Xilinx Inc. and Subsidiaries v. Commissioner , 125 T.C. No. 4 ( 2005 )

125 T.C. No. 4UNITED STATES TAX COURT
XILINX INC. AND SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
XILINX INC. AND CONSOLIDATED SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 4142-01, 702-03. Filed August 30, 2005.
P entered into a cost-sharing agreement to develop
intangibles with S, its foreign subsidiary. Each party
was required to pay a percentage of the total research
and development costs based on its respective
anticipated benefits from the intangibles. P issued
stock options to its employees performing research and
development. In determining the allocation of costs
pursuant to the agreement, P did not include in
research and development costs any amount related to
the issuance of stock options to, or exercise of stock
options by, its employees. R, in his notices of
deficiency, determined that for cost-sharing purposes,
pursuant to sec. 1.482-7(d), Income Tax Regs., the
spread (i.e., the stock’s market price on the exercise
date over the exercise price) or, in the alternative,
the grant date value, relating to compensatory stock
options, should have been included as a research and
development cost.
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1. Held: R’s allocation is contrary to the
arm’s-length standard mandated by sec. 1.482-1(b),
Income Tax Regs., because uncontrolled parties would
not allocate the spread or the grant date value
relating to employee stock options.
2. Held, further, P’s allocation satisfies the arm’s-
length standard mandated by sec. 1.482-1, Income Tax Regs.
Kenneth B. Clark, Ronald B. Schrotenboer, William F. Colgin,
Tyler A. Baker, Jaclyn J. Pampel, Anthony D. Cipriano, and Allen
Madison, for petitioners.
David P. Fuller, Jeffrey A. Hatfield, Bryce A. Kranzthor,
Lloyd T. Silberzweig, Kendall Williams, David N. Bowen, John E.
Hinding, and Paul K. Webb, for respondent.
OPINION
FOLEY, Judge: Respondent determined deficiencies in the
amounts of $24,653,660, $25,930,531, $27,857,516, and $27,243,975
and section 6662(a) accuracy-related penalties in the amounts of
$4,935,813, $5,189,389, $5,573,412, and $5,448,795 relating to
petitioners’ 1996,1 1997, 1998, and 1999 Federal income taxes,
respectively. The issues for decision are whether: (1)
Petitioner and its foreign subsidiary must share the cost, if
any, of stock options petitioner issued to research and
development employees, (2) respondent’s allocations meet the
arm’s-length requirement set forth in section 1.482-1(b), Income
Tax Regs., and (3) petitioners are liable for section 6662(a)
accuracy-related penalties.
1
Pursuant to the parties’ Apr. 4, 2002, stipulation of
settled issues, the 1996 taxable year is no longer in issue.
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Background
I. Xilinx’s Line of Business and Corporate Structure
Xilinx Inc.,2 is in the business of researching, developing,
manufacturing, marketing, and selling field programmable logic
devices,3 integrated circuit devices, and other development
software systems. Petitioner uses unrelated producers to
fabricate and assemble its wafers into integrated circuit
devices.
During the years in issue, petitioner was the parent of a
group of affiliated subsidiaries including, but not limited to
Xilinx Holding One Ltd., Xilinx Holding Two Ltd., Xilinx
Development Corporation (XDC), NeoCAD Inc.,4 Xilinx Ireland (XI),
and Xilinx International Corporation. XI was established in 1994
as an unlimited liability company under the laws of Ireland and
was owned by Xilinx Holding One Ltd., and Xilinx Holding Two Ltd.
(i.e., Irish subsidiaries of petitioner). XI was created to
manufacture field programmable logic devices and to increase
petitioner’s European market share. It manufactured, marketed,
and sold field programmable logic devices, primarily to customers
2
All references to “petitioner” are to Xilinx Inc. All
references to “petitioners” are to Xilinx Inc. and its
consolidated subsidiaries.
3
Field programmable logic devices are integrated circuits
that can be programmed, using development software, to perform
complex functions.
4
NeoCAD Inc., was liquidated in 1998.
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in Europe, and conducted research and development.
II. The Cost-Sharing Agreement
On April 2, 1995, petitioner and XI entered into a
Technology Cost and Risk Sharing Agreement (cost-sharing
agreement). The cost-sharing agreement provided that all “New
Technology” developed by either petitioner or XI would be jointly
owned. New Technology was defined as technology developed by
petitioner, XI, or petitioner’s consolidated subsidiaries, on or
after the execution date of the cost-sharing agreement. Each
party was required to pay a percentage of the total research and
development costs based on the respective anticipated benefits
from 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.
Petitioner and XI were required to share direct costs,
indirect costs, and acquired intellectual property rights costs.
Direct costs were defined in the agreement as those 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 were defined as
those costs, incurred by other departments, that generally
benefit all research and development including, but not limited
to, administrative, legal, accounting, and insurance costs.
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Acquired intellectual property rights costs were defined as 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, petitioner did not
include in research and development costs any amount related to
the issuance of employee stock options (ESOs).
Cost-sharing percentages for petitioner and XI relating to
1997, 1998, and 1999 were as follows:
Year Petitioner XI
1997 73.61% 26.39%
1998 73.35 26.65
1999 65.09 34.91
In 1997, 1998, and 1999, the following number of petitioner’s and
XI’s employees engaged in research and development:
Year Petitioner XI
1997 338 6
1998 343 10
1999 394 16
III. Petitioner’s Stock Option Plans
ESOs are offers to sell stock at a stated price (i.e., the
exercise price) for a stated period of time. They are used by
many companies to attract, retain, and motivate employees and
align employee and employer goals. There are basically three
types of ESOs: statutory or incentive stock options (ISOs),
nonstatutory stock options (NSOs), and purchase rights issued
pursuant to an employee stock purchase plan (ESPP purchase
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rights). ISOs and NSOs allow employees to purchase stock at a
fixed price for a specified period of time. ESPP purchase rights
allow employees to purchase stock at a discount through the use
of payroll deductions. ISOs and ESPP purchase rights receive
special tax treatment and are typically not subject to tax when
they are granted or exercised, but the stock acquired pursuant to
the exercise of these options is subject to tax when such stock
is sold.5 NSOs, however, are, pursuant to section 83,6 Property
Transferred in Connection with the Performance of Services,
subject to tax upon exercise unless the option has a readily
ascertainable fair market value.7 Sec. 83(a). If an NSO has a
5
Pursuant to secs. 422 and 423, respectively, ISOs and
ESPP purchase rights are subject to a holding period requirement.
