Menu
Tax Notes logo

Unofficial Transcript of IRS Hearing on Stock-Based Compensation Regs

NOV. 20, 2002

Unofficial Transcript of IRS Hearing on Stock-Based Compensation Regs

DATED NOV. 20, 2002
DOCUMENT ATTRIBUTES
  • Institutional Authors
    Internal Revenue Service
  • Cross-Reference
    For related coverage, see Doc 2002-25957 (4 original pages), 2002 TNT

    225-2 Database 'Tax Notes Today 2002', View '(Number', or H&D, Nov. 21, 2002, p. 1681.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2002-26761 (33 original pages)
  • Tax Analysts Electronic Citation
    2002 TNT 235-11

 

INTERNAL REVENUE SERVICE

 

HEARING ON PROPOSED REGULATIONS

 

IRS Headquarters

 

 

1111 Constitution Avenue, N.W.

 

Room 4718

 

Washington, D.C. 20224

 

Wednesday, November 20, 2002

 

 

HEARING ON REG. 106359-02

 

 

APPEARANCES:

 

 

INTERNAL REVENUE SERVICE:

 

 

ELIZABETH BECK, CHIEF, BRANCH 6, INTERNATIONAL

 

DOUGLAS GIBLEN, SENIOR COUNSEL, BRANCH SIX, ASSOCIATE CHIEF

 

COUNSEL, INTERNATIONAL

 

 

TREASURY:

 

 

ROCCO FEMIA, ATTORNEY-ADVISOR, OFFICE OF TAX POLICY,

 

 

WITNESSES:

 

 

ERIC RYAN - PRICEWATERHOUSECOOPERS

 

RON SCHROTENBOER - FENWICK & WEST

 

JOHN M. PETERSON, JR. - BAKER & MCKENZIE

 

CAROLINE GRAVES HURLEY - AMERICAN ELECTRONICS ASSOCIATION

 

PROCEEDINGS

 

 

[10:00 a.m.]

 

 

[1] MR. GIBLEN: Good morning. This is the hearing on Reg. 106359-02, the proposed regulations entitled, Compensatory Stock Options, under section 482.

[2] I'm Douglas Giblen, senior counsel, Branch Six, Associate Chief Counsel, International. On the panel with me are Elizabeth Beck, Chief of Branch Six, and Rocco Femia, attorney-advisor, Office of Tax Policy, Treasury.

[3] We have four speakers scheduled for today, and the technological situation is such that speakers will need to sit in that end chair by the clock.

[4] The protocol, as usual, is that each speaker will have a total of 10 minutes to speak. When you have three minutes left, the light will turn from green to yellow. When the light turns red, your time is up and we'll have to ask you to stop. If a member of the panel asks a question while you are speaking, that stops the clock and won't count against the 10 minutes.

[5] So let's proceed. The first speaker is Ronald Schrotenboer from Fenwick & West.

MR. SCHROTENBOER: Thank you. My name is Ron Schrotenboer. I am a partner at Fenwick & West, Palo Alto, California.

[6] I begin with a question: Where is the evidence? The proposed regulations provide that an arm's-length result occurs automatically when its provisions are followed, including a sharing of stock options. Conversely, they provide -- when they are not satisfied, the answer will be deemed not arm's length. But where's the evidence?

[7] Two years ago in the Seagate case, the IRS agreed that including stock options was a question of fact. It was a question of fact. The prior regulations required the sharing of all the costs, quote, "On an arm's length basis," end quote.

[8] In Seagate, the court held that evidence was necessary and that sufficient evidence in the motion for summary judgment had not been presented. How can the IRS now deem the result to be arm's length without providing any evidence? Moreover, if the IRS position is correct in the proposed regulation that the result actually produces an arm's length result, why didn't they prove that to the court in Seagate and to all taxpayers?

[9] Under U.S. treaties, the arm's length standard applies. And in the explanation to the model treaty the -- each country can examine related-party arrangements, including cost-sharing arrangements, to determine if the results are what would occur with unrelated party transactions.

