Monday, March 24, 2008

Whether the expenses of compensatory stock options constitute intangible development costs that must be included in the costs to be shared in a qualified cost sharing arrangement under Treas. Reg. §1.482-7. The IRS disagrees with the result in Xilinx Inc. v. Commissioner , 125 T.C. 37 (2005),

Qualified cost-sharing arrangement : Intangible development costs : Stock options .

Internal Revenue Service

United States Department of the Treasury

Cost Sharing Stock Based Compensation


Effective Date: March 20, 2008




UIL 482.11-13


Whether the expenses of compensatory stock options constitute intangible development costs that must be included in the costs to be shared in a qualified cost sharing arrangement under Treas. Reg. §1.482-7.


The taxpayer, a U.S. corporation, is the parent of an affiliated group of domestic and foreign corporations (USP). USP enters into a qualified cost-sharing arrangement (QCSA) with a foreign subsidiary pursuant to Treas. Reg. §1.482-7. The QCSA provides that the parties will share all costs related to intangible development of the covered intangibles, including but not limited to, salaries, bonuses, and other payroll costs and benefits. The taxpayer includes all forms of compensation in the cost pool except those costs related to stock-based compensation.



I.R.C. §482 consists of two sentences. The first sentence authorizes the Secretary to allocate income and deductions among commonly controlled organizations as necessary to clearly reflect the income of such organizations. The second sentence prescribes that, "[i]n the case of any transfer or license of intangible property, the income with respect to the transfer or license shall be commensurate with the income attributable to the intangible(s)."1 Congress added this second sentence in 1986, after noting the recurrent problem of the absence of comparable arm's length transactions between unrelated parties. The purpose for the 1986 commensurate with income amendment was to ensure an allocation of intangibles income between commonly controlled entities that reasonably reflects the relative economic activity undertaken by each and thus remedy the inappropriate reliance on comparables. H.R. Conf. Rep. No. 841, 99\th/ Cong., 2d Sess. (1986).

The 1986 addition of the second sentence to I.R.C. §482 was part of the impetus behind Notice 88-123 (the "White Paper"), the 1992 proposed cost sharing regulations,2 and ultimately, the final 1995 cost sharing regulations.3 Under the 1995 regulations, a cost sharing arrangement is an agreement under which the parties (1) allocate economic exploitation rights with respect to any intangibles that may be jointly developed under the agreement, and (2) agree to share costs of such development in proportion to the benefits each party reasonable expects to realize from its economic exploitation of those rights.4 Controlled parties must share all costs (except as specifically excluded by the regulations) related to the applicable intangible development activity in order for Treas. Reg. §1.482-7 to apply.5 Transactions wherein parties share only some costs of the applicable intangible development are not qualified cost sharing arrangements and may be evaluated under Treas. Reg. §§1.482-4 through 1.482-6.6

Under the 1995 regulations, whether stock-based compensation (SBC) is a cost to be shared under Treas. Reg. §1.482-7 depends on whether SBC is in fact a cost, and whether the SBC is related to the intangible development activity. The Service has consistently considered SBC to be a cost under Treas. Reg. §1.482-7. While taxpayers often argue that SBC is not a cost to be shared, it is quite clear that the regulations include all operating expenses, as defined by Treas. Reg. §1.482-5(d)(3), except depreciation or amortization expense. Employee compensation is an expense under Treas. Reg. §1.482-5(d)(3). To the extent a taxpayer offers employee stock options as part of its compensation package, such employee stock options are also includible as employee compensation expenses under Treas. Reg. §1.482-5(d)(3). For employees whose services were related to the intangible development at issue in the cost sharing arrangement, the SBC costs must be included in the pool of costs to be shared.

In general, the Service has measured SBC expense for compensatory stock options under the 1995 regulations in terms of the "spread" value (the amount of the "spread" between the fair market value on the date of exercise and option's exercise price) or the "grant date" value (using the "fair value" approach of Statement of Financial Accounting Standards No. 123 (SFAS 123)). Other methods could be used to measure the SBC expense, if the taxpayer is able to establish the reasonableness of such method and consistently applies such method.7


In Xilinx Inc. v. Commissioner , 125 T.C. 37 (2005), the taxpayer prevailed in the Tax Court in a case of first impression involving the 1995 cost sharing regulations. The Tax Court held that the Commissioner's adjustments to include SBC in the pool of shared costs pursuant to a QCSA were "arbitrary and capricious" because they were contrary to the arm's length standard mandated by Treas. Reg. §1.482-1(b). On the basis of expert testimony, the Tax Court opined that uncontrolled parties would not share the spread or the grant date value of SBC. In reaching its conclusion, the Court assumed for the purposes of its opinion that SBC was a "cost."

The Commissioner disagrees with the Tax Court's interpretation of Treas. Reg. §§1.482-1(b) and 1.482-7, and has appealed the Tax Court's decision to the U.S. Court of Appeals for the Ninth Circuit (Ninth Circuit). The Commissioner believes that its adjustments to include SBC costs under Xilinx's QCSA were in accordance with the requirements of Treas. Reg. §§1.482-1(b) and 1.482-7. In the event of a "final" Ninth Circuit decision holding that the Commissioner's adjustments to include SBC in the pool of Xilinx's shared costs were improper, such decision would be binding only on cases that involve the application of the 1995 cost sharing regulations and that are within the appellate jurisdiction of the Ninth Circuit. For cases under the 2003 SBC Regulations, such a decision would not be controlling. For controversies subject to the appellate jurisdiction of circuits other than the Ninth, such a decision would not be controlling.


