Page 8 - Altera And Cost-Sharing Requirements Under Section 482 By Jerald David August

The decision poses challenges to the issuance of “legislative” regulations that are currently under consideration and also into the future.
January/February 2016
BUSINESS ENTITIES 11
Streamlined Participation Rules.
The 1995 regulations, in streamlining the participation rules, omitted the sub- group rules and eliminated the active conduct rule under Reg. 1.482-7(c) as a requirement for qualification as a con- trolled participant in a qualified cost sharing arrangement. Reg. 1.482-7(c)(1) was modified to require only that the controlled participant will qualify under a CSA only if it reasonably anticipates that it will derive benefits from the use of covered intangibles. The modifica- tions announced in the 1995 Regula- tions were intended to ensure that a controlled participant must benefit from the arrangement, that the basis for mea- suring benefits must be consistent for all controlled participants, and that, in the event of intragroup transfers, there will be “look through” treatment for reli- ably measuring benefits. These rules allow a participant to exploit covered intangibles itself or through transfer- ring or licensing them to others, so long as the benefits to be derived can be con- sistently and reliably measured for all controlled participants.
Xilinx Decision
In Xilinx, Inc., 34 the taxpayer contested proposed deficiencies in tax under the 1995 cost-sharing final regulations,
maintaining that cost-sharing arrange- ments should not include the value of stock-based compensation in the intan- gible development cost pool.
Xilinx researched, developed, man- ufactured, and marketed integrated cir- cuit devices and related development software systems. It wanted to expand its business operations into Europe and, in 1994, formed Xilinx Ireland (XI) as an unlimited liability company under the laws of Ireland. XI sold program- mable logic devices and conducted research and development (R&D). Two wholly owned Irish subsidiaries of Xil- inx owned XI during the tax years 1997, 1998, and 1999, which were the years in issue before the courts. In 1995, Xilinx and XI entered into a CSA which pro- vided any new intangibles developed by either Xilinx or XI would be joint- ly owned. Each party was required to pay a percentage of the total R&D costs in proportion to the anticipated bene- fits to each from the new technology to be created. The CSA required the shar- ing of:
1. Direct costs, defined as costs direct- ly related to the R&D of new tech- nology, including, but not limited to, salaries, bonuses and other payroll costs and benefits.
2. Indirect costs, defined as costs incurred by departments not
involved in R&D that generally ben- efit R&D, including, but not limited to, administrative, legal, accounting and insurance costs.
3. Costsincurredtoacquireproductsor intellectual property rights necessary to conduct R&D.
The agreement did not specifically
address whether employee stock options (ESOs) were part of the shared costs under the CSA. Xilinx had two ESO plans, incentive stock options (ISOs) and nonstatutory stock options (NSOs).35
In determining the R&D costs to be shared under the agreement for the tax years 1997, 1998, and 1999, Xilinx did not include any amount related to ESOs. In the tax years 1997, 1998, and 1999, Xilinx deducted as business expenses under Sections 83 and 162 approxi- mately $41 million, $40 million, and $96 million respectively, based on its employees’ exercises of NSOs or dis- qualifying dispositions of ISOs and employee stock option plans. Xilinx also claimed an R&D credit under Section 41 for wages related to R&D activity, of which approximately $34 million, $23 million, and $27 million in the respective tax years were attributable to exercised NSOs or disqualifying dis- positions of ISOs and ESPPs. Further- more, in 1996 Xilinx and XI entered into two agreements that allowed XI employees to acquire options for Xilinx stock. Both agreements provided XI would pay Xilinx for the “cost” of the XI employees’ exercise of the stock options, which was to equal the stock’s market price on the exercise date minus the exercise price. In the 1997, 1998, and 1999 tax years, XI paid Xilinx $402,978, $243,094, and $808,059 respectively under these agreements.
The Service issued notices of defi- ciency against Xilinx for the tax years 1997, 1998, and 1999, contending that the stock compensation rights issued to its employees involved in or sup- porting R&D activities were costs that should have been shared between Xil- inx and XI under the agreement. Specif- ically, the IRS concluded the amount
COST-SHARING