Altera, a semiconductor company, now a subsidiary of Intel, has been in a dispute with the IRS over its non-inclusion of stock-based compensation (SBC) costs in the payments made under its intangible development qualified cost sharing arrangement (CSA). Altera’s position in this matter was based on its belief that including SBC did not meet the regulatory arm’s length standard despite clear regulatory requirements to the contrary for the periods concerned. The case moved through the Tax Court with a win for Altera, that the government appealed to the United States Court of Appeals for the Ninth Circuit (Ninth Circuit).
On July 24, 2018, the Ninth Circuit released an opinion on the appeal of the Tax Court ruling in the Altera case, overturning the opinion of the Tax Court. That Ninth Circuit opinion, however, was quickly withdrawn on August 7, 2018. Judge Stephen Reinhardt, who had sided with the majority in overturning the Tax Court’s opinion, passed away in March after the hearing but months before the opinion was issued, some parties wondered about the propriety or issuing the final opinion several months after one of the three judges had passed away. More can be read about this in the TP Times released September 5, 2018 available here. After the withdrawal of the opinion, the three-judge panel was reconstituted, replacing Judge Reinhardt with Judge Susan Graber.
On June 7, 2019 the Ninth Circuit released their decision on the appeal.1 This case focused on the validity of amendments made to the cost sharing regulations in August of 2003 (2003 CSA SBC Regulations) which explicitly required the inclusion of SBC costs in intangible development cost (IDC) pools for CSAs. In a 2:1 majority decision, the Ninth Circuit overturned the earlier Tax Court decision and found that Treasury had met the requirements of the Administrative Procedures Act (APA) in promulgating the 2003 CSA SBC Regulations and therefore those regulations were valid, enforceable and IRS proposed adjustments to Altera were appropriate. While this recent opinion has some differences, the basis and nature of the 2019 opinion has much in common with the withdrawn 2018 opinion.
In its majority opinion, the Ninth Circuit provided detailed account of the rule making process around the 2003 CSA SBC Regulations as well as its interpretation of the legislative, regulatory and court finding history under Internal Revenue Code (IRC) §482 and its predecessors. The court’s analysis especially focused on the evolution of the tax code, related congressional intent, and Treasury regulations as a result of the Tax Reform Act of 1986, which led to the addition of the commensurate with income (CWI) language in IRC §482 applicable to intangibles to counter perceived abuses related to taxpayer transfer pricing and activity around intangibles and intangible development. It also pointed to the detailed review in the transfer pricing “White Paper” presented to Congress in 1988 and Treasury’s subsequent rewrite of its regulations under IRC §482 which were finalized in 1994 generally, and for cost sharing in 1995. The opinion noted that Treasury wrestled with the difficulty in finding reliable comparable transactions between unrelated parties for often unique intangibles in these regulations by clarifying the standard of comparability for the use of transactional methods and including specified non-transactional methods aimed at determining an arm’s length result in the absence of more reliable uncontrolled comparable transactions. It interpreted the 1995 CSA Regulations as providing for such a method that sought to determine an arm’s length result consistent with congressional intent and therefore standards of comparability more relevant to transaction-based methods were less relevant to cost sharing arrangements.
The Ninth Circuit found Treasury acted reasonably in adapting its regulations to account for changing circumstances, specifically in its promulgation of the 2003 CSA SBC Regulations to address the increased use of employee stock-based compensation by many companies, especially those in technology industries. The Ninth Circuit looked at the rule making process behind the 2003 CSA SBC Regulations and found that Treasury was not arbitrary or capricious. Regarding arguments advanced by Altera that Treasury had not adequately considered and responded to comments about the absence of SBC sharing in similar third-party arrangements, the majority concluded:
“We cannot find a failure in Treasury’s refusal to consider comments that proved irrelevant to the decision-making process…because the comments had no bearing on the “relevant factors” to the rulemaking, nor any bearing on the final rule, there was no APA violation.”
The majority concluded in this manner because it found that Treasury did not believe the evidence of SBC sharing between unrelated parties were sufficiently comparable transactions to related party CSAs to meaningfully address the question of arm’s length outcomes in CSAs. Treasury further believed that the arm’s length standard did not require analysis from comparable transactions to address the question of SBC inclusion.
