“Cost Sharing” Pacts Come Under Scrutiny

A recent court ruling sets an ominous tone for joint venture arrangements with foreign affiliates.
Robert WillensJune 8, 2009

Many multinational companies establish joint venture arrangements with their foreign affiliates, particularly with those affiliates that are organized in countries that have relatively low corporate tax rates in relation to the United States. If a disproportionate share of the income the venture produces can be apportioned to the partner located in the low-tax jurisdiction, the worldwide income tax burden of the economic family will decline and obvious benefits are reaped.

Such a cost-sharing arrangement was at issue in an important case that was recently decided involving Xilinx Inc. Although the tax court had found in favor of the company, the U.S. Court of Appeals for the Ninth Circuit recently reversed the lower court’s decision with the result that similarly situated multinationals, who embraced the accounting conventions that Xilinx employed, may find that their tax returns for any years which remain “open” will come under withering Internal Revenue Service scrutiny.

In Xilinx, Inc. v. Commissioner_F.3d_ (9th Cir. 2009), we find that the software maker wanted to “expand its position” in the European market and, to this end, it established Xilinx Ireland (XI) in 1994. In 1995, Xilinx and XI entered into a “cost and risk sharing agreement” which provided that all right, title, and interest in new technology developed by either entity would be jointly owned. The agreement required that the parties share direct costs, including salaries, bonuses and other payroll costs and benefits; indirect costs; and costs incurred to acquire products or intellectual property rights necessary to conduct research and development.

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Xilinx offered employee stock options (ESOs) to its workers under two plans. In determining the R&D costs to be shared in connection with the agreement, Xilinx did not include any amount related to ESOs. The IRS, in response to this omission, issued notices of deficiency against Xilix in which it contended that ESOs issued to employees involved in or supporting R&D activities were costs that should have been shared under the agreement.

The tax court found that two unrelated parties in a cost sharing agreement would not share any costs related to ESOs and concluded that the commissioner’s allocation (of ESO costs to XI) was both arbitrary and capricious and, therefore, should be set aside. The commissioner, as expected, appealed the decision to the Ninth Circuit Court of Appeals. There, the IRS argued that ESOs are a cost that must be shared under Regulation Section 1.482-7(d)(1) even if unrelated parties would not share them.

Irreconcilable Regulations

Section 482 of the Internal Revenue Code provides that in any case of two or more organizations, trades, or businesses owned or controlled by the “same interests,” the Secretary of the Treasury may allocate gross income, deductions, credits or allowances between or among the businesses under two circumstances. If the secretary determines that the allocation is necessary to prevent evasion of taxes or needed to “clearly to reflect” the income of the organizations, trades or businesses.

Moreover, Regulation Section 1.482-1(b)(1) specifies that the “true taxable income” of controlled parties is calculated based on how parties operating at arms-length would behave. This so-called “arms-length standard” is to be applied in every case. Thus, in the context of cost sharing agreements, this standard would require controlled parties to share only those costs that uncontrolled parties would share. 

By contrast, Regulation Section 1.482-7(d)(1) specifies that controlled parties in a cost sharing agreement must share all costs “related to the intangible development activity.” As a result, each provision’s plain language mandates a diametrically opposite result.

The court noted that because the all-costs requirement is irreconcilable with the arms-length standard, the standard controls the situation. Indeed, the tenet of statutory construction provides that:  …”where there is no clear indication otherwise, a specific statute will not be nullified by a general one…”

In short, the all-costs requirement is not affected by unrelated parties’ conduct based on the regulatory regime’s plain language. Therefore, the court found that the arms-length regulation and the all-costs regulation “cannot be harmonized” with the result that the latter, being the more specific of the two, must control.1

Costs “Related To” Intangible Development Activity

In light of the fact that Regulation Section 1.482-7(d)(1) controls the situation, the court found that the Commissioner properly allocated the ESO amounts only if they were “costs incurred by Xilinx related to the intangible development activity.” Xilinx maintained that ESOs are not costs.

Bob Willens 2“The court found that Xilinx’s argument was fatally undermined by both the regulatory language and company’s own income tax return. Thus, costs incurred related to the intangible development activity are “operating expenses.” — Robert Willens

However, the court found that Xilinx’s argument was fatally undermined by both the regulatory language and company’s own income tax return. Thus, costs incurred related to the intangible development activity are “operating expenses” as defined in Regulation Section 1.482-5(d)(3). Operating expenses, in turn, encompass all expenses not included in cost of goods sold – except for any expenses not related to the operation of the relevant business activity.

Here, Xilinx stipulated that it did not include the value of ESOs in cost of goods sold. Further, it claimed tax deductions for exercised “non-qualified” options and the “disqualifying dispositions” of the incentive stock options and employee stock purchase plans as business expenses. But the court reasoned that Xilinx could not have claimed deductions of those ESOs unless they were an expense which is, as indicated, the key term in the definition of “cost.” Accordingly, the court held that the ESO value that Xilinx deducted as a business expense is, indeed, a cost for purposes of Regulation Section 1.482-7(d)(1).

The court noted that Xilinx never suggests that salaries or benefits for employees involved in R&D activities are not related to their work on the R&D activities. To be sure, the court observed that it is difficult to view ESOs “as anything but” part of Xilinx’s employee compensation package because it is undeniably a benefit conferred in exchange for services rendered.

In other words, ESOs are “just as related to” an employee’s work as any other employment benefit or compensation. In fact, the court noted that Xilinx claimed the ESOs as part of a tax credit available for wages paid or incurred to an employee for “qualified research services” performed by such employee. So Xilinx’s inclusion of ESOs for purposes of the R&D credit clearly undermined its (futile) attempt to argue that those ESOs are somehow not “related to” the same research activity.

As a result, the court concluded that the ESO costs for employees who were involved in activities that would contribute to the joint venture between Xilinx and XI should have been shared. Therefore, the Commissioner’s attempt to increase Xilinx’s taxable income – by allocating expenses to XI – was successful.

The implications of this decision for other taxpayers who have been involved in cost sharing arrangements with affiliates situated in low-tax jurisdictions is both obvious and ominous.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

Footnotes1The Internal Revenue Service has since modified the regulations to state, explicitly, that ESOs are costs that must be shared and that the all costs requirement is, indeed, an arms-length result. (See Regulation Sec. 1.482-7T(a) and (d)(1)(iii). )



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