What Should You Make of the Tax Court’s Transfer Pricing Decision in Xilinx?
(September 8, 2005)

How much discretion does the IRS have to determine what tax return positions “clearly reflect income”? One would think quite a lot because § 482 provides sweeping authority to the IRS to make this determination and the IRS regularly uses it to attack tax abuses. The § 482 regulations, however, state that the “arm’s length standard” determines when a taxpayer’s transfer pricing results “clearly reflect income.”

The Tax Court held the IRS to its regulations by ruling that the IRS could not mandate the inclusion of stock option costs in cost sharing agreements (“CSAs”) no matter how broad its § 482 authority. Xilinx v. Commissioner, 125 T.C. no. 4 (Aug. 30, 2005). So what does Xilinx mean to you? Probably not much outside of the transfer pricing context, and even for taxpayers with CSAs, Xilinx presents some difficult choices.

Xilinx: The Case: Xilinx was a simple dispute. The IRS thought that CSAs among related parties can only reach an “arm’s length result” if the full value of each participant’s contribution is appropriately measured. The IRS argued that leaving out stock based compensation would substantially distort the measure, and proposed a tax deficiency of more than $105 million and penalties of another $21 million.

Xilinx argued that “arm’s length” means the terms to which unrelated parties would agree, and unrelated parties do not agree to compensate each other for employee stock options. The Court agreed with Xilinx and rejected the IRS’s proposed adjustments as arbitrary and capricious. The Court hedged on how it viewed new § 482 regulations finalized in Aug. 2003 (i.e., after the tax years at issue in Xilinx) that state that stock based compensation must be included in a CSA. The Court simply stated that “the regulations applicable to the years in issue did not authorize respondent to require taxpayers [to include stock option costs].”

Recommendations: Taxpayers with CSAs for pre-August 2003 tax years should consider seeking refunds for any open year on the basis of Xilinx, although they should weigh the costs, benefits and risks of doing so. For instance, the IRS may yet successfully appeal Xilinx. Taxpayers with CSAs after that date face a harder choice on whether to amend CSAs to exclude stock option costs. Unlike Xilinx, such taxpayers would be challenging an explicit regulation requiring the inclusion of such costs that is based on expansive statutory authority. Taxpayers should also be mindful that the IRS could modify their regulations to address the court’s decision. In either case, taxpayers would need to assess the likelihood of a successful legal challenge to a § 482 regulation on point.

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