"Cost Sharing" Pacts Come Under Scrutiny

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.

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.

"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.

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