9th Circuit Rejects Cost-sharing of Stock-based Compensation

March 31, 2010 (PLANSPONSOR.com) - In a reversal of a previous opinion the 9th U.S. Circuit Court of Appeals has held that stock option compensation costs need not be shared by participants in a cost sharing arrangement where such costs would not be shared at arm's length between unrelated parties.

A press release from law office Cooley Godward Kronish LLP said that in its prior opinion in Xilinx, Inc. v. Commissioner, the appellate court held that Xilinx’s stock option compensation was subject to cost sharing, even if such costs would not be shared at arm’s length. The court withdrew that prior opinion on January 10, 2010, and has now reversed its position, affirming that the arm’s-length standard is paramount in cost-sharing, as in other areas of transfer pricing, the announcement said.      

Under a qualified cost sharing arrangement, a U.S. company and a related non-U.S. company may split future revenues from intangible property developed under the arrangement as long as they share R&D costs in the same proportion as anticipated future revenues. Whether stock option compensation expenses must be included in the pool of costs that must be shared under a cost sharing arrangement has been highly disputed, the law office explained.      

At the crux of the Xilinx dispute was a conflict between the general arm’s-length standard of the transfer pricing regulations and a specific regulatory requirement that “all costs” be shared in cost-sharing arrangements. A Tax Court previously found that unrelated parties in a cost-sharing agreement would not share employee stock option costs and that requiring Xilinx and its Irish subsidiary to share such costs was a violation of the arm’s-length standard.      

On appeal, the 9th Circuit ultimately found that the arm’s-length standard could not be reconciled with the requirement that cost-sharing participants share all costs. Although it previously held that the specific “all costs” requirement should be interpreted as trumping the arm’s-length standard, the appellate court ultimately rejected this argument, choosing instead to uphold the arm’s-length standard.       

The Xilinx dispute involved tax years 1997, 1998 and 1999, which were not governed by the current cost-sharing regulations, but the current cost-sharing regulations provide specifically that stock option compensation costs must be shared.       

The announcement said the Xilinx opinion also clears the way for the Tax Court to enter its opinion in Veritas Software Corp., another taxpayer-favorable case in which the Tax Court rejected the current IRS theories for valuation of cost-sharing “buy-in” payments. The IRS has shown some uncertainty regarding how to proceed with buy-in examinations in light of Veritas, and is expected to appeal Veritas to the 9th Circuit.