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Justice Responds to Xilinx and Amici Briefs in Appeal of Tax Court Ruling

APR. 26, 2007

Xilinx Inc et al. v. Commissioner

DATED APR. 26, 2007
DOCUMENT ATTRIBUTES
  • Case Name
    XILINX, INC. AND CONSOLIDATED SUBSIDIARIES, Petitioner-Appellee v . COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant
  • Court
    United States Court of Appeals for the Ninth Circuit
  • Docket
    Nos. 06-74246, 06-74269
  • Authors
    O'Connor, Eileen J.
    Korb, Donald L.
    Morrison, Richard T.
    Rothenberg, Gilbert S.
    Farber, Richard
    Catterall, Arthur T.
  • Institutional Authors
    Justice Department
  • Cross-Reference
    For the Tax Court opinion in Xilinx Inc. et al. v.

    Commissioner, 125 T.C. No. 4 (Aug. 25, 2005), see Doc 2005-

    18073 [PDF] or 2005 TNT 168-4 2005 TNT 168-4: Court Opinions.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2007-10882
  • Tax Analysts Electronic Citation
    2007 TNT 91-19

Xilinx Inc et al. v. Commissioner

 

IN THE UNITED STATES COURT OF APPEALS

 

FOR THE NINTH CIRCUIT

 

 

ON APPEAL FROM THE DECISION OF

 

THE UNITED STATES TAX COURT

 

REPLY BRIEF FOR THE APPELLANT

 

 

Eileen J. O'Connor

 

Assistant Attorney General

 

 

Donald L. Korb

 

Chief Counsel, Internal Revenue Service

 

 

Richard T. Morrison

 

Deputy Assistant Attorney General

 

 

Gilbert S. Rothenberg (202) 514-3361

 

Richard Farber (202) 514-2959

 

Arthur T. Catterall (202) 514-2937

 

Attorneys

 

Tax Division

 

Department of Justice

 

Post Office Box 502

 

Washington, D.C. 20044

 

 

                       TABLE OF CONTENTS

 

 

 Table of authorities

 

 

 Glossary

 

 

 Introduction

 

 

 A. Neither § 1.482-1(b)(1) nor any other provision of §

 

 1.482-1 requires consideration of external benchmarks in every

 

 instance, which would be the only reason for not applying the

 

 "all costs" requirement of § 1.482-7(d)(1) in accordance

 

 with its terms

 

 

      1. Xilinx expressly disclaims any argument that § 1.482-

 

      1(b)(1) requires consideration of external benchmarks in every

 

      instance

 

 

      2. Xilinx's reliance on other provisions of § 1.482-1 is

 

      misplaced

 

 

 B. Xilinx's attempt to reconcile the Tax Court's decision with the

 

 "all costs" requirement of § 1.482-7(d)(1) is unavailing

 

 

      1. Xilinx's assertion that costs unrelated parties would not

 

      share are not "related" to the intangible development

 

      area and therefore are not subject to the "all costs"

 

      requirement of § 1.482-7(d)(1) ignores the Tax Court's

 

      regulatory analysis and disregards the plain meaning of the word

 

      "related"

 

 

      2. In asserting that § 1.482-1 operates to exclude from the

 

      pool of "all costs" required to be shared under §

 

      1.482-7(d)(1) any costs that unrelated parties would not share,

 

      Xilinx assumes the issue to be decided

 

 

      3. Xilinx's implication that, as a factual matter, the stock-

 

      based compensation expense at issue was not related to its

 

      intangible development activity assumes a factual determination

 

      that the Tax Court did not make

 

 

      4. Xilinx ignores the Tax Court's assumption that Xilinx's

 

      stock-based compensation expenses were costs within the meaning

 

      of § 1.482-7(d)(1)

 

 

 C. Xilinx and the amici have no answer to the 1986 Conference Report,

 

 which expressly contemplates that a cost-sharing arrangement will

 

 satisfy the commensurate-with-income requirement if the parties

 

 thereto share all costs in proportion to profits

 

 

 D. Xilinx and the amici make no attempt to demonstrate that their

 

 position is consistent with the commensurate-with-income requirement

 

 

 E. The treaty-based arguments of Xilinx and the amici similarly fail

 

 to account for the commensurate-with-income requirement, which has

 

 been part of U.S. transfer pricing law for more than 20 years

 

 

 Conclusion

 

 

 Addendum

 

 

 Certificate of compliance

 

 

 Certificate of service

 

 

                      TABLE OF AUTHORITIES

 

 

 Cases:

 

 

 A-Z Int'l v. Phillips, 323 F.3d 1141 (9th Cir. 2003)

 

 

 Greger v. Barnhart, 464 F.3d 968 (9th Cir. 2006)

 

 

 Nealon v. Cal. Stevedore & Ballast Co., 996 F.2d 966 (9th Cir. 1993)

 

 

 United States v. LSL Biotechnologies, 379 F.3d 672 (9th Cir. 2004)

 

 

 Statutes:

 

 

 Internal Revenue Code (26 U.S.C.):

 

 

      § 41

 

      § 482

 

 

 Rules and Regulations:

 

 

 Fed. R. Evid. 401

 

 

 Treasury Regulations (26 C.F.R.):

 

 

      § 1.482-1

 

      § 1.482-1(a)(1)

 

      § 1.482-1(a)(2)

 

      § 1.482-1(b)(1)

 

      § 1.482-1(c)(1)

 

      § 1.482-1(d)(1)

 

      § 1.482-1(i)

 

      § 1.482-1(i)(9)

 

      § 1.482-2(b)(3)

 

      § 1.482-2(b)(5)

 

      § 1.482-5(d)(3)

 

      § 1.482-7

 

      § 1.482-7(a)(2)

 

      § 1.482-7(d)(1)

 

      § 1.482-7(f)(3)

 

      § 1.482-7(f)(3)(I)

 

 

 Miscellaneous:

 

 

 American Heritage Dictionary of the English Language (3d ed. 1992)

 

 

 H.R. Conf. Rep. No. 99-841 (1986), reprinted in 1986-3 C.B. (Vol. 4)

 

 

 H.R. Rep. No. 99-426 (1985), reprinted in 1986-3 C.B. (Vol. 2)

 

 

 Notice 88-123, 1988-2 C.B. 458

 

 

 Temp. Treas. Reg. § 1.482-1T(a)(1) (1993)

 

 

 T.D. 8552, 1994-2 C.B. 93

 

 

 United States Model Technical Explanation Accompanying the United

 

 States Model Income Tax Convention of November 15, 2006, reprinted

 

 in 1 Tax Treaties (CCH) ¶ 215

 

 

                            GLOSSARY

 

 

      As used herein:

 

 

      "AB" refers to the brief of amici curiae.

