Opinion ID: 4404666
Heading Depth: 3
Heading Rank: 2

Heading: Treatment of Stock-Based Compensation

Text: In the early 1990s, related companies began to compensate certain employees who performed research and development activities pursuant to QCSAs by granting stock options and other stock-based compensation. See id. at 1192–93. This manner of compensation allowed companies to avoid the income reallocation mechanisms available under § 482 by including only the employees’ cash compensation in the cost pool under the agreement, but not their stockbased compensation. To address this loophole, Treasury promulgated new regulations governing the tax treatment of controlled transactions in 1994 and 1995. These regulations affirmed that “the standard to be applied in every case” was the arm’s length standard and that “an arm’s length result generally will be determined by reference to the results of comparable transactions” because “identical transactions can rarely be located.” Treas. Reg. § 1.482-1(b)(1) (as amended in 1994). They also provided that intangible development costs included “all of the costs incurred by . . . [an uncontrolled] participant related to the intangible development area.” 1 As the majority observes, more recent tax treaty explanations have also cited the alternative commensurate with income standard. Op. 32–33 (citing Technical Explanation of the US-Poland Tax Treaty, at 31 (Feb. 13, 2013)). Even these explanations, however, emphasize the primacy of the arm’s length standard, and they assure the reader that the commensurate with income standard “operates consistently with the arm’s-length standard.” Technical Explanation of the US-Poland Tax Treaty, at 30–31 (Feb. 13, 2013). 58 ALTERA CORP. V. CIR Treas. Reg. § 1.482-7(d)(1) (as amended in 1995). The IRS interpreted this latter “all costs” provision to include stockbased compensation, so that related companies in cost-sharing agreements would have to share costs of providing such compensation. Xilinx II, 598 F.3d at 1193–94. When Xilinx, Inc. (“Xilinx”) challenged the IRS’s interpretation, the Tax Court decided that the agency’s interpretation was inconsistent with Treas. Reg. § 1.482-1 because the IRS had not adduced evidence sufficient to show that unrelated parties transacting at arm’s length would, in fact, share expenses related to stock-based compensation. Xilinx v. Commissioner (“Xilinx I”), 125 T.C. 37, 53 (2005). The Commissioner did not appeal this underlying factual finding and, instead, argued on appeal to this court that Treas. Reg. § 1.482-7 superseded the arm’s length requirement of Treas. Reg. § 1.482-1. All three members of the divided panel therefore assumed that sharing expenses related to stock-based compensation would be inconsistent with the arm’s length standard. Xilinx II, 598 F.3d at 1194 (“The Commissioner does not dispute the tax court’s factual finding that unrelated parties would not share [employee stock options] as a cost.”); id. at 1199 (Reinhardt, J., dissenting) (assuming that the Tax Court “correctly resolved” the issue of whether sharing stock-based compensation costs would constitute an arm’s length result). The panel also assumed that Treas. Reg. § 1.482-7 required stock-based compensation expenses to be shared. Id. at 1196 (majority opinion) (noting that the “all costs” provision “does not permit any exceptions, even for costs that unrelated parties would not share”); id. at 1199 (Reinhardt, J., dissenting) (assuming that the “all costs” provision includes “employee stock option costs”). But a majority of the panel ultimately held that the arm’s length standard, which it described as the fundamental ALTERA CORP. V. CIR 59 “purpose” of the regulations, trumped Treas. Reg. § 1.482-7, and that stock-based compensation expenses could not be shared in the absence of evidence that unrelated parties would share such costs. Id. at 1196 (majority opinion); see also id. at 1198 n.1 (Fisher, J., concurring) (finding “the arm’s length standard” to be “Congress’ intended touchstone for § 482”). On that ground, this court affirmed the Tax Court’s judgment in favor of Xilinx. Id. at 1196 (majority opinion).