With the U.S. Treasury’s regulatory requirement that employee stock based compensation should be included in the cost base for multinationals (“MNE”) who are engaged in cost sharing agreements, many tax authorities have begun to argue that these “expenses” ought to also be included in standard contract R&D arrangements, whether or not a cost sharing arrangement exists. At the same time, subsequent to the U.S. Treasury Department’s inclusion of the stock based compensation in the cost base for cost sharing arrangements, this regulatory requirement is being challenged in U.S. tax court, and may not be deemed to be arm’s length behavior. We note as well that the OECD Guidelines have not provided any succinct or direct opinion on this issue, so any argumentation on whether such expenses should be included in the expense base for standard cost plus R&D arrangements, must rely on regulatory pronouncements in the U.S., or on research pertaining to third party behavior.
In Israel, the Israel Tax Authority issued a circular translated on the OECD website in which the ITA argues that stock based option expenses should be included in the cost base on standard R&D sub-contracting arrangements. However, no justification is provided either from third party behavior or from any other regulatory authorities. Much of the work at present in the U.S. courts has argued that stock based options expenses do not appear to be included in third party sub-contracting arrangements.
Herein, we will briefly review the current U.S. regulations in place for these situations and their impact on a firm’s current transfer pricing policies, as they are the most detailed and comprehensive regulations pertaining to this issue and the issues that surround the inclusion of stock options expenses in the cost base.
US Transfer Pricing Regulations
Transfer Pricing Regulations, specifically U.S. Section 1.482, attempt to maintain and regulate the way companies perform intercompany transactions across borders and tax authorities. The regulations were formed into law in 1994 and define the general arm’s length standard. With the arm’s length standard in place, the IRS and Treasury continue the 482 Regulations with the provision of guidelines for how affiliate companies may operate together and develop additional technology, IP and other intangible assets. Entities seeking to develop such intangible property may enter into cost-sharing arrangements (“CSA”), which allow the parties to the agreement to attribute proportional shares of costs relating to the development of intangible property based on their anticipated share of the benefits to be derived from that property. Cost-sharing arrangements have become increasingly more common and are sometimes setup by hi-tech companies, especially between U.S. software developers and their affiliated entities abroad, in order to develop their IP. These affiliated entities may be providing R&D or other activities that assist in the development of the intangible assets.
The 482 cost sharing regulations specify that the structure for cost sharing agreements includes the payments, expected benefits from the IP, and covered intangibles. While Treasury regulations stipulate that costs must be shared in proportion to the pattern of future “benefits” each entity is expected to receive from the intangibles, there is some vagueness as to how “benefits” are to be determined. Based on these regulations, companies that formed cost sharing agreements (CSA) are supposed to determine the intangibles’ cost pool pertaining to the development of the intangible assets. This cost pool must be split between the cost sharing participants. As of 2003, the U.S. has argued that stock based compensation should be a portion of the cost pool. However, this regulatory requirement is for cost sharing arrangements.
In one of the largest stock based compensation cases in the US, based on transfer pricing regulations prior to 2003, the Court reversed its earlier decision, and upheld the supremacy of the arm’s-length standard for transfer pricing. It held that employee stock option (“ESO”) expenses in cost-sharing agreements related to developing intangible property are not subject to reallocation under then applicable US transfer pricing rules (Reg. § 1.482-1), because unrelated parties jointly developing intangibles and transacting on an arm’s-length basis would not include ESO expenses in such a cost-sharing agreement. This argument is critical: the U.S. tax court found that no evidence exists that third parties include ESOs in their assessment of costs in arrangements dealing with the development of intangibles.
Subsequent to 2003, the U.S. Treasury Department amended its cost sharing regulations and required inclusion of stock-based compensation expenses in a CSA. We note that at present, there is a post 2003 court case in which the taxpayer is arguing that in spite of the post 2003 CSA regulations, ESOs should not be included in the cost base for CSAs. This argument is based on the fact that the U.S. Treasury Department did not make any assessment regarding whether third parties actually behave in such a manner.
While Treasury and the IRS have amended the Transfer Pricing regulations to specifically include the ESOs in the 2003 amendments, we again note that no proof has been shown to show that unrelated parties jointly developing intangibles and transacting on an arm’s-length basis would indeed include ESO expenses in such a CSA. As such, many taxpayers are arguing that the amended regulation is inconsistent with the arm’s length standard.
We note that in addition, the IRS and Treasury had received commentary from various Transfer Pricing practitioners, that they knew of no evidence of transactions in which unrelated parties agreed to share amounts attributable to stock based expenses.
We note as well that while the U.S. transfer pricing regulations for CSAs specifically state that stock based expenses should be included in the cost pool of a CSA, there are several major problems with the Treasury’s and IRS’s ability to make such a regulation.
- The adjustments would create conflict between various sub-sections of the U.S. transfer pricing regulations; and
- The IRS does not have any evidence that unrelated parties have ever agreed or would ever agree to share the cost of stock options in a CSA.
Inclusion of Stock Based Costs in Sub-Contracting Arrangements:
The 2003 regulations modified the comparable profits method (CPM) provisions to require adjustments for:
material differences in the utilization of or accounting for stock-based compensation, as between the tested party and the uncontrolled comparables… As another example, it may be appropriate to adjust the operating profit of a party to account for material differences in the utilization of or accounting for stock-based compensation (as defined by § 1.482–7(d)(2)(i)) among the tested party and comparable parties.”[1]
Based on these regulations the CPM-related provisions of the temporary services regulations included examples that showed comparability adjustments for stock-based compensation costs. In other words, the CPM for services incorporates all general CPM guidance, including Regs. §1.482-5(c)(2)(iv), which after 2003 required adjustments for differences in the utilization of or accounting for stock-based expenses. The IRS included four examples for how the CPM needed to be adjusted in order to make companies that had stock option costs more comparable to those that did not.
In each of the examples, the taxpayer, a publicly traded U.S. corporation, performs controlled services for its wholly-owned subsidiaries. The arm’s length price of these controlled services is evaluated under the comparable profits method for services in paragraph (f) of this section by reference to the net cost plus profit level indicator (PLI). The examples continue to provide explanations and provisions for the taxpayer to make adjustments to improve comparability as the different accounting methods used would materially affect the measure of an arm’s length result.
We note that each of these examples are brought only to improve comparability between the taxpayers and the uncontrolled comparables. The regulations were written at a time before the FASB had standardized the accounting methods, which have since then become normalized amongst public companies. These comparability issues have become less relevant since the standardization of accounting methods, and we note that the regulations do not mention that the option expenses are required to be included in the total cost pool for CSA’s or Cost Plus situations.
Conclusions:
In regards to stock based expenses amongst affiliated companies, it is still unclear whether or not stock based compensation should be included in the cost base for CSAs, due to the continuously changing regulations, current tax court disputes, and an understanding of how options actually function. For standard sub-contracting arrangements, the argument to include the costs is even less definitive. The two basic arguments against such an inclusion are:
- While Reg. 1.482-7 states that stock option expenses should be included in a CSA, this regulation conflicts with 1.482-1 which is the arm’s length standard as third parties do not include such expenses in their third party agreements;
- No empirical research was done by the IRS or Treasury in making this amendment and by doing so they are actually going against industry practices.
[1] Reg 1.482-5(c)(2)(iv)