IRS Releases Memo on Cost-Sharing Arrangements and Inclusion of Stock-Based Compensation Costs

In a memorandum released on July 16, 2021, the IRS Office of Chief Counsel addressed its views on the treatment of stock-based compensation (SBC) costs in cost-sharing arrangements (CSAs) that include a "reverse claw-back" provision but do not share SBC costs (non-SBC CSAs).

Under the cost-sharing rules, controlled parties may enter a CSA to share the costs and risks associated with the development of intangibles in proportion to each party's share of reasonably anticipated benefits (RAB) expected to result from use of these cost-shared intangibles. The cost-sharing regulations provide that the results of a CSA are consistent with the arm's length standard only if, among other requirements, each controlled participant's share of intangible development costs (IDCs), which includes SBC, is proportionate to its RAB share.

In the context of a CSA, "claw-back" provisions generally allow a taxpayer to remove, or claw back, SBC included in the cost pools if the 2003 SBC regulation is any of the following:

1. Invalidated as the result of a final decision in a court of law
2. Revised
3. Withdrawn

"Reverse claw-back" provisions, on the other hand, generally provide that taxpayers who excluded SBC from their cost pools may later include those SBC amounts upon a certain triggering event (such as a final decision in the Altera case) and make a true-up payment to reflect the sum of SBC costs that should have been shared in prior years.

Highlights of the Memorandum

The IRS takes the position that SBC should be included in the cost pools under the cost-sharing regulations. The IRS further asserts that it can adjust the results of a cost-sharing transaction in the year in which IDCs were incurred under Treas. Reg. Section 1.482-7(i)(2), regardless of whether there is a reverse claw-back provision. In support of this position that it can ignore the terms of reverse claw-back provisions, the IRS asserts that excluding SBC would result in an imbalance between IDC shares and RAB shares in any given year of exclusion.

Further, the IRS specifically addresses the following covered issues that may arise when the IRS makes the adjustment: (1) the correct year to include the SBC costs in the cost pool; (2) whether the adjustment affects the taxpayer's true-up obligation amount; and (3) whether the IRS can make an adjustment in a different year if it is unable to do so in the year the IDCs were incurred because the period of limitations on assessments has expired.

In the memo, the IRS concludes that, under Treas. Reg. Section 1.482-7(i)(2), it may make allocations to adjust the results of a CST so that each controlled taxpayer's IDC share for each tax year is equal to its RAB share. In connection with the above covered issues, the IRS argues that:

1. The allocation must be reflected for tax purposes in the year in which the IDCs were incurred.
2. The allocations should be treated as reducing the amount of the taxpayer's reverse claw-back true-up obligation by a corresponding amount in order to avoid an overpayment of the SBC costs.
3. If the adjustments cannot be made in the year the IDCs were incurred, the IRS may make other adjustments in the year of the taxpayer's triggering event to reflect the terms of a controlling agreement or ensure that the non-SBC CSA agreement produces results that are consistent with an arm's length result.

Financial Impacts and Timing

So, what is the real impact to companies and taxpayers moving forward? We outline some key items below:

• Reverse claw-backs - Taxpayers should review their CSA in light of reverse claw-back provisions and determine if adjustments should be made to retroactively share SBC costs.
• Generally, adjustments to cost-sharing transactions should be allocated to the tax years in which the IDCs were incurred, meaning amending tax returns for open years.  Taxpayers can consider filing an amended return sharing SBC before it is under examination by the authorities. A taxpayer cannot file a qualified amended return (QAR) for a year under examination.
• Any Section 482 adjustments to share SBC could reduce earnings and profit in the foreign participant – leading to adjustments in Section 965 calculations or reducing tested income in Section 951A calculations.
• Taxpayers may face double taxation if the SBC expenses cannot be deducted in the current year or prior years in the foreign jurisdictions.
• ASC 740 - Generally, most taxpayers should have accrued a tax provision for the additional income and interest in the U.S. if SBC had been included in the cost-sharing arrangements, based on the Ninth Circuit decision and subsequent denial of Altera’s petition for a writ of certiorari by the U.S. Supreme Court.
• Penalties - Taxpayers that have not been sharing the costs of stock-based compensation may be exposed to penalties. Penalties that could apply include the penalty for negligence or disregard of the regulations (20%) and the transfer pricing net adjustment penalty (20% or 40%). If taxpayers have not been including SBC expenses in their CSAs, existing transfer pricing documentation does not preclude the IRS from asserting penalties since the taxpayer did not follow the relevant requirements under Section 482.

The impact of including SBC in the CSA should be reviewed for prior year tax returns, current year-end estimated tax payment calculations, and other reporting requirements.

For questions or assistance, contact our tax experts.