[10] If the IRS doesn't present any evidence now, how is the IRS going to convince our treaty partners that the results under the proposed regulation is arm's length, particularly -- and how will they convince them to grant taxpayers a deduction for making these cost-sharing payments, particularly when the income the employee earns is all taxed in the U.S.?

[11] Canada has already said that they will not allow a deduction for cost-sharing payments that include stock options.

[12] Our treaty partners will demand evidence as the explanations to the model treaty says that they may. Where is the evidence to convince them?

[13] Currently, in the Zylinks case in tax court, the position that the IRS is arguing, they are asserting that it's arm's length. However, that position in tax court, under these proposed regulations, will be deemed to be not arm's length. Let me repeat that: The position that the IRS is arguing in tax court, where they are asserting that that is arm's length, that same adjustment, that same position, will be deemed to be not arm's length under these regulations.

[14] Let me explain. The position in the litigation is that incentive stock options and ESOPs that satisfy the holding period, do not generate a cost and do not need to be cost-shared. That the IRS is asserting is arm's length.

[15] These proposed regulations say -- come to a different conclusion, and they say it's not arm's length. The proposed regulations say that all ISOs, all ESOPs, must be included in the stock cost-sharing, whether or not they satisfy the holding periods.

[16] So on the one hand you have in court a position that you say is arm's length. On the other these proposed regulations say the exact same position is deemed to be not arm's length. Which one's correct? What's the evidence? There's no evidence that says either is correct.

[17] All of the differences -- and there are about a half a dozen differences between what the IRS is asserting in the litigation and what these proposed regulations say. All of them create this problem that what is now being asserted is arm's length, and yet -- today -- and yet tomorrow, when these regulations were adopted, they would become non-arm's length. What happens if the court adopts the IRS position?

[18] In addition, the proposed regulations are inconsistent with other methods under the 482 regulation. The Service's regulation -- dash-two -- requires the charge for non-integral services to be the cost of other services. Yet that word "cost" has been applied for the dozens of years that that regulation has been around as not including stock options.

[19] Further, the regulation allows taxpayers to provide evidence, if that is not the arm's length result. However, these proposed regulations preclude evidence. You are not allowed to provide it.

[20] What's going to happen? And it's not just the Service's regulation. There are a variety of others across CPM and whatnot. What's going to happen is that similar transactions are going to be tested, using different standards, and you'll get vastly different results. Yet the regulations will end up saying that both of them are arm's length.

[21] For example, the entrant to an R&D services contract, covered by dash-two, is either cost or cost-plus. People at arm's length, plenty of agreements out there for R&D services contracts, they do not include stock options. Cost-sharing must include stock options. Two different tests, two different results. Both now are deemed to be arm's length.

[22] Moreover, even if stock options generate a cost, they should not be cost-shared. One of the arguments that the IRS has presented, or is based on, is that all costs must be shared. And this is based on the conference reports to the 1986 Tax Act, which is adopted commensurate with income. So that -- which stated that all costs in a cost-sharing agreement should be shared in proportion to anticipated benefits.

[23] But I'd point out that the prior regulation, the regulation that was existing at that time, says all costs and risks must be shared. There's no difference. That was the regulation that was applicable in the Seagate case.

[24] The IRS conceded the case. It can't be the basis for saying that stock options must be shared, that all costs must be shared.

[25] Moreover, even the current regulation doesn't require all costs. For example, interest expense is excluded. The White Paper, 1988, proposed that interest should be included in the cost, and people commented on that. In fact, it was stated to be the issue that generated the most comments about cost.

[26] Two of the reasons that were stated to exclude interest were that it was really a cost of capital, and that payers would never pay interest because they had no control over how leveraged the other party would be, and so they would not do that. The IRS stated that to be very persuasive, and interest was not included in the current cost-sharing regulations. Those same reasons are applicable for stock options today.

[27] The IRS should not issue these proposed regulations. There is no evidence that their proposed treatment produces an arm's length result. They will create problems, serious problems with our treaty partners. It's a radical departure from the arm's length standard, and it really only complies with arm's length, if the definition for "arm's length" is treated to be something else.

[28] Thank you.

[29] MR. GIBLEN: Any questions?