This period begins on the exercise date and ends on the date that
is the later of 2 years after the grant date or 1 year after the
transfer of the share of stock. Secs. 422(a)(1) and 423(a)(1).
If the employee disposes of the stock before the holding period
expires, this disposition will be considered a “disqualifying
disposition”. A disqualifying disposition requires the employee
to recognize ordinary income (i.e., equal to the stock’s market
price on the exercise date over the exercise price) in the
taxable year in which the disposition occurred. Sec. 421(b).
6
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
7
An option has a readily ascertainable fair market value
if it is actively traded on an established market or the taxpayer
can establish all of the following conditions: (1) The option is
transferable by the optionee; (2) the option is exercisable
immediately in full by the optionee; (3) the option is not
subject to any restriction which has a significant effect on the
fair market value of the option; and (4) the fair market value of
(continued...)
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readily ascertainable fair market value, income is recognized on
the grant date, and the issuer is entitled to a deduction. Sec.
83(h); sec. 1.83-7(a), Income Tax Regs.
NSOs, when granted, may be “in-the-money”, “out-of-the-
money”, or “at-the-money”. ISOs, however, may only be “at-the-
money” or “out-of-the-money”.8 An option is deemed in-the-money
when the exercise price on the grant date is below the stock’s
market price. Conversely, an option is out-of-the-money when the
exercise price on the grant date is above the stock’s market
price. An option that has an exercise price equal to the stock’s
market price on the grant date is considered at-the-money.
An employee typically cannot exercise options, until the
employee has a vested right (i.e., a legal right that is not
contingent on the performance of additional services) in the
option pursuant to the stock option plan’s terms. Some companies
permit immediate vesting upon issuance of an option, while others
delay vesting several years or allow incremental vesting over a
period of years.
7
(...continued)
the option privilege is readily ascertainable. Sec. 1.83-7(b)(1)
and (2), Income Tax Regs. “Option privilege” is the value of the
right to benefit from any future increase in the value of the
property subject to the option, without risking any capital.
Sec. 1.83-7(b)(3), Income Tax Regs.
8
Pursuant to sec. 422, the exercise price relating to ISOs
may not be less than the stock’s market price on the grant date.
Sec. 422(b)(4).
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Petitioner, pursuant to broad-based plans (i.e., plans that
offer ESOs to 20 percent or more of a company’s employees),
offered three types of stock option compensation: ISOs, NSOs,
and ESPP purchase rights. All ISOs and NSOs issued by petitioner
were at-the-money. All ESPP purchase rights were issued with an
exercise price equal to 85 percent of the stock’s market price.
Prior to and during the 1997 taxable year, the options were
generally subject to a 5-year vesting period. After 1997,
petitioner decreased the vesting period from 5 to 4 years.
Pursuant to the stock option plan, employees could exercise
options by delivering to petitioner’s broker a notice of exercise
with irrevocable instructions and consideration equal to the
exercise price. The broker would then deliver the instructions
and consideration to petitioner. Employees could elect to
exercise their options in either a “same-day-sale” or “buy-and-
hold” transaction. In a same-day-sale, the employee does not
make a payment for the stock relating to the option. Instead,
simultaneous execution of the option and sale of the stock
results in the excess of the stock’s market price on the grant
date over the exercise price going to the employee and the amount
of the exercise price going to petitioner. In a buy-and-hold
transaction, the employee pays the exercise price by presenting a
check or other form of consideration to petitioner’s broker and
in exchange receives the shares of stock.
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A. 1988 Stock Option Plan
In 1988, petitioner established the Xilinx 1988 Stock Option
Plan (1988 Stock Option Plan). The 1988 Stock Option Plan
provided for the grant of ISOs and NSOs. Under the 1988 Stock
Option Plan, petitioner granted options as part of the employee
hiring process and retention program. Petitioner also granted
merit and discretionary stock options. Merit options were based
on job performance and granted after an employee’s annual review.
Discretionary stock options were a separate pool of options made
available to petitioner’s vice presidents to reward their
subordinates for significant project achievements.
Under the 1988 Stock Option Plan, former employees generally
could exercise options if the exercise occurred within 30 days
after the cessation of the employee’s tenure at the company. In
April of 1998, the 1988 Stock Option Plan was replaced by the
Xilinx, Inc. 1997 Stock Plan (1997 Stock Option Plan). The 1997
Stock Option Plan provided for the grant of ESPP purchase rights
in addition to ISOs and NSOs.
B. 1990 Employee Qualified Stock Purchase Plan
The Xilinx, Inc. 1990 Employee Qualified Stock Purchase Plan
(ESPP) allowed full-time employees to purchase petitioner’s stock
at a discount. Beginning January 1, 1990, the ESPP provided 24-
month offering periods which commenced during the beginning of
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January and July. Eligible employees could participate in the
ESPP by completing a Subscription Agreement authorizing payroll
deductions. During a 24-month offering period, employees could
contribute to the plan through payroll deductions in any amount
between 2 and 15 percent of their total compensation. Upon
exercise, petitioner would deduct the exercise price from the
employee’s accumulated payroll deductions. The exercise price
was equal to the lower of 85 percent of the stock’s market price
on the offering date (i.e., the first day of each offering
period), or 85 percent of the stock’s market price on the
exercise date. Stock could be purchased twice a year (i.e., on
June 30 and December 31).
Petitioner also maintained a stock buy-back program.
Pursuant to the program, petitioner, during 1997, 1998, and 1999,
purchased stock from stockholders and transferred such stock
(i.e., treasury shares) to employees who had exercised options or
purchased stock pursuant to petitioner’s ESPP.
IV. Petitioner’s Stock Option Intercompany Agreements With XI
On March 31, 1996, petitioner and XI entered into The Xilinx
Ireland/Xilinx, Inc. Stock Option Intercompany Agreement. The
purpose of the Stock Option Intercompany Agreement was to allow
XI employees to acquire stock in petitioner. The Stock Option
Intercompany Agreement provided that the cost incurred by
petitioner for the grant or exercise of options by XI employees
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would be borne by XI. The cost equaled the stock’s market price
on the exercise date over the exercise price. Upon receipt of
petitioner’s notice specifying the appropriate amount, XI was
required to pay petitioner.
On March 31, 1996, petitioner and XI also entered into the
Xilinx, Inc./Xilinx Ireland Employee Stock Purchase Plan
Reimbursement Agreement (ESPP Reimbursement Agreement), which
allowed XI employees to purchase, with payroll deductions,
petitioner’s stock. XI was required to pay petitioner the cost
associated with the exercise of the options. Pursuant to the
agreement, the cost equaled the stock’s market price on the
exercise date over the exercise price. Upon receipt of
petitioner’s notice specifying the appropriate amount, XI was
required to pay petitioner.
