Multinational corporations (MNCs) with research and development facilities overseas that have given stock-based compensation to employees are likely to find themselves with larger tax deductions and going forward, higher earnings.
A US Tax Court recently overturned a controversial International Revenue Service (IRS) rule, in a case titled Altera Corp. et al. v. Commissioner, that required costs to be allocated to foreign subsidiaries developing intangible assets such as research and development. The court essentially determined the IRS’ explanation for the rule was inadequate, and that contrary to the IRS’s standard of rules being at arm’s length, there was little evidence that any third party would agree to such an arrangement.
The Tax Court ruling represents a “stunning defeat” for the IRS, according to James Klein, senior counsel at Pillsbury Winthrop Shaw Pittman, and it would appear to open up a new approach to litigation when the agency issues rules with insufficient explanation.
Mr. Klein noted that companies typically can deduct employ compensation, including exersized stock options. However, when the company begins operating subsidiaries outside the US, particularly operations that ultimately drive earnings such as R&D, the situation becomes more complicated. IRS rules require US companies to allocate costs to those subsidiaries in cost sharing arrangements, to prevent companies from burying significant income in those subsidiaries, which tend to be in low-tax jurisdictions.
In 2003, the IRS used its statutory authority to require those rules to include the cost of stock-based compensation given to employees primarily based in the US, a type of compensation that’s especially prevalent among technology firms, which are also likely to have R&D-focused subsidiaries overseas. Altera had several million in such deductions, and the IRS ruled that the San Jose-headquartered company had to allocate approximately half to its overseas subsidiaries.
In a “homey” example, Mr. Klein compared the situation to a third party ordering a million pizzas from a pizza-parlor chain, and agreeing to price changes if, for example, the cost of flour goes up. If the pizza-parlor company then asks for a higher price because the contract has increased the value of its franchise, the third party would almost certainly call the request illogical and refuse pay the increase.
Similarly, the IRS’ 2003 ruling essentially said the company should allocate more of its stock-based compensation costs to foreign subsidiaries if the stock’s market price increases, thereby reducing the domestic tax deductions it can take for employee compensation.
“There’s no evidence that any third party would ever agree to this kind of arrangement,” Mr. Klein said, adding that IRS received numerous comment letters making that argument during the rule’s proposal stage, but it chose to finalize it anyway.
Mr. Klein added that by definition the deduction would be all-but useless in the tax havens where such subsidiaries are typically incorporated, and many other jurisdictions simply don’t recognize such deductions. He argued further that even if foreign jurisdictions provide deductions for stock-based compensation, they would be unlikely to do so in this instance and forego the tax revenue, since the deduction would be for a corporate entity’s costs in another jurisdiction.
Most MNCs providing stock-based compensation are likely to feel some impact from this ruling, Mr. Klein said, adding that’s more likely to be the case if a company’s stock price has increased significantly and it has a significant overseas R&D budget.
“From a corporate treasurer’s perspective, the company will have a larger than anticipated tax deduction, freeing up some earnings,” Mr. Klein said, adding that depending on several factors the company can file for up to three or more years of refunds.