 

[No verbal response.]

 

 

[30] MR. GIBLEN: The next speaker is Eric Ryan from PriceWaterhouseCoopers.

[31] MR. RYAN: Thank you. My name is Eric Ryan. I am a tax partner with PriceWaterhouseCoopers in San Jose, California, and specialize in transfer pricing matters.

[32] I would like to thank the Internal Revenue Service and the Treasury for the opportunity for PriceWaterhouseCoopers to provide these oral comments today. Our firm has provided written comments, as you know, and my comments today will follow those written comments in general. I would be happy to answer anyone's questions on either the oral comments today or our full written submission.

[33] First, we do agree with the universal criticism of the proposed regulations that they seem contrary to the arm's length standard as evidenced by actual transactions and solid economic theory. And we also agree that if these regulations are finalized they will quite clearly lead to increased tax controversies and double taxation for U.S. multinationals.

[34] We further believe that if the underlying framework of these proposed regulations is expanded to other areas in the transfer pricing arena, in particular for example the Service's regulations under 1.482(6), we think that the number of companies affected by this framework, the number of issues, the number of countries involved, and the amount at issue, will be magnified by thousands of -- tens of thousands of times.

[35] So despite the fact that there may be a relatively small number of speakers here today, if this framework is expanded, it is frankly a very enormous issue. And we are confident that others today will talk about the arm's length standards, and so we really won't focus on that. We would like to focus on some other particular issues within the regulations themselves.

[36] We would argue -- we would seriously like to propose that Treasury and the IRS wait to finalize any such regulations until there is international consensus on how to deal with the stock options in this kind of a context. The OECD is currently addressing this particular issue.

[37] As we understand it, OECD Working Group 6 is dealing with the issue of corporate deductions for stock options and cost contribution arrangements, which is similar to the U.S.'s cost- sharing arrangement, as well as other similar issues as well. The OECD has indicated this is a top priority for the OECD. And although we haven't seen any draft analyses to date, we think that the U.S. should work through that kind of forum.

[38] Towards that end, we think that this situation is very similar to a situation the Treasury Department itself not too long ago urged, universally -- urged global consensus on before file rules were issued. And that situation was when the European Union suggested that value-added taxes be applied to imports into the EU of e- commerce goods and services.

[39] And there I think what I would like to do, if I can, is just either paraphrase or read directly from the statement of Deputy Treasury Secretary Kenneth Dam back in February -- I think it's February 8th of this year -- where he said in that context, "While universal proposals, such as the EU's, may encourage others to take universal measures, rather than waiting for the global consensus that can be developed through a deliberative and inclusive process, such as the OECD" -- it goes on basically to talk about -- "and please hold up on the EU e-commerce activities until we can collaborate through the OECD on this highly, sort of complex and contentious issue." We think that that same logic applies here.

[40] Second, we also would say that the Treasury and the Service should hold up in terms of finalizing these proposed regulations, until the issue can be harmonized within the regulations themselves. And there has been some discussion already about expanding the concept to the service area and other areas.

[41] But we would point out as well that we think there are other correlative adjustments that may be necessary, if this is put in place. And by that what I mean is that if you have the requirement to include stock options in a cross charge for a cost-sharing, it may very well be that the appropriate thing is to adjust any other transactions that those parties might have, such as a transfer of technology, a buy-in royalty, to account for the fact that this cost- sharing amount is unpredictably large and might in fact bankrupt the recipient.

[42] In that particular case, we think an arm's length -- a party would insist that the other arrangements, whether they be licenses or sales of goods, be tailored to make sure that that entity not be bankrupt and some sort of offsetting adjustment put in place. So we think that there are a number of correlative areas within the regulations themselves that need to be thought through.

[43] In terms of the regulations themselves during this period of waiting, we would suggest that a couple of the issues be addressed nonetheless.

[44] The first issue that we think should be addressed within these regulations is that the election to use the grant date should be -- that methodology should be available to all taxpayers. Under the proposed regulations, only taxpayers that are listed on a U.S. stock exchange are given the opportunity to have the grant date methodology apply.

