Opinion ID: 3064714
Heading Depth: 3
Heading Rank: 1

Heading: Certain ESO amounts are a cost.

Text: Xilinx relies on the considerable evidence and testimony presented to the tax court that unrelated parties in a cost sharing agreement do not treat ESOs as costs to be shared. This evidence is beside the point — whether or not unrelated parties share an item is immaterial to whether it is a cost to either party. Xilinx also maintains ESOs are not costs because two provisions of § 1.482-7 allow taxpayers to use any accounting method as long as it is used consistently.12 Xilinx reads these provisions to allow a taxpayer to establish conclusively what is or is not a cost by using a particular accounting method and sticking with it. Xilinx then argues that under one particular business accounting method, which was widely accepted when Congress passed 26 U.S.C. § 482 in the 1980s and was still an acceptable method during the tax years at issue, ESOs are not treated as costs. [5] Xilinx’s argument that § 1.482-7’s accounting requirements allow taxpayers to self-define what is and is not a cost 12 Those two subsections establish accounting requirements that taxpayers in a qualified cost sharing agreement must meet. First, they must “use a consistent accounting method to measure costs and benefits.” 26 C.F.R. § 1.482-7(i). Second, they must maintain documentation to establish “[t]he accounting method used to determine the costs and benefits of the intangible development . . . and, to the extent that the method materially differs from U.S. generally accepted accounting principles, an explanation of such material differences.” 26 C.F.R. § 1.482-7(j)(2)(i)(D). XILINX, INC. v. CIR 6173 by consistently using a particular accounting method is creative but unsound. The accounting requirements are minimum eligibility requirements for a qualified cost sharing agreement. It does not logically follow that whatever accounting method a taxpayer uses, even a nonstandard one, conclusively establishes what is a cost, even if that method differs from how the regulation defines costs. Rather, the regulation’s accounting requirements are clearly intended to ensure the government has a basis upon which to verify whether taxpayers who obtain the benefit of a qualified cost sharing agreement are accurately reporting and sharing costs, i.e., not treating items that are costs under the regulation as something other than costs. Also, the official accounting method upon which Xilinx relies, Accounting Principles Board Opinion No. 25 (1972) (“APB 25”), was superseded by Statement of Financial Accounting Standards No. 123 (1995) (“SFAS 123”). Although SFAS 123 allowed taxpayers to employ APB 25’s methodology (under which these ESOs have zero cost) during the relevant tax years, SFAS 123 explained that the APB 25 method was no longer the preferred method for valuing ESOs, going so far as to require companies employing APB 25 also to report the cost of ESOs under SFAS 123’s preferred fair value based method. Xilinx used APB 25 and treated the ESOs as a zero cost on its books, but it also complied with SFAS 123 and reported the ESO cost under the SFAS 123 fair value method in footnotes to its public income statements. Thus, although Xilinx did not violate business accounting practices in ascribing zero cost on its books to ESOs, the preferred business accounting practice during the relevant tax years treated ESOs as costs. [6] In the end, Xilinx’s argument is undermined by the regulatory language and its own tax returns. “Costs incurred related to the intangible development area [are] . . . operating expenses as defined in § 1-482.5(d)(3),” 26 C.F.R. § 1.482- 7(d)(1), which provides that “operating expenses” include “all 6174 XILINX, INC. v. CIR expenses not included in cost of goods sold except for . . . any . . . expenses not related to the operation of the relevant business activity,” 26 C.F.R. § 1-482.5(d)(3).13 Xilinx stipulated that it did not include the value of the ESOs in the cost of goods sold, and it claimed tax deductions under 26 U.S.C. §§ 83 and 162 for the exercised NSOs and the disqualifying dispositions of the ISOs and ESPPs as business “expenses.”14 See 26 U.S.C. § 162(a)(1) (allowing employers to deduct “all the ordinary and necessary expenses paid or incurred” (emphasis added)). Xilinx could not have claimed deductions on these ESOs unless they were an “expense,” which is the key term in the definition of “cost” under § 1.482-7(d)(1). Moreover, Xilinx required XI to pay it for the value of the ESOs XI employees exercised. Requiring reimbursement for ESOs granted to another company’s employees further supports the conclusion that the ESOs are costs. In short, the preferred business accounting method in effect during the relevant tax years treated ESOs as costs, and Xilinx itself treated certain amounts of ESOs as “expenses” in claiming them as a tax deduction. Accordingly, we hold the ESO value that Xilinx deducted as a business expense is a “cost” for the purposes of § 1.482-7(d)(1).15 13 For the sake of clarity, we analyze whether the ESOs are a “cost” and whether they are “related to” the joint venture separately. We recognize that this distinction is not altogether appropriate, because the meaning of “cost” turns on whether an item is an “operating expense,” the definition of which focuses on whether the expense is “related to” the “relevant business activity.” The proper construction of “cost” therefore turns on whether it is “related to” the activity. Because we conclude ESOs are “related to” the intangible product development area, however, our separate analysis of the two questions poses no problem. 