The dissent from Justice O’Malley found that the majority has gone out of its way to justify the agency’s rulemaking based on grounds that weren’t invoked when the rules were being made–a direct violation of what is permissible under case law. In enacting the 2003 amendments to the cost sharing rules, Treasury repeatedly stated that they believed they were being consistent with the arm’s length standard–something that’s not true based on the finding of Xilinx.
The Ninth Circuit’s decision might have also affected the services regulations under Treas. Reg. §1.482-9 effective July 31, 2009 (Services Regulations).2 These regulations also expressly require the inclusion of SBC costs in its definition of costs required for taxpayer’s elective application of the Services Cost Method. For other methods, however, the Services Regulations leave open the position on inclusion of SBC costs to the comparability and reliably standards under best method selection, providing several examples of their views in the application of the Services Comparable Profits Method where SBC costs are included. The latest decision leaves these positions intact.
Altera/Intel now must decide whether to continue the dispute over SBC costs either through an application for rehearing by all the Ninth Circuit justices en banc, by appealing the case to the U.S. Supreme Court or to let the decision stand. In an issue that has no shortage of procedural controversy, we note that a similar en banc rehearing was accepted by the Ninth Circuit in the Xilinx case which looked at the same issue for the period preceding the 2003 CSA SBC Regulations, as a result of which the Ninth Circuit vacated a panel opinion overturning the Tax Court decision leaving the underlying Tax Court decision as it stood in favor of Xilinx.
As a result of this latest Ninth Circuit decision on the treatment of stock-based compensation cost, taxpayers with cost sharing arrangements, and potentially those with similar positions under the Services Regulations, have to wrestle with a number of things depending on the materiality of the decision to their facts and circumstances. These include, but are not limited to, various primary and secondary impacts of the case decision such as:
- Changes to financial accounting tax reserve positions under ASC 740-10 or other GAAP disclosures.
- Potential disclosures of a post quarter-end event in SEC filings.
- Changes to SBC-related transfer pricing practices:
- In the current fiscal year;
- For closed fiscal years with unfiled tax returns; and
- For closed fiscal years with filed tax returns.
- Whether to make historical adjustments in amended tax returns for prior years, or cumulative adjustments in unfiled tax years or the current fiscal year, and the interaction of this opinion with any specific terms agreed between the cost sharing participants around the resolution of this issue in the CSA agreement.3
- Potential changes to calculations and payments of tax under the 2017 Tax Cuts and Jobs Act (TCJA)4 including:
- The transition tax on unrepatriated foreign earnings and profits;
- Global Intangible Low Tax Income (GILTI) income and deduction calculations; and
- Foreign Derived Intangible Income (FDII) deduction calculations.
- Foreign tax credits and subpart F
- Potential changes to pre-TCJA historical dividend repatriations and tax credits;
- Potential changes to the calculation of other cost share related transactions currently or in the past such as:
- Initial platform contribution transactions (PCTs);
- Acquisition PCTs; and
- Cost sharing change-in-interest transactions for companies that have on-shored, moved or changed their intangible rights under cost sharing.
- Amendments that may need to be made to a CSA agreement to reflect new transfer pricing practices and related filings with the IRS or other tax authorities around cost sharing arrangements.
- How and when to treat changes in U.S. state and local tax returns.
- How and when to treat the adjustments in foreign tax returns.
- Treatment of SBC cost sharing adjustments in Country by Country filings currently and in the past.
Some of the changes that companies may need to consider will also be informed by what those same taxpayers did when the 2003 regulations were invalidated by the original Tax Court decision or by the CSA agreement terms that the parties have around changes in the tax position on this issue. Hopefully many companies would have contemplated much of this after the previous “false start” associated with the initial withdrawn decision. Regardless, it may be a busy time for many tax departments to assimilate the impact of the decision through their arrangements and numerous filing positions.
Going forward, the net tax effect of the portion of SBC cost that is shared through cost sharing is not as impactful as it was in the past with reduced tax rate differentials between U.S. and non-U.S. income. Foreign profits will be reduced, reducing GILTI income, and the additional U.S. income will potentially be eligible for FDII deductions. TCJA, however, has many complex interactions, so each taxpayer will need to review the impact on their tax profile.