[45] Well, that of course excludes privately-held companies, and that excludes companies that are listed on foreign exchanges. Now, in privately-held companies' cases, we acknowledge the fact that actually doing a computation of the grant date methodology may be a new computation for that taxpayer.

[46] In other words, they may not be doing that already for their financial statements. But we think that that new requirement is no more burdensome than the requirement that would already apply to a private company, in terms of having to do with separate off-line economic analysis under the exercise method, because a privately-held company isn't listed on a public exchange.

[47] So that company is already going to have to do some off- line analysis under the one methodology given it. Why not give it -- why not give a private company two methodologies?

[48] Similarly, on the international side, we are concerned that the denial of that approach to a foreign-based multinational might in fact violate some non-discrimination clauses within the treaties.

[49] We also think that the exercise date methodology should be fully conformed to a tax deduction, and that no amount of incentive stock option or employee stock purchase plan deduction, which was never taken in the first place, should be denied. That we think goes beyond the commissioner's ability to adjust and allocate deductions.

[50] Lastly, the method -- we believe that any reasonable method should be allowed. Consideration should be given to the minimum valuation method, in addition to the two methods allowed at the moment.

[51] The last comment we would say is that we do believe that these regulations, if they are finalized, should be prospective, only. We recognize that this issue is highly contentious. It's been the subject -- it is the subject of current litigation. It's been the subject of past litigation as well. The Internal Revenue Service has conceded the issue with Seagate.

[52] In our experience, the only taxpayers who are following this type of methodology are those taxpayers -- a very limited number of taxpayers who have settled the issue that has been raised on audit, that none of the companies that we know voluntarily would follow these proposed regulations.

[53] So despite the language in the preamble of the proposed regulations that this is a clarification, that's just not the case. This is clearly a departure from the existing framework that is being applied. And I think that we need to recognize that as a legal matter, most companies have embodied accounting-based methodology within their inter-company agreement, within their cost-sharing agreement.

[54] So as a legal matter, they may be unable to now go back and charge these costs for prior years. And we believe that that in fact will be another reason that foreign governments will not allow this particular cross charge.

[55] A little bit of history in this area is probably useful as well. In 1992, cost-sharing regulations were proposed. Treasury and the Service at that point specifically asked for comments on what type of accounting methodology should we use. The commentators at that point said, Please do not use a tax methodology. That was a universal sort of answer.

[56] If you have any questions, I'll be happy to answer them.

[57] MR. GIBLEN: Questions?

 

[No verbal response.]

 

 

[58] MR. GIBLEN: Thank you.

[59] The third speaker is John M. Peterson, Jr., from Baker & McKenzie, on behalf of the Software Finance and Tax Executive Council.

[60] MR. PETERSON: Thank you very much. I am John Peterson from Baker and McKenzie. Again, appearing on behalf of SoFTEC.

[61] Again, like the prior speakers, I also appreciate the opportunity to sort of supplement our written comments with some oral comments. I am going to try very much not to be too repetitive of what the other speakers have -- you are hearing more or less the same thing I think from most of the people that are speaking here -- but instead try to focus on some of the key elements I think in our comments.

[62] You know -- at this point, you know, for all the rhetoric that has been exchanged on both sides about whether the arm's length standard applies to cost-sharing agreements or not, you know, I think that's probably not really the issue here. The regulations more or less acknowledge, I think, that the arm's length standard applies in the cost-sharing area, you know, by framing, if you will, the regulatory fix as a determination of what is arm's length and what is the best method.

[63] Certainly, even the Service's litigating position, now that it's on record in brief in terms of what the arm's length standard has to play as a role here in the cost-sharing area, I think the government, even in its litigating position, would acknowledge that the arm's length standard applies. But the real issue here is how do you apply it in the context of stock options, not whether it should be applied.

[64] It seems to me that, you know, if one tries to follow the normal arm's length standard practice, you know, it's an inherently factual exercise. It's typically driven in the first instance -- and I think the government's own briefs would acknowledge this in the Zylinks case, it's driven in the first instance by comparables.

