The Xilinx case: a new landmark in transfer pricing?

On 13 January 2010, the US Court of Appeals withdrew its opinion and dissent filed in May 2009 in one of the most important transfer pricing disputes in recent years – Xilinx, Inc. and Subsidiaries vs. Commissioner of Internal Revenue. The surprise move by the US Court of Appeals leaves both Xilinx and the IRS uncertain about the outcome of the case.

The story…

Xilinx Inc. (“Xilinx”) is a US company, active in the business of researching, developing, manufacturing, marketing and selling field programmable logic devices, integrated circuit devices and other development software systems. The company is the parent of several subsidiaries, including Xilinx Ireland.

Xilinx Ireland was created in 1994, as a manufacturer of field programmable logic devices, with a view to increasing the group’s European market share. It manufactured, marketed and sold field programmable logic devices, primarily to customers in Europe, and conducted research and development.

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In 1995, Xilinx and its Irish subsidiary entered into a cost-sharing agreement, providing that all new technology developed by either of the two companies would be jointly owned. Each party was required to pay a percentage of the total research and development costs based on the respective anticipated benefits from the new technology. The cost-sharing agreement further provided that each year the parties would review and, when appropriate, adjust such percentages to ensure that costs continued to be based on the anticipated benefits to each party.

Within the cost-sharing agreement, both companies were required to share the following types of costs:

Direct costs: costs directly related to the research and development of new technology including, but not limited to, salaries, bonuses and other payroll costs and benefits.

Indirect costs: costs incurred by other departments that generally benefit from all research and development including, but not limited to, administrative, legal, accounting and insurance costs.

Acquired intellectual property rights costs: costs incurred in connection with the acquisition of products or intellectual property rights.

In determining the allocation of costs pursuant to the cost-sharing agreement, Xilinx did not include in research and development costs any amount related to the issuance of employee stock options.

…the case…

In 2000 and 2002, the IRS issued notices of deficiency relating to 1996 through 1998 and 1999, respectively. In these notices, the IRS determined that Xilinx was required, pursuant to its cost-sharing agreement, to share with Xilinx Ireland the costs of certain employee stock options – and originally tagged Xilinx with over $120 million in additional taxes and penalties.

Under the US transfer pricing regulations in effect at the time, it was unclear whether such costs were required to be included in the pool of costs to be shared under a cost sharing agreement. During the Tax Court’s consideration of the case, the IRS conceded that the stock-based compensation costs would not have been shared by unrelated companies operating at arm’s length, but, nevertheless, argued that the regulations in effect at the time still required such costs to be shared.

Still, after lengthy procedures, a tax-court decision issued in late 2005 ruled in Xilinx’s favour, exactly based on the fact that such sharing of costs would not be accepted by unrelated companies in an arm’s length transaction. The ruling was issued in spite of the fact that the wording of the legislation specifically that “all costs… related to the intangible development area” be shared – as it was considered that the arm’s length principle should in fact be at the heart of such cost-sharing agreements.

But Xilinx’s victory was only temporary. The case was taken to the US Court of Appeals, and, in May 2009, the court ruled that companies in a cost-sharing arrangement must share all costs related to the joint venture, including employee stock options. The court has effectively ruled that the arm’s length standard does not apply to costs incurred in connection with cost-sharing arrangements, as the arm’s length standard was irreconcilable with the all-costs requirement.

The court stated that in the context of a cost-sharing agreement, the arm’s length standard would require the sharing of costs related to the cost-sharing arrangement only in those cases in which unrelated companies would also share such costs. On the other hand, the all-costs requirement would mandate the sharing of all costs related to the cost-sharing arrangement, regardless of whether unrelated companies would share such costs.

Relying upon the rule of statutory construction that a specific provision controls a more general provision, the court found that the all-costs requirement was more specific than the arm’s length standard under the regulations and, thus, precluded the arm’s length principle.

And still further along the timeline, in January 2010, the US Court of Appeals made the most surprising move in this case, withdrawing its opinion and dissent issued in 2009 – but without stating any particular reasons in this regard. This withdrawal has left both Xilinx and the IRS uncertain about the outcome of this lengthy litigation.

…and the conclusions

While we are still left waiting for the final decision in the litigation, we nevertheless need to note the importance of the decision issued in 2009, i.e. that it is not the arm’s length standard that should be followed in all inter-company transactions. In this one case, the US Court of Appeals held (and maintained its opinion for almost a year) that the arm’s length standard is not to be followed in cost-sharing arrangements, supporting the IRS in issuing regulations that may result in non-arm’s length results.

On the short term, this approach could clearly lead to difficult double-tax cases with US tax treaty partners who have generally embraced the arm’s length standard. Could this mean that we may be facing a completely new era in transfer pricing? It is this particular question that makes the Xilinx case a possible landmark in the transfer pricing history.

By Ariadna Popa Manager, Tax Advisory – Mazars

By Anamaria Acristini Supervising Senior, Tax Advisory – Mazars