American Bar Association Section of Taxation 2009 Joint Fall CLE Meeting

Transcription

1 Will & Emery American Bar Association Section of Taxation 2009 Joint Fall CLE Meeting CreationITransfers of lntangi bles Outside of Cost Sharing September 25, 2009 Fred Chilton Kenneth Christman Bodon Brussels Chicago DorseLlod Houllon London Los Angeles Mlrml Mllan Munlsh New York Olsnge County Rome San Dlego Sllkon Valley Warhlnglon. D.C. Slrdeglc alliance wllh MWE Chlna Law OEsrr (Shanghai) a009 McDormon a ll B Emery LLP. McDcrmon operates Us pnctlce lhrovgh reparale legal snlnlsr in aaeh d the countrlrs where It has omcer. nio sommunicallon may be sonrldsrsd albmey advertising. Previous rcsulb are no1 a guarantee of luture outcome. I. Overview of Temporary Cost Sharing Regulations Proposed regulations were issued on August 29, 2005 and comments were received. The Temporary regulations replace the Proposed regulations. The Temporary regulations are effective January 5, 2009 and generally expire on or before December 30, (sunset provision.)

2 McDcrn~ot t Will &Emcry I. Overview of Temporary Cost Sharing Regulations The Temporary Regulations have the same force and effect as final regulations The Temporary Regulations retain many of the concepts in the 2005 Proposed Regulations, but also embody a number of changes Various transition rules modify the application of the Temporary Regulations to pre-existing CSAs Treasury and the IRS believe that the Temporary Regulations "merely spell out in greater detail 'principles we always thought were in the [I 9951 regs'..." Christopher Bello, Office of Associate Chief Counsel (International), May 1, 2009 Do we agree with the latter assertion? corn klcdcrmott 'I,\iill &Emcry II. Intangible Development Arrangements That Are CSAs A. Introduction Commentators criticized the 2005 proposed regulations for lack of flexibility concerning arrangements which are eligible for CSA treatment. Commentators suggested broadening the scope of intangible development arrangements that meet the definition of CSA. Some commentators suggested that any arrangement that uncontrolled parties might call a CSA should be treated as one, even though such arrangement may involve materially different risk allocations and provisions than addressed in the cost sharing rules. Preamble to 2009 Temporary Regulations, 74 Fed. Reg www rnwe corn

3 McDermo~ t II. Intangible Development Arrangements That Are CSAs B. Definition of Certain Arrangements as CSAs. = Temporary regulations largely declined to broaden definition of CSA. Preamble says that since the cost sharing rules are designed to provide guidance for specific types of transactions, the IRS continues to believe that the new rules set forth for CSAs should apply only to the transactions intended. a However, in response to these comments, the temporary regulations provide taxpayers with greater flexibility in choosing basis on which to divided interests in cost shared intangibles. Preamble to 2009 Temporary Regulations 74 Fed. Reg. at 341. w rnwe.com bf.c.dermott: Will $Emery II. Intangible Development Arrangements That Are CSAs C. Treatment of Certain arrangements as CSAs An arrangement is treated as a CSA in three situations. 1) The first is if the arrangement, in fact meets all the requirements to be a CSA: a. Pay all CSTs (i.e. share costs pro rata to RAB share) b. Pay all PCTs (i.e. compensate controlled participant with pre-existing resource, right, or capability of arm's length) c. Divide interest in cost shared intangibles in permitted manner. d. Observe administrative requirements of paragraph (k)