The 1995 cost sharing regulations, while requiring all intangible development costs (except as specifically excluded by the regulations) to be included in the cost pool, did not affirmatively include SBC. Final regulations promulgated on August 26, 2003, T.D. 9088 (the 2003 SBC Regulations) clarified that SBC must be taken into account in determining the operating expenses treated as intangible development costs of a controlled participant in a QCSA under Treas. Reg. §1.482-7.

The preamble to the 2003 SBC Regulations described Congress's intent with respect to cost sharing arrangements.

The legislative history of the Tax Reform Act of 1986 expressed Congress's intent to respect cost sharing arrangements as consistent with the commensurate with income standard, and therefore consistent with the arm's length standard, if and to the extent that the participants' shares of income "reasonably reflect the actual economic activity undertaken by each." See H.R. Conf. Rep. No. 99-481, at II-638 (1986)....In order for the costs incurred by a participant to reasonably reflect its actual economic activity, the costs must be determined on a comprehensive basis. Therefore, in order for a QCSA to reach an arm's length result consistent with legislative intent, the QCSA must reflect all relevant costs, including such critical elements of cost as the cost of compensating employees for providing services related to the development of the intangibles pursuant to the QCSA.

See T.D. 9088 (August 26, 2003).

In other words, a QCSA produces an arm's length result if, and only if, the requirements of Treas. Reg. §1.482-7 are met.8 Consequently, the 2003 SBC Regulations clarified the existing 1995 regulations by stating directly that parties to a QCSA must share all intangible development costs, including SBC. To wit, stock based compensation was specifically listed as a cost to be shared.9

The 2003 SBC Regulations further clarify that under Treas. Reg. §1.482-1(b)(2)(i), relating to arm's length methods, that Treas. Reg. §1.482-7 is the specific method to be used to evaluate whether a QCSA produces results consistent with an arm's length result.10

The determination of whether stock-based compensation is related to the intangible development area within the meaning of Treas. Reg. §1.482-7(d)(1) is generally made as of the date of grant.11 Accordingly, all stock-based compensation that is granted during the term of the qualified cost sharing arrangement and is related (at date of grant) to the development of intangibles covered by the arrangement is generally included as an intangible development cost under Treas. Reg. §1.482-7(d)(1).12

The regulations provide guidance concerning the measurement and timing of the SBC expense. Generally, the amount of the SBC includible as intangible development costs under a QCSA is the amount allowable as a federal income tax deduction with respect to the SBC.13 As discussed above, with respect to compensatory stock options, this amount is generally referred to as the "spread at exercise."14 With respect to statutory stock options (i.e., incentive stock options and employee stock purchase plan stock options), the spread generally is taken into account for QCSA purposes on exercise, even though I.R.C. §421 denies a deduction.15

Alternatively, taxpayers may elect to take into account all operating expenses attributable to SBC on publicly traded stock in the same amount, and at the same time, as the fair value of the stock options reflected as a charge against income in audited financial statements or disclosed in footnotes to such financial statements.16 In Notice 2005-99, the IRS extended this elective method to restricted shares and restricted share units within the meaning of Statement of Financial Accounting Standards No. 123 (revised 2004, SFAS 123R).


On January 12, 2004, Communications, Technology and Media Industry Director issued an Industry Director Directive ("IDD") that reinforces the Service's long-standing position of including SBC in the pool of costs to be shared. For the reasons set forth in this coordinated issue paper and the 2004 IDD, the audit approach set forth in the directive should continue to be followed.

1 I.R.C. §482.

2 Prop. Treas. Reg. §1.482-2(g) (1992).

3 See T.D. 8632, 1996-1 C.B. 85.

4 See Treas. Reg. §1.482-7(a)(1) (1995).

5 Treas. Reg. §1.482-7(b)(2) and (d)(1).

6 Alternatively, Treas. Reg. §1.482-7(a)(1) permits the Commissioner to apply Treas. Reg. §1.482-7 to arrangements that in substance constitute cost sharing arrangements, notwithstanding a failure to comply with any of that section's requirements.

7 See FSA 200003010 .

8 Treas. Reg. §1.482-7(a)(3) states: Coordination with §1.482-1 . A qualified cost sharing arrangement produces results that are consistent with an arm's length result within the meaning of §1.482-1(b)(1) if, and only if, each controlled participant's share of the costs (as determined under paragraph (d) of this section) of intangible development under the qualified cost sharing arrangement equals its share of reasonably anticipated benefits attributable to such development (as required by paragraph (a)(2) of this section) and all other requirements of this section are satisfied.

9 Treas. Reg. §1.482-7(d)(2)(i).

10 Treas. Reg. §1.482-1(c)(1).

11 Treas. Reg. §1.482-7(d)(2)(ii). Cf . Notice 2005-99, 2005-2 C.B. 1214.

12 Id.

13 Treas. Reg. §1.482-7(d)(2)(iii)(A).

14 See I.R.C. §83.

15 Treas. Reg. §1.482-7(d)(2)(iii)(A)(1).

16 Treas. Reg. §1.482-7(d)(2)(iii)(B).

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