[65] If there aren't good comparables, you would then sort of devolve into all sorts of economic analysis and coulda-woulda- shoulda, economic testimony, opinions, as to what people might have done, what an arm's length result would appear to be, and so forth. But the starting point typically is our comparables.

[66] And it seems to me that while this is not the place necessarily today to argue the facts of whether there are or are not comparables and what the right answer is in the absence of any comparables, it seems to me that for a regulation to more or less declare by fiat that it is arm's length to share certain stock-option costs as defined by the regulations -- in effect, to declare "This is the one and only method, this is the arm's length result" -- it seems to me is sort of preempting the field and precluding the normal factual inquiry.

[67] I mean, if you took the regulation literally -- and I think this is what it means -- if a taxpayer proffered a perfect comparable in terms of an R&D cost-sharing arrangement with a third party, wherein stock-option costs were not shared, that wouldn't be good enough.

[68] Now, the government's own litigating position would say, "Well, if you have" -- they don't think anybody has that, but if you did have that, the briefs would seem to acknowledge that, well, that should be controlling.

[69] Now, in the absence of comparables, one can get involved in all sorts of economic analysis. One economist will say the third parties would have somehow shared them. Other economists will say they won't. But even then, if the factual exercise is probably better determined in some sort of factual forum, it's simply not appropriate, from our perspective, to declare in a regulation, "This is the one and only arm's length result."

[70] And I think it's compounded by the fact that the regulation would use, as its base amount -- you know, maybe this is to protect the litigating position -- I don't know -- but the regulation would use, as its base amount, the section 83 inclusion and deduction for the exercise.

[71] And if there's anything, to me at least that's clear as a matter of fact, is that that is not an arm's length result. I mean, for a recipient of a service of some sort -- R&D cost-sharing, let's say -- to agree to pay a price, based on the performance of the stock of the vendor of those services, is more or less economically the same as shorting the stock, the impact -- the price in the end will bear no relationship to the results of a particular research project necessarily.

[72] But there are so many things that go into the price of a stock. And it seems to me that it's fairly clear that nobody would ever do that, and there's probably no economist on either side that has yet or will opine that anybody would do that. When you start getting into costs that appear in people's financial statements, I think that's a little bit more arguable territory. But, again, it's still a question of fact.

[73] Now, once you sort of move beyond that legal point, if you will, I think there is -- you know, there's also a very real risk of whipsaw on the part of the government. If these regulations were to go through as proposed, one can assume that the foreign taxpayers, at least those who didn't have a high tax jurisdiction on the other side of the line, would probably go ahead and load in stock-option costs in the cost-sharing. And we, of course, would have to follow the regulations and accept that treatment.

[74] On the other hand, other taxpayers won't. Even if U.S. taxpayers do include these stock-option expenses, treaty partners may push back, and there may very well be correlative adjustments or authority resolutions that will refuse to accept these costs, meaning the U.S. will eat the deduction on that side.

[75] Whereas other taxpayers are sustaining the deduction in the U.S. on the other side. And even for U.S. taxpayers who are unable to secure a roll-back of the adjustment in authority, if there are foreign taxes on the other side, there will still be a cost to the Treasury in the form of the foreign tax credits, with double taxation on the other side.

[76] So it seems to me that there is a very real whipsaw risk here. Because if this becomes an official, codified-in-regulation position, then that is going to be allowable to anybody who wants it. Yet, on the other hand, not everybody is going to end up with that result who doesn't want it.

[77] Either taxpayers may possibly litigate them in, or they'll find that in authority the adjustments are returned in any event.

And so, sort of in response to all this, I guess what our comments are sort of offering is a possible alternative approach, trying to think out of the box a little bit. I mean, the government, I think, fairly obviously believes that it's arm's length for taxpayers to share this cost. It certainly prefers that taxpayers share stock-option costs.

[78] It seems to be prepared, based on the sort of election in the regulations, or the sort of "if you cost-share stock-option expense" under any feasible method in your return, you then won't be set up on section 83 under the current LMSB directive.

[79] And the Service seems to be prepared to accept that that may even be at sort of, you know, financial-statement cost, if you will. More of the so-called FASB footnote amount.