4 illcde,rmott Will &,Emery II. lntangible Development Arrangements That Are CSAs C. Treatment of Certain Arrangements as CSAs (cant.) 2) The second is if: a. the administrative requirements are met; and b. the controlled taxpayers reasonably concluded that the arrangement was a CSA that met the other three substantive requirements of Treas. Reg. Section T(b)(l). Temp. Treas. Reg. Section (b)(5)(i). 3) The third is if: a. the administrative requirements are met; and b. notwithstanding failure of the arrangement to meet the technical requirements of the substantive rules, the Commissioner concludes that application of these rules will provide the most reliable measure of an arm's length result. Treas. Reg. Section (b)(5)(ii). Ill. lntangible Development Arrangements That Are Not CSAs ("Non-conforming lntangible Development Arrangements") A. Disqualification of Certain Arrangements as CSAs. kkdermolt 'IVill k- Emer y For an arrangement to fall within one of any of the three categories treated as CSAs, it must at least meet the administrative requirements of T(k). In other words, taxpayer must have evinced the intention for it to be a CSA. If an arrangement does not fall into one of the three situations previously described, then it is a non-conforming intangible development arrangement. Such arrangement may be for the transfer of, or the development of intangible property, or may include both a transfer and development of intangibles. www mwe corn

5 McDermot t Will &Emcry Ill. lntangible Development Arrangements That Are Not CSAs ("Non-conforming lntangible Development Arrangements") B. Treatment of Non-conforming Arrangements Some commentators suggested that arrangements that were not CSAs should only be treated under Treas. Reg. Section and would not be governed by the regulations sections dealing with specific types of transactions. Preamble to 2009 Temporary Regulations, 74 Fed. Reg www rnwe corn hlcncrmott JVill &Emery ill. lntangible Development Arrangements That Are Not CSAs ("Non-conforming lntangible Development Arrangements") B. Treatment of Non-conforming Arrangements intangible development arrangements, including partnerships, outside the scope of the cost sharing rules are governed by the specific rules of Sections and T. Preamble to 2009 Temporary Regulations. Presumably, the -4 regulations apply to transfers of intangibles outside of cost sharing and the -9 regulations apply to intangible development activities that are services. www rnwe corn

6 i'vf.cdc.rniott TVill &.Emery I I I. lntangible Development Arrangements That Are Not CSAs ("Non-conforming lntangible Development Arrangements") B. Treatment of Non-conforminq Arrangements 1. Section T(g) (dealing with transfers of intangibles in non-conforming arrangements) now provides: "In the case of such an arrangement, consideration of the principles, methods, comparability and reliability considerations set forth in I.482-7T is relevant in determining the best method, including an unspecified method, under this section, as appropriately adjusted in light of the differences in the facts and circumstances between such arrangements and a cost sharing arrangement." 2. Section (T(m)(3) (dealing with provision of services in non-conforming arrangements) is similar. IV. Questions hnfccdermott 1. How broad is the definition of "CSA? Is it easy to become a Nonconforming lntangible Development Arrangements? 2. How significant is failure to be characterized as a CSA. Are the rules that will be applied to "Non-conforming lntangible Development Arrangements" similar to those that apply to CSAs? For CSTs For PCTs? 3. What are the general principles that govern the application of section 482 to Non-conforming lntangible Development Arrangements? How different are these general principles from those that govern the application of section 482 to CSAs?

7 ABA 2009 Joint Fall CLE Meeting Reassessing Transfer Pricing In a Slow Economy The Xilinx Case by: Fred Chilton, Will & Emery 1 1. Overview of the Ninth Circuit Decision in Xilinx On May 27, 2009, the Ninth Circuit Court of Appeals rendered a twoone opinion in Xilinx, lnc. v. Commissioner of Internal Revenue, reversing the Tax Court's decision. The Tax Court held ( in 2005) that the arm's length standard applied to R&D "cost sharing arrangements", and found as a fact that parties at arm's length wouldn't agree to share costs associated with employee stock options ("ESOs") The Ninth Circuit admitted that uncontrolled parties would not share stock option costs, but held that the arm's length standard was not controlling and that "all costs' relating to intangible development had to be shared. 2