V. Financial Accounting Disclosure Rules
A. Background
The Financial Accounting Standards Board (FASB) is the
professional organization primarily responsible for establishing
financial reporting standards in the United States. FASB's
standards are known as Generally Accepted Accounting Principles
(GAAP). For more than 30 years, FASB has recognized certain ESOs
as an expense to the issuing corporation.
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B. Accounting Principles Board Opinion No. 25, “Accounting
for Stock Issued to Employees” (APB 25)
In 1972, FASB authorized APB 25, which required ESOs to be
valued using the “intrinsic value method” (IVM). From 1972 to
December 15, 1995, the IVM was the only authorized financial
accounting method for valuing ESOs. Under the IVM, the value of
ESOs is the excess of the stock’s market price on the grant date
over the exercise price. This value is reported directly on the
employer’s income statement relating to the year in which the
ESOs are granted. ESOs granted at-the-money have no intrinsic
value because the stock’s market price on the grant date is equal
to the exercise price.
C. Statement of Financial Accounting Standard No. 123,
“Accounting for Stock-Based Compensation” (SFAS 123)
In October of 1995, FASB issued SFAS 123, which is effective
for fiscal years ending after December 15, 1995. SFAS 123 added
the “fair value method” (FVM) as the preferred method for valuing
ESOs. Pursuant to SFAS 123, companies continuing to use the IVM
were required to “make pro forma disclosures of net income and,
if presented, earnings per share, as if the * * * [FVM] had been
applied.”
The value of an ESO is composed of two components: the
intrinsic value and the call premium. While the intrinsic value
is equal to the stock’s market price on the grant date over the
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exercise price, the call premium is the amount, in excess of an
ESO’s intrinsic value, that a purchaser would be willing to pay
for the ESO. An ESO’s call premium is difficult to measure
because it, unlike the call premium of a publicly traded option,
cannot be valued daily based on market transactions. FASB
readily recognized that the IVM fails to measure adequately the
call premium relating to ESOs.9 Nevertheless, the IVM remained a
permissible accounting method during the years in issue.
Although the FVM was added as the preferred method in 1996, most
companies continued to use the IVM during the years in issue.
Pursuant to the FVM, a corporation must measure the amount
of the expense as equal to the fair value of the ESO on the grant
date and amortize such expense over the vesting period. Under
SFAS 123, fair value is measured using option pricing models that
consider the following six attributes of equity-based
instruments: (1) The exercise price, (2) the expected life of
the option, (3) the current price of the underlying stock, (4)
the expected price volatility of the underlying stock, (5)
expected dividends, and (6) the risk-free interest rate for the
expected life of the option.
The FVM utilizes option pricing models, such as the Black
9
FASB, in SFAS 123, stated: “Zero is not within the range
of reasonable estimates of the value of employee stock options at
the date they are granted, the date they vest, or at other dates
before they expire.”
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Scholes model (BS model), for purposes of measuring the value of
ESOs. The BS model was originally designed to measure publicly
traded options and, as a result, fails to adequately take into
account numerous differences between ESOs and publicly traded
options. For example, ESOs are nontransferable and have terms to
maturity that are usually longer than those of publicly traded
options. The extended term of an ESO complicates the task of
estimating the volatility of the stock price, which is an
essential input in the pricing of any option. Furthermore, ESOs
cannot be traded, so they must be discounted to account for the
difference in value between tradeable and nontradeable options
(i.e., tradeable options are worth more than nontradeable
options). Yet, the appropriate discount is difficult to
determine with reasonable accuracy because the discount is based
on the value of the ESO to an employee. Moreover, an ESO’s value
is affected by whether an employee forfeits the option by failing
to exercise it or exercises the option prior to the expiration of
the ESO’s maximum life. These employee decisions cannot be
reliably modeled. Thus, FAS 123 requires companies to make
certain adjustments to take into account the differences between
ESOs and publicly traded options. For example, to account for
option forfeiture, SFAS 123 requires that an ESO’s value be
discounted to reflect the amount of forfeitures expected
annually. With respect to early exercise, the expected life of
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the option is used instead of the ESO’s actual or maximum life.
During the years in issue, petitioners, on their Securities
and Exchange Commission Forms 10-K, elected to use the IVM, as
prescribed in APB 25, to measure expenses attributable to ESOs.
As required by SFAS 123, petitioners disclosed net income and
earnings per share as if the FVM had been applied. In
determining the fair value of ESOs, petitioners used an adjusted
BS model.
VI. Procedural History
A. Petitioners’ Federal Income Tax Returns
Petitioners are accrual basis taxpayers and timely filed
consolidated Federal income tax returns for their taxable years
ended March 29, 1996, March 29, 1997, March 28, 1998, and April
3, 1999. During the years in issue, GAAP, pursuant to APB 25,
provided that the issuing company did not incur an expense
related to options granted at-the-money. In accordance with APB
25, petitioner did not, for purposes of its cost-sharing
agreement with XI, include any costs related to ESOs issued to
employees.
On December 28, 2000, and October 17, 2002, respondent
issued notices of deficiency relating to 1996 through 1998 and
1999, respectively. In his notices of deficiency, respondent
determined that petitioners were required, pursuant to its cost-
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sharing agreement, to share with XI the costs of certain ESOs.
Respondent determined that the cost required to be taken into
account equaled the spread (i.e., the stock’s market price on the
exercise date over the exercise price) relating to ESOs exercised
by petitioner’s employees (spread theory). Respondent defined
the spread as the amount of petitioners’ section 83 deduction
relating to the exercise of NSOs and disqualifying dispositions
of ISOs and ESPP purchase rights.10 Respondent’s determination
resulted in the following deficiencies and penalties:11
Penalty
Year Deficiency Sec. 6662(a)
1996 $24,653,660 $4,935,813
1997 25,930,531 5,189,389
1998 27,857,516 5,573,412
1999 27,243,975 5,448,795
On March 26, 2001, and January 14, 2003, respectively,
petitioners timely filed their petitions with the Court seeking a
redetermination of the deficiencies set forth in the December 28,
2000, and October 17, 2002, notices. Petitioner’s principal
place of business was San Jose, California, at the time the
10
ISOs and ESPP purchase rights meeting the requirements
of secs. 422 and 423, however, were not included in respondent’s
definition because they are not subject to tax under sec. 83 (see
supra note 5).
