Equity Compensation in Cost Sharing Arrangements: The Altera Supreme Court Case
Cost-sharing agreements, or CSAs, are rarely the subject of front-page news. Typically they remain obscured in the complex, behind-the-scenes world of corporate tax strategy. However, the accounting for equity compensation within CSAs has entered the spotlight over the past year.
On June 22, 2020, the US Supreme Court announced that it would not hear the Altera Corp. v. Commissioner case emanating from the Ninth Circuit. Many companies have been waiting for the result to determine the next course of action. But if your company isn’t among those following this case closely given everything happening in the world this past year, let’s quickly recap and see why it might be relevant to you.
In 2003, the Internal Revenue Service issued regulations that require stock-based compensation costs to be included in any qualified CSA, or QCSA, and therefore to be shared among related parties. At the time, Altera Corp., a semiconductor company headquartered in the US, was six years into a 10-year research and development CSA with Cayman Islands-based Altera International. During this period, Altera issued stock-based compensation (SBC) to employees engaged in the cost-shared activities but did not include SBC expense in the cost-sharing with Altera International. The IRS notified Altera that this was noncompliant and instructed Altera to include the SBC in the cost-sharing. Altera decided to challenge the 2003 Regulations in the US Tax Court.
On July 27, 2015, the Tax Court ruled that the IRS could not require related parties to include SBC costs within cost-sharing agreements because the IRS had not proven that this requirement existed in transactions between unrelated parties. Upon appeal, on June 7, 2019, the Ninth Circuit Court of Appeals reversed that ruling. On February 10, 2020, Altera filed a petition to the Supreme Court to review the Ninth Circuit’s ruling. The Supreme Court denied Altera’s petition on June 22, 2020, likely putting an end to Altera’s claim and leaving many other companies with potential tax liabilities.
Background on CSAs
Although some readers may already be familiar with CSAs, we’ll provide a brief review to help explain why Altera was fighting this case and how the Supreme Court’s decision may affect other companies. According to the IRS, “A cost-sharing arrangement is an agreement under which the parties agree to share the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement.”
There are many benefits that come with cost-sharing, especially for multinational companies. US-based corporate headquarters often have vast resources and expertise to perform R&D activities that will generate revenue in the future. Cost-sharing allows foreign subsidiaries to share in the profits from these developed intangibles without having to invest the same resources or reimburse the US parent for future overseas profits.
Typically, the US parent will enter into a CSA with a low or no-tax jurisdiction, and the agreement will stipulate that a portion of the pooled cost will be allocated to the foreign jurisdiction. A payment is then required from the foreign subsidiary to the parent based on the estimated future income from the shared intangibles. From a tax perspective, this type of arrangement can reduce the company’s global effective tax rate by minimizing the US taxable income, as the US parent can transfer a certain amount of income generated from the agreed intangibles to jurisdictions with lower tax rates.
The rationale in cost-sharing is clear. By allocating certain expenses to low-tax jurisdictions, companies also get to allocate a portion of income to those jurisdictions. As long as the tax savings on the income is greater than the deductions lost, there is an economic benefit.
As an example, consider a company headquartered in the US spending $200 million to develop intangibles that can benefit both the US parent (which has a 20% tax rate) and a foreign subsidiary (which has a 10% tax rate). If the present value of the estimated revenues are $300 million for the parent and $100 million for the subsidiary, this implies that the subsidiary will share in 25% of the revenue ($100 million for the subsidiary divided by the total of $400 million). Therefore, the subsidiary shares in 25% of the cost, or $50 million ($200 million * 25%). This amount is paid by the subsidiary to the parent. The global tax impact in this case would a net $5 million liability, calculated as $10 million for the US parent ($50 million income to the parent multiplied by the parent’s 20% tax rate) less $5 million savings for the subsidiary ($50 million deduction for the subsidiary multiplied by its 10% tax rate).
Without a CSA, the subsidiary would have paid the entire $100 million in present value terms to the parent. In that case, the company’s net tax payments would have been be $10 million ($100 million * 20% for the parent, less $100 million * 10% for the subsidiary), or twice as much. The tax savings can be simplified as the profit transferred from the parent to the subsidiary multiplied by the difference in tax rate: $50 million * (20%-10%). The larger the difference in tax rates, the larger the savings.
Tax Reporting Implications
It’s only natural that companies want to recognize income in lower-tax jurisdictions and recognize expense in higher-tax jurisdictions. This explains why companies would prefer not to include equity compensation in cost-sharing. However, now that the Supreme Court has deferred to the Ninth Circuit, the tax implications need to be considered. There are generally two methods for sharing SBC costs, using the actual tax deduction (exercise date method) or using the book expense (grant date method).
Consider a CSA where an overseas affiliate in a jurisdiction with zero taxes on corporate earnings is reimbursing the parent for 30% of a pool of costs which includes SBC. Assume the company has elected to include amounts in their cost pool based on the actual tax deduction (the so-called exercise date method). In this situation, the company should record a deferred tax asset for only 70% of the book expense, since the US company will effectively receive a tax deduction for only 70% of the SBC. Upon settlement of the SBC, the subsidiary will reimburse the parent for 30% of the full tax deduction and will not realize any benefit for the payment due to its zero-percent tax rate.
If the company instead elects the so-called grant date method, whereby the amount included in the cost pool is based on book expense, the foreign subsidiary will make payments to the US parent equal to 30% of the related book expense as it’s recorded. This payment will be subject to tax in the US at the time it’s made, and the deferred tax accounting will be the same as it would be absent the CSA.
Identifying and tracking the impact of CSAs can be time-consuming and complicated under the exercise date method since it’s dependent on individual settlement events. In addition, under the exercise date method, companies will incur a higher tax liability when the tax deduction exceeds the book expense because the subsidiary is reimbursing a larger amount to the high-tax parent. The grant date method is much simpler, though it accelerates the payment of additional taxes since the reimbursement is made over the vesting period as opposed to waiting until there is a settlement event. The grant date method may also result in payments being made for options that expire worthless. Companies that have entered into CSAs should consider all of these factors before deciding which approach to take.
In light of the Supreme Court’s deference to the Ninth Circuit, affected companies must carefully review their CSAs and associated SBC costs, on a retrospective basis. While there is likely to be more litigation on this topic, and technically the Tax Court’s decision offers favorable precedent to companies outside the purview of the Ninth Circuit, companies should expect the IRS to enforce cost-sharing of SBC expense across all jurisdictions. For that reason, we recommend that companies evaluate their facts and circumstances in order to form a robust strategy. If you have any questions or need assistance tracking expenses, deductions, and/or mobility, please feel free to reach out.