Stock Option Costs Subject to Sharing

[5] "Research and development costs" was not a term defined in the agreement. The agreement simply stated that the parties agreed to share "all R&D costs and expenditures incurred or expended in developing any intangible property described in paragraph 2.1."

[6] In * * *, * * * (* * *) * * * ("* * *") was added as a sub-part to the cost sharing arrangement. * * * and * * * entered into a cost sharing agreement that mirrored the * * * agreement. * * * and * * * agreed to have exclusive intangible rights in * * * and * * *, respectively, and to share intangible rights in the rest of the world (apart from the areas controlled by * * * under the main agreement). Costs were to be shared equally.

[7] For * * *, the * * * agreement was amended so that costs would be divided * * *% * * *, * * *% * * *. For * * *, the * * * agreement was amended so that costs would be divided * * * * * *, * * *. These amendments were based on the fact that * * * was "more dominant in developing the market" in its geographic area.

[8] During the years in issue, * * * and * * * also were parties to a services agreement. Under that agreement, the parties were required to pay an arm's length charge for services rendered to each other. However, no charge was required for duplicative services, or for services where the benefit was indirect or remote. In addition, the arm's length charge for all services except those that were an integral part of the business activity of either party would be deemed to be equal to the costs incurred.

[9] According to your memorandum, employees of * * * performed R&D for the benefit of * * * and * * * under the cost sharing agreement and services for the benefit of * * * under the services agreement. These activities are not described in detail, but you indicate that the R&D was for the production of * * * and other * * * products, and the services related to product support. Thus, for purposes of this memorandum, we assume that these activities were performed, at least in part, for the benefit of the foreign affiliates, and that the cost sharing arrangement was, in other, respects, a bona fide cost sharing arrangement. We also assume that the services under the services agreement were eligible for the cost safe harbor under section 1.482-2(b)(3).

[10] As part of its compensation package, * * * gave the employees nonqualified stock options. In * * *, * * * did not include any amount associated with exercise of these stock options as a cost to be shared under the cost sharing agreement or as a cost charged to * * * under the services agreement, although it shared/charged out the employees' other compensation. In * * * and * * *, * * * did include the option exercise spread as a cost to be shared/charged out. ³

[11] However, * * * now asserts, for all * * * years, that the amount of the exercise spread was not a cost that should have been shared/charged out, and that * * * should be able to deduct the exercise spread in full. This has resulted in * * * informally proposing affirmative adjustments, decreasing its income, of $* * * and $* * * for the years * * * and * * *, respectively. Amended returns have not yet been filed. You ask whether any portion of the exercise spread must be shared with/charged out to the foreign affiliates pursuant to the cost sharing and services agreements.

[12] As used in this memorandum, a "stock option" is a right to purchase shares of stock during a defined period of time at a price which is either specified in the option or calculable under a formula provided in the option. A "non-qualified stock option" is a stock option that does not count as an "incentive stock option" under Internal Revenue Code Section 422(b). That is, a non-qualified stock option does not provide an employee with the special tax benefits of section 421.

1. Financial Accounting Rules

[13] For purposes of the financial accounting rules pertaining the years in issue, options are considered compensation for services rendered, and the value of the compensation must be recorded as an expense when it is paid. ⁴ The value is generally calculated as the spread between the quoted market price for the stock and the option exercise price, without regard to the time value of the option (i.e., the value to the employee of being able to benefit from a future appreciation in the value of the stock). The compensation value is measured as of the date on which both the number of shares optioned and the option exercise price are known. ⁵ If the services for which the option is given have already been rendered (e.g., if the option is exercisable immediately) then the compensation value must be taken as an immediate charge on the corporation's statement of income. Otherwise, the charge must be spread over the period that the services are received. ⁶

[14] For example, if a corporation issues a five-year option for 1000 shares of stock, exercisable in two years with an $8.50/share exercise price, the compensation value of the stock is calculated as the spread between the fair market value of the stock on the date of issuance (say, $10/share) and the exercise price: (1000 x $10) - (1000 x $8.50) = $1500. The cost will be expensed over the two-year vesting period. ⁷ If the option were to expire unexercised after the compensation cost had been expensed, then compensation costs in the year of expiration would be reduced by the previously expensed amount. ⁸

[15] In order to avoid a compensation expense charge on its statement of income, a company could, during the years in issue, issue options whose exercise price at some future time was equal to the stock's quoted price on the date of the option's issuance (thus, in the example above, the exercise price would be $10: (1000 x $10) - (1000 x $10) = 0). This apparently became the standard practice, and according to your information, it was * * *'s practice during the years in issue. Thus, while a company might have thousands of stock options outstanding, no charge for these options would appear on the company's financial statements.

