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Allocation of employee stock options to cost-sharing agreement.

P is in the business of researching, developing, manufacturing, marketing and selling field-programmable logic devices, integrated circuit devices and other development software systems. P entered into a cost-sharing agreement to develop intangibles with X, its foreign subsidiary.

The Agreement

Under the cost-sharing agreement, all new technology developed by either P or X would be jointly owned. Each party was required to pay a percentage of the total research and development (R&D) costs, based on its anticipated benefits from the intangibles. P issued stock options to its employees performing R&D. However, for purposes of determining the cost allocation under the agreement, P did not include the cost of issuance or exercise of such options in R&D costs.

In deficiency notices, the IRS determined that for cost-sharing purposes under Regs. Sec. 1.482-7(d), the spread (i.e., the stock's market price on the exercise date over the exercise price) or, in the alternative, the grant date value of the options, should have been included as an R&D cost.


Sec. 482 provides "[i]n the case of any transfer ... of intangible property ... the income with respect to such transfer ... shall be commensurate with the income attributable to the intangible" Participants in a qualified cost-sharing agreement relinquish exclusive ownership of all exploitation rights in new intangibles they individually develop and agree to share ownership of (and costs associated with) such intangibles. For Sec. 482 purposes, this relinquishment is a transfer of specified future exploitation rights; see Regs. Sec. 1.482-7(a)(3) and (g).

Regs. Sec. 1.482-7(a)(1) requires participants "to share the costs of development of one or more intangibles in proportion to their ... [respective] shares of reasonably anticipated benefits." Under Regs. Sec. 1.482-7(e)(1), anticipated benefits are defined as "additional income generated or costs saved by the use of covered intangibles." If parties fail to share such costs in proportion to their benefits, the IRS is authorized to make allocations "to the extent necessary to make each controlled participant's share of the costs ... equal to its share of reasonably anticipated benefits"; see Regs. Sec. 1.482-7 (a) (2).

Sec. 482 gives the Service wide latitude in allocating income and deductions between controlled parties, to ensure they report their true taxable income. This broad grant of authority, however, is constrained by Regs. Sec. 1.482-1, which sets forth the "general principles and guidelines to be followed under section 482." The subsections to which these general principles and guidelines apply include Regs. Sec. 1.482-7.

Arm's-Length Standard

Regs. Sec. 1.482-1(a)(2) authorizes the IRS to "make allocations between or among the members of a controlled group if a controlled taxpayer has not reported its true taxable income." In determining true taxable income, "the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer" (Regs. Sec. 1.482-1 (b) (1)).The arm's-length standard is employed to ensure that related-party transactions dearly reflect the income of each party and to prevent tax evasion.

Under Regs. Sec. 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. 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.

Neither party disputes the absence of comparable transactions in which unrelated parties agree to share the spread or the grant date value, nor do the parties dispute the fact that unrelated parties would not "explicitly share the spread or the grant date value " (i.e., within the written terms of their agreements).

The Service presented no evidence or testimony establishing that its determinations are at arm's length. It simply contends, the "application of the express terms of Treas. Reg. 1.482-7 itself produces an arm's-length result," and "it is unnecessary to perform any type of comparability analysis to determine ... whether parties at arm's length would share ... [the spread or the grant date value]." According to the IRS," the identification of costs, and the corresponding adjustments to the cost pool under qualified cost-sharing arrangements, should be determined without regard to the existence of uncontrolled transactions."

However, the regulation does not state that any allocation proposed by the Service automatically produces an arm's-length result without reference to what arm's-length parties would do. The IRS's litigating position is contrary to its regulations; see Phillips, 88 TC 529, 534 (1987), aff'd, 851 F2d 1492 (DC Cir. 1988) (the IRS "may not choose to litigate against the officially published rulings ... without first withdrawing or modifying those rulings. The result of contrary action is capricious application of the law"). Under the express language of Regs. Sec. 1.482-1(a)(1), the arm's-length standard is applicable in determining the appropriate allocation of costs under Regs. Sec. 1.482-7.

Accordingly, if unrelated parties would not share the spread or the grant date value, the IRS's determinations are arbitrary and capricious. It contends that unrelated parties "implicitly" share the spread and the grant date value, but both parties agree that unrelated parties would not explicitly share these amounts. P, through the testimony of numerous credible witnesses, established that companies do not implicitly take into account the spread or the grant date value for purposes of determining costs relating to cost-sharing agreements. Further, P established that if unrelated par ties believed that the spread and grant date value were costs related to intangible development activities, they would he very explicit about their treatment for purposes of their agreements. In short, the Service's implicit cost theory is specious and unsupported.

The Spread

Unrelated parties would not share the spread, because it is difficult to estimate, unpredictable and potentially large. P's uncontradicted evidence established that certainty and control are of paramount importance to unrelated parties involved in cost-sharing arrangements. Yet, the spread size is affected by a variety of factors, many of which are not within the contracting parties' control.

Accordingly, the IRS's allocation relating to the spread theory fails to meet the arm's-length standard mandated by Kegs. Sec. 1.482-1(b).

Grant Date Value

The Service presented no evidence that unrelated parties would, pursuant to the fair-value method (FVM), make a cost-sharing allocation of at-the-money options or employee-stock-purchase-plan purchase rights. To the contrary, P's uncontradicted evidence established that in determining cost allocations, unrelated parties would not include any cost related to the issuance of options. Accordingly, the IRS's allocation relating to the grant date value fails to meet the arm's-length standard mandated by Regs. Sec. 1.482-1(b).

During the years in issue, P employed the intrinsic value method (IVM), which did not treat at-the-money options as expenses. From 1972 until Dec. 15, 1995, the IVM was the only financial accounting method authorized by the Financial Accounting Standards Board for measuring and reporting the value of options and, thus, the only available method during the first year of P's cost-sharing agreement. Thus, the FVM was the preferred method, yet P was under no affirmative obligation to elect it. In addition, during the years in issue, most companies used the IVM for purposes of valuing options. Thus, unrelated parties would treat options in a manner consistent with the IVM, rather than with the FVM. Accordingly, P's allocation relating to its options satisfies the arm's-length standard in Regs. Sec. 1.482-1(b).


The express language in Regs. Sec. 1.482-1(a)(1) establishes that the arm's-length standard applies to Regs. Sec. 1.482-7 in determining appropriate cost allocations. Because unrelated parties would not share the spread or the grant date value, the IRS's position is inconsistent with Regs. Sec. 1.482-1. Accordingly, its allocations are arbitrary and capricious; P's allocations meet the arm's-length standard.

XILINX, INC., 125 TC No. 4 (2005)

David O'Driscoll, J.D., LL.M.
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Author:O'Driscoll, David
Publication:The Tax Adviser
Date:Nov 1, 2005
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