International Tax Bulletin (August 2015)
Tax Court Altera Decision
Stock-Based Compensation Not
Included in Cost
By James P. Klein, senior counsel,
and Susan P. Serota, partner,
both in the New York office of Pillsbury Winthrop Shaw Pittman LLP and
William E. Bonano, a tax partner in the
firm's San Francisco office.
If you have or can obtain the
or have an Acrobat-enabled web browser,
you may wish to
download or view our
August 2015 International
Tax Bulletin (a 218K pdf file),
containing a printed version
of this article
and also available via ftp at:
See Available Material for links
to the opinion discussed in this article.
This bulletin concerning tax
matters is part of the
Page, a World Wide Web demonstration project, no
portion of which is intended and cannot
be construed as legal or tax advice.
on the design or content of this material.
Employee stock options are an important part of compensationboth as
income to the executives and as a deduction for the employer. But when stock options are used
by multinational companies, the tax implications are complex and sometimes baffling. A new Tax
Court case has just given the IRS a stunning defeat by holding the 2003 Treasury Regulations
under Internal Revenue Code section 482 invalid as not reflecting reasoned decision making and
being contrary to real-life evidence. The result is a taxpayer victory permitting, in effect,
full deduction of stock-based compensation costs under a cost sharing arrangement. As a consequence,
multinational employers with equity-based compensation may have reduced U.S. taxes based on not
having to include such costs in the pool of costs to be shared under a cost sharing arrangement.
Such arrangements are commonly used to allow affiliates in tax-favored jurisdictions to acquire
tax ownership of territorial IP exploitation rights, resulting generally in decreasing the
multinational's overall effective tax rate.
Basic Issue of Allocation of Income and Deductions
The basic U.S. tax rule relating to stock-based compensation is that the
employer gets a tax deduction in the same amount and in the same tax year as the compensation
income is recognized by its employees when non-qualified stock options are exercised. If the
employer has operations outside the U.S., an employee may not be fully taxable on this income
(for example, for aliens employed inside and outside the U.S.); but the employer still gets a
full deduction for its employees' stock-based compensation.
That basic rule was altered by the Internal Revenue Service's (IRS) rules
on qualified cost sharing arrangements. This complicated area is based on the principle that
under the Internal Revenue Code section 482, related companies must allocate certain costs and
income consistent with an arms-length standard, i.e., shared among the related companies
consistent with how unrelated parties would have shared such costs and income. There are lengthy
regulations issued under section 482, but the treatment of the "cost" of compensation based on
stock-based compensation under the regulations has been an area of controversy for many years.
Historic Taxpayer View
The regulations under section 482 have long permitted U.S. taxpayers to
share the costs of developing intangible property, e.g., intellectual property, including
the cost of compensation of employees working on the development, with affiliated companies. For
example, a U.S. company might enter into a cost sharing arrangement with an offshore subsidiary
located in a low tax rate or tax haven country, granting that subsidiary exploitation rights as
to any resulting products or technology in a specified territory outside of the U.S. Section
482 and its implementing regulations provide the rules as to which (and the amount of) costs
must be allocated to the subsidiary under such an arrangement. There has never been an
argument about direct compensation costs of the employees of the U.S. parent who work on the
project. The argument has been whether the compensation must include stock-based compensation
such as the "spread" between a stock option strike price and the price of the underlying shares.
The basic rule under section 482 is that cost allocation should be comparable
to that found in arm's-length transactions. For the IRS, this meant that all compensation
costs should be allocated, including compensation from stock options. U.S. taxpayers, however, argued
that unrelated parties in an arm's-length agreement would not share these costs. The IRS litigated and
lost on its position (Xilinx, 598 F.3d 1191 (9th Cir. 2010)) based on 1995 Treasury regulations.
The IRS and Treasury amended the regulations in 2003 to make the stock-compensation costs specifically
included. Treasury finalized these regulations notwithstanding extensive taxpayer comments that there
was no evidence that in arm's-length transactions any buyer ever accepted a cost sharing arrangement
that included the future, speculative costs associated with the enhanced value of a participant's
business (which might increase its equity value).
Altera Corporation is a U.S. corporation with a Cayman Islands subsidiary.
Under their cost sharing agreement, the U.S. parent required the Cayman subsidiary to make cost-sharing
payments to the U.S. parent of over $100 million a year to develop certain intellectual property. But
in determining those payments, compensation of the U.S. employees derived from stock options was excluded.
The IRS claimed that the costs shared should have been $15 to $25 million more, taking intp account the
stock option compensation, and effectively reversed Altera's deduction for the costs that the IRS
contended should have been allocated to the Cayman subsidiary.
The IRS argued that the 2003 regulation (Income Tax Regulations section
1.482-7(d)(2)) was a proper exercise of its rule making authority. The taxpayer argued the
regulation was arbitrary and not consistent with the rationale asserted by the IRS in issuing
the regulation. In a rare opinion upholding a taxpayer challenge to a regulation, the Tax Court
held the final regulation invalid because:
"Treasury failed to rationally connect the choice it made with the facts found, Treasury failed
to respond to the significant comments when it issued the final rule, and Treasury's conclusion
that the final rule is consistent with the arm's-length standard is contrary to all of the
evidence before it."
The case points very specifically to the importance of filing comments on
regulations. It was the strong arguments made by commentators on the proposed regulation that
convinced the Tax Court that there was no empirical evidence supporting Treasury's view that
arm's-length parties would share stock-based compensation costs; instead, the evidence was the
opposite, as the commentary included several examples of third-party arrangements where share-based
compensation was specifically excluded from the cost pool. This led to the court invoking the
"reasoned decision making" Administrative Procedure Act (APA) standard of review from State
Farm (463 U.S. 29 at 43 (1983)) and the Chevron "Step 2" arbitrary and capricious
standard. Chevron (467 U.S. 837, 842-843 (1984)). This was a significant loss to Treasury
and the IRS as courts typically are deferential in reviewing Internal Revenue Code regulations,
affording considerable discretion to the Treasury and the IRS. Notably, the Tax Court confirmed
that the APA is applicable to Treasury regulations, holding that the IRS is no different from any
other agency in that respect, following (562 U.S. 44 at 55 (2011)).
What Does this Mean for Multinationals?
Based on the Altera decision, U.S. corporations that have been following
the final 2003 regulation requiring the allocation of stock-based compensation in cost sharing
arrangements should consider removing such costs going forward and filing protective amended
returns for past years to preserve the ability to claim refunds. It is unknown whether the
IRS will appeal the opinion, but it seems probable given the potential for the holding to support
challenges to other regulations where comments and supporting evidence were not afforded due regard.
In most cases, removing share based compensation costs from the cost sharing pool would increase U.S.
tax deductions (i.e., removing an offset) for compensation paid to employees, particularly if
the allocation of the costs would not result in a current tax benefit to the non-U.S. subsidiary.
Tax Page Search
© Pillsbury Winthrop
Shaw Pittman LLP
[an error occurred while processing this directive]