[16] This method of accounting for stock options was reviewed by the Financial Accounting Standards Board in 1993. At that time, the Board issued an "exposure draft" that proposed a new accounting system for the compensatory value of stock options. The proposed changes would have required a company to take into account the "time value" of options. Thus, virtually all options would have had a value that would have had to be currently expensed. ⁹ Once expensed, the cost would not be reversed if the options expired unexercised, on the theory that the method for determining an option's fair market value would be based on statistical valuation techniques for an issuance of options in the aggregate. ¹⁰ This proposal was severely criticized by business leaders, however, and FASB ultimately adopted a "choice" approach. Under this approach, a company has a choice of either (1) using the proposed system (i.e., including the "time value" cost in its financial statement), or (2) continuing to follow the existing system under APB 25 and disclosing in the notes to its financial statement what the charge would have been under system (1). System (1) is considered preferable, and if a company adopts that system, it is not able to change back to system (2) later. This "choice" approach was formally embodied in FASB Statement 123, which is effective for transactions entered into after December 15, 1995.

2. Tax Accounting Rules

[17] For federal income tax purposes, assuming that an option's value is not readily ascertainable at the time of grant, an employee that exercises non-qualified stock options is taxed on income equal to the spread between the exercise price and the fair market value of the stock obtained when the option is exercised. ¹¹ Correspondingly, the employer receives a section 162 deduction for the same amount at the same time. ¹² This deduction must be taken by the employer, even if the issuer of the stock is a parent or subsidiary of the employer. ¹³

[18] As these rules show, there almost inevitably will be a difference in timing and amounts between the compensation expense charged for financial reporting purposes and tax deductions claimed upon the exercise or disposition of non-qualified stock options. No financial accounting expense would generally be recorded (at least under the pre-1995 system) when an option was granted, and no tax deduction would be allowed as of that date. However, a tax deduction would usually become available on the date that the option was exercised.

3. Section 482 Requirements

a. Cost Sharing

[19] Under I.R.C. Section 482, the Service may distribute, apportion or allocate gross income, deductions, credits or other tax items among controlled businesses if necessary in order to clearly reflect the income of such businesses. In 1986, Congress added a sentence to section 482 noting that in the case of intangible transfers among controlled businesses, the income of the transferor of the intangible must be commensurate with the income attributable to the intangible.

[20] The regulations under section 482 provide guidance in determining an arm's length charge for intercompany loans, services, rentals of tangible property, transfers or licenses of intangible property and transfers of tangible property. The cost sharing rules of Treas. Reg. section 1.482-2(d)(4) offer a safe harbor from the intangible transfer rules. These regulations read, in part, as follows:

[21] Where a member of a group of controlled entities acquires an interest in intangible property as a participating party in a bona fide cost sharing arrangement with respect to the development of such intangible property, the district director shall not make allocations with respect to such acquisition except as may be appropriate to reflect each participant's arm's length share of the costs and risks of developing the property. A bona fide cost sharing arrangement is an agreement, in writing, between two or more members of a group of controlled entities providing for the sharing of the costs and risks of developing intangible property in return for a specified interest in the intangible property that may be produced. In order for the arrangement to qualify as a bona fide arrangement, it must reflect an effort in good faith by the participating members to bear their respective shares of all the costs and risks of development on an arm's length basis. In order for the sharing of costs and risks to be considered on an arm's length basis, the terms and conditions must be comparable to those which would have been adopted by unrelated parties similarly situated had they entered into such an arrangement.

