The IRS recently issued three Private Letter Rulings (PLRs) consenting to taxpayers’ requests to change from the default spread-at-exercise method to the elective fair value method for purposes of determining the measurement of stock based compensation (SBC) included in the taxpayers’ Cost Sharing Arrangement (CSA) cost pools.i
Below, we briefly review the background of the requirement to include SBCs in the CSA cost pool, provide an overview of the default and elective methods for measuring SBCs, and discuss these three recent PLRs. We conclude by considering circumstances in which requesting a method change may be advantageous to the taxpayer.
Background: Xilinx, the 2003 CSA regulations and Altera
The inclusion of SBC costs in CSA cost pools has been a long-standing area of controversy with the IRS. The IRS lost a court battle against Xilinx, the US semiconductor company, when both the Tax Court and the Ninth Circuit (reversing their own original decision) found that the IRS requirement to include SBC costs in a CSA cost pool was contrary to the arm’s length standard required under the transfer pricing rules.
In 2003, during the Xilinx controversy, the IRS issued new regulations that required the inclusion of SBC costs into CSA cost pools. The 2003 rules are being challenged by Altera, another US semiconductor company; the case is currently pending.
SBC measurement methods: Commissioner’s consent required to change
The Section 482 cost sharing regulations provide that the default method for determining the measurement of SBC costs is typically the amount that would be allowed as a deduction – for example, with respect to stock options, the spread between the stock option exercise price and the fair market value at time of exercise – an amount commonly known as spread-at-exercise. Alternatively, the regulations permit public companies to elect the use of the fair value method of measuring SBC in accordance with the Statement of Financial Accounting Standards No. 123 (rev. 2004), commonly known as FAS123R.ii The regulations further provide that any change in SBC measurement method, including revocation of a previous election, is permitted only prospectively and only with the consent of the Commissioner.
Recent rulings: PLR 201311001, PLR 201311018 and 201312024
The facts and circumstances in each of these PLRs were different. iii For example, the facts as described in PLR 201311001 indicate that the taxpayer intended to elect the SFAS123R method, but discovered it had failed to do so. It subsequently requested consent to prospectively use the elective method.
In PLR 201311018, the taxpayer at issue was a public company that underwent a restructuring of its foreign operations after entering into a CSA; one of the controlled participants in the CSA had been replaced, and the PLR noted that the taxpayer anticipated further restructuring in the future. The taxpayer requested consent to prospectively switch to the elective method.
Lastly, with respect to PLR 201312024, the taxpayer, a domestic corporation, was a private company when it entered into a CSA with a subsidiary. Post-IPO, the taxpayer adopted a new SBC plan and requested consent to prospectively use the elective method. The PLR noted that the SFAS123R method of SBC measurement was consistent with the taxpayer’s measurement for financial reporting purposes.
In each of these PLRs, the IRS granted prospective consent to use of the elective method, in part based on a series of representations made by each taxpayer. It should be noted that none of the rulings indicated whether the change benefitted the taxpayer (for example, by reducing tax liability). Each PLR stated that the regulations provide the election must be made by specific reference in the CSA documentation required under Treas. Reg. 1.482-7(k)(1) or by written amendment to the CSA entered into with the consent of the Commissioner.
Prospective consent to change measurement methods
The recent rulings indicate that prospective consent to measurement method changes may be granted, including in the event of altered taxpayer circumstances. Consequently, taxpayers that entered into a CSA while a private company and that have subsequently gone public or those companies that have undergone restructuring since entering into a CSA should consider whether they would benefit by using the elective method for SBC measurement.
It is important to note, however, that any method change with respect to SBC measurement, including revocation of a previous election, requires the consent of the Commissioner. The granting of consent is not assured. Any decision to change methods should be made with that fact in mind.iv