11
Respondent’s reallocation of petitioner’s expenses, in
turn, reduced petitioner’s deductible business expenses and
increased petitioner’s taxable income.
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petitions were filed. On April 4, 2002, the parties stipulated
that no amount relating to ESOs would be included in petitioner’s
1996 cost-sharing pool.
B. Summary Judgment Motions
The Court filed petitioners’ motion for partial summary
judgment on February 4, 2002, and on March 6, 2002, filed
respondent’s cross-motion for partial summary judgment. On
October 28, 2003, we denied both parties’ motions, addressed
whether the spread is a cost pursuant to section 1.482-7(d)(1),
Income Tax Regs., and concluded:
respondent has not established that the spread is
indeed a cost or that the exercise date is the
appropriate time to determine and measure such cost.
* * * In addition, * * * petitioner has not
sufficiently established that it did not incur an
expense upon the employee’s exercise of the options at
issue.
The Court also addressed whether respondent’s lack of knowledge
of comparable transactions (i.e., where unrelated parties agree
to share the spread), or a finding that uncontrolled parties
would not share the spread, would have any effect on respondent’s
authority to make allocations pursuant to section 1.482-1(a)(2),
Income Tax Regs. We concluded:
Section 1.482-1(b)(2), Income Tax Regs., does not
require respondent to have actual knowledge of an
arm’s-length transaction as a prerequisite to
determining that an allocation should be made. See
Seagate Technology, Inc. v. Commissioner, T.C. Memo.
2000-388. If, however, it is established that
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uncontrolled parties would not share the spread, we may conclude
that respondent’s determination is arbitrary, capricious, or
unreasonable. * * * neither party has presented sufficient
evidence or established facts adequately addressing whether the
arm’s-length standard has been met.
C. Promulgation of Regulations Addressing Cost Sharing of
Stock-Based Compensation
On July 29, 2002, the U.S. Department of the Treasury
(Treasury) issued proposed regulations regarding the treatment of
ESOs for cost-sharing purposes. In the preamble accompanying
these proposed regulations, Treasury stated:
The proposed regulations provide that in determining a
controlled participant's operating expenses within the
meaning of § 1.482-7(d)(1), all compensation, including
stock-based compensation, * * * must be taken into
account.
67 Fed. Reg. 48999 (July 29, 2002). As a result of this change
(i.e., the inclusion of stock-based compensation) to section
1.482-7(d)(1), Income Tax Regs., Treasury stated that it was
adding:
express provisions coordinating the cost sharing rules
of § 1.482-7 with the arm's length standard as set
forth in § 1.482-1. New § 1.482-7(a)(3) clarifies that
in order for a qualified cost sharing arrangement to
produce results consistent with an arm's length result
within the meaning of § 1.482-1(b)(1), all requirements
of § 1.482-7 must be met, including the requirement
that each controlled participant's share of intangible
development costs equal its share of reasonably
anticipated benefits attributable to the development of
intangibles. The proposed regulations also make
amendments to § 1.482-1 to clarify that § 1.482-7
provides the specific method to be used to evaluate
whether a qualified cost sharing arrangement produces
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results consistent with an arm's length result, and to
clarify that under the best method rule, the provisions
of § 1.482-7 set forth the applicable method with
respect to qualified cost sharing arrangements.
Id. at 49000. Sections 1.482-1 and 1.482-7, Income Tax Regs.,
were modified as follows:
SEC. 1.482-1. Allocation of Income and Deductions Among
Taxpayers.
* * * * * * *
(2) * * * Section 1.482-7 provides the specific method
to be used to evaluate whether a qualified cost sharing
arrangement produces results consistent with an arm’s
length result.
* * * * * * *
SEC. 1.482-7. Sharing of Costs.
* * * * * * *
(3) Coordination with § 1.482-1.--A qualified cost
sharing arrangement produces results that are
consistent with an arm's length result within the
meaning of § 1.482-1(b)(1) if, and only if, each
controlled participant's share of the costs (as
determined under paragraph (d) of this section) of
intangible development under the qualified cost sharing
arrangement equals its share of reasonably anticipated
benefits attributable to such development (as required
by paragraph (a)(2) of this section) and all other
requirements of this section are satisfied.
* * * * * * *
(2) Stock-based compensation.--(i)* * * a controlled
participant's operating expenses include all costs
attributable to compensation, including stock-based
compensation. * * * stock-based compensation means any
compensation provided by a controlled participant to an
employee * * * in the form of equity instruments,
options to acquire stock (stock options), or rights
with respect to (or determined by reference to) equity
instruments or stock options, including but not limited
to property to which section 83 applies and stock
options to which section 421 applies, regardless of
whether ultimately settled in the form of cash, stock,
or other property.
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(ii) * * * all stock-based compensation that is granted
during the term of the qualified cost sharing
arrangement and is related at date of grant to the
development of intangibles * * * is included as an
intangible development cost * * *.
(iii) Measurement and timing of stock-based
compensation expense.--(A) In general.-Except as
otherwise provided in this paragraph (d)(2)(iii), the
operating expense attributable to stock-based
compensation is equal to the amount allowable to the
controlled participant as a deduction for federal
income tax purposes with respect to that stock-based
compensation (for example, under section 83(h)) and is
taken into account as an operating expense under this
section for the taxable year for which the deduction is
allowable.
(1) Transfers to which section 421 applies.--Solely for
purposes of this paragraph (d)(2)(iii)(A), section 421
does not apply to the transfer of stock pursuant to the
exercise of an option that meets the requirements of
section 422(a) or 423(a).
Id. at 49001. On August 26, 2003, Treasury finalized its
proposed regulations without modifying the above-referenced
provisions. The final regulations are applicable to stock-based
compensation provided to employees in taxable years beginning on
or after August 26, 2003.
D. Respondent’s Amendments to Answer
In the December 28, 2000, notice of deficiency, respondent
determined that the cost-sharing pool included ESOs granted to
petitioner’s research and development employees prior to and
after April 2, 1995 (i.e., the cost-sharing agreement’s execution
date), and exercised during 1997 and 1998. On August 4, 2003,
the Court filed respondent’s motion for leave to file an
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amendment to the answer in docket No. 4142-01 (i.e., relating to
1997 and 1998). On October 21, 2003, the Court granted the
motion and filed respondent’s amendment to answer which asserted
that the only ESOs at issue were those granted on or after April
2, 1995, and exercised during 1997 and 1998. As a result of this
amendment, respondent’s adjustments to petitioner’s cost-sharing
pool, relating to ESOs exercised in 1997 and 1998, decreased from
$4,504,781 to $389,037 and $5,195,104 to $1,263,006,
respectively.