 

 

      "CB" refers to the Commissioner's opening brief.

 

 

      "ER" refers to Appellant's excerpts of record.

 

 

      "OECD" refers to the Organization for Economic

 

 Cooperation and Development.

 

 

      "QCSA" refers to "qualified cost-sharing

 

 arrangement" within the meaning of Treas. Reg. § 1.482-7 as

 

 in effect during the years at issue.

 

 

      "R&D" refers to research and development.

 

 

      "XB" refers to Xilinx's answering brief.

 

 

      "XI" refers to Xilinx Ireland, an Irish limited

 

 liability company indirectly owned by petitioner-appellee Xilinx,

 

 Inc. during the years at issue.

 

INTRODUCTION

 

 

I.R.C. § 482 authorizes the Commissioner to allocate income and deductions among commonly controlled organizations as necessary "to prevent evasion of taxes or clearly to reflect the income" of such organizations. In 1986, Congress added the requirement that, in the case of a transfer or license of intangible property, the income with respect to the transfer or license must be commensurate with the income attributable to the intangible.

In determining whether the Commissioner is authorized to exercise his authority under § 482, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer (the arm's-length standard). See Treas. Reg. § 1.482-1(a)(2), (b)(1).1 Section 1.482-1(b)(1) further provides that "whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances."

In the area of intangible development activity, Treas. Reg. § 1.482-7(a)(2) provides that the Commissioner shall not make allocations with respect to a qualified cost-sharing arrangement (QCSA) (i.e., such an arrangement will be deemed to satisfy the arm's-length standard) if each controlled participant's share of the costs of intangible development equals its share of reasonably anticipated benefits attributable to such development. Section 1.482- 7(d)(1) provides that the costs of intangible development required to be shared under this rule include all of the costs related to the intangible development area, except depreciation or amortization expense and, by reference to § 1.482-5(d)(3), interest expense and foreign and domestic income taxes.

Xilinx jointly developed intangible property with its Irish subsidiary (XI) pursuant to an agreement to share development costs in proportion to the parties' shares of reasonably anticipated benefits from the intangible property so developed. Xilinx wants to take advantage of the relative certainty afforded a QCSA under § 1.482-7(a)(2) without having to share with (allocate to) XI any portion of its stock-based compensation expense related to the intangible development activity, as required under the "all costs" rule of § 1.482-7(d)(1). The Tax Court held that § 1.482-7(d)(1) conflicts with, and is overridden by, the provisions of § 1.482-1 relating to the arm's-length standard. In particular, the court found the "all costs" requirement of § 1.482-7(d)(1) to be invalid because it requires controlled participants in a QCSA to share all costs related to the intangible development activity, without regard to whether uncontrolled participants in similar cost-sharing arrangements would share all such costs.

In our opening brief, we demonstrated that the language of § 1.482-1(b)(1) does not require consideration of uncontrolled parties or transactions (hereafter, "external benchmarks") in every instance and therefore does not conflict with the "all costs" requirement of § 1.482-7(d)(1). CB 24-31.2 Perhaps recognizing the vulnerability of a regulatory interpretation that creates an irreconcilable conflict with another provision of the same regulations, see, e.g., Nealon v. Cal. Stevedore & Ballast Co., 996 F.2d 966, 972 (9th Cir. 1993), Xilinx expressly disclaims any argument that § 1.482-1(b)(1) requires consideration of external benchmarks in all instances. As a consequence, Xilinx is forced to argue that the Tax Court's decision is entirely consistent with the "all costs" requirement of § 1.482-7(d)(1), an argument that is fatally flawed in several respects.

We also demonstrated in our opening brief that the "all costs" requirement of § 1.482-7(d)(1) (as well as the sharing ratio mandated by § 1.482-7(a)(2)) flows directly from the report of the House-Senate Conference Committee (the "Conference Report") accompanying the legislation that added the commensurate-with-income requirement to § 482 in 1986. CB 38-40. Neither Xilinx nor the amici have any answer to the Conference Report, which directly supports the Commissioner's interpretation of his own regulations in this case.

The failure of Xilinx and the amici to deal with the Conference Report reveals a common thread running through their respective briefs: the lack of any attempt to account for the role of the commensurate-with-income requirement in transfer pricing analysis in general or its application to cost-sharing arrangements specifically. To fill that void, we examine the interrelationship between the arm's-length standard and the commensurate-with-income requirement, thereby providing a broader context for our analysis of the specific regulatory language at issue. When considered in this broader context, the treaty arguments proffered by both Xilinx and the amici reveal themselves for what they are -- rehashed criticism of Congress's enactment of the commensurate-with-income requirement in 1986. These attacks do nothing to cast doubt on the Commissioner's promulgation of the "all costs" requirement in § 1.482-7(d)(1), which, as indicated above, is clearly authorized under the commensurate-with-income requirement.