14 The Commissioner stipulated that the exercise (as opposed to disqualifying dispositions) of ISOs and ESPPs are not “operating expenses” within the meaning of § 1.482-5(d)(3). Accordingly, we have no occasion to decide whether those items are “costs” that must be shared. 15 Xilinx also suggests the ESOs should not be treated as costs because they require no cash outlay. Presumably, however, Xilinx could obtain full market value for the stock shares it allows its employees to obtain at a lower price, so, at a minimum, the difference between the exercise price and the then-current market price is an opportunity cost to Xilinx. In any event, ESOs were treated as costs during the relevant tax years under tax accounting principles and the preferred business accounting methodology. XILINX, INC. v. CIR 6175 2. ESOs are related to the intangible development area. [7] The tax court found the ESOs are part of Xilinx’s employee recruitment and retention program, and Xilinx does not suggest salaries or benefits, like healthcare and retirement contributions, for employees involved in R&D activities are not “related to” their work on the R&D activities. It is difficult to view ESOs as anything but part of Xilinx’s employee compensation package, because it is a benefit conferred in exchange for services rendered. ESOs are just as “related to” (“connected [or] associated” with) an employee’s work as any other employment benefit or compensation. See American Heritage College Dictionary 1152 (3d ed. 2000). In fact, Xilinx claimed the ESOs as part of a tax credit available for “wages paid or incurred to an employee for qualified [research] services performed by such employee.” 26 U.S.C. § 41(b)(2)(A). Xilinx’s inclusion of ESOs as part of employee wages for the R&D tax credit undermines its attempt to avoid tax liability by arguing those ESOs are not “related to” the same research activity. Although “related to” in 26 C.F.R. § 1.482-7(d)(1) and “for” in 26 U.S.C. § 41(b)(2)(A) are not identical terms, they convey essentially the same thing in the context of each provision: the expense must be part of the compensation given to an employee involved in the relevant activity. Accordingly, Xilinx’s arguments that its ESOs have nothing to do with R&D, are issued company wide and are not viewed by the employees who receive them as related to their R&D are misplaced. The same can be said of any component of an employee’s compensation package. For example, health benefits given to a company’s employees are not tied to any particular task an employee performs, yet the cost of those benefits borne by the employer is still related to the work its employees do. (The cost of health benefits was specifically included among the items to be shared between Xilinx and XI as part of the total R&D costs.) For employees who work on 6176 XILINX, INC. v. CIR R&D, the cost of health benefits for that employee is plainly related to the company’s R&D activities. Xilinx also focuses on the considerable evidence it presented to the tax court proving companies operating at arm’s length do not share the cost of ESOs. It maintains those companies would share ESO costs if they were in fact related to a joint venture, just as they share all other costs related to the project, and points out that not even the United States allows contractors hired to conduct R&D to bill the government for the cost of ESOs. Xilinx believes the reason companies operating at arm’s length do not share ESOs must be that the cost is not related to the joint venture. The evidence presented to the tax court, however, suggests three reasons why companies operating at arm’s length do not share ESO costs, none of which have anything to do with whether the cost is related to the joint venture. First, as Xilinx has pointed out, unlike most costs, companies bear no out-of-pocket expense for ESOs (in fact, the exercise of ESOs results in cash inflow). Even though companies can estimate the accounting cost of ESOs, the tax court found those costs cannot be measured precisely, so companies operating at arm’s length may elect not to share ESOs, because agreeing how to value something with no present out-of-pocket cost might be a sticking point in negotiating an agreement. Second, the tax court noted the cost of ESOs is tied to the value of one company’s stock, so sharing this cost might create a perverse incentive for the other company to minimize the economic value of the joint venture in order to keep its partner’s stock value low and thereby limit its own share of the cost for its partner’s ESOs. Finally, a company operating at arm’s length has an incentive not to share ESO costs, to the extent those costs can be deducted as a business expense. What company would not like to bear the full cost of something that imposes no out-of-pocket expense and confers the benefit of a tax deduction? Although the record conclusively establishes that companies in a joint venture operating at arm’s length do not share ESO costs, none of the XILINX, INC. v. CIR 6177 possible explanations for this fact demonstrate ESO costs are unrelated to the joint venture. [8] Accordingly, we hold ESOs are related to the work performed by the employees who receive them. The ESO costs for employees who were involved in activities that would contribute to the joint venture between Xilinx and XI therefore should have been shared. Based on the record before us, however, we cannot conclusively determine whether the Commissioner’s allocation is limited only to employees involved in the joint venture and takes into account whether employees spent all or only part of their time on tasks relevant to the joint venture. Accordingly, we remand to the tax court on the narrow issue of determining whether the Commissioner’s allocation accurately reflects ESO costs for employees involved in tasks related to the joint venture.