On November 25, 2003, the Court granted the parties' joint
motion to consolidate docket No. 4142-01 and docket No. 702-03
(i.e., relating to 1999) for purposes of trial, briefing, and
opinion.
The Court, on February 6, 2004, filed respondent’s motion
for leave to file a second amendment to the answer in docket No.
4142-01 and an amendment to the amended answer in docket No. 702-
03. In this motion, respondent sought permission to contend that
ESOs provided to petitioner’s research and development employees
be valued as of the date those options were granted (grant date
theory). On April 8, 2004, the Court denied respondent’s motion
because the motion failed to provide sufficient information
(i.e., the number of options at issue or the amounts of the
revised deficiencies) relating to respondent’s grant date theory.
The Court, on May 11, 2004, filed respondent’s motion for
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leave to file a second amendment to the answer in docket No.
4142-01 and an amendment to the amended answer in docket No. 702-
03. In this motion, respondent included the number of options at
issue and the amounts of the revised deficiencies. Pursuant to
his grant date theory, the amounts of the revised deficiencies
relating to 1997, 1998, and 1999 are $25,121,951, $27,854,698,
and $24,784,465, respectively. On June 3, 2004, the Court
granted respondent’s motion but concluded that respondent’s
amendment raised a new matter because “the grant date theory
requires different evidence (i.e., includes additional options
and utilizes a different method of valuation)” and alters the
original deficiency. On July 14, 2004, the trial commenced.
Discussion
I. Applicable Statute and Regulations
A. Purpose and Scope of Section 482
Section 482 was enacted to prevent tax evasion and ensure
that taxpayers clearly reflect income relating to transactions
between controlled entities. It accomplishes this purpose by
authorizing respondent:
[to] distribute, apportion, or allocate gross income,
deductions, credits, or allowances between or among
* * * [controlled entities], if he determines that such
distribution, apportionment, or allocation is necessary
* * * to prevent evasion of taxes or clearly to reflect
the income of * * * [such entities].
-23-
Section 482 places a controlled taxpayer on a tax parity
with an uncontrolled taxpayer by determining the true taxable
income of the controlled taxpayer. Sec. 1.482-1(a)(1), Income
Tax Regs. In determining true taxable income, “the standard to
be applied in every case is that of a taxpayer dealing at arm's
length with an uncontrolled taxpayer.” See United States Steel
Corp. v. Commissioner, 617 F.2d 942, 947 (2d Cir. 1980) (stating
the “‘arm's length’ standard is * * * meant to be an objective
standard that does not depend on the absence or presence of any
intent on the part of the taxpayer to distort his income.”),
revg. T.C. Memo. 1977-140; sec. 1.482-1(b)(1), Income Tax Regs.
Because identical transactions are rare, the arm’s-length result
will “generally * * * be determined by reference to the results
of comparable transactions under comparable circumstances.” Sec.
1.482-1(b)(1), Income Tax Regs.
B. Application of Section 482 to Qualified Cost-Sharing
Agreements
Section 482 provides that “In the case of any transfer * * *
of intangible property * * * the income with respect to such
transfer * * * shall be commensurate with the income attributable
to the intangible.” Participants in a qualified cost-sharing
agreement (QCSA) relinquish exclusive ownership of all
exploitation rights in new intangibles they individually develop
and agree to share ownership of, and costs associated with, such
-24-
intangibles. For purposes of section 482, this relinquishment
constitutes a transfer of specified future exploitation rights.
See sec. 1.482-7(a)(3), (g), Income Tax Regs.
Section 1.482-7(a)(1), Income Tax Regs., requires
participants “to share the costs of development of one or more
intangibles in proportion to their * * * [respective] shares of
reasonably anticipated benefits.” Anticipated benefits are
defined as “additional income generated or costs saved by the use
of covered intangibles”. Sec. 1.482-7(e)(1), Income Tax Regs.
If parties fail to share such costs in proportion with their
benefits, respondent is authorized to make allocations “to the
extent necessary to make each controlled participant’s share of
the costs * * * equal to its share of reasonably anticipated
benefits”. Sec. 1.482-7(a)(2), Income Tax Regs.
II. Are the Spread and Grant Date Value Costs for Purposes of
Section 1.482-7, Income Tax Regs.?
Intangible development costs are defined as “all of the
costs incurred * * * related to the intangible development area
* * * [which] consist of the following items: operating expenses
as defined in * * * [section] 1.482-5(d)(3), other than
depreciation or amortization expense”. Sec. 1.482-7(d)(1),
Income Tax Regs. Operating expenses are defined as “all expenses
not included in cost of goods sold except for interest expense,
foreign income taxes * * *, domestic income taxes, and any other
-25-
expenses not related to the operation of the relevant business
activity.” Sec. 1.482-5(d)(3), Income Tax Regs.
Respondent contends that petitioner paid its employees ESOs
in exchange for research and development services, and such
services contributed to petitioner’s development of intangibles.
In support of his position, respondent emphasizes petitioners’
tax treatment of options for section 41, Credit For Increasing
Research Activities, and section 83 purposes.
Petitioners contend that there was no outlay of cash upon
the issuance of its ESOs, and thus, no cost was incurred.
Petitioners further contend that any cost associated with the
ESOs was borne by shareholders because the exercise of ESOs
increased the outstanding shares and reduced existing
shareholders’ earnings per share. In addition, petitioners
contend that the costs determined by respondent are not related
to petitioner’s intangible development area. Assuming arguendo
that the spread and the grant date value are costs for purposes
of section 1.482-7(d), Income Tax Regs., we conclude that
respondent’s allocations fail to meet the requirements of section
1.482-1(b), Income Tax Regs. (discussed infra section III.D).
-26-
III. Respondent’s Allocations Are Inconsistent With the Arm’s-
Length Standard Mandated by Section 1.482-1, Income Tax
Regs.
