Cost-sharing agreements and the arm's-length standard.

• Author: Wilkinson, Brett

In 2009, the Ninth Circuit Court of Appeals ignited a firestorm with its Xilinx decision. (1) At issue in the case was whether related parties in a cost-sharing agreement should be required to share the costs of employee stock options. Although the court agreed that unrelated parties would not share such costs, it concluded that the more specific cost-sharing provision in the regulations (which required parties to share "all costs") trumped the general arm's-length requirement. That is, although the court accepted that sharing the stock option costs would be inconsistent with the arm's-length standard, there were instances in which the law imposed a requirement that went beyond arm's length. Not surprisingly, the position that the arm's-length standard could be overridden was highly controversial. (2)

Following the public outcry over its initial decision, the court withdrew the decision in early 2010. On March 22, 2010, the Ninth Circuit issued a new decision in which it reversed its prior holding in Xilinx (3) The new decision affirms the Tax Court's position that unrelated parties to cost-sharing agreements should not be forced to include the cost of stock options in cost-sharing agreements because unrelated parties do not share such costs. (4)

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Despite this reversal, there is still uncertainty around this issue for several reasons. First, the court was divided in its decision, and it is not clear that this is the final word on stock options and cost-sharing agreements. In fact, the comments of the dissenting judge suggest some possible grounds for appeal. In his dissenting opinion, Judge Reinhardt argued that although there may be an error in the law, the courts are given only the task of interpreting the law and not correcting perceived inequities or errors. (5) The latter role belongs to congressional lawmakers and not to the courts. All three judges appeared to acknowledge inconsistency in the law but resolved this in different ways. It would therefore seem that there is a high likelihood of further legal review to resolve this inconsistency.

Second, if the current decision stands, it calls into question the validity of the revised cost-sharing regulations that explicitly require stock option costs to be shared. Several commentators raised this concern after the initial Tax Court decision (6) and questioned whether Treasury can require a result that has been shown to be inconsistent with arm's-length behavior. If anything, the Ninth Circuit's affirmation likely exacerbates this concern. Noting the conflict in the law, Judge Fisher of the Ninth Circuit stated in a footnote to his concurring opinion that "[i]t is an open question whether these flaws have been addressed in the new regulations Treasury issued after the tax years at issue in this case." (7) In effect, a question remains as to whether Treasury will issue new or revised regulations and whether the regulations as they exist would withstand a challenge.

Tax Court

The Xilinx controversy centers on the cost-sharing agreement between Xilinx Incorporated (Xilinx) and its Irish subsidiary, Xilinx Ireland (XI). The parties agreed to split both direct and indirect costs involved in the research and development process in a ratio that reflected the reasonably anticipated benefits that each party would derive from the resulting intangible property. With respect to the employees engaged in the active research process, the parties shared a variety of salary and payroll expenses but chose not to share any costs related to the stock options made available to Xilinx's U.S. employees. In effect, this permitted the entire cost of the options to be deducted in the United States, despite the fact that the resultant technology was shared between Xilinx and XI.

In support of its...