Multi-national tech companies like Google, Facebook, Amazon, and Apple will pay billions of dollars in additional taxes as a result of the Supreme Court’s recent refusal to review the Ninth Circuit Court of Appeal’s decision in Altera Corporation & Subsidiaries v. Commissioner, 2019-1 USTC ¶ 50,231, 926 F.3d. 1061 (2019), cert. denied June 22, 2020. These additional taxes will apply to stock based compensation (SBC) in transactions with foreign subsidiaries governed by the transfer pricing rules.
The treatment of SBC costs for transfer pricing purposes is a common issue among high tech companies that develop intangible property with related foreign subsidiaries (usually located in low-tax-rate jurisdictions). However, this issue may also affect other industries that issue SBC in connection with a joint intangibles project.
Ninth Circuit’s Altera Decision Reversed Taxpayer’s Tax Court Victory
In Altera, the Ninth Circuit in a 2 -1 “panel decision” issued on June 7, 2019, reversed a unanimous (15-0) Tax Court decision (145 TC 91, Dec. 60,354) that declared IRS transfer pricing regulation §1.482-7A(d)(2) invalid. The regulation requires related entities to include SBC costs as shared intangible development costs in qualified cost-sharing arrangements.
The Tax Court ruled that adoption of the regulation in 2003 (T.D. 9088) violated the Administrative Procedure Act (APA) because the IRS did not consider and respond to evidence submitted during the regulatory comment period. This evidence showed that SBC costs are not shared in actual arms-length transactions between unrelated parties. As a result, the Tax Court concluded that the regulation was issued in an arbitrary and capricious fashion.
The Ninth Circuit reversed the Tax Court decision. Instead, the court agreed with the IRS that the arm’s length standard used in transfer pricing does not need to be based on comparable transactions in the context of SBC costs. It was simply too difficult to find truly comparable transactions. Thus, it was reasonable to allocate SBC costs based on the anticipated profits of each company.
IRS Moves Forward With SBC Audits
Within two months after the Ninth Circuit’s decision, IRS auditors proceeded full speed ahead to enforce the IRS position on the SBC issue. The Service did not wait for the outcome of an unsuccessful request for a rehearing by the Ninth Circuit with a full panel of judges or the Supreme Court’s decision on the subsequent certiorari request. Instead, it quickly withdrew a directive that prevented auditors from opening new examinations for issues related to SBCs included in cost sharing agreements (LB&I-04-0118-005 (July 31, 2019) withdrawing LB&I-04-0118-005 (January 12, 2018)). The withdrawn directive had also required IRS auditors in ongoing examinations to stand down if the taxpayer agreed to extend the statute of limitations until the results of the Altera appeal were known, plus any additional period necessary to develop the case.
What Next for SBCs in Cost-Sharing Agreements?
The Ninth Circuit’s decision applies only in the nine western states that are part of its jurisdiction. These states include California which is home to the “silicon valley.” Taxpayers in other states, of course, remain free to dispute the validity of the SBC rules of Reg. §1.482-7A(d)(2) in other circuits.
However, taxpayers in the Ninth Circuit (or any other circuit for that matter) also have another option. They may follow the regulations, pay the resulting tax liability, and file a refund claim in the Court of Federal Claims.
The Court of Federal Claims is bound only by precedent in the Court of Appeals for the Federal Circuit. The Court of Appeals for the Federal Circuit is not bound by decisions of the Federal Appellate Courts with geographical jurisdiction.
And Could the Supreme Court Still Get Involved?
It is also possible that another Appellate Court could side with the Tax Court position, setting up a potential conflict that could spur the Supreme Court to revisit the issue. However, there are no SBC or similar cases in the “pipeline,” and it would take several years for such a case to wind through the court system.
One thing is for certain. The IRS will vigorously defend any taxpayer challenges to the SBC regulation in any judicial venue or jurisdiction.
By Ray G. Suelzer, J.D., LL.M.