[80] But if you want people to do this, if it seems to us that the best way to do it is not to promulgate a regulation that may very well be invalid, and end up not applying to anybody in the end anyway, but instead you offer it as a safe harbor within the existing cost-sharing regulations with a sufficient sort of "carrot-and- stick" incentive/disincentive that a substantial number of people will, in fact, opt for that approach.

[81] That way you'll get the result of more taxpayers, cost- sharing, stock-option costs in some respect or other, reducing the amount of controversy, if you will, in those cases. And then, at the same time, not have, if you will, the countermand of the arm's length standard by declaring a factual result in the regulations in a fashion that could very well lead to the regulations being knocked out, either in litigation in the U.S. or by treaty practice, or the adjustments not being accepted by foreign governments.

[82] Now, if you're going to follow a safe-harbor approach, it seems to us that there has to be a sufficient incentive in terms of carrot and stick for people to follow that approach. The stick is fairly obvious.

[83] You know, you litigate or challenge, if taxpayers don't opt in. But the carrot probably has to be a little more than just the adverse of the stick. You know, you're not going to be litigated or challenged if you do follow it.

[84] It would seem to us that an appropriate carrot would be to offer some preferential treatment for prior years to taxpayers who opt into the safe-harbor approach. One possible preferential treatment, if you will, would be to agree not to examine cost-sharing agreements for prior years.

[85] Now, there are some administrative issues that will arise, I think, in this context, as with the regs, I think, as written. If there's going to be any sort of safe-harbor approach, I think we would acknowledge that it has to be binding on the taxpayer for some period of time. You can't opt in and out on a year-by-year basis, whether that's three years, five years, or whatever amount of time.

[86] I don't know that we have a firm position on that. Like the other speakers, I think we would want the ability to use any reasonable method to value stock-option costs. I think it's fairly obvious that the financial-statement treatment is evolving for stock options. The IASB has more or less laid down its marker. The FASB is probably no more than a year or so behind.

[87] You roll the clock forward a couple of years and everybody's probably going to have to include something in their profit and loss with respect to stock options. Companies have to face the music, if you will, from a financial accounting perspective. I would expect that you'll see some evolution or creativity or some action, if you will, on the valuation front.

[88] And I think people will take the whole valuation issue a bit more seriously than they may have taken it in the past. And I think that may very well lead to methods that we haven't seen yet in terms of valuing stock options.

[89] I read recently that one or more exchanges are going to start trading 10-year futures in stock options, which may produce yet another possible valuation that tracks more closely with the time period for employee stock options. So it seems to me that valuation methods are going to be very important.

[90] One last administrative point, I think, is that I think it's important that taxpayers have the ability to track employees who move around from departments. If you just say you're in this department one day, all the costs are in or out. It seems to us that that's going to produce a non-arms length result.

[91] Thank you very much.

[92] MR. GIBLEN: Any questions?

 

[No verbal response.]

 

 

[93] MR. GIBLEN: The fourth speaker is Caroline Graves Hurley from the American Electronics Association.

[94] MS. HURLEY: Good morning, and thank you for inviting me today to testify.

[95] I am Caroline Graves Hurley. And as your wrap-up speaker today, I am here on behalf of AEA, the American Electronics Association. I'm going to do my best to try to present the business community taxpayers' perspective with regard to those regulations. You've heard from some really good practitioners. And I'd like to give you our association's view of what these regulations will do. In many respects, have perhaps a very anti-competitive effect on our economy.

[96] Advancing the business of technology, AEA is the nation's largest high-tech trade association, representing more than 3,000 member companies that span the high-technology spectrum from software, semiconductors and computers to Internet technology, advanced electronics and telecommunication systems and services.

[97] AEA has been the accepted voice of the high-tech community since 1943. The overwhelming majority of AEA member companies issue both non-statutory and statutory stock options to their employees.

[98] In fact, the high-tech industry was the first in the U.S. economy to distribute stock options to its entire workforce, from the entry-level positions all the way up to top executives. Stock options help employers to attract and retain a qualified workforce, and that's really important right now in this economy that we're in. And it helps to give these employees a financial stake in the future of the companies for which they work.