As a final introductory point, we note that Xilinx misstates the issue as "[w]hether the Tax Court erred in determining that, pursuant to Treas. Reg. § 1.482-1(a)(1), the arm's length standard applies to determining the appropriate allocation of costs in a cost sharing arrangement subject to Treas. Reg. § 1.482-7." XB 1.3 That, plainly, is not the issue -- § 1.482-1(b)(1) clearly states that the arm's-length standard is applicable "in every case." The issue, rather, is whether § 1.482-1(b)(1) (or any other provision of § 1.482-1 relating to the arm's-length standard), contrary to the "all costs" requirement of § 1.482-7(d)(1), affords controlled participants in a QCSA the right to determine the pool of costs required to be shared thereunder by reference to the costs that unrelated parties would share.4See CB 3-4.

A. Neither § 1.482-1(b)(1) nor any other provision of § 1.482-1 requires consideration of external benchmarks in every instance, which would be the only reason for not applying the "all costs" requirement of § 1.482-7(d)(1) in accordance with its terms

 

1. Xilinx expressly disclaims any argument that § 1482-1(b)(1) requires consideration of external benchmarks in every instance

 

The interpretive issue in this case involves the second and third sentences of § 1.482-1(b)(1):

 

. . . A controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm's length result). However, because identical transactions can rarely be located, whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances. . . .

 

The Commissioner's position throughout this litigation has been that the unambiguous language of § 1.482-7(d)(1), requiring controlled participants in a QCSA to share "all of the costs" related to the intangible development activity (i.e., without reference to whether uncontrolled parties would share all such costs), is consistent with the statement in the third sentence of § 1.482-1(b)(1) that "whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances." [Emphasis added.]5

The Tax Court rejected the Commissioner's position, concluding that the opening clause of the third sentence ("However, because identical transactions can rarely be located,"), read in conjunction with the immediately preceding (second) sentence, indicates that " 'comparable transactions' are the broad exception available when there are no identical transactions." ER 34. Based on that statement, and because the "all costs" requirement of § 1.482-7(d)(1) would be dispositive in the absence of a rule requiring consideration of external benchmarks in all cases, the Commissioner interpreted the Tax Court's decision as requiring consideration of uncontrolled transactions (be they identical or comparable) in all cases.6 CB 25, 26.

In our opening brief, we demonstrated that the Tax Court had erroneously transformed the second sentence of § 1.482-1(b)(1) from a recitation of the general standard for evaluating controlled transactions to a rule providing the preferred means for satisfying that standard (i.e., evidence of actual, identical transactions). CB 25-26.7 Xilinx wisely does not defend the Tax Court's anomalous interpretation, acknowledging that, under a "straightforward and common sense reading" of § 1.482- 1(b)(1), XB 24,

 

the second sentence sets forth a general standard and a measure (arm's length result) to evaluate taxpayers' controlled transactions. The third sentence of the section then explains that comparable transactions are the general way to test whether the standard is met. . . . [ Ibid.]

 

Given this common ground between the parties, on what valid basis could the Tax Court conclude that § 1.482-1(b)(1) requires consideration of external benchmarks in all instances? The answer is that there is no such valid basis; indeed, Xilinx does not even attempt to defend the Tax Court's decision in this regard. Instead, Xilinx expressly states that the question whether § 1.482-1(b)(1) requires consideration of external benchmarks in all instances is irrelevant: "The relevant point is that, at the very least, [ § 1.482-1(b)(1)] permits comparability analysis and does not require exclusion of evidence." XB 24.

That § 1.482-1(b)(1) generally contemplates the use of comparability analysis -- and, more broadly, does not, by its terms, preclude consideration of external benchmarks in any case -- is beside the point, given that the regulation specifically applicable to cost-sharing arrangements (and thus the regulation that is controlling here) does preclude consideration of external benchmarks to establish the cost pool under a QCSA by requiring the parties to share "all of the costs" related to the intangible development activity. As indicated above, the "all costs" requirement of § 1.482-7(d)(1) is dispositive here in the absence of a rule requiring consideration of external benchmarks in all cases. As a matter of simple logic, a general provision that does not preclude consideration of external benchmarks in any case does not require consideration of such benchmarks in all cases.8

Xilinx's misconception of this point is evident in its account of the proceedings below. Xilinx correctly states that "[d]uring trial, [the Commissioner] asserted that evidence of what arm's length parties actually would do [in terms of cost sharing] should be precluded." XB 14. However, Xilinx incorrectly states that the Commissioner "assert[ed] that the third sentence of [ § 1.482-1(b)(1)] precluded consideration of" such evidence. Id. at 15; see also id. at 30 (similar). The Commissioner argued nothing of the sort. The Commissioner argued (and continues to argue) that the unambiguous language of § 1.482- 7(d)(1), requiring controlled participants in a QCSA to share "all of the costs" related to the intangible development activity, precludes consideration of external benchmarks in that regard. As indicated by the colloquy between the Tax Court and the Commissioner's trial counsel cited by Xilinx, id. at 14-15, it is the Commissioner's position that § 1.482-1(b)(1) does not stand in the way of applying § 1.482-7(d)(1) in accordance with its terms.

 

2. Xilinx's reliance on other provisions of § 1.482-1 is misplaced

 

Xilinx asserts that "[t]he plain meaning of numerous other provisions of Treas. Reg. § 1.482-1 confirms that comparable transactions evidence is not precluded." XB 25. Again, the issue is not whether any provision of § 1.482-1 precludes consideration of external benchmarks -- it is the "all costs" requirement of § 1.482-7(d)(1) that does so. The issue presented by the Tax Court's decision is whether any provision of § 1.482-1, contrary to the "all costs" requirement, requires the consideration of external benchmarks in all instances. As demonstrated below, none of the "numerous other provisions" cited by Xilinx does so.

Xilinx asserts that the Commissioner "did not directly address" the Tax Court's conclusion that "[t]he express language in section 1.482-1(a)(1) . . . establishes that the arm's-length standard applies to section 1.482-7 . . . for purposes of determining appropriate cost allocations." XB 25-26; ER 46. The Commissioner saw no need to address that conclusion in terms of § 1.482-1(a)(1), having already observed that § 1.482-1(b)(1) provides that the arm's-length standard applies "in every case." CB 18, 20.

