                     125 T.C. No. 4



                 UNITED 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.
                                -2-



          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.
                                -3-

                            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.
                                   -4-

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.
                                   -5-

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
                                 -6-

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...)
                                    -7-

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).
                                -8-

     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.
                                 -9-

     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
                               -10-

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
                                -11-

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.
                                 -12-

     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
                                  -13-

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.”
                                -14-

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
                                -15-

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-
                               -16-

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.
                               -17-

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
                              -18-

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
                               -19-

     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.
                                 -20-

     (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
                               -21-

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
                                 -22-

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.]