[99] It can rightly be said that stock options are a key engine of growth and innovation in the U.S. economy. Correspondingly, as a result of the high speed of innovation and change, the high- technology sector also boasts the most volatile issues in the stock market.

[100] Furthermore, due to the global reach of technology and the high level of international merger and acquisition activity in the sector, a high level of research and develop cost-sharing plays an important role in the business strategies of high-technology companies.

[101] Many AEA member companies rely on these qualified cost- sharing arrangements to facilitate the development of their intangible property. The high-technology industry is notable for its global scale, where even the newest and smallest players face competition from companies around the world.

[102] In response, most high-technology companies have established research, manufacturing and distribution operations in several countries, at times -- as a result of cross-border mergers or acquisitions. And until this current conflict with the IRS over stock options presented itself, these high-tech companies have found cost- sharing to be an indispensable tool for managing global and tangible property rights in a way that has avoided contentious and costly disputes with tax authorities over arm's length licenses and royalties.

[103] Although AEA commends the Treasury and IRS for opening up this matter to the notice-and-comment rule-making procedure, in an attempt to resolve this important issue, AEA firmly believes that this approach of the proposed regulations is really fundamentally flawed because it violates the international arm's length standard, which is the very foundation of transfer pricing law and policy.

[104] As a result of this defect, a number of anti-competitive effects on the industry can be foreseen, if the regulations are finalized in the proposed form. And AEA respectfully requests that these regulations, in their current form, be withdrawn.

[105] To begin, although the proposed regulations purport to be consistent with the arms length standard, it's clear to AEA that they do not produce an arm's length result. I wish to emphasize that the central inquiry should be what costs independent parties would share under the same circumstances and how they would measure and share those costs.

[106] Actual commercial dealings and sound economic reasoning both demonstrate that independent parties would not share amounts on the evaluation of employee stock options under either of the allowed methods outlined by the proposed regulations. There's also no evidence to suggest that third parties dealing at arm's length agree to share costs that include unmeasurable and unpredictable stock- option costs.

[107] Several of the AEA member companies have reviewed their co-development and joint-venture agreements and have found none which provided any compensation for employee stock options. For those few agreements that were ambiguous on the issue of stock options, the companies investigated invoices and accounting records relating to the agreement and found that in no case were any costs associated with the value of stock options charged out.

[108] If it would be helpful, I wish to offer that one or more of these AEA member companies would be willing to discuss these agreements with the IRS and Treasury, provided they can receive assurances that the information discussed would be kept confidential and that proprietary business information would not be disclosed. That's one reason why today you have your trade association representative giving these remarks and not our member companies, for precisely that reason.

[109] Due to their inconsistency with the international arm's length standard, the proposed regulations can be expected to produce a number of side effects that will damage the competitiveness of the U.S. industry and harm the U.S. job market.

[110] Many of the largest trading partners of the United States, including Canada, Japan and several European countries, appear very unlikely to accept the proposed regulation's view of the arm's length standard, and AEA is aware of U.S. companies that have cost-sharing arrangements that include participants from each of these countries.

[111] Moreover, the negative effects would be magnified if the IRS and Treasury extend the principles of the regulations to other areas of transfer pricing, such as inter-company services. And we strongly believe that it is inadvisable to pursue the proposed regulations without first seeking harmony within the international community among the different transfer pricing areas.

[112] To further demonstrate the anti-competitive effect of the proposed regulations and what effect it would have on the U.S. industry, it's important to realize that many U.S. multinationals will suffer double taxation with foreign tax authorities to disallow deductions for cost-sharing payments paid by the local subsidiaries to its U.S. parent to the extent the payments are based on stock- option valuations.

[113] Conversely, the proposed regulations would create an opportunity for some foreign multinationals to receive U.S. tax deductions for stock options that would not otherwise be available to them under their home-country law. Both the double-taxation effect and the new foreign benefit would be greatly magnified, if the IRS and Treasury extend the principles of the proposed regulation to these other areas of transfer pricing besides cost-sharing.

