (i.e., the stock's market price on the exercise date over the exercise price) or, in the alternative, the grant date value, relating to compensatory stock options, should have been included as a research and development cost.
1. Held: R's allocation is contrary to the arm's-length standard mandated by sec. 1.482–1(b), Income Tax Regs., because uncontrolled parties would not allocate the spread or the grant date value relating to employee stock options.
2. Held, further, P's allocation satisfies the arm's-length standard mandated by sec. 1.482–1, Income Tax Regs.
Kenneth B. Clark, Ronald B. Schrotenboer, William F. Colgin, Tyler A. Baker, Jaclyn J. Pampel, Anthony D. Cipriano and Allen Madison, for petitioners.
David P. Fuller, Jeffrey A. Hatfield, Bryce A. Kranzthor, Lloyd T. Silberzweig, Kendall Williams, David N. Bowen, John E. Hinding, and Paul K. Webb, for respondent.
Respondent determined deficiencies in the amounts of $24,653,660, $25,930,531, $27,857,516, and $27,243,975 and section 6662(a) accuracy-related penalties in the amounts of $4,935,813, $5,189,389, $5,573,412, and $5,448,795 relating to petitioners' 1996,1 1997, 1998, and 1999 Federal income taxes, respectively. The issues for decision are whether: (1) Petitioner and its foreign subsidiary must share the cost, if any, of stock options petitioner issued to research and development employees, (2) respondent's allocations meet the arm's-length requirement set forth in section 1.482–1(b), Income Tax Regs., and (3) petitioners are liable for section 6662(a) accuracy-related penalties.
Xilinx Inc.,2 is in the business of researching, developing, manufacturing, marketing, and selling field programmable logic devices, 3 integrated circuit devices, and other development software systems. Petitioner uses unrelated producers to fabricate and assemble its wafers into integrated circuit devices.
During the years in issue, petitioner was the parent of a group of affiliated subsidiaries including, but not limited to Xilinx Holding One Ltd., Xilinx Holding Two Ltd., Xilinx Development Corporation (XDC), NeoCAD Inc.,4 Xilinx Ireland (XI), and Xilinx International Corporation. XI was established in 1994 as an unlimited liability company under the laws of Ireland and was owned by Xilinx Holding One Ltd., and Xilinx Holding Two Ltd. (i.e., Irish subsidiaries of petitioner). XI was created to manufacture field programmable logic devices and to increase petitioner's European market share. It manufactured, marketed, and sold field programmable logic devices, primarily to customers in Europe, and conducted research and development.
On April 2, 1995, petitioner and XI entered into a Technology Cost and Risk Sharing Agreement (cost-sharing agreement). The cost-sharing agreement provided that all “New Technology” developed by either petitioner or XI would be jointly owned. New Technology was defined as technology developed by petitioner, XI, or petitioner's consolidated subsidiaries, on or after the execution date of the cost-sharing agreement. Each party was required to pay a percentage of the total research and development costs based on the respective anticipated benefits from New Technology. The cost-sharing agreement further provided that each year the parties would review and, when appropriate, adjust such percentages to ensure that costs continued to be based on the anticipated benefits to each party.
Petitioner and XI were required to share direct costs, indirect costs, and acquired intellectual property rights costs. Direct costs were defined in the agreement as those costs directly related to the research and development of New Technology including, but not limited to, salaries, bonuses, and other payroll costs and benefits. Indirect costs were defined as those costs, incurred by other departments, that generally benefit all research and development including, but not limited to, administrative, legal, accounting, and insurance costs. Acquired intellectual property rights costs were defined as costs incurred in connection with the acquisition of products or intellectual property rights. In determining the allocation of costs pursuant to the cost-sharing agreement, petitioner did not include in research and development costs any amount related to the issuance of employee stock options (ESOs).