8 WilltkEmery < T".'. In 1995, Xilinx and it's Irish subsidiary, XI, entered into a cost sharing agreement ("CSA") permitted under Treas. Reg (the "Cost Sharing Regulations"). 2. Facts of Xilinx Ireland Under the CSA, Xilinx and XI agreed to share ongoing R&D costs based on their respective anticipated benefits from exploiting any new technology created. Xilinx offered employee stock options ("ESOs") to its employees. 3 Will& Emery 2. Facts of Xilinx -- IRS adjustment.-the IRS asserted that ESO amounts Xilinx deducted in should have been included in the CSA pool of shared costs. Effect on Xilinx of IRS adjustment.-by including ESO costs in the CSA pool, the share of ESO costs Xilinx should have gotten from XI would be increased and would reduce Xilinx's deductions, thus increasing Xilinx's taxable income for Xilinx filed Tax Court petition. 4

9 3. Tax Court Decision Arm's length standard.-the Tax Court held that the Cost Sharing Regulations were subject to the arm's length standard in Treasury regulations (b)(l): (b) Arm's length standard--(i) In general. In determining the true taxable income of a controlled taxpayer, the standard to be applied & every case is that of a taxpaver dealinn at arm's length with an uncontrolled taxpaver. 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 (arm's length result) Tax Court Decision Cost Sharing Regulations.-The Cost Sharing Regulations held by the Tax Court to be subject to the arm's length standard defined the pool of costs to be shared: (d) Costs-41) Intangible development costs. For purposes of this section, a controlled participant's costs of developing intangibles for a taxable year mean all of the costs incurred by that participant related to the intangible development area,.... The Cost Sharing Regulations required the parties to the CSA to share intangible development costs "in proportion to their shares of reasonablv anticipated benefits" from exploiting technology assigned to them under the CSA. 6

10 3. Tax Court Decision Factual finding.-the Tax Court found that Xilinx's "uncontradicted evidence established that in determining cost allocations unrelated parties would not include any cost related to the issuance of ESOs." Tax Court holding.-xilinx's length standard. allocations met the arm's - 7 I 4. Appeal to the Ninth Circuit The IRS appealed the Tax Court decision to the U.S. Ninth Circuit. Both the IRS and Xilinx agreed that the arm's length standard applied to cost sharing arrangements--they differed on what the arm's lenath standard was: - Xilinx argued it was the traditional arm's length standard-i.e., parties at arm's length would do The IRS argued that the Cost Sharing Regulations had its own unique arm's length standard-whether parties share all costs in proportion to reasonably anticipated benefits. what The IRS did not contest the Tax Court's factual finding that unrelated parties would not share ESO costs. 8

11 5. Overview of the Ninth Circuit Decision The Ninth Circuit majority's reversal rejected the use of an arm's length standard in determining costs to be shared, which standard was advocated by both the taxpayer and the IRS. The majority opinion refused to apply the U.S.-Ireland Income Tax Treaty by concluding that the regulation controlled as opposed to the Treaty, notwithstanding the Technical Explanation under the Treaty, which specifically mentioned cost sharing as a transaction to which the arm's length standard was to be applied Ninth Circuit Majority Will & Emery a. The Ninth Circuit majority's (two out of three) analysis of the regulations.-the majority held the regulation language of the arm's length standard in (b)(l) (standard to be applied "in every case") and the costs to be shared in (d)(1) ("all of the costs") to be unambiguous yet "distinct and irreconcilable." Majority analyzed the "all costs" language: "'All' means the "entire number, amount of quantity"...[ This term ] describe[s] a fixed set of costs that must be shared in their totality and that will not vary based on the type of intangible property being developed." 10

12 6. Ninth Circuit Majority a. The Ninth Circuit majority's analysis of the regulations.-the majority continued: "Transporting an arm's length standard into section -7(d)(l) would transform this apparently all encompassing and self-contained description of the costs to be shared into a methodology under which the costs to be shared would not be fixed by these defined terms but would rather ultimately be defined by the conduct of unrelated parties. Sianificantlv, achievina an arm's lenath result is not itself the regulatorv regime's aoal; rather, its purpose is to prevent tax evasion by ensurina taxpavers accuratelv reflect taxable income attributable to controlled transactions." Ninth Circuit Majority a. The Ninth Circuit majority's analysis of the regulations.- The majority then used the canon of statutory interpretation that specific provisions control general provisions-the "all of the costs" language trumped the arm's length standard and required that Xilinx had to share ESO costs. b. The Majority held the U.S.-Irish Treaty did not apply. The majority acknowledged that: (1) "the Technical Explanation, which was issued while the tax regulations at issue in this case were in effect, states that the treaty incorporates the arms' length principle from United States tax law". 12