[22] Thus, in analyzing whether * * *'s foreign affiliates should have shared the cost of the R&D employees' stock options, it is necessary to determine whether those costs were associated with the development of the intangible property. ¹⁴

[23] In 1995, the cost sharing regulations were revised in an effort to clarify issues such as the costs that should be shared under a section 482 cost sharing arrangement. ¹⁵ While the 1995 regulations do not apply to the years in issue, they do provide a helpful framework for interpreting the general language of section 1.482-2(d)(4), above. The 1995 regulations provide that the costs to be shared in a cost sharing arrangement consist of operating expenses related to the intangible development, other than depreciation or amortization expense. ¹⁶ Operating expenses are defined in section 1.482-5(d)(3), and they consist of all expenses not included in the cost of goods sold except for interest expense, foreign income taxes, domestic income taxes, and any other expenses not related to the operation of the relevant business activity. Thus, operating expenses would include the compensation of employees involved in the intangible development.

[24] The 1995 regulations further note that costs that do not contribute to the intangible development area are not taken into account. ¹⁷ Therefore, the Service may adjust the pool of costs shared in order to accurately reflect the costs attributable to the intangible development area.

[25] Finally, the 1995 regulations provide that "the controlled participants in a qualified cost sharing arrangement must use a consistent method of accounting to measure costs and benefits, and must translate foreign currencies on a consistent basis." ¹⁸ Upon a request of the Service, this accounting method must be disclosed and any material differences from U.S. generally accepted accounting principles must be explained. ¹⁹ Thus, as a general matter, the section 482 regulations envision that true economic costs should be the costs shared (e.g., the fair rental value of tangible property rather than the value of that property for purposes of the depreciation rules). However, the 1995 regulations also envision that taxpayers will begin with financial accounting numbers in calculating their costs and anticipated benefits. Nevertheless, as noted above, the Service did not foreclose the possibility of adjusting a participant's pool of costs in order to accurately reflect the costs attributable to the intangible development area.

b. Services

[26] Under the section 482 regulations pertaining to intercompany services, an arm's length fee must be charged whenever one member of a group of controlled entities performs marketing, managerial, technical or other services for the benefit of, or on behalf of another group member. ²⁰ However, the arm's length charge is deemed to equal the costs or deductions of the renderer unless the services are an integral part of the business activity of either the renderer or the recipient of the services. ²¹ No charge is required under the regulations for certain services, but those types of services are not in issue here. ²² As noted above, we assume for purposes of this memorandum that the services under * * *'s services agreement were eligible for the cost safe harbor.

[27] Under the services regulations, costs or deductions to be taken into account "include, but are not limited to, costs or deductions for compensation, bonuses, and travel expenses attributable to employees directly engaged in performing such services, for material and supplies directly consumed in rendering such services, and for other costs such as the cost of overseas cables in connection with such services." ²³

STOCK OPTIONS SHOULD BE TAKEN INTO ACCOUNT AT THEIR ECONOMIC VALUE UNDER BOTH THE COST SHARING AND SERVICES REGULATIONS

[28] * * * has argued that since its stock option compensation cost is not an expense on its financial statements, the amount of the cost should not be shared with or otherwise charged to its foreign affiliates. You argue, on the contrary, that the cost is a real economic cost that must be allocated to the foreign affiliates in order to clearly reflect the taxpayer's income for purposes of section 482.

[29] The lack of an expense for financial accounting purposes is not a bar to the allocation of the stock option costs to the foreign affiliates under the section 482 regulations. The purpose of the financial accounting rules, which is to accurately report a company's status and performance for use by the company's managers, its investors and its creditors, is not the same as the purpose of section 482. The purpose of section 482 is to clearly reflect the income of controlled corporations. Therefore, if a controlled corporation has incurred costs in the course of performing R&D or other services for another controlled corporation, the latter must be charged under section 482, regardless of whether the costs are recorded or charged for financial accounting purposes.

[30] Treas. Reg. section 1.482-2(d)(4) states that the Service may make cost sharing allocations "as may be appropriate to reflect each participant's arm's length share of the costs and risks of developing the [intangible] property." This language does not limit "costs" to costs as defined in a company's financial statements. Similarly, Treas. Reg. section 1.482-2(b)(4)(ii) refers to "compensation" as a cost to be taken into account in determining a charge for services provided to a controlled entity. Compensation is not further defined.

