| ||Untangling the Stock Option Cost Sharing Loophole|
McKee Nelson LLP
Intercompany transfer pricing is one of the most important tax issues for many multinational businesses. Cost sharing adds certainty to a particularly vexing area of transfer pricing-the allocation of income attributable to intangible assets. One controversial tax issue threatens the vitality of the cost sharing regulations: the accounting for stock option compensation paid to employees for work covered by cost sharing arrangements. Current law provides no desirable solution. The taxpayer's interpretation of the cost sharing regulations would drain the FISC; but the Service's interpretation would trigger an administrative nightmare, intergovernmental disputes, double taxation, and conflicts among cost sharing participants.
Many U.S. multinational businesses attempt to reduce their U.S. tax liability by manipulating intercompany royalties. The Service may counter by adjusting intercompany royalties when it determines that, based on the actual income produced by the intangible, the royalty does not reflect an arm's length result. The arm's length royalty requirement has two inherent problems: (1) establishing royalties is an expensive, contentious process; and (2) it is impossible to predict the actual income that unique intangible assets will generate.
To reduce compliance costs and provide more predictability, the Service "liberalize[d] the rules" governing developed intangible assets by promulgating the cost sharing regulations in 1968 and completely overhauling them in 1995. Under these regulations, qualified cost sharing arrangements provide an exception to the arm's length royalty requirement for the joint development of intangible assets. Participants share intangible development costs in proportion to the anticipated benefits of their interests in the developed intangibles. In this respect, cost sharing arrangements are analogous to joint ventures where companies share income in proportion to the value of their contributions. Because the arm's length royalty requirement does not apply to cost sharing arrangements, the Service can only make adjustments when a participant's share of costs differs from its share of anticipated benefits.
Conceptually, cost sharing is a wager between the taxpayer and the government. By entering into a cost sharing arrangement, the taxpayer agrees to forego current research and development (R&D) deductions; in exchange, the Service agrees to defer taxation of an uncertain amount of future income. Cost sharing arrangements involving U.S. R&D and foreign manufacturing can shift income to foreign subsidiaries that are not subject to U.S. taxation. Accordingly, a U.S. parent bets that the present value of deferring taxation of future income will exceed the value of claiming current R&D deductions. The parent wins when a project succeeds but loses when a project fails. Overall, cost sharing is revenue neutral because the government's wins and losses, like a casino's, offset each other in the aggregate.
The Service's treatment of employee stock options (ESOs) granted to personnel involved in activities covered by cost sharing arrangements is one of the most visible and contentious unresolved international tax issues associated with cost sharing arrangements. ESOs typically differ from publicly traded options (PTOs) in four ways: ESOs (1) have longer exercise periods (typically three to nine months versus ten years), (2) cannot be transferred (thus they have no readily identifiable market value), (3) cannot be exercised until after a vesting period (typically a total of four to five years), and (4) are forfeited by employees who quit before vesting occurs. The Service believes that many U.S. companies abuse cost sharing-i.e., they cheat on the bet-by claiming more than their share of the cost of ESOs. Taxpayers, in contrast, complain that instead of revising the cost sharing regulations to close the loophole, the Service has mounted back-door attacks, thereby increasing uncertainty and compliance costs.
The Service intended Seagate Technology, Inc. v. Commissioner to be the test case that would resolve the stock option cost sharing issue under the 1968 regulations. The Service coordinated the litigation under the Notice Case Procedure program, indicating that it was litigating to establish precedent. The Service's trial attorneys argued that participants must share the value of ESOs granted to employees conducting R&D activities pursuant to a cost sharing arrangement. The Service's National Office supported the position in four field service advices, and the Service Advance Pricing Agreement (APA) Program refused to enter into APAs covering cost sharing arrangements that do not account for ESO costs. Next, in a puzzling move, the Service conceded the issue for the contested tax years and for all ESOs Seagate had granted to date (almost ten years not directly at issue, including five years governed by different regulations). The magnitude of the concession suggests the Service feared losing and was desperately trying to prevent the courts from setting adverse precedent-perhaps because the Service may have a stronger case under the 1996 regulations than under the 1968 regulations. Sometime after the concession in Seagate, the Service announced that it will no longer argue that ESOs must be shared under the 1968 regulations, but that it still will argue that ESOs must be shared under the 1996 regulations. Two cases under the 1996 regulations remain docketed in the Tax Court: Adaptec, Inc. v. Commissioner and Xilinx, Inc. v. Commissioner.
Despite its concession in Seagate, the Service still officially maintains that ESO costs should be shared like other compensation expenses. While this argument is conceptually persuasive, the plain language of the 1968 and 1996 regulations suggests that ESOs should not be shared. The 1968 regulations provide that "the terms and conditions [of a cost sharing agreement] must be comparable to those which would have been adopted by unrelated parties similarly situated had they entered into such an arrangement." The key issue, therefore, is whether unrelated companies would share ESO costs. In Seagate, the Service asserted that companies would implicitly share ESO costs in arm's length negotiations. However, this theory would be difficult to prove; in fact, to date, the Service has been unable to produce supporting empirical evidence. The taxpayer in Seagate maintained that only explicit terms and conditions should be compared. Although the Tax Court denied the taxpayer's motion for summary judgment, holding that its analysis did not have to be limited to a comparison of explicit cost sharing terms and conditions, the court noted that actual agreements provide the best evidence.
Unrelated companies never explicitly agree to share ESO costs for four reasons: (1) valuation and timing problems, (2) potential manipulation by selective grant and exercise of the ESOs, (3) the weak connection between the values of ESOs and employee services, and (4) a reluctance to reimburse the issuing company in cash for a cost that requires no cash outlay and is based on the appreciation of the issuing company's stock. For instance, if IBM and Microsoft entered into a joint venture, almost certainly neither would agree to share ESO costs. Even the U.S. government refuses to reimburse contractors for ESO costs.
The 1996 regulations, in contrast, implement the arm's length standard by focusing on the definition of shared costs. Participants must share "the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles." Thus, the key issue is whether ESO costs constitute an intangible development cost. The 1996 regulations appear to permit the adoption of generally accepted accounting principles (GAAP), which encourage but do not require the recognition of ESO costs. If this interpretation is correct, then participants may elect not to share ESO costs by adopting GAAP for cost sharing purposes. Although the 1996 regulations focus on establishing an appropriate measure of costs, it appears that the arm's length standard still applies. Accordingly, the question of how unrelated companies would account for ESOs remains relevant and must be resolved.
If the Service's interpretation prevails, then ESO valuation will become an administrative nightmare, intergovernmental disputes will intensify (potentially triggering double taxation), and conflicts among participants will increase. In response, U.S. companies that rely on ESOs might abandon cost sharing, an unfavorable result for both taxpayers and the government because annual royalty adjustments make tax liabilities less predictable and impose greater compliance burdens. Conversely, if the taxpayer's interpretation prevails, the revenue losses could drain the FISC because U.S. companies will claim current ESO deductions and indefinitely postpone taxation of the income allocated to their foreign subsidiaries.
The Seagate fiasco has left taxpayers and revenue agents uncertain of the Service's position, especially given that the Service has not issued binding administrative guidance. Companies that have been awaiting resolution of this issue will continue to be left in limbo. The Service has further confused the issue by indicating that it "will argue in the cases going forward that the options should be valued at exercise date," even though a number of field service advices indicate that the Service will accept "any reasonable valuation," including grant date valuation. Ironically, the Service has created the very unpredictability and administrative burden that cost sharing was intended to eliminate. In response, several companies have abandoned planned cost sharing arrangements.