13 6. Ninth Circuit Majority.... b. The Majority held the U.S.-Irish Treaty did not apply. The majority stated that: "As we have explained, we do no believe the Secretary accidentally promulgated a highly specific regulation that plainly requires related parties in cost sharing agreements to share all costs. The treaty document do not alter our view." Thus, the majority concluded that the U.S.-Irish Treaty did not apply Ninth Circuit Dissent a. Ninth Circuit dissent's analysis of the regulations.-the dissenting judge agreed with the majority that the two provisions (b)(l) and (d)(1) were irreconcilable. Dissent rejected mechanical application of specific-controlsgeneral canon, arguing -1 (b)(l) controls because: Two provisions should be interpreted consistently with the pumose of the regulations, which is to achieve parity between taxpayers in controlled transactions and taxpayers in uncontrolled transactions; and Canon resolving inconsistencies in a statute against the government (drafter) should be applied. 14

14 Ninth Circuit Dissent Will #.; Emery Dissent asserted that the U.S.-Irish Treaty should be a guide in the analysis of the ESO issue.-the U.S. Treasury Department Technical Explanation of Article 9 (Associated Enterprises) of the treaty, stated: "Similarly, the facts that associated enterprises may have concluded arrangements, such as cost sharing arrangements or general services agreement, is not in itself an indication that the two enterprises have entered into a non-arm's length transaction.... As with any other kind of transaction, when related parties enter into an arrangement, the specific arrangement must be examined to see whether or not it met the arm's lenath standard." Other Issues Accounting for "costs" of ESOs Treas. Reg (j)(2)(i)(D), required taxpayers "to establish an accounting method to determine costs and benefits," and let the taxpayer choose "a consistent method of accounting to measure costs and benefits." Treas. Reg (i). Xilinx elected a consistent GAAP method (APB 25) resulting in zero ESO values on its facts. The majority opinion stated: "[Allthough 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." 16

15 9. Ninth Circuit en banc Review Rules allow a party to petition for rehearing.-federal rules allow a party to petition the Ninth Circuit to have the original three-judge panel or an en banc panel rehear the case. Xilinx submitted a petition for rehearing on August 12, On September 15, 2009 the Ninth Circuit accepted four amicus briefs and ordered the Justice Department to respond the Xilinx's petition for rehearing by October 6,

16 ABA Tax Section September 25,2009 Ninth Circuit Decision in Xilinx 1. Section 482 does not explicitly mention arm's length. Is the arm's length standard only "regulatory gloss?" - What is required by Section 482? - Legislative reenactment? - What is the standard for determining whether income is clearly reflected and taxes have not been evaded? - What is implication of the decision on other regulations (current and proposed)? 2. Is the Irish treaty relevant to Section 482? - What is the relevance of the treaty technical explanation? - What is the relevance that the savings clause does not apply to the correlative relief provision (Article 9(2)) and the mutual agreement procedure (Article 26)? - What is the relevance of the treaty parties understanding about arm's length and the purpose of the treaty to avoid double taxation? 3. The cost sharing regulation did not explicitly specify a method to determine costs. - What is the relevance of the reference in the cost sharing regulation to (d)? - What does the requirement of a ccconsistent'' method mean? - Does FAS 123R now mean that ESOs must be a cost? 4. Are ESOs "related to" intangible development? - Should "related to" have an unrelated party element? - ' Does the employee control over exercising timing and therefore spread amount have any impact?