The 9th Circuit Court of Appeals reversed the Tax Court in an interesting case involving issues of Section 482 cost sharing, precepts of regulatory interpretation, and penalties.
The Section 482 cost sharing issue related to the question whether compensation expenses of a U.S. participant in a cost sharing arrangement relating to stock options can be allocated exclusively to the U.S. participant (thus fully reducing taxable income of the U.S. participant), or whether the Section 482 cost sharing regulations required that such compensation expenses are “costs” that had to be allocated in part to the (non-U.S.) cost sharing participant. This became an issue because two Treasury Regulations under Section 482 conflicted with each other.
The conflict was between the general Section 482 regulation that only costs that are normally shared between unrelated parties are subject to Section 482 adjustment, and a specific regulation relating to cost sharing that said that all costs had to be shared to be respected under Section 482. The Tax Court had found that stock option costs are not typically costs that are shared between unrelated parties in a cost sharing arrangement, and thus the general rule in the regulations precluded the stock option costs from being reallocated in part away from the U.S. participant under Section 482 .
The appellate court gave more weight to the specific cost sharing regulation, and less to the general statement of Section 482 principles. It based this weighting on the statutory and regulatory interpretative rule that a provision that is specific takes precedence over a more general provision. The appellate court also rejected as not applicable the principle that ambiguities in the tax law should be interpreted against the government.
The appellate decision is not as relevant to Section 482 cost sharing law as it might appear, since the IRS had already revised its Regulations to require the same result that the appellate court eventually reached. It made this change after it had lost in the Tax Court. Since Section 482 is a very short Code provision, with the meat on its bones being provided by extensive Regulations, the IRS has a fairly free hand to write the Regulations in any reasonable manner (unlike other areas of the Code where it may be more constrained by Code language) and thus set clear law for future tax years and taxpayers regardless of how the appellate court resolved the current case.
One area where the new Regulations might still be challenged is if a different interpretation of cost sharing arises in a treaty context. However, the appellate court opinion will likely constrain such challenges, since a treaty was involved in the case and the court did not feel it constrained them in its decision. Further, it noted that even if the treaty language did mandate a different result, the typical provision of a treaty that provides that it will not impact the taxation of taxpayer by its own taxing jurisdiction will act to negate the application of the treaty provision when it relates to U.S. taxpayers.
The one ray of sunshine for the taxpayer in the case related to the government seeking to impose accuracy related penalties on the taxpayer for not having allocated the stock option costs in part to the other participant. The appellate court noted that the Tax Court found for the taxpayer, and that the Treasury Department felt compelled to rewrite the Regulations to avoid the above conflict. As such, the court questioned whether the taxpayer should be subject to penalty when both the Tax Court and the IRS noted the uncertainty of the Regulations, and remanded the case for further action in regard to the imposition of penalties.
Xilinx, Inc. v Commissioner of Internal Revenue, 9th Circuit Court of Appeals, Case No. 06-74246 & –74269, May 27, 2009