[31] * * * is unlikely to dispute that the stock options provided to the employees performing the R&D under the cost sharing agreement, and performing the services under the services agreement, were an important part of their overall compensation package. There is an economic cost to this type of compensation, otherwise * * * would grant unlimited stock options to all its employees. At arm's length, this economic cost would be shared/charged out and would not simply be ignored. We conclude that stock options must be taken into account at their economic value, both for purposes of the cost sharing and services regulations.

YOU MAY WISH TO CONSIDER FURTHER THE AMOUNT AND TIMING OF THE ACCOUNTING FOR THE STOCK OPTION COST

[32] Having reached the basic conclusion that stock options must be taken into account at their economic value, and may not simply be ignored, there remain other issues that you may wish to explore further. The issues are (1) how to measure the value of the stock option compensation, and (2) when to take such cost into account. Some general discussion is included below that may provide you with a context for your further consideration.

[33] The economic cost of a stock option is not adequately reflected by the APE 25 financial accounting rules inasmuch as those rules do not reflect the "time value" of the option privilege. The economic cost of a stock option is also not adequately reflected by the amount ultimately deducted by an employer because, for example, that amount is not adjusted to reflect the "time-value" of the options (exercised and unexercised) that were granted for a particular service.

[34] Generally, the value of a stock option should be measured as of the time of grant. As a matter of administrative convenience, the income inclusion and deduction rules permit the use of the spread upon exercise as a proxy for the option value where that is not "readily ascertainable" at the time of grant. In our view, section 482 does not allow for that administrative convenience and the effort must be made to measure the value at grant as reliably as possible. ²⁴ We note, however, that the section 482 regulations do not specify a method for valuing compensatory stock options.

[35] In proposing revisions to APB 25, and in ultimately adopting the "choice" approach, we understand that the Financial Accounting Standards Board was aware that there are mathematical models for calculating the economic value of compensatory stock options at the time of their grant. The 1993 FASB "exposure draft" noted that:

[36] During the last 20 years, mathematical models to estimate the fair value of options have been developed to meet the needs of investors. Those mathematical models and variations of them are used by employers and compensation consultants in determining the amount of .compensation to pay in the form of employee stock options. Software available for personal computers reduces the application of those models to a fill-in-the-blank exercise. ²⁵

[37] We believe that such a model may well provide the best method for determining the stock option cost to be shared/charged out under section 482. You may wish to consider further the issue of how best to measure the value of the * * * stock options.

[38] After determining the amount that * * * should have shared/charged out, it is necessary to determine when that amount should have been shared or charged out. Section 482 requires that allocations of costs be reflected for tax purposes in the year in which the costs were incurred. ²⁶ In this case, the year in which the option costs were incurred would generally be the year of grant or, if later, the year in which the R&D or other services were performed. Thus, any adjustment should generally be made for the year of grant, and not for the year of exercise. ²⁷ If the years of grant of the options (or of performance of the services) are closed, you may wish to consider further the issue of whether any relief from the statute of limitations is available (e.g., under change of accounting method rules, mitigation rules, or duty of consistency).

[39] Apart from the timing of an adjustment on account of the options exercised by * * * employees during the years at issue, you may wish to consider whether any adjustment may be warranted on account of stock options granted during those years.

ADJUSTMENT UNDER SECTION 482 IS PREFERABLE IN THIS CASE TO AN ADJUSTMENT UNDER SECTION 162

[40] Treas. Reg. section 1.83-6(a)(1) allows a deduction under section 162 for the cost to an employer of a compensatory stock option, "but only to the extent the amount meets the requirements of section 162 . . . and the regulations thereunder." As you note in your memorandum, when one corporation pays the expenses of another, those expenses are not considered the ordinary and necessary expenses of the payor. ²⁸

[41] Nevertheless, it should be noted that courts have expressed a preference for section 482 income allocations, rather than all-or-nothing income inclusions or deduction denials under other sections, when section 482 is available. In Foglesong v. Commissioner, 621 F. 2d 865, 873 (7th Cir. 1980), the Seventh Circuit stated that, where more precise devices for coping with unacceptable tax avoidance are available, those devices should be used rather than broader provisions such as section 61. Similarly, in Rubin v. Commissioner, 429 F. 2d 650, 653-54 (2d Cir. 1970), the Second Circuit noted that:

[43] Therefore, we recommend that you focus here on making any adjustments under section 482. Accordingly, the taxpayer's deduction on account of its employees' exercise of stock options should not be affected, assuming the options did not have a readily ascertainable value at the time of grant within the meaning of section 1.83-7(b).