Similarly, Xilinx observes that the second sentence of § 1.482-1(a)(1) introduces the concept of "true taxable income," the definition of which ("the taxable income that would have resulted had [the controlled taxpayer] dealt with the other member or members of the group at arm's length") applies to cost sharing by operation of § 1.482-1(i). XB 26 & n.20; see Treas. Reg. § 1.482-1(i)(9). That definition, however, simply restates the arm's-length standard, which the Commissioner agrees applies in all cases. See Treas. Reg. § 1.482-1(b)(1) (first sentence).

Xilinx next points to the third sentence of § 1.482-1(a)(1), which provides: "This § 1.482-1 sets forth general principles and guidelines to be followed under section 482." XB 27. It follows, Xilinx asserts, that "all of the guidelines in § 1.482-1 apply to cost sharing, including the best method rule at § 1.482-1(c) and the comparability rules at § 1.482-1(d)." Ibid. Regarding the best-method rule, Xilinx focuses on the penultimate sentence of § 1.482-1(c)(1), which provides that "if two or more applications of a single method provide inconsistent results, the arm's length result must be determined under the application that, under the facts and circumstances, provides the most reliable measure of an arm's length result." XB 28. Xilinx then reasons that its "application" of the cost-sharing regulation "provided the most reliable measure because it matched the uncontroverted evidence." XB 29. The flaw in Xilinx's reasoning is that it did not "apply" the cost-sharing regulation in accordance with its terms, which require the sharing of all costs related to the intangible development activity.

An example from another part of the § 482 regulations (as in effect during the years at issue) illustrates the defect in Xilinx's reasoning. Under § 1.482-2(b)(3), one of the methods for determining an arm's-length charge for services rendered is by establishing the costs or deductions incurred with respect to such services by the controlled organization performing the services. Section 1.482-2(b)(5), however, lists certain costs or deductions that are not to be taken into account for these purposes. Under Xilinx's interpretation of the best-method rule, taxpayers could "apply" this method without regard to § 1.482-2(b)(5) simply by arguing that such "application" produces a more appropriate result than that obtained by applying the regulation in accordance with its terms.9

Xilinx's reliance on "the comparability rules at § 1.482-1(d)," XB 27, is similarly misplaced. As Xilinx notes, § 1.482-1(d)(1) provides that "[w]hether a controlled transaction produces an arm's length result is generally evaluated by comparing the results of that transaction" to comparable uncontrolled transactions. XB 29-30. That language simply echoes the third sentence of § 1.482-1(b)(1) ("whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances"), which, as demonstrated above, clearly does not require consideration of external benchmarks in all instances. Fittingly, Xilinx repeats here the irrelevant statement it makes in the context of § 1.482-1(b)(1) -- that § 1.482-1(d)(1) permits a court (rather than requires a court in all instances) to consider external benchmarks. XB 30; see supra pp. 10-11.

B. Xilinx's attempt to reconcile the Tax Court's decision with the "all costs" requirement of § 1.482-7(d)(1) is unavailing

 

1. Xilinx's assertion that costs unrelated parties would not share are not "related" to the intangible development area and therefore are not subject to the "all costs" requirement of § 1.482-7(d)(1) ignores the Tax Court's regulatory analysis and disregards the plain meaning of the word "related"

 

Xilinx begins its quest to reconcile the Tax Court's decision with the "all costs" requirement of § 1.482-7(d)(1) by asserting (XB 38) that if an alleged expense is not of a type that unrelated parties would share, then "[t]he item is not a 'cost . . . related to the intangible development area' " within the meaning of § 1.482-7(d)(1). That argument is a non sequitur that flies in the face of the Tax Court's regulatory analysis. If the Tax Court had shared Xilinx's view that "related" costs within the meaning of § 1.482-7(d)(1) are only those costs that uncontrolled parties would share, then the court would have simply held for Xilinx on the ground that its cost-sharing arrangement satisfied all of the requirements of that regulation, i.e., that Xilinx and XI shared all "related" costs as required by the regulation. Instead, the Tax Court ruled that the provisions of § 1.482-1(b)(1) trumped those of § 1.482-7(d)(1) so as to excuse Xilinx's failure to share all related costs with XI, because the related costs that were not shared (stock-based compensation expenses) were costs that uncontrolled parties would not share. Xilinx cannot eliminate the conflict between §§ 1.482-1(b)(1) and 1.482-7(d)(1) created by the Tax Court's decision by ignoring the actual basis for that decision.

Moreover, whether a cost is "related" to the intangible development activity is a matter that is entirely distinct from the question whether uncontrolled parties operating under a cost-sharing arrangement would agree to share such cost. Uncontrolled parties might choose not to share a particular cost, even though related to the intangible development activity, because of the nature of the cost. Thus, Xilinx's attempt to limit the term "related costs" to those costs that uncontrolled parties would share violates the plain meaning of the word "related": "being connected; associated." American Heritage Dictionary of the English Language 1523 (3d ed. 1992); see, e.g., A-Z Int'l v. Phillips, 323 F.3d 1141, 1146 (9th Cir. 2003) ("unless otherwise defined, words will be interpreted as taking their ordinary, contemporary, common meaning").

 

2. In asserting that § 1.482-1 operates to exclude from the pool of "all costs" required to be shared under § 1.482-7(d)(1) any costs that unrelated parties would not share, Xilinx assumes the issue to be decided

 

Xilinx next makes an astonishingly circular argument: The Tax Court's decision does not create a conflict between §§ 1.482-1 and 1.482-7, because the pool of "all costs" required to be shared under § 1.482-7(d)(1) does not include costs that unrelated parties would not share, "which are expressly excluded by operation of Treas. Reg. § 1.482-1." XB 38. That argument begs the question presented by this case -- whether the Tax Court erred in holding that, "by operation of Treas. Reg. § 1.482-1," the pool of "all costs" required to be shared under § 1.482-7(d)(1) includes only those costs that uncontrolled parties would share. Xilinx cannot reconcile the Tax Court's decision with § 1.482-7(d)(1) on the basis of the very proposition that created the conflict in the first place.

