Tax Court Rules "No" for Cost Sharing of Stock Options

On July 27, 2015, the US Tax Court served another blow to the long-standing position of the IRS and 2003 cost-sharing regulations.

In Altera Corp. v. Commissioner, a panel of 15 judges agreed with the taxpayer, Altera, that unrelated parties in a qualified cost sharing arrangement that are operating at arm’s length shouldn’t be required to share stock-based compensation (SBC) costs. The ruling went against the regulations’ requirement that SBC expenses must be shared among parties engaged in so-called qualified cost-sharing agreements (QCSA). In surprisingly strong language, the court granted summary judgment relief to the taxpayer and deemed the 2003 cost-sharing regulations invalid.

The decision, which favors the taxpayer, has broad implications for taxpayers engaged in cost-sharing arrangements.

Next Steps

Pending an appeal by the IRS, taxpayers now have a much clearer authority to exclude SBC-related costs from their cost-sharing calculations. For some taxpayers, particularly publicly traded technology companies, the amount of tax deductible expense lost due to sharing SBC costs has been material.

Review Cost-Sharing Calculations

Taxpayers may wish to review their cost-sharing calculations for all open years. If SBC-related costs were included in the calculations, taxpayers may want to consider if there’s an opportunity to amend tax returns to claim additional deductions with respect to those SBC-related costs. In addition, taxpayers may wish to consider explicitly altering the terms of currently existing cost-sharing agreements in order to benefit from the authority of the Altera case.

Account for Financial Statement Impact

The Altera verdict may also impact tax provisions for financial statement reporting. If you don’t include SBC-related costs in your cost-sharing calculations, then you should account for it as a provision on your financial statement.

Background on Cost Sharing and SBC

For many years, the IRS maintained that participants in a “valid” cost-sharing agreement must include SBCs—stock options or stock appreciation rights, for example—in the base of costs to be shared, despite scant evidence that third parties engaged in similar transactions would ever agree to share such costs. For US taxpayers, such a requirement has the practical effect of making cost sharing with a foreign entity more expensive due to the loss of US tax deductions for such noncash compensation.

In Xilinx Inc. v. Commissioner, the court held—while applying the previous version of the cost-sharing regulations from 1995—that controlled entities entering into QCSAs needn’t share SBC-related costs because parties operating at arm’s length would likely not do so.

In response to its loss in the Xilinx case, the IRS issued the 2003 cost-sharing regulations that explicitly stated that SBC-related costs must be shared under QCSAs.

The result of Altera further reinforces the Xilinx position that SBC-related expenses shouldn’t be included in the calculations when allocating intangible development costs pursuant to a QCSA.

The difference between the Xilinx and Altera cases is that the Xilinx ruling was under the 1995 cost-sharing regulations, which didn’t explicitly require the sharing of SCB costs, whereas the Altera ruling comes under the newer 2003 cost-sharing regulations, in which the IRS used its regulatory authority to explicitly include a rule requiring the sharing of SBC costs.

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