The Ninth Circuit’s decision also directly affects the later amendments to the cost sharing regulations under Treas. Reg. §1.482-75 finalized in December 2011 (2011 CSA Regulations), which include the exact same SBC inclusion language. It also may be an indication of how the Ninth Circuit could approach other cases still before it and future cases. For example, the Amazon case, in which the Tax Court found in favor of the taxpayer referencing comparable uncontrolled transactions over IRS arguments to apply more formulary than transactional benchmarked valuation concepts and methods under the 2011 CSA Regulations which were not effective at the time.6 Future cases directly under the 2011 CSA Regulations will include consideration of its changes that arguably make conforming CSA’s an elective. These regulations also require consideration of the realistic alternatives of the parties and state that selected methods for the valuation of a transfer of intangible property and intangible development rights under CSAs under Treas. Regs. §§ 1.482-4 and 1.482-7 should in aggregate yield results consistent with the specified Income Method; the Income Method being a results-based rather than comparable-based valuation approach.7 It also impacts the application of the TCJA on intangibles valuation which made more fundamental changes to the list of compensable intangibles and codified many of the previously mentioned regulatory changes around aggregation and realistic alternatives.
Internationally, the OECD transfer pricing guidance on cost contribution arrangements is largely silent on the issue of SBC costs. Among individual countries, the view and treatment of SBC’s as a cost is mixed. Some, like the UK, have positions similar to the U.S. Treasury; other countries, like Canada, seemingly not. There seems to be a trend among countries addressing the impact of SBC’s towards their recognition as a cost for financial reporting GAAP purposes which then often leads to similar positions for tax and transfer pricing as can be seen in India. With respect to cost sharing, with inclusion of SBC’ in financial reporting costs, there is an increased likelihood of observable arrangements between unrelated parties that include SBC costs while many may still expressly exclude them because of their nature and the subjectivity around valuation. The same likelihood of observations for the treatment of SBC’s as costs is true of services, however, it seems unlikely that the U.S. Federal Acquisition Regulation will be amended to allow inclusion of SBC’s in cost-based service fee arrangements it enters into with its unrelated contractors and suppliers.8
Perhaps more importantly, a further secondary consequence of this decision may well be to fuel on-going debate over the applicability and use of the arm’s length standard in the international community which is still trying to find consensus and under heavy pressure within the OECD BEPS Action 1 initiative and debate around the future taxation of the digital economy. In particular, it may embolden the use, and potential abuse, of results based non-transactional or methods, including the profit split methods, by tax authorities that prefer allocation-based methods in cases involving intangible contributions. The reliability of these methods and their consistency and relationship with the arm’s length standard seems to be the key to any international consensus, and the Altera decision.
While Treasury are probably very pleased with the outcome of the Altera case, many taxpayers and practitioners are surprised by the decision, and opinion is certainly divided. A continuation of the dispute seems possible and, regardless of this case, the issue and what it represents more broadly will continue to be the subject of considerable ongoing debate.
1The Tax Court Case was Altera Corp. v. Com’r., 145 T.C. 91 (2015)
2T.D. 9456, 1.482-9 Treatment of Services Under Section 482; Allocation of Income and Deductions from Intangible Property; Apportionment of Stewardship Expense (26 CFR Parts 1 and 31, and 602)
3Many companies put in claw back payment provisions for cost shared SBC’s with specific triggering events when the 2003 CSA SBC regulations were promulgated. When the Xilinx and/or Altera Tax Court decisions came out many companies stopped sharing SBC costs and may have also included additional adjustment terms in the event that SBC’s were later found to be chargeable.
4H.R. 1, Public Law 115–97 (12/22/2017)
5T.D. 9568, 1.482-7 Section 482: Methods to Determine Taxable Income in Connection With a Cost Sharing Arrangement (26 CFR Parts 1, 301 and 602)
6We note that the Ninth Circuit did not try and apply the regulations retroactively in the Xilinx case, and we hear again Judge Foley’s comments in the opinion in the Veritas case about taxpayers needing to be “compliant but not prescient”.
7Consideration the realistic alternatives of the parties and aggregation were both part of the 1994/1995 rewrite of the Treasury regulations under IRC §482 but the terms were only added to the language of IRC §482 as part of the TCJA at the end of 2017.
8FAR 31.205-6(i) deems compensation based upon stock performance strictly an unallowable cost, stating in part: “Any compensation which is calculated, or valued, based on changes in the price of corporate securities is unallowable.”