 

3. Xilinx's implication that, as a factual matter, the stock- based compensation expense at issue was not related to its intangible development activity assumes a factual determination that the Tax Court did not make

 

Still undeterred, Xilinx asserts that excluding the costs at issue from the pool of "all of the costs . . . related to the intangible development area" referenced in § 1.482-7(d)(1) is "supported by the facts" and "accords with the plain meaning" of that provision because unrelated parties do not consider stock-based compensation expense to be related to intangible development. XB 39. The implication here is that, as a factual matter, the stock-based compensation expense at issue was not related (in the ordinary sense of that word, see Point B.1, supra) to Xilinx's intangible development activity. Xilinx acknowledges elsewhere, however, that the Tax Court did not resolve that factual issue.10 XB 67. Xilinx cannot reconcile the Tax Court's decision with § 1.482-7(d)(1) by assuming the correctness of its position on a disputed factual issue that the Tax Court did not resolve.

 

4. Xilinx ignores the Tax Court's assumption that Xilinx's stock-based compensation expenses were costs within the meaning of § 1.482-7(d)(1)

 

As a last gasp, Xilinx argues that excluding the costs at issue from the cost pool does not conflict with the "all costs" requirement of § 1.482-7(d)(1) because stock-based compensation expense is not a cost. Specifically, Xilinx claims that "[u]nder the CPM and other section 482 methods, [stock-based compensation expense is] not a cost or operating expense" and that excluding stock-based compensation expense from the § 1.482-7 cost pool pursuant to § 1.482-1(b)(1) would be consistent with that characterization. XB 39-40; see also id. at 37 & nn.29, 30 (discussing whether businesspersons considered stock-based compensation expense to be a cost). Apart from its dubious premise, this argument completely disregards the fact that the Tax Court expressly assumed, for purposes of its decision, that the stock-based compensation costs at issue are "costs" for purposes of § 1.482-7. Xilinx cannot reconcile the Tax Court's decision with § 1.482-7(d)(1) by ignoring the key assumption on which that decision was predicated.

C. Xilinx and the amici have no answer to the 1986 Conference Report, which expressly contemplates that a cost-sharing arrangement will satisfy the commensurate-with-income requirement if the parties thereto share all costs in proportion to profits

The report of the House-Senate Conference Committee (the "Conference Report") accompanying the legislation that amended § 482 in 1986 states that the purpose of the commensurate-with-income requirement is to ensure that, in the context of intangibles transactions, "the division of income between related parties reasonably reflect[s] the relative economic activity undertaken by each." H.R. Conf. Rep. No. 99-841, at II-637 (1986), reprinted in 1986-3 C.B. (Vol. 4) 1, 637. The Conference Report further indicates that a cost-sharing arrangement will satisfy this requirement if the parties thereto share all research and development costs associated with the joint development activity in proportion to their profits from the activity. Id. at II-638. Although the Tax Court discussed the corresponding report of the House Committee on Ways and Means (the "House Report"), it made no reference in its opinion to the Conference Report. See CB 38.

Xilinx's attempt to explain away the Conference Report is unpersuasive. First, Xilinx makes the irrelevant observation that the Conference Report "did not dictate that evidence of comparable transactions . . . may never be used to determine relative economic activity." XB 52.11 The Commissioner submits that, from an evidentiary standpoint, transactions between unrelated parties cannot possibly be relevant to determining the relative economic activity of the parties to a different transaction, controlled or otherwise. See Fed. R. Evid. 401.

Xilinx then makes the same flawed argument it makes in its regulatory analysis, substituting "economic activity" for "costs": "If a possible expense item is not or would not be shared at arm's length, it is not part of the parties' relative economic activity." XB 52. This argument, whether couched in terms of "economic activity" or "costs," completely ignores the fact that the Tax Court expressly assumed, without deciding the matter, that stock-based compensation expense is a "cost" for purposes of § 1.482-7. See supra Point B.4. Xilinx's ensuing discussion (XB 53-54) of the views of Messrs. Chellam, Carter, Lewin, and Murphy on this issue, as well as the treatment of stock-based compensation expense under GAAP in 1986, is therefore completely irrelevant to this appeal.12

For their part, the amici devote ten pages of their brief to the pre-1986 history of the arm's-length standard, AB 5-14, but only two paragraphs, id. at 14-16, to the 1986 amendment of § 482 that factors so prominently in this case. First, the amici assert that the 1986 amendment "reaffirmed that the arm's length standard based on uncontrolled transactions applies to all allocations." Id. at 15-16 (emphasis added). This statement flies in the face of the House Report, which clearly indicates that the driving force behind the enactment of the commensurate-with-income requirement was Congress's sense that, particularly in the context of intangible property transactions, it is not always appropriate to rely on uncontrolled transactions in determining whether a controlled transaction satisfies the arm's-length standard. See H.R. Rep. No. 99-426, at 423-425 (1985), reprinted in 1986-3 C.B. (Vol. 2) 1, 423-425; see also CB 35-37; AB 15 n.2.

The amici then casually assert that "the commensurate with income concept simply does not apply to cost sharing arrangements," because such arrangements do not involve a "transfer" of an intangible in the traditional sense of the word. AB 16. Given that almost half of the substantive discussion in the Conference Report relating to the commensurate-with-income requirement is devoted to its applicability in the context of cost- sharing arrangements (and given the amici's acknowledgment of that discussion, id. at 15 n.3), this assertion of nonapplicability is difficult to comprehend.13

D. Xilinx and the amici make no attempt to demonstrate that their position is consistent with the commensurate-with-income requirement

The foregoing discussion of legislative history reveals a common weakness in the respective briefs of Xilinx and the amici: the lack of any coherent discussion of the commensurate-with-income requirement. Xilinx and the amici are content to simply keep repeating what the commensurate-with-income requirement does not do (i.e., it does not supplant the arm's-length standard), without ever coming to grips with the purpose of the requirement. This "head in the sand" approach suggests, and the following discussion confirms, that the position of Xilinx and the amici cannot be reconciled with that purpose.