A. Respondent’s Authority To Make Allocations
Section 482 provides respondent with wide latitude in
allocating income and deductions between controlled parties to
ensure such parties report their true taxable income. This broad
grant of authority, however, is constrained by section 1.482-1,
Income Tax Regs., which sets forth the “general principles and
guidelines to be followed under section 482.” Sec. 1.482-
1(a)(1), Income Tax Regs. The sections to which these general
principles and guidelines apply include, but are not limited to,
section 1.482-7, Income Tax Regs. Id.Section 1.482-1(a)(2), Income Tax Regs., authorizes
respondent to “make allocations between or among the members of a
controlled group if a controlled taxpayer has not reported its
true taxable income.” In determining true taxable income, “the
standard to be applied in every case is that of a taxpayer
dealing at arm’s length with an uncontrolled taxpayer” (i.e.,
arm’s-length standard). Sec. 1.482-1(b)(1), Income Tax Regs.
(emphasis added). The arm’s-length standard is employed to
ensure that related party transactions clearly reflect the income
of each party and to prevent tax evasion.
-27-
B. Respondent’s Interpretation of Sections 1.482-1 and
1.482-7, Income Tax Regs., Is Incorrect
Neither party disputes the absence of comparable
transactions in which unrelated parties agree to share the spread
or the grant date value. Nor do the parties dispute the fact
that unrelated parties would not “explicitly” (i.e., within the
written terms of their agreements) share the spread or the grant
date value. The parties, however, disagree about what effect
these facts have on respondent’s authority to make allocations
pursuant to section 1.482-1, Income Tax Regs.
Pursuant to section 1.482-1(b)(1), Income Tax Regs., “A
controlled transaction meets the arm’s length standard if the
results of the transaction are consistent with the results that
would have been realized if uncontrolled taxpayers had engaged in
the same transaction under the same circumstances”. Section
1.482-1(b)(1), Income Tax Regs., further states:
because identical transactions can rarely be located,
whether a transaction produces an arm’s length result
generally will be determined by reference to the
results of comparable transactions under comparable
circumstances. [Emphasis added.]
Respondent presented no evidence or testimony establishing
that his determinations are arm’s length. He simply contends
that the “application of the express terms of Treas. Reg. §
1.482-7 itself produces an arm’s-length result,” and that “it is
unnecessary to perform any type of comparability analysis to
-28-
determine * * * whether parties at arm’s length would share * * *
[the spread or the grant date value]”. Thus, respondent contends
that the spread and the grant date value amounts he determined
automatically meet the arm’s-length standard. In support of his
contention, respondent focuses on the meaning of the term
“generally” in section 1.482-1(b)(1), Income Tax Regs. He
asserts:
A rule that applies only “generally” must, by its own
terms, have exceptions. In light of the legislative
history and extensive regulations interpreting the 1986
commensurate with income statutory amendment, qualified
cost sharing arrangements constitute an appropriate
exception from the general rule.
According to respondent, “the identification of costs, and the
corresponding adjustments to the cost pool under qualified cost-
sharing arrangements, should be determined without regard to the
existence of uncontrolled transactions.” We disagree.
Respondent’s interpretation of the word “generally” is
incorrect because he ignores the preceding clause (i.e., “because
identical transactions can rarely be located”). The regulation
simply states that “comparable transactions” are the broad
exception available when there are no identical transactions.
See Union Carbide Corp. & Subs. v. Commissioner, 110 T.C. 375,
384 (1998) (stating “When the plain language of the statute or
regulation is clear and unambiguous, * * * the inquiry * * *
[ends].”). The regulation does not state that any allocation
-29-
proposed by respondent automatically produces an arm’s-length
result without reference to what arm’s-length parties would do.
Therefore, respondent’s litigating position is contrary to his
regulations. See Phillips v. Commissioner, 88 T.C. 529, 534
(1987) (stating respondent “may not choose to litigate against
the officially published rulings * * * without first withdrawing
or modifying those rulings. The result of contrary action is
capricious application of the law”), affd. 851 F.2d 1492 (D.C.
Cir. 1988). Pursuant to the express language of section 1.482-
1(a)(1), Income Tax Regs., we conclude that the arm’s-length
standard is applicable in determining the appropriate allocation
of costs pursuant to section 1.482-7, Income Tax Regs.
C. Legislative and Regulatory History Support the
Applicability of the Arm’s-Length Standard to Section
1.482-7, Income Tax Regs.
Respondent contends that the legislative and regulatory
history relating to the 1986 amendment to section 482 establishes
that, for purposes of determining the arm’s-length result in
cost-sharing arrangements, Congress intended to supplant the use
of comparable transactions with internal measures of cost and
profit.
It is unnecessary and inappropriate to resort to
legislative, and certainly not to regulatory, history, because
section 1.482-1(b)(1), Income Tax Regs., is unambiguous. Union
Carbide Corp. & Subs. v. Commissioner, supra at 384. Even if the
-30-
regulations were ambiguous, our conclusion would not change
because the legislative and regulatory history relating to
section 482 supports our holding that the arm’s-length standard
is applicable in determining the appropriate allocation of costs
pursuant to section 1.482-7, Income Tax Regs.
In 1986, Congress amended section 482 by adding “In the case
of any transfer * * * of intangible property * * * the income
with respect to such transfer * * * shall be commensurate with
the income attributable to the intangible.” This change
reflected a concern that the statute had failed to effectively
prevent transfer pricing abuses in controlled transactions (e.g.,
companies transferring intangibles to related foreign companies
in exchange for a “relatively low royalty [rate]” based on
“industry norms for transfers of less profitable intangibles.”).
H. Rept. 99-426, at 424 (1985), 1986-3 C.B. (Vol. 2) 424; accord
Staff of Joint Comm. on Taxation, General Explanation of the Tax
Reform Act of 1986, at 1014-1015 (J. Comm. Print 1987); see H.
Rept. 99-426, supra at 424-425, 1986-3 C.B. (Vol. 2) 424-425.
The committee stated:
In making this change, Congress intended to make it
clear that industry norms or other unrelated party
transactions do not provide a safe-harbor payment for
related party intangibles transfers.
H. Rept. 99-426, at 414 (1985), 1986-23 C.B. (Vol. 2) 424. The
committee concluded: “it is appropriate to require that the
-31-
payment made on a transfer of intangibles to a related foreign
corporation * * * be commensurate with the income attributable to
the intangible.” H. Rept. 99-426 at 414 (1985), 1986-23 C.B.
(Vol. 2) 424.
Respondent contends that the regulatory history, including
Treasury’s publication of Notice 88-123, 1988-2 C.B. 458 (the
White Paper), establishes that the commensurate with income
standard replaced the arm’s-length standard mandated in section
1.482-1, Income Tax Regs. We note that regulatory history, like
legislative history, is a far less accurate embodiment of intent
than plain language and is susceptible to a wide array of
interpretations. Nevertheless, our conclusion is consistent with
the White Paper and the 1992 and 1995 regulations. Contrary to
respondent’s contentions, the commensurate with income standard
was intended to supplement and support, not supplant, the arm’s-
length standard. Nothing in section 482, its accompanying
regulations, or its legislative history indicates that internal
measures of cost and profit should be used to the exclusion of
the arm’s-length standard.
