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IRS to Enforce Stock-Based Compensation Rule After Altera

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Posted on Aug. 6, 2019

Despite a pending request before the Ninth Circuit for an en banc rehearing in Altera v. Commissioner , the IRS will resume enforcement of a regulation that requires sharing of stock-based compensation costs by cost-sharing participants.

In a memorandum posted August 5, Douglas O’Donnell, commissioner of the IRS Large Business and International Division, formally withdrew a January 2018 directive suspending adjustments determined by applying the regulation challenged in Altera v. Commissioner, No. 16-70496, No. 16-70497. The 2003 regulation at issue, reg. section 1.482-7A(d)(2), required that parties to a cost-sharing arrangement (CSA) include stock-based compensation in the shared cost pool. The Ninth Circuit upheld the regulation in June, reversing a 2015 Tax Court decision that invalidated the regulation under the Administrative Procedure Act.

The memorandum, like the 2018 directive, also applies to a parallel provision, reg. section 1.482-7(d) of the current cost-sharing regulations. The resumption of adjustments attributable to the sharing of stock-based compensation is effective July 31, according to the memorandum.

“Based on the Ninth Circuit’s decision in Altera, I am formally withdrawing Directive LB&I-04-0118-005. With the issuance of this withdrawal, examiners should continue applying Treas. reg. [sections] 1.482-7A(d)(2) and 1.482-7(d)(3), including opening new examinations of CSA [stock-based compensation] issues when appropriate,” O’Donnell wrote in the memorandum. “These issues may be factually intensive, and transfer pricing teams should develop the facts to support their analyses and conclusions.”

The withdrawn 2018 directive instructed examiners to cease the opening of new examinations based on failure to share stock-based compensation and, for examinations already in progress, to suspend issue development pending the outcome of Altera if the taxpayer agrees to extend the statute of limitations accordingly. The withdrawn directive also instructed examiners to consult with LB&I division counsel before requiring inclusion of stock-based compensation in the services cost base under reg. section 1.482-9(j).

The IRS’s withdrawal of the directive is bad news for U.S. multinationals because it increases the uncertainty associated with stock-based compensation in CSAs, according to Guy Sanschagrin of WTP Advisors.

“The inclusion of [stock-based compensation] in intangible development costs may not align with the arm’s-length standard in certain cases, creating confusion among taxpayers over which part of the regulations apply or take precedent,” Sanschagrin told Tax Notes. “Since [section] 482 emphatically states that the standard in all cases is that of companies doing business at arm’s length, any detailed provisions that contradict the arm’s-length standard seem invalid. The [section] 482 regulations should be restructured to address this fundamental incoherence.”

In its June decision, a Ninth Circuit panel held that section 482 — especially after the 1986 addition of the commensurate with income standard — authorizes internal allocation methods that don't refer to arm's-length transactions. However, Altera Corp. has not conceded the issue and has continued its challenge in a June 22 petition for a rehearing en banc. According to Altera, the 2003 regulation fails to adequately address comments submitted during the notice and comment period arguing that the regulation is inconsistent with the arm's-length standard because unrelated parties do not share stock-based compensation.

The IRS’s withdrawal of the directive is unsurprising in light of the Ninth Circuit’s decision, according to Barbara Mantegani of Mantegani Tax PLLC. However, Mantegani told Tax Notes that an agreement to rehear the case en banc cannot be ruled out, given that the panel’s June 7 decision wasn’t unanimous.

“They are all down the [Administrative Procedure Act] road, so it is too late for common sense to prevail and for someone to say, ‘Hey, if you want the benefits of the CSA, you need to include all your intangibles development costs, and [stock-based compensation] is a cost directly related to the human beings who perform the intangibles development, so they have to be included, period.’ That ship has sailed, unfortunately,” Mantegani said.

Further Challenges

J. Clark Armitage of Caplin & Drysdale said he wasn’t surprised by the IRS announcement, noting that the Ninth Circuit’s decision “was clearly a meaningful win. I would have to think they’re pretty confident this is going to be a permanent outcome.”

Armitage said it’s likely that many other companies have contractual provisions with their foreign subsidiaries that they wouldn’t expense stock-based compensation costs unless the IRS won in Altera.

“It’s very possible that the IRS is aware of a number of those companies and had put making audit adjustments on hold, and will now communicate to those companies that they’re going to make adjustments for that issue,” Armitage said.

As for how companies may be gearing up to challenge any adjustments, Armitage said they’ll have to decide whether they want to be relatively aggressive in their reporting.

Another sticky issue is the effect on the treatment of stock-based compensation in other transfer pricing contexts, like when applying the comparable profits method, Armitage said.

“Those are probably a more unpredictable [situation] because you don’t know which entities necessarily have that issue, whereas with cost sharing it’s pretty likely that the issue exists,” Armitage explained. “The IRS could be pursuing that as well. One of the things that will be telling is if we get a practice unit from the IRS that tells examiners, 'Here’s the scope of the issue and what to look for' — or whether this memo was enough.”

Companies will likely develop several different approaches when challenging the Ninth Circuit’s decision, Armitage said.

“It’s always struck me that the basic argument shouldn’t be that because the IRS has always followed the arm’s-length standard, it must follow it in this case,” Armitage explained. “I see it instead as the regulation could produce a result that doesn’t reflect true taxable income, which is the standard in the statute.”

The business to be cost-shared “may be a tiny piece of the public company, and you’re imputing the economics of the entire company performance to this little piece,” Armitage continued. “There’s a disconnect there between the benefit from the appreciation or depreciation of the stock and the specific activity that is going on,” he added.

Armitage noted that that argument is weaker if both sides of the transaction grant stock-based compensation and the business to be cost-shared is a very large percentage of the taxpayer’s business. “But it’s still very possible you have an improper economic outcome and you don’t get true taxable income because of this regulation,” he said.

Code Sections
Subject Areas / Tax Topics
Institutional Authors
Tax Analysts
Tax Analysts Document Number
DOC 2019-30071
Tax Analysts Electronic Citation
2019 TNTI 151-1
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