The Commissioner consistently has taken the position that the commensurate-with-income requirement added to § 482 in 1986 does not alter or supplant the arm's-length standard. See Notice 88-123, 1988-2 C.B. 458, 458. The commensurate-with-income requirement simply reflects Congress's determination that an allocation of income from an intangible among controlled parties does not reflect the parties' true taxable income unless it reasonably reflects the relative economic activity undertaken by each party with respect to the intangible -- the theory being that "[l]ooking at the income related to the intangible and splitting it according to relative economic contributions is consistent with what unrelated parties do." Notice 88-123, supra at 472.

The language in the preamble to the final regulations issued in 1994 (the "1994 Preamble") that Xilinx quotes, XB 60, confirms this thinking. Like the final version of § 1.482-1(a)(1), § 1.482-1T(a)(1) provided that tax parity between controlled and uncontrolled taxpayers is achieved "by determining the true taxable income of the controlled taxpayer"; however, the temporary regulation included the following additional clause: "in a manner that reasonably reflects the relative economic activity undertaken by each taxpayer." The 1994 Preamble explains why the additional clause was dropped:

 

The definition of true taxable income in § 1.482-1(i)(9) already incorporates the notion that, under section 482, the controlled taxpayer should earn the amount of income that would have resulted had it dealt with other controlled taxpayers at arm's length. Because a transaction at arm's length naturally would reflect the "relative economic activity undertaken," this definition incorporates that concept, and it is unnecessary to include the additional language in this provision. [T.D. 8552, 1994-2 C.B. 93, 98 (emphasis added).]

 

Xilinx cites only the italicized portion of the foregoing excerpt and concludes that such language "reinforces that [the Commissioner] . . . understood that the goal of Congress to 'reflect the economic activity' is met by looking at arm's length [ i.e., uncontrolled] transactions." XB 60-61. The Commissioner agrees that, as a general matter, "the goal of Congress to 'reflect the economic activity' " is met by looking at uncontrolled transactions. But if the attainment of that goal were inextricably tied to the consultation of uncontrolled transactions, then the addition of the commensurate-with-income requirement to § 482 would be mere surplusage, contrary to basic canons of statutory construction. See, e.g., United States v. LSL Biotechnologies, 379 F.3d 672, 679 (9th Cir. 2004).

In enacting the commensurate-with-income requirement in 1986, Congress was of the view that in at least two instances reference to uncontrolled transactions is either inappropriate or unnecessary to the determination of whether a controlled transaction satisfies the arm's-length standard. The first instance, and admittedly the impetus for amending § 482, involves licenses of unique, high-profit potential intangibles. Congress was concerned in this regard that uncontrolled transactions "frequently are not realistic comparables in these cases." H.R. Rep. No. 99-426, supra at 425. The second circumstance involves the situation presented here -- the joint development of intangibles through cost-sharing arrangements. H.R. Conf. Rep. No. 99-841, supra at II-638.

As discussed above, the Conference Report establishes that the purpose for adopting the commensurate-with-income requirement with respect to intangibles transactions was to ensure that the division of income from such transactions between related parties reasonably reflects the relative economic activity undertaken by each party. H.R. Conf. Rep. No. 99-841, supra at II-637. This requirement is a natural fit for cost-sharing arrangements, which are premised on the notion that the parties' relative economic contributions to a project should be proportionate to their anticipated economic benefits from the project. Thus, it is not at all surprising that Congress would contemplate that, in the context of cost-sharing arrangements, the goal of "reflecting the economic activity" is met by looking within rather than without; that is, a cost-sharing arrangement will satisfy the commensurate-with-income requirement if the parties thereto share all costs related to the intangible development activity in proportion to their expected profits from the activity. Id. at II-638. Conversely, if the parties exclude an activity-related cost from the cost-sharing pool, then the goal of "reflecting the economic activity" is not met, because the allocation of anticipated income from the intangible necessarily will not be proportionate to the parties' relative economic activity with respect to the intangible. See CB 30-33.

In the instant case, Xilinx indisputably excluded from the cost-sharing pool its stock-based compensation expense. If, as the Tax Court assumed, that expense constitutes a cost related to the intangible development activity, then the division of income between Xilinx and XI necessarily fails to reflect the relative economic activity undertaken by each party. Viewed in this light, Xilinx's position cannot be reconciled with the purpose of the commensurate- with-income requirement.

E. The treaty-based arguments of Xilinx and the amici similarly fail to account for the commensurate-with-income requirement, which has been part of U.S. transfer pricing law for more than 20 years

Xilinx's contention that the "all costs" requirement of § 1.482-7(d)(1) violates the 1997 U.S.-Ireland Tax Treaty (the "Ireland Treaty") flows from its attempt to ignore the commensurate-with-income requirement enacted more than 10 years before the advent of that treaty.14 Thus, Xilinx argues that because the Ireland Treaty incorporates the arm's-length standard, it "would be inconsistent with the treaty to construe the cost sharing regulations to permit an adjustment that does not correspond with" evidence of uncontrolled cost-sharing arrangements. XB 64-65. However, as demonstrated above, in adding the commensurate-with-income requirement to § 482 in 1986, Congress recognized the limitations of comparability analysis as a means of determining whether a controlled transaction involving intangibles satisfies the arm's-length standard. The promulgation of § 1.482-7 in 1995 properly implements the congressional objectives of the 1986 amendment to § 482 as they pertain to cost-sharing arrangements, and the arm's-length standard incorporated into the Ireland Treaty cannot be viewed apart from those objectives.