[114] Whether a foreign corporation, even a foreign affiliate of a U.S.-based multinational, is entitled to a corporate tax deduction for stock options issued to its employees, depends upon the tax rules of the foreign country where it operates. Clearly the decision whether to encourage employee stock ownership and entrepreneurship within its borders is appropriately a matter of domestic policy for each country.

[115] U.S.-based multinationals take tax policies of each of these foreign countries into consideration where they operate, when deciding whether or not to extend stock-option benefits to the local employees. The proposed regulations, however, would turn these policy considerations on their head, because costs charged out to a foreign participant under qualified cost-sharing arrangements reduce tax deductions otherwise available to U.S. participants.

[116] The proposed regulations would have the effect of denying part of the deduction for U.S. employee stock options. As a result, U.S. participants would have to consider foreign tax treatment of option-related cost-sharing payments before deciding whether to extend stock-option benefits to U.S. employees.

[117] It's also significant to note that the proposed regulations would provide an unwarranted benefit to foreign companies to the extent that they perform research and development, and other stock-compensated activities outside the United States. And the unintended consequence of this is it would encourage many U.S. multinationals to perhaps move their research-and-development facilities overseas.

[118] With the rapid growth of well-educated engineers and other skilled professionals in places like India and China, that possible side effect cannot be lightly dismissed. And AEA is very frustrated by this negative effect, as we have been a very strong and vocal proponent of encouraging U.S.-based research and development, not to mention making permanent the research-and-experimentation tax credit.

[119] In the same vein, Treasury should not find it surprising to expect that private contractors will have a strong incentive and rationale to request changes in how the government contracting procurement regulations allow them to charge out employee stock options and military procurement, and now in new homeland security government contracts.

[120] If the U.S. government truly believes that parties at arm's length compensate others for their employee stock options, AEA believes that the government should do so itself. It's worth noting on this very day, the day following final congressional approval of the Department of Homeland Security, that the high-tech members of AEA very much wish to partner with this new agency and supply the United States with anti-terrorism technology and services, and hopes to significantly increase the number of high-technology government procurement contracts.

[121] It's altogether possible that by extending new tax deductions to foreign corporations and by causing the government to incur new charges on procurement contracts, the proposed regulations will have a significant negative impact on the FISC.

[122] In conclusion, strengthening the arm's length standard must remain a tax policy priority if U.S. companies are to be competitive in the global economy. Only if there is broad international consensus on arm's length principles, including the measurement of costs under cost-sharing arrangements, can U.S. companies achieve parity with foreign competitors and avoid debilitating disputes with foreign tax authorities. Imposing U.S. tax accounting rules for cost-sharing would undercut this very worthy goal.

[123] AEA believes the proposed regulations should be withdrawn, both because they contravene the arm's length standard which is central to U.S. international tax policy, and because their direct and indirect effects will undermine the competitiveness of the U.S. high-technology industry.

[124] Thank you for the opportunity to present these remarks. And should you find it informative, we would be happy to meet with you separately, again, to further discuss our industry's co- development and joint-venture agreements.

[125] Thank you.

[126] MR. GIBLEN: Any questions?

 

[No verbal response.]

 

 

[127] MR. GIBLEN: I should say, on behalf of the panel, that, as with all the remarks we've heard this morning and as with all the written comments we've received, we will be -- both Treasury and the IRS will be taking these -- considering these very carefully.

[128] That concludes our scheduled speakers. Is there anyone else present who would like to speak?

 

[No verbal response.]

 

 

[129] MR. GIBLEN: Okay, then, we've completed our business here. Thanks for coming. And the hearing is adjourned.

 

[Whereupon, at 10:43 a.m., the proceedings were adjourned.]
DOCUMENT ATTRIBUTES
  • Institutional Authors
    Internal Revenue Service
  • Cross-Reference
    For related coverage, see Doc 2002-25957 (4 original pages), 2002 TNT

    225-2 Database 'Tax Notes Today 2002', View '(Number', or H&D, Nov. 21, 2002, p. 1681.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2002-26761 (33 original pages)
  • Tax Analysts Electronic Citation
    2002 TNT 235-11
Copy RID