Cost-sharing percentages for petitioner and XI relating to 1997, 1998, and 1999 were as follows:
+-----------------------+
¦Year¦Petitioner ¦XI ¦
+----+-----------+------¦
¦ ¦ ¦ ¦
+----+-----------+------¦
¦1997¦73.61% ¦26.39%¦
+----+-----------+------¦
¦1998¦73.35 ¦26.65 ¦
+----+-----------+------¦
¦1999¦65.09 ¦34.91 ¦
+-----------------------+
In 1997, 1998, and 1999, the following number of petitioner's and XI's employees engaged in research and development:
+-------------------+
¦Year¦Petitioner ¦XI¦
+----+-----------+--¦
¦ ¦ ¦ ¦
+----+-----------+--¦
¦1997¦338 ¦6 ¦
+----+-----------+--¦
¦1998¦343 ¦10¦
+----+-----------+--¦
¦1999¦394 ¦16¦
+-------------------+
III. Petitioner's Stock Option Plans
ESOs are offers to sell stock at a stated price (i.e., the exercise price) for a stated period of time. They are used by many companies to attract, retain, and motivate employees and align employee and employer goals. There are basically three types of ESOs: statutory or incentive stock options (ISOs), nonstatutory stock options (NSOs), and purchase rights issued pursuant to an employee stock purchase plan (ESPP purchase rights). ISOs and NSOs allow employees to purchase stock at a fixed price for a specified period of time. ESPP purchase rights allow employees to purchase stock at a discount through the use of payroll deductions. ISOs and ESPP purchase rights receive special tax treatment and are typically not subject to tax when they are granted or exercised, but the stock acquired pursuant to the exercise of these options is subject to tax when such stock is sold.5 NSOs, however, are, pursuant to section 83,6 Property Transferred in Connection with the Performance of Services, subject to tax upon exercise unless the option has a readily ascertainable fair market value.7 Sec. 83(a). If an NSO has a readily ascertainable fair market value, income is recognized on the grant date, and the issuer is entitled to a deduction. Sec. 83(h); sec. 1.83–7(a), Income Tax Regs.
NSOs, when granted, may be “in-the-money”, “out-of-the-money”, or “at-the-money”. ISOs, however, may only be “at-the-money” or “out-of-the-money”. 8 An option is deemed in-the-money when the exercise price on the grant date is below the stock's market price. Conversely, an option is out-of-the-money when the exercise price on the grant date is above the stock's market price. An option that has an exercise price equal to the stock's market price on the grant date is considered at-the-money.
An employee typically cannot exercise options, until the employee has a vested right (i.e., a legal right that is not contingent on the performance of additional services) in the option pursuant to the stock option plan's terms. Some companies permit immediate vesting upon issuance of an option, while others delay vesting several years or allow incremental vesting over a period of years.
Petitioner, pursuant to broad-based plans (i.e., plans that offer ESOs to 20 percent or more of a company's employees), offered three types of stock option compensation: ISOs, NSOs, and ESPP purchase rights. All ISOs and NSOs issued by petitioner were at-the-money. All ESPP purchase rights were issued with an exercise price equal to 85 percent of the stock's market price. Prior to and during the 1997 taxable year, the options were generally subject to a 5–year vesting period. After 1997, petitioner decreased the vesting period from 5 to 4 years.
Pursuant to the stock option plan, employees could exercise options by delivering to petitioner's broker a notice of exercise with irrevocable instructions and consideration equal to the exercise price. The broker would then deliver the instructions and consideration to petitioner. Employees could elect to exercise their options in either a “same-day-sale” or “buy-and-hold” transaction. In a same-day-sale, the employee does not make a payment for the stock relating to the option. Instead, simultaneous execution of the option and sale of the stock results in the excess of the stock's market price on the grant date over the exercise price going to the employee and the amount of the exercise price going to petitioner. In a buy-and-hold transaction, the employee pays the exercise price by presenting a check or other form of consideration to petitioner's broker and in exchange receives the shares of stock.
In 1988, petitioner established the Xilinx 1988 Stock Option Plan (1988 Stock Option Plan). The 1988 Stock Option Plan provided for the grant of ISOs and NSOs. Under the 1988 Stock Option Plan, petitioner granted options as part...
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