Xilinx also points to language in the Treasury Department's Technical Explanation of the Ireland Treaty ("Ireland Treaty Explanation) that, in Xilinx's view, is inconsistent with the "all costs" requirement of § 1.482-7(d)(1): "As with any other kind of transaction, when related parties enter into an arrangement, the specific arrangement must be examined to see whether or not it meets the arm's-length standard." XB 65. According to Xilinx,

 

The word "must" in the 1997 Ireland Treaty Explanation makes little sense if a cost sharing arrangement automatically produced an arm's length result. An arrangement would not need to be "examined" like "any other kinds [sic] of transaction." . . . [XB 66.]

 

Xilinx overstates the practical effect of the "all costs" requirement. In particular, Xilinx's suggestion that such requirement obviates the need to "examine" a cost-sharing arrangement for compliance with the arm's-length standard completely ignores the other aspect of the sharing ratio mandated by § 1.482-7(a)(2): the establishment of the parties' respective shares of reasonably anticipated benefits. See supra note 9. Section 1.482-7(f)(3) provides several pages of guidance in that regard, dispelling any notion that a cost-sharing arrangement that complies with the "all costs" requirement of § 1.482-7(d)(1) "automatically produce[s] an arm's length result." XB 66. Thus, the "all costs" requirement is entirely consistent with the proposition that, as with any other type of controlled transaction, cost-sharing arrangements must be examined on a case-by- case basis.

Finally, Xilinx's reference to an Irish tax official's concern that the "all costs" requirement of § 1.482-7(d)(1) "could potentially conflict with the OECD [Organization for Economic Cooperation and Development] arm's length principle" and the Ireland Treaty, XB 66, is wholly irrelevant to this case. As discussed below, the relevant point here is that the Treasury Department views the commensurate-with-income requirement, as implemented by the Commissioner in the § 482 regulations, to be entirely consistent with the OECD arm's-length principle and the treaty obligations of the United States. See AB 24 n.7.

The amici look beyond the Ireland Treaty, focusing primarily on the OECD Model Treaty and the U.S. Model Treaty. Their argument, however, is subject to the same infirmities that plague Xilinx's analysis. Most notably, the amici ignore the commensurate-with-income requirement, focusing, instead, on the "traditional" or "established" arm's-length standard (more accurately, the arm's-length standard without giving effect to the commensurate- with-income requirement). When the amici warn that "[t]his 'new' arbitrary approach . . . will undermine the U.S. treaty network and result in double taxation," AB ix, they are actually criticizing the commensurate-with-income requirement, not the "all costs" requirement of § 1.482-7(d)(1) that is clearly consistent with that requirement. Thus, the amici are merely attempting to revive 20- year-old "double taxation" arguments made in the wake of the 1986 legislation. See Notice 88-123, supra at 472.

The amici make much of the November 2006 release of the new U.S. Model Treaty ("2006 Model Treaty"), claiming that Treasury thereby "confirmed that the traditional arm's length standard based on uncontrolled transactions governs cost sharing arrangements." AB 22 (emphasis added). In support of that statement, the amici quote the same language in the accompanying Model Technical Explanation ("2006 Explanation") that Xilinx quotes from the Ireland Treaty Explanation regarding the need to examine cost-sharing arrangements on a case-by-case basis. Id. at 25; see supra pp. 32-33. To infer from that language, as the amici do, that "Treasury effectively advised potential treaty partners that the U.S. intends to evaluate cost sharing arrangements by reference to observable, uncontrolled transactions," AB 25, is pure fantasy.

Furthermore, from a timing standpoint, the release of the 2006 Model Treaty undermines the amici's implication that the Commissioner is acting at odds with the Treasury Department by refusing to follow U.S. treaty policy. As the amici acknowledge, AB 24 n.7, the 2006 Explanation states that

 

the commensurate with income standard for determining appropriate transfer prices for intangibles, added to Code section 482 by the Tax Reform Act of 1986, was designed to operate consistently with the arm's length standard. The implementation of this standard in the section 482 regulations is in accordance with the general principles of paragraph 1 of Article 9 of the Convention, as interpreted by the OECD Transfer Pricing Guidelines. [Emphasis added.]

 

The Secretary and the Commissioner are on the same page here. In the 2006 Explanation, the Treasury Department has reaffirmed its position that the commensurate-with-income requirement, as well as the regulations implementing that requirement (including, of course, § 1.482-7), which have been part of U.S. transfer pricing law for more than 20 years and 10 years, respectively, are entirely consistent with the treaty obligations of the United States.

 

CONCLUSION

 

 

For the reasons stated above and in the Commissioner's opening brief, this Court should reverse the decision of the Tax Court and remand the case for a determination by the Tax Court of the amount of Xilinx's stock-based compensation expense related to its intangible development activity under its cost-sharing arrangement with XI for the years at issue.

Dated: April 26, 2007

Respectfully submitted,

 

 

Eileen J. O'Connor

 

Assistant Attorney General

 

 

Donald L. Korb

 

Chief Counsel, Internal Revenue

 

Service

 

 

Richard T. Morrison

 

Deputy Assistant Attorney General

 

 

Gilbert S. Rothenberg

 

(202) 514-3361

 

Richard Farber (202) 514-2959

 

Arthur T. Catterall (202) 514-2937

 

Attorneys

 

Tax Division

 

Department of Justice

 

Post Office Box 502

 

Washington, D. C. 20044

 

FOOTNOTES

 

 

1 Unless otherwise noted, all references to Treasury Regulations are to regulations in effect during the years at issue.

2 References to "CB," "XB," and "AB" are to the Commissioner's opening brief, Xilinx's answering brief, and the brief of amici curiae, respectively. References to "ER" are to Appellant's excerpts of record.

3 This misstatement runs throughout Xilinx's brief. See, e.g., XB 20 (Point III of the Argument), 40 (Point IV.C.2), 47 (Point V), 63-64 (Point VI).

