Xilinx Inc v. Comm'r Of Internal, 06-74246

• Decision Date: 22 March 2010
• Docket Number: No. 06-74246,No. 06-74269.,06-74246,06-74269.
• Citation: 598 F.3d 1191
• Parties: XILINX, INC., and Consolidated Subsidiaries, PetitionerAppellee, v. COMMISSIONER OF INTERNAL REVENUE, RespondentAppellant. Xilinx, Inc., and Consolidated Subsidiaries, PetitionerAppellee, v. Commissioner of Internal Revenue, Respondent-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

598 F.3d 1191

XILINX, INC., and Consolidated Subsidiaries, PetitionerAppellee, v. COMMISSIONER OF INTERNAL REVENUE, RespondentAppellant. Xilinx, Inc., and Consolidated Subsidiaries, PetitionerAppellee, v. Commissioner of Internal Revenue, Respondent-Appellant.

No. 06-74246

No. 06-74269.

United States Court of Appeals Ninth Circuit.

Argued and Submitted March 12, 2008.

Filed March 22, 2010.

Gilbert S. Rothenberg, Richard Farber and Arthur T. Catterall (argued), Tax Division, Department of Justice, Washington D.C., for the respondent-appellant.

Ronald B. Schrotenboer, Kenneth B Clark (argued) and Tyler A. Baker, Fenwick & West LLP, Mountain View, CA Seth P. Waxman, Edward C. DuMont, WilmerHale, LLP, Washington, DC, for the petitioner-appellee.

Alice E. Loughran, Steptoe & Johnson LLP, Washington, D.C., for amici curiae Cisco Systems, Inc., and Altera Corporation.

A. Duane Webber, Baker & McKenzie LLP, Washington, D.C., for amici curiae Software Finance and Tax Executives Council and AeA.

Appeal from a Decision of the United States Tax Court Maurice B. Foley, Tax Court Judge, Presiding. Tax Ct. Nos 702-03, 4142-01.

Before: STEPHEN REINHARDT, JOHN T. NOONAN, JR. and RAYMOND C. FISHER, Circuit Judges.

Opinion by Judge NOONAN; Concurrence by Judge FISHER; Dissent by Judge REINHARDT.

NOONAN, Circuit Judge:

On this appeal from the tax court, we must decide whether, under the tax regulations in effect during tax years 1997 1998 and 1999, related companies engaged in a joint venture to develop intangible property must include the value of certain stock option compensation one participant gives to its employees in the pool of costs to be shared under a cost sharing agreement, even when companies operating at arm's length would not do so. The tax court found related companies are not required to share such costs and ruled that the Commissioner of Internal Revenue's attempt to allocate such costs was arbitrary and capricious. We affirm.

I. BACKGROUND

Xilinx, Inc. ("Xilinx") researches, develops, manufactures, and markets integrated circuit devices and related development software systems. Xilinx wanted to expand its position in the European market and established Xilinx Ireland ("XI") in 1994 as an unlimited liability company under the laws of Ireland. XI sold programmable logic devices and conducted research and development ("R & D"). Two wholly owned Irish subsidiaries of Xilinx owned XI during the tax years of 1997, 1998 and 1999, the only years at issue in this appeal.

In 1995, Xilinx and XI entered into a Cost and Risk Sharing Agreement ("the Agreement"), which provided that all right, title and interest in new technology developed by either Xilinx or XI would be jointly owned. Under the Agreement, each party was required to pay a percentage of the total R&D costs in proportion to the anticipated benefits to each from the new technology that was expected to be created. Specifically, the Agreement required the parties to share: (1) direct costs, defined as costs directly related to the R&Dof new technology, including, but not limited to, salaries, bonuses and other payroll costs and benefits; (2) indirect costs, defined as costs incurred by departments not involved in R & D that generally benefit R & D, including, but not limited to, administrative, legal, accounting and insurance costs; and (3) costs incurred to acquire products or intellectual property rights necessary to conduct R&D. The Agreement did not specifically address whether employee stock options ("ESOs") were a cost to be shared.

Xilinx offered ESOs to its employees under two plans. Under one plan, employees were granted options as part of the employee hiring and retention program. The options were of two varieties: incentive stock options ("ISOs") and nonstatutory stock options ("NSOs"). Employees could exercise these options two ways: (1) by purchasing the stock at the market price on the day the option was issued ("exercise price") regardless of its thencurrent market price or (2) by simultaneously exercising the option at the exercise price and selling it at its then-current price, pocketing the difference. Under the other plan, employees could acquire employee stock purchase plan shares ("ESPPs") by contributing to an account through payroll deductions and purchasing stock at 85 percent of either its exercise price or its market price on the purchase date. Employees must always pay taxes on NSOs, see 26 U.S.C. § 83, but have to pay taxes on ISOs and ESPPs only if they sell acquired stock shares before a specified waiting period has expired ("a disqual ifying disposition"), see 26 U.S.C. § 421(b). In determining the R&D costs to be shared under the Agreement for tax years 1997, 1998 and 1999, Xilinx did not include any amount related to ESOs.

