## Facts

- Xilinx, Inc. formed an Irish affiliate, Xilinx Ireland (XI), to sell products and conduct European R&D.
- In 1995, Xilinx and XI entered a cost-and-risk sharing agreement (CSA) to jointly develop intangible technology, sharing R&D costs in proportion to anticipated benefits.
- The CSA required sharing of direct R&D costs (e.g., salaries and benefits), indirect supportive costs (e.g., administrative and legal), and certain acquisition-related costs, but did not list employee stock options (ESOs).
- During 1997–1999, Xilinx granted ESOs, including to R&D employees, and claimed deductions under I.R.C. § 83(h) upon option exercises and certain disqualifying dispositions; it also treated ESO-related amounts as R&D wages for I.R.C. § 41 purposes.
- XI employees could receive Xilinx stock options, and XI reimbursed Xilinx for XI-employee option costs.
- After audit, the IRS reallocated income and deductions under I.R.C. § 482, asserting ESO compensation was an R&D “cost” that had to be included in the CSA cost pool and shared with XI, resulting in asserted deficiencies for 1997–1999.
- The Tax Court rejected the IRS adjustment, finding that uncontrolled parties dealing at arm’s length would not share ESO costs in a comparable arrangement and holding the IRS allocation arbitrary and capricious.
- The Ninth Circuit affirmed the Tax Court after rehearing.

## Issues

1. Whether, under the pre-2003 § 482 regulations applicable to 1997–1999, a CSA must include employee stock-option compensation in shared costs even if arm’s-length parties would not share such costs.
2. How to reconcile the general arm’s-length standard in Treas. Reg. § 1.482-1(b)(1) with the CSA cost-sharing requirement in Treas. Reg. § 1.482-7(d)(1) to share “all costs” related to the development area.
3. Whether the Commissioner’s interpretation was supported by deference principles and consistent with the U.S.–Ireland treaty’s arm’s-length approach to associated enterprises.

## Decision

- The Ninth Circuit affirmed the Tax Court.
- Under the pre-2003 § 482 regulations, Xilinx was not required to share ESO compensation costs with XI in the CSA for 1997–1999.
- The court held the Commissioner’s allocation was arbitrary and capricious because it conflicted with the controlling arm’s-length standard.
- The court declined to read Treas. Reg. § 1.482-7(d)(1)’s “all costs” language as overriding Treas. Reg. § 1.482-1(b)(1)’s command that arm’s-length results govern “in every case.”
- The court declined to defer to the Commissioner’s interpretation where it contradicted the regulatory text and the Tax Court’s accepted factual finding about arm’s-length behavior.

## Legal Principles

- For tax years governed by the pre-2003 § 482 regulations, the arm’s-length standard in Treas. Reg. § 1.482-1(b)(1) applies to CSAs and controls the interpretation of cost-sharing rules.
- A cost-sharing regulation requiring inclusion of “all costs” must be applied consistently with arm’s-length outcomes and does not require sharing items that uncontrolled parties would not share in comparable circumstances.
- The Commissioner’s § 482 allocations may be set aside as arbitrary and capricious when they compel results inconsistent with the governing arm’s-length standard.
- Deference to an agency’s interpretation of its regulations does not apply where the interpretation conflicts with the regulation’s text and structure.
- Later regulatory amendments explicitly requiring inclusion of stock-based compensation in CSAs supported the conclusion that the earlier regulatory text did not unambiguously impose that requirement.

## Conclusion

The Ninth Circuit held that, under the § 482 regulations applicable to 1997–1999, related CSA participants could not be compelled to share employee stock-option compensation when uncontrolled parties acting at arm’s length would not share those costs, rendering the IRS allocation invalid under the arm’s-length standard.


Xilinx, Inc. v. Comm’r of Internal Revenue, 598 F.3d 1191 (9th Cir. 2010)