4 If the answer to that question were "yes," then the Court would still need to determine which of the conflicting regulatory provisions should prevail. Faced with the canon of construction holding that a specific provision prevails over a general one, see CB 23 n.8, Xilinx makes an incomprehensible argument denying that §§ 1.482-7 and 1.482-1 represent the specific provision and the general provision, respectively, for these purposes. XB 32 n.24.

5 Xilinx's assertion (XB 16) that the Commissioner's position is "devised for this litigation," and thus would not be entitled to deference if § 1.482-1(b)(1) were deemed ambiguous, see CB 27 n.11, is unsupportable. Suffice it to say that the preamble to the final cost-sharing regulations issued in 1995, confirming the comprehensive nature of the "all costs" requirement, see CB 43, necessarily presupposes the Commissioner's position in this case -- that § 1.482-1(b)(1) does not invariably require consideration of external benchmarks.

6 Xilinx quibbles with the Commissioner's characterization of the Tax Court's holding, insisting that the court "considered, but did not mandate," evidence of uncontrolled transactions. XB 15. In any event, the effect of the Tax Court's decision is to require consideration of uncontrolled transactions in the context of § 1.482-7 whenever the taxpayer so requests.

Xilinx also notes that the Tax Court did not limit its holding to "comparable transaction evidence," pointing to the court's "specific invitation for all kinds of evidence" (including expert opinions) regarding "what constitutes arm's length conduct." XB 14. The distinction is irrelevant for our purposes; that is, in light of the "all costs" requirement of § 1.482-7(d)(1), consideration of evidence of any kind regarding costs that unrelated parties would not share could be appropriate only if § 1.482-1(b)(1) requires consideration of external benchmarks in all instances.

7 Xilinx's contention that the Commissioner somehow raised a new issue on appeal, XB 22 & n.19, is both erroneous and irrelevant. Regarding the second point, see, e.g., Greger v. Barnhart, 464 F.3d 968, 973 (9th Cir. 2006) (Court will consider new issue on appeal where the issue presented is purely one of law and does not depend on the factual record developed below).

8 Xilinx's own bit of logic -- that even if § 1.482-1(b)(1) does not require consideration of external benchmarks in all cases, "it does not follow that evidence of comparable transactions must never be considered or that all evidence is precluded," XB 19 -- is accurate but irrelevant. The inappropriateness of consulting external benchmarks to determine the costs required to be shared under a QCSA follows from the plain meaning of the "all costs" requirement of § 1.482-7(d)(1), not § 1.482-1(b)(1).

Similarly, contrary to Xilinx's assertion (XB 18), the fact that the "willing buyer, willing seller" standard applicable to estate and gift tax valuation permits "evidence of what the hypothetical buyer and seller would agree on," ibid., does not support Xilinx's position that it may likewise refer to external benchmarks to establish the cost pool under a QCSA. Simply put, there is no analog to the "all costs" requirement of § 1.482- 7(d)(1) in the estate and gift tax regulations.

9 That is not to say that the best-method rule has no applicability to § 1.482-7. See Treas. Reg. § 1.482- 7(f)(3)(i) (applying best-method principles for purposes of determining the most reliable estimate of reasonably anticipated benefits).

10 Indeed, in addition to expressly assuming that such expenses were "costs," the Tax Court implicitly assumed that they were "related to" the intangible development activity; otherwise, there would have been no need for the court to look beyond § 1.482-7. Cf. supra pp. 17-18.

11 The sentence reads in full: "The Conference Report did not dictate that evidence of comparable transactions or any other evidence may never be used to determine relative economic activity." XB 52 (emphasis added). The Commissioner has never suggested that parties to a controlled transaction may not introduce evidence of their own activities (as opposed to someone else's) in establishing the relative economic activity undertaken by each with respect to the transaction.

12 We do note that, although Xilinx asserts (XB 53) that stock-12 based compensation expense played "no role" in its measurement of R&D activity, Xilinx included such expense to the tune of $34,566,403, $23,793,151, and $27,041,892, respectively, in its measurement of R&D activity for the years at issue for purposes of claiming tax credits "for increasing research activities" per I.R.C. § 41. See CB 8.

13 Xilinx similarly attempts to make the Conference Report disappear in this manner. XB 50 n.40. Xilinx's argument is particularly specious; based on language in an IRS Field Service Advice (FSA) to the effect that cost-sharing arrangements do not involve "transfers" of intangibles, it asserts that the Commissioner's "administrative position appears to be that the 1986 Act does not apply to cost sharing" and that the legislative history of the commensurate-with-income requirement therefore "is a particularly tangential interpretive guidepost." Ibid. Xilinx conveniently overlooks the very next sentence in the FSA:

 

However, Congress expected cost sharing arrangements "to produce results consistent with the purposes of the commensurate with income standard in section 482 -- i.e., that 'the income allocated among the parties reasonably reflect the actual economic activity undertaken by each.' " IRS FSA 200003010 (Jan. 21, 2000) (fn. ref. omitted).

 

14 We note that the Ireland Treaty has no direct application to this case. Absent an actual controversy under the Ireland Treaty, Xilinx's reliance on the treaty is premature, and its discussion thereof has little, if any, relevance to this case.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Case Name
    XILINX, INC. AND CONSOLIDATED SUBSIDIARIES, Petitioner-Appellee v . COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant
  • Court
    United States Court of Appeals for the Ninth Circuit
  • Docket
    Nos. 06-74246, 06-74269
  • Authors
    O'Connor, Eileen J.
    Korb, Donald L.
    Morrison, Richard T.
    Rothenberg, Gilbert S.
    Farber, Richard
    Catterall, Arthur T.
  • Institutional Authors
    Justice Department
  • Cross-Reference
    For the Tax Court opinion in Xilinx Inc. et al. v.

    Commissioner, 125 T.C. No. 4 (Aug. 25, 2005), see Doc 2005-

    18073 [PDF] or 2005 TNT 168-4 2005 TNT 168-4: Court Opinions.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2007-10882
  • Tax Analysts Electronic Citation
    2007 TNT 91-19
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