On June 22, 2020, the Supreme Court declined to hear the appeal of Altera (now owned by Intel) of the Ninth Circuit’s decision in Altera Corporation v. Commissioner. The Court’s action on this appeal, which dealt with the technical issue of the validity of tax regulations allocating the cost of stock-based compensation under cost sharing agreements (CSAs), will affect the tax treatment of billions of dollars of stock-based compensation.
Brief history of cost-sharing agreements
Under US tax transfer pricing rules, if a US corporation develops an intangible asset and transfers it to a foreign affiliate, the US transferor generally must recognize as income a deemed royalty based on the use or productivity of the intangible. Treasury Regulations on CSAs provide an alternative to these general rules. Under a CSA, members of multi-national groups split the costs of developing new intangible assets in exchange for rights to those assets in their respective jurisdictions. Thus, if a US corporation develops an intangible under a CSA with its foreign affiliates, the US corporation need not report any royalty income or otherwise charge an arm’s length price for use of the intangible by those affiliates in their jurisdictions. CSAs have become important tools for multinational groups—particularly technology and pharmaceutical groups—in managing transfer pricing issues that arise when they develop intellectual property in the US for use by their foreign affiliates. By sharing developments costs under CSAs, they avoid the need to determine “arm’s-length” royalties for that use. US taxpayers using CSAs nonetheless must reduce their deductions (or, equivalently, recognize income) for the share of development costs properly borne by foreign affiliates. Thus, US taxpayers using CSAs have a strong incentive to minimize the amounts that their foreign affiliates must contribute to such costs.
CSAs have long been controversial because they are seen as facilitating shifting profits from intangibles outside US taxing jurisdiction. Senate subcommittee reports in 2012 and 2013 criticized cost sharing agreements used by prominent US multinationals as understating—and under-allocating to foreign affiliates—the true costs of developing new intangibles. The Internal Revenue Service litigated the terms of CSAs in Veritas Software Corp. v. Commissioner (2009), Xilinx Inc. v. Commissioner (2010) and Amazon.com Inc. v. Commissioner (2019), but lost all three of these cases in the Tax Court or the Ninth Circuit. The decisions in these cases turned on the appropriateness of the methodology used by the IRS to challenge the terms of CSAs; in each case the court upheld the taxpayer’s determination of payments required by foreign affiliates. The US Treasury Department substantially updated the regulations on CSAs in 2003 and again in 2011, and tax reform legislation enacted at the end of 2017 amended section 482 of the Internal Revenue Code (the section that governs transfer pricing) to support theories that the IRS had advanced unsuccessfully to require greater income recognition by US companies transferring intangibles to foreign affiliates.
Cost-sharing and stock-based compensation
The Xilinx case, decided by the Ninth Circuit in 2010, addressed the treatment of stock-based compensation expense as a cost in CSAs, but the CSA in that case was governed by the regulations in effect prior to 2003; those regulations did not specifically address stock-based compensation. In Xilinx, the Tax Court determined that unrelated parties would not share costs related to stock-based compensation, and that the IRS’s position that Xilinx and its non-US affiliates had to share stock-based compensation costs under a CSA—thereby increasing the taxable income of the US developer—was “arbitrary and capricious” and therefore invalid. The Ninth Circuit affirmed the Tax Court.
As Xilinx was being litigated, however, Treasury amended the transfer pricing regulations to specifically address stock-based compensation under CSAs and require that foreign parties bear a portion of that cost. Altera involved a CSA entered into after the 2003 regulations had been finalized; because the regulations had been finalized, Altera dealt with the narrow issue of whether the 2003 regulations on stock-based compensation were valid. The Tax Court found that the 2003 regulations were invalid, because in adopting the 2003 regulations, the Treasury had concluded that unrelated parties would share stock-based compensation costs but had not articulated a basis for this conclusion. On its subsequent appeal to the Ninth Circuit, however, the IRS adopted a new position—that in adopting regulations, the Treasury did not need to consider how unrelated parties would behave (that is, it is permitted to allocate costs under a CSA with no analysis of comparable transactions). The Ninth Circuit accepted this argument, reversing the Tax Court’s decision, and holding that the 2003 regulation was valid. With the Supreme Court’s refusal to hear Altera’s appeal on June 22, the Ninth Circuit’s ruling is now final.
Outlook for cost-sharing agreements
Altera may be a turning point for CSAs and transfer pricing. Prior cases, such as Xilinx and Amazon, had adopted a narrow view of the government’s ability to contest transfer pricing. The Ninth Circuit’s decision in Altera, however, adopts a more permissive approach, which gives the IRS more scope to challenge transfer pricing without necessarily referring to arm’s length standards. Furthermore, the adoption of revised transfer pricing regulations in 2003 and 2011 and the 2017 amendment of section 482 itself signals that the pendulum may now have swung in the government’s favor on transfer pricing methodologies. For the time being, the issue of how to allocate the costs of stock-based compensation in CSAs appears settled—at least in the Ninth Circuit. Going forward, taxpayers should consider other aspects of CSAs carefully, and may wish to consider entering into Advanced Pricing Agreements (APAs) with the IRS to pre-agree the terms of CSAs.
If CSAs become less attractive, multinational groups may also wish to reconsider how they develop and hold intangible assets. The decision in Altera will substantially reduce the tax benefits of CSAs for many technology and pharmaceutical companies and increase the tax costs of moving intangibles outside the US. The “global intangibles low taxed income” (GILTI) provisions introduced by the 2017 tax reform act have also made ownership of intangibles outside the US more expensive for US-based groups. On the other hand, the reduction of the headline US corporate tax rate and the introduction of the foreign-derived intangibles income (FDII) deduction makes ownership of intangibles in the US significantly more attractive than before 2017. The Altera decision—effectively final as of June 22—and its impact on the tax costs of owning US-developed offshore may serve as a catalyst for the restructuring of ownership of intangibles by multinational groups.
