Ninth Circuit affirms Tax Court in Xilinx
The Ninth Circuit on March 22 issued its new opinion in Xilinx Inc. v. Commissioner, holding that stock-based compensation need not be included in the research and development cost base of companies that have entered into a cost sharing arrangement (CSA) under reg. section 1.482-7, prior to its amendment in 2003. Comments in the concurring opinion may make it more likely that taxpayers will challenge the post-2003 cost sharing regulations that specifically require the sharing of stock-based compensation.
In Xilinx, the Commissioner contended that stock-based compensation related to a cost sharing arrangement during the 1997, 1998, and 1999 tax years had to be shared. The Tax Court held in August 2005 that stock-based compensation did not need to be shared because parties acting at arm's length would not share such costs. The Service appealed, and in May 2009 the Ninth Circuit issued its first decision in the case, reversing the Tax Court and holding that Xilinx and its Irish subsidiary were required to share stock-based compensation costs under the pre-2003 cost sharing regulations. In January 2010, the Ninth Circuit withdrew its first decision without explanation.
First appellate opinion
In the original opinion, the majority, led by Judge Fisher and joined by Judge Reinhardt, found that reg. section 1.482-1(b), which provides that the arm's length standard should apply "in every case," was irreconcilable with reg. section 1.482-7(d)(1), which provides that "all costs" are to be shared in a CSA, and that in such a case, the canon of statutory construction that the specific controls the general should prevail. In his dissent, Judge Noonan asserted that the canon relied on by the majority was but one of many available, and that in deciding between the two provisions, the overall purpose of the statute (parity with unrelated taxpayers) and the Treasury Department's practice in applying section 482, particularly in the context of income tax treaties, should prevail.
In the new opinion, Judges Reinhardt and Noonan essentially retain their respective positions, with Judge Noonan, now writing for the court, focusing on the overall purpose and treaty interpretation, and Judge Reinhardt, now in dissent, focusing on the canon of specific over the general, as well as reg. section 1.482-1(a)(1)'s "clear reflection of income . . . to prevent the avoidance of taxes" mandate.
Judge Fisher, however, now agrees with Judge Noonan, if for different reasons. In writing his concurring opinion, Judge Fisher continued his belief that the regulations are "hopelessly ambiguous," but has now concluded that "the ambiguity should be resolved in favor of what appears to be the commonly held understanding of the meaning and purpose of the arm's length standard prior to this litigation." In reaching this conclusion, Judge Fisher comments that he considered not only the plain language of the regulations but also various interpretive tools brought before the court by the amici, including the regulatory history, the drafting history of the regulations, persuasive authority from international tax treaties, and "what appears to be the understanding of corporate taxpayers in similar circumstances."
Ultimately, Judge Fisher appears to have been persuaded by the difficulty with which the Service sought to justify its position. Judge Fisher states that "the Commissioner's attempts to square the 'all costs' regulations with the arm's length standard have only succeeded in demonstrating that the regulations are at best ambiguous." To those ends, Judge Fisher notes that he was "troubled by the complex, theoretical nature of many of the Commissioner's arguments trying to reconcile the two regulations. Not only does this make it difficult for the court to navigate the regulatory framework, it shows that taxpayers have not been given clear, fair notice of how the regulations will affect them." (Judge Fisher noted in footnote 3 that the Commissioner in his reply brief only supported the court's result, not its reasoning.) Thus, Judge Fisher concludes, "Xilinx's understanding of the regulations is the more reasonable even if the Commissioner's current interpretation may be theoretically plausible."
The decision will clearly be viewed as a setback to the Commissioner, and provides hope to those taxpayers who believe that the current rules requiring the inclusion of stock-based compensation are invalid because they are inconsistent with the arm's length standard. Judge Noonan's opinion, which focuses on the purpose of the statute, the regulations, and the U.S. Income Tax Treaties, provides at least some arguments for taxpayers that believe the post-2003 regulations, while much clearer, suffer some of the same infirmities as the pre-2003 regulations.
But the decision should not be viewed solely from Judge Noonan's perspective. Judge Fisher appeared to focus on the Commissioner's new interpretation of the regulations and the uncertainty that it engendered. However, Judge Fisher also noted in footnote 4 that "it is an open question whether these flaws have been addressed in the new regulations the Treasury issued after the tax years at issue in this case."
Looking ahead, the decision does not provide favorable precedence for the likely appeal of the Commissioner's Tax Court loss in Veritas v. Commissioner. The Ninth Circuit's focus on the regulations as written may not be helpful in sustaining the Commissioner's position that a new controversial unspecified method, the income method with a perpetual life, developed years after the tax years in question, is the best method.
Finally, taxpayers can take solace from the fact that the decision no longer contains the highly criticized statement in the original majority opinion that the arm's length standard is simply a regulatory gloss on the statute.