In tax years 1997, 1998 and 1999, Xilinx deducted as business expenses under 26 U.S.C. §§ 83 and 162 approximately $41,000, 000, $40,000, 000 and $96,000, 000, respectively, based on its employees' exercises of NSOs or disqualifying dispositions of ISOs and ESPPs.¹ It also claimed an R & D credit under 26 U.S.C. § 41 for wages related to R & D activity, of which approximately $34,000, 000, $23,000, 000 and $27,000, 000 in the respective tax years were attributable to exercised NSOs or disqualifying dispositions of ISOs and ESPPs.² Furthermore, in 1996 Xilinx and XI entered into two agreements that allowed XI employees to acquire options for Xilinx stock. Both agreements provided XI would pay Xilinx for the "cost" of the XI employees' exercise of the stock options, which was to equal the stock's market price on the exercise date minus the exercise price. In the 1997, 1998 and 1999 tax years, XI paid Xilinx $402,978, $243,094 and $808,059, respectively, under these agreements.

The Commissioner of Internal Revenue ("Commissioner") issued notices of deficiency against Xilinx for tax years 1997, 1998 and 1999, contending ESOs issued to its employees involved in or supporting R & D activities were costs that should have been shared between Xilinx and XI under the Agreement. Specifically, the Commis-sioner concluded the amount Xilinx deducted under 26 U.S.C. § 83(h) for its employees' exercises of NSOs or disqualifying dispositions of ISOs and ESPPs should have been shared. By sharing those costs with XI, Xilinx's deduction would be reduced, thereby increasing its taxable income. The Commissioner's determination resulted in substantial tax deficiencies and accuracy-related penalties under 26 U.S.C. § 6662(a).

Xilinx timely filed suit in the tax court. The tax court denied cross motions for summary judgment. After a bench trial, the tax court found that two unrelated parties in a cost sharing agreement would not share any costs related to ESOs. After assuming ESOs were costs for purposes of 26 C.F.R. § 1.482-7A(d)(l), the tax court then found 26 C.F.R. § 1.482-l(b)(D— which requires cost sharing agreements between related parties to reflect how two unrelated parties operating at arm's length would behave—dispositive and concluded the Commissioner's allocation was arbitrary and capricious because it included the ESOs in the pool of costs to be shared under the Agreement, even though two unrelated companies dealing with each other at arm's length would not share those costs.

The Commissioner timely appealed. On appeal, the parties focused primarily on whether the requirement in 26 C.F.R. § 1.482-7A(d)(l) that "all costs" be shared between related parties in a cost sharing agreement or whether the controlling requirement was 26 C.F.R. § 1.482-l(b)(l) that all transactions between related parties reflect what two parties operating at arm's length would do. After oral argument, we requested supplemental briefing on whether ESOs were "costs" and whether they were "related to" the intangible product development for purposes of 26 C.F.R. § 1.482-7A(d)(l), and whether a literal application of 26 C.F.R. § 1.482 7A(d)(l) would conflict with a tax treaty between the United States and Ireland that was in effect during the 1998 and 1999 tax years.

II. STANDARD OF REVIEW

"Decisions of the tax court are reviewed on the same basis as decisions from civil bench trials in the district court." DHL Corp. v. Comm'r, 285 F.3d 1210, 1216 (9th Cir.2002). "Thus, we review the tax court's conclusions of law de novo and its factual findings for clear error." Id.

III. DISCUSSION

The Commissioner does not dispute the tax court's factual finding that unrelated parties would not share ESOs as a cost. Instead, the Commissioner maintains ESOs are a cost that must be shared under § 1.482-7A(d)(l), even if unrelated parties would not share them.

Ambiguity. Congress has authorized the Secretary of the Treasury to allocate income and deductions among related business entities to prevent tax avoidance.

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)) the income with respect to such transferor license shall be commensurate with the income attributable to the intangible.

26 U.S.C. § 482. The Secretary in turn promulgated regulations authorizing the Commissioner to allocate income and deductions among related entities. The introduction to these regulations explains:

The purpose of section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the...