The White Paper reexamined the theory and administration of
section 482 and concluded:
Looking at the income related to the intangible and
splitting it according to relative economic
contributions is consistent with what unrelated parties
do. The general goal of the commensurate with income
standard is, therefore, to ensure that each party earns
-32-
the income or return from the intangible that an
unrelated party would earn in an arm’s length transfer
of the intangible.
Notice 88-123, 1988-2 C.B. 458, 472. In 1992, respondent
promulgated regulations, interpreting section 482, which were
finalized in 1995. Neither the 1992 nor 1995 regulations contain
language indicating any intention to remove the arm’s-length
standard with respect to cost-sharing determinations or prevent
consideration of uncontrolled transactions. In fact, the
preamble to the 1992 proposed regulations states that section
1.482-1(b)(1), Income Tax Regs., “clarifies the general meaning
of the arm’s length standard * * * [as] whether uncontrolled
taxpayers exercising sound business judgment would have agreed to
the same terms given the actual circumstances under which
controlled taxpayers dealt.” See DHL Corp. & Subs. v.
Commissioner, 285 F.3d 1210, 1222 (9th Cir. 2002) (relying on the
preamble to interpret section 1.482-2(d), Income Tax Regs.);
Armco, Inc. v. Commissioner, 87 T.C. 865, 868 (1986) (stating "A
preamble will frequently express the intended effect of some part
of a regulation * * * [and] might be helpful in interpreting an
ambiguity in a regulation."); Proposed Income Tax Regs., 57 Fed.
Reg. 3571 (Jan. 30, 1992).
Finally, respondent contends that the general rules of
statutory interpretation require us to construe the regulations
in a manner that “avoids conflict within the regulatory scheme,
-33-
and harmonizes with the underlying * * * [statute’s]” purpose.
The Court, however, will not ignore the regulations’ explicit
terms in order to accommodate respondent’s litigating position.
While Treasury has the authority to modify its regulations to
resolve any conflict within the regulatory scheme, we must “apply
the provisions of respondent's regulations as we find them and
not as we think they might or ought to have been written.”
Larson v. Commissioner, 66 T.C. 159, 186 (1976). The arm’s-
length standard is included without exception, and the 1986
modification of section 482 did not eliminate the use of
comparable transactions in determining a controlled taxpayer’s
income. Section 1.482-1, Income Tax Regs., explicitly provides
that the arm’s-length standard applies to “all transactions”.
Cost-sharing determinations pursuant to section 1.482-7, Income
Tax Regs., are not exempted. Accordingly, if unrelated parties
would not share the spread or the grant date value, respondent’s
determinations are arbitrary and capricious.
D. Unrelated Parties Would Not Share the Spread or
Grant Date Value
Respondent contends that unrelated parties “implicitly”
share the spread12 and the grant date value,13 but both parties
12
As a result of respondent’s Oct. 21, 2003, amendment to
answer, the parties dispute who has the burden of proof with
respect to the spread theory. Our conclusion is based on the
preponderance of the evidence. Thus, the burden of proof is
(continued...)
-34-
agree that unrelated parties would not explicitly share these
amounts. Indeed, Scott T. Newlon, the only witness proffered by
respondent to address this issue, testified that parties “don’t
* * * explicitly [share any amount for ESOs] because * * * it
would be hard for the parties to agree on a measurement * * * and
it may * * * [leave them] open to * * * potential disputes.”
These considerations are aptly summarized by Irving Plotkin, one
of petitioners’ experts, who testified:
In the real world, these measures [the spread and grant
date value] are so speculative and controversial, and
the link between them and the value of R&D functions
performed by the ESO holder is so tenuous, that
unrelated parties in joint research arrangement simply
do not agree to pay any amount for ESOs granted to the
employees of an entity providing R&D services.
Petitioners also established that, for product pricing purposes,
companies (i.e., those who enter into cost-sharing arrangements
relating to intangibles) do not take into account the spread or
the grant date value relating to ESOs.
While respondent concedes that unrelated parties do not
explicitly share costs attributable to ESOs, he contends that
unrelated parties “negotiate terms that implicitly compensate
12
(...continued)
immaterial. See Martin Ice Cream Co. v. Commissioner, 110 T.C.
189, 210 n.16 (1998).
13
Because we determined, in our June 3, 2004, order, that
the grant date theory is a new matter, respondent bears the
burden of proof with respect to this theory. Rule 142(a); Shea
v. Commissioner, 112 T.C. 183 (1999).
-35-
* * * [development] costs not directly shared or reimbursed.”
(Emphasis added.) Respondent, however, did not present any
credible evidence that unrelated parties implicitly share the
spread or grant date value related to ESOs. Scott T. Newlon, the
only witness respondent proffered to address this issue, did not
reference any other economists, unpublished or published
articles, or any transactions supporting his theory. In fact, he
conceded that it was not possible to test whether parties
implicitly include ESOs as a compensation cost in cost-sharing
agreements. Petitioners, however, through the testimony of
numerous credible witnesses, established that companies do not
implicitly take into account the spread or the grant date value
for purposes of determining costs relating to cost-sharing
agreements. Furthermore, petitioners established that if
unrelated parties believed that the spread and grant date value
were costs related to intangible development activities, such
parties would be very explicit about their treatment for purposes
of their agreements. In short, respondent’s implicit cost theory
is specious and unsupported.
1. The Spread
Unrelated parties would not share the spread because it is
difficult to estimate, unpredictable, and potentially large in
amount. Petitioners’ uncontradicted evidence established that
certainty and control are of paramount importance to unrelated
-36-
parties involved in cost-sharing arrangements. Yet, the size of
the spread is affected by a variety of factors, many of which are
not within the control of the contracting parties. More
specifically, the size of the spread is based on the exercise
price and the stock price on the exercise date. It is
indisputable that changes in stock prices are frequent and
unpredictable, and that a wide variety of external factors may
influence such prices. In fact, the entire market, or stock in
individual companies, may move up or down based on market and
industry trends and a myriad of factors including, but not
limited to, inflation, interest and unemployment rates, consumer
demand, energy prices, programmed trading, etc. As a result,
petitioner’s stock price may move in response to such trends and
be affected by these factors. For example, respondent concedes
that he does not know whether the rises in petitioner’s stock
price were attributable to increases in the market as a whole or
the semiconductor industry in particular.