[45] If you have any questions, please call me or Lisa Sams at (202) 622-3840.

² Shared projects were to be determined at the beginning of each fiscal year.

³ We assume that the amount shared/charged out by * * * was equal to * * *'s section 83(h) deduction. That is, the amount shared/charged out was the spread between the market price of the stock, when exercised, and the exercise price. Note, the services to which this amount related were likely to have been performed in years preceding those at issue.

⁴ Herbert Kraus, Executive Stock Options and Stock Appreciation Rights, Law Journal Seminars-Press (1994), 4-3.

⁵ Id. at pp. 4-3 - 4-5, citing Opinion 25 of the Accounting Principles Board, "Accounting for Stock Issued to Employees," (October 1972).

⁶ Id. at p. 4-5.

⁷ Id. at 4-6.

⁸ Id. at p. 4-7.

⁹ Id. at pp. 14-13 - 14-14.

¹⁰ Id. at p. 4-15 - 4-16.

¹¹ I.R.C. Section 83; Treas. Reg. section 1.83-7. An employee is also taxed on income received from the disposal of an option in a third party transaction. Treas. Reg. section 1.83-1(b)(1).

¹² I.R.C. Section 83(h); Treas. Reg. section 1.83-6.

¹³ Treas. Reg. section 1.83-6(d)(1); Tilford v. Commissioner, 705 F. 2d 828 (6th Cir. 1983); Transamerica Corp. v. United States, 71 Cl. Ct. 119 (1984), 85-1 U.S.T.C. P9120.

¹⁴ Note that, before making an adjustment under section 482, it is also appropriate to determine whether the division of costs under the arrangement was at arm's length. If, for example, * * * was bearing too great a share of the costs relative to its anticipated benefits, then an allocation of additional costs to * * * might result in a set-off claim. See Treas. Reg. section 1.482-1(d)(3).

¹⁵T.D. 8632, 1996-4 I.R.B. 6. These regulations are effective for taxable years beginning on or after January 1, 1996. There is a one year transition period allowing cost sharing arrangements to be conformed to the requirements of the 1995 regulations. Treas. Reg. section 1.482-7(k), (l).

¹⁶ Treas. Reg. section 1.482-7(d)(1).

¹⁷ Treas. Reg. section 1.482-7(d)(1) .

¹⁸ Treas. Reg. section 1.482-7(i).

¹⁹ Treas. Reg. section 1.482-7(j)(2)(iv).

²⁰ Treas. Reg. section 1.482-2(b)(1).

²¹ Treas. Reg. section 1.482-2(b)(3).

²² These chiefly consist of stewardship services. See Treas. Reg. section 1.482-2(b)(5). The * * * services agreement specifically excludes a charge for such services.

²³ Treas. Reg. section 1.482-2(b)(4)(ii).

²⁴ Note, the fact that an option's fair market value may not be "readily ascertainable" does not mean that the option does not have a value at the time of grant. Section 1.83-7(b) acknowledges "[o]ptions have a value at the time they are granted, but that value is ordinarily not readily ascertainable unless the option is actively traded on an established market."

²⁵ Herbert Kraus, Executive Stock Options and Stock Appreciation Rights, Law Journal Seminars-Press (1994), 4-16, citing Exposure Draft, Proposed Statement of Financial Accounting Standards, "Accounting for Stock-based Compensation," Financial Accounting Series No. 127-C (June 30, 1993).

²⁶ See Treas. Reg. section 1.482-7(f)(4) (1995 cost sharing regulations).

²⁷ You note that the Tax Court has held that non-qualified stock option payments were expenses that qualified for the research and development credit, even though they were incurred in a year after the year the qualifying services were performed. Apple Computer, Inc. v. Commissioner, 98 T.C. 232 (1992). We consider the timing issue in the Apple Computer case to be different than the timing issue discussed in the text.

²⁸ See Transamerica Corp. v. United States, 7 Cls. Ct. 119 (1984), 85-1 U.S.T.C. P9120.

²⁹ 429 F. 2d at p. 654. See also R.T. French Co. v. Commissioner, 60 T.C. 836 (1973).