Stock prices are also sometimes affected by investor trading
based on erroneous information. In such cases, a temporary
change in stock price may be based on transient misperceptions of
value among investors.
The spread is also significantly affected by an employee’s
investment decision regarding when to exercise the option.
Indeed, the timing of the ESO-holder’s decision to exercise the
-37-
ESO may have a dramatic impact on the size of the spread. While
the exercise price is fixed at the grant date, the value of the
stock is not fixed until the ESO-holder exercises the option.
This personal decision is based on the employee’s liquidity
needs, aversion to risks, and other miscellaneous factors. In
essence, the market and ESO-holder, rather than the contracting
parties, determine the size of the spread and when the spread
will be incurred. Simply put, rational profit-maximizing
unrelated parties would not cede this control over costs or be
willing to accept such a high degree of uncertainty relating to
costs.
In short, the value of petitioner’s stock, and thus the
potential size of the spread relating to ESOs, could rise and
fall in line with the vicissitudes and vagaries of the market.
The semiconductor industry, of which petitioner is a prominent
member, may be particularly subject to these types of market
swings and trends. Thus, the spread is affected by a myriad of
factors and calculated and incurred at a point in time when the
contracting parties have no control over the amount.
Finally, we note that sharing the spread could also create
perverse incentives for unrelated parties. One of petitioners’
experts, Mukesh Bajaj, stated:
A well-designed economic contract would ensure that
both partners have an incentive in seeing the value of
the other partner rise. If * * * the Spread * * * has
-38-
to be cost-shared, the cost sharing partner has a
perverse incentive to diminish (or at least help
contain) the stock price of the other firm because the
lower this price, the less the spread-based cost that
the partner has to bear.
Unrelated parties would not be inclined to enter into a contract
which contains terms that could encourage such counterproductive
conduct. Accordingly, respondent’s allocation relating to the
spread theory fails to meet the arm’s-length standard mandated by
section 1.482-1(b), Income Tax Regs.14
2. Grant Date Value
Respondent, who had the burden of proof with respect to the
grant date theory, presented no evidence that unrelated parties
would, pursuant to the FVM, make a cost-sharing allocation of at-
the-money options or ESPP purchase rights. To the contrary,
petitioners’ uncontradicted evidence established that in
determining cost allocations unrelated parties would not include
any cost related to the issuance of ESOs. In essence, respondent
contends that petitioner was required to allocate, and thereby
sustain tangible economic consequences relating to, an amount
that unrelated parties do not treat as an expense for tax or
14
Petitioners’ treatment of the spread as a reimbursable
expense for purposes of its intercompany agreement with XI has no
bearing on our conclusion. Sec. 482 looks to transactions
between unrelated, not related, parties to determine whether the
arm’s-length standard in sec. 1.482-1, Income Tax Regs., has been
satisfied.
-39-
financial accounting purposes.15 Accordingly, respondent’s
allocation relating to the grant date value fails to meet the
arm’s-length standard mandated by section 1.482-1(b), Income Tax
Regs.
During the years in issue, petitioners employed the IVM,
which did not treat at-the-money options as expenses. From 1972
until December 15, 1995, the IVM was the only financial
accounting method authorized by FASB for measuring and reporting
the value of options, and thus, the only available method during
the first year of petitioner’s cost-sharing agreement.
Thereafter, the FVM was the preferred method, yet petitioners
were under no affirmative obligation to elect the FVM.16 In
addition, during the years in issue most companies used the IVM
for purposes of valuing ESOs.17 Thus, consistent with the
15
ESOs generally do not have an ascertainable fair market
value on the grant date for purposes of sec. 1.83-7(b)(3), Income
Tax Regs. Thus, the grant date value is not a tax expense
pursuant to sec. 83. During the years in issue, most companies
used the IVM, and thus, were not required, for financial
accounting purposes, to record an expense relating to options
issued at-the-money and certain ESPP purchase rights.
16
In 1996, petitioner employed the IVM to calculate ESO
costs. Respondent, in his Dec. 28, 2000, notice of deficiency,
determined that petitioner’s 1996 cost-sharing pool should be
increased by $14,939,494 relating to stock options and ESPP
purchase rights. The parties subsequently stipulated that this
amount would not be included in the 1996 cost-sharing pool.
17
Although the IVM has been criticized for not measuring
the call premium of an ESO, both parties’ experts acknowledged
that an ESO’s call premium may have some value but cast doubt on
(continued...)
-40-
parties’ expert testimony, unrelated parties would treat ESOs in
a manner consistent with the IVM, rather than the FVM.18
Accordingly, petitioners’ allocation relating to its ESOs
satisfies the arm’s-length standard in section 1.482-1(b), Income
Tax Regs.
IV. Section 6662(a) Penalty
Section 6662(a) imposes a 20-percent accuracy-related
penalty on the portion of an underpayment of tax which is
attributable to a taxpayer’s negligence or disregard of rules or
regulations. Sec. 6662(b)(1). Because we reject respondent’s
determinations, petitioners are not liable for section 6662(a)
penalties.
V. Conclusion
The express language in section 1.482-1(a)(1), Income Tax
Regs., establishes that the arm’s-length standard applies to
section 1.482-7, Income Tax Regs., for purposes of determining
appropriate cost allocations. Because unrelated parties would
not share the spread or the grant date value, respondent’s
imposition of such a requirement is inconsistent with section
17
(...continued)
whether it could be reliably measured.
18
The parties stipulated that “Immediately after SFAS 123
became effective, the vast majority of public companies chose to
continue to follow the intrinsic value method of APB 25.” No
evidence, however, was presented concerning the companies who
used the FVM.
-41-
1.482-1, Income Tax Regs. Simply put, the regulations applicable
to the years in issue did not authorize respondent to require
taxpayers to share the spread or the grant date value relating to
ESOs. Petitioners are merely required to be compliant, not
prescient. Accordingly, we hold that respondent’s allocations
are arbitrary and capricious; petitioners’ allocations meet the
arm’s-length standard mandated by section 1.482-1, Income Tax
Regs.; and petitioners are not liable for the section 6662(a)
penalties.
Contentions we have not addressed are irrelevant, moot, or
meritless.
To reflect the foregoing and concessions made by the
parties,
Decisions will be
entered under Rule 155.
[Reporter’s Note: This opinion was modified by Order dated September 29, 2005.]