IRS consents to a cost-sharing participant switching to the elective method for counting stock-based compensation

Plain-English summary

A U.S. company shares the cost of developing intangible property with a foreign affiliate under a cost sharing arrangement (CSA) governed by the transfer-pricing rules of IRC § 482. When employees who work on that development are paid in stock (stock options, restricted shares, restricted share units), the value of that stock-based compensation must be counted as a shared "intangible development cost." The rules offer two ways to measure it: the "default method" (based on the tax deduction) and an "elective method" under Treas. Reg. § 1.482-7(d)(3)(iii)(B) and Notice 2005-99 (based on the fair value shown in audited financial statements), plus a choice between grant-date and period-by-period identification. Because the company had already been using the default method, switching required the Commissioner's advance consent. The IRS granted that consent, effective for 60 days, so the company may adopt the elective method and period-by-period identification going forward. The letter rules on nothing else about the CSA.

Ruling snapshot

• Question: May a CSA participant that used the default method switch, with the Commissioner's consent, to the elective method and period-by-period identification for stock-based compensation?
• Outcome: Approved (consent granted; effective 60 days)
• Key authorities: Treas. Reg. § 1.482-7(d)(3)(iii)(A), (B), (C), (ii); Notice 2005-99; IRC § 482

Full text (IRS public release)

 Internal Revenue Service                                     Department of the Treasury
                                                              Washington, DC 20224

 Number: 202227006                                            Third Party Communication: None
 Release Date: 7/8/2022                                       Date of Communication: Not Applicable
 Index Number: 482.11-13
                                                              Person To Contact:
 ---------------------------                                  ------------------------------, ID No. ----- ------
 -----------------------------------------------              ------------
 -------------------------------                              Telephone Number:
 --------------------------------                             ---------------------
 ----------------------------------                           Refer Reply To:
                                                              CC:INTL:B06
                                                              PLR-124103-21
                                                              Date:
                                                              April 12, 2022

                 TY:-------

Legend

Company W = ---------------------------------
Company X = ----------------------------------
Company Y = -----------------------------
Company Z = ---------------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Tax Year 1 = ----------------------------------------------
Month 1 = -------------
Date 1 = ----------------
Date 2 = ---------------------


Dear ----------:

This responds to a correspondence dated November 24, 2021, March 21, 2022, and
April 11, 2022, submitted by your representatives. The correspondence requests that
the Internal Revenue Service (the “Service”) grant Company W consent to use the
methods described in U.S. Treasury Regulations (“Treas. Reg.”) § 1.482-7(d)(3)(iii)(B)
and Notice 2005-99, 2005-2 C.B. 1214, for measuring, timing, and identifying employee
stock options, restricted shares, and restricted share units for purposes of determining
the amount Company W must include in its cost sharing arrangement (“CSA”) as
intangible development costs (“IDCs”) for Tax Year 1 and subsequent tax years (the
“Ruling Request”).
The rulings contained in this letter are based upon information and representations
submitted by Company W and its representative and accompanied by a penalties of
perjury statement executed by an appropriate party. This office has not verified any of
the material submitted in support for the request for rulings. Verification of the factual
information, representations, and other data may be required as part of the audit
process.
                                           FACTS
Company Z, a public domestic corporation, was incorporated in Year 1. Company W, a
domestic entity, was incorporated in Year 2 and acquired by Company Z in Month 1.
Company W is currently a limited liability company and a disregarded domestic entity
wholly-owned by Company Z. On Date 1, prior to the acquisition of Company W by
Company Z, Company W and Company X entered into an agreement that they intended
would qualify as a CSA within the meaning of Treas. Reg. § 1.482-7(b). The CSA was
subsequently amended and Company X was replaced as a controlled participant. As of
Date 2, Company Y was the only foreign controlled participant to the CSA.

At the time of entering into the CSA (i.e., on Date 1), Company W was a private
company and was required to use the method provided in Treas. Reg. § 1.482-
7(d)(3)(iii)(A) (the “default method”) for measurement and timing for including stock-
based compensation (“SBC”) in IDCs, and the method provided in Treas. Reg. § 1.482-
7(d)(3)(ii) (“grant date identification”) for identifying SBC as related to intangible
development activity (“IDA”).

For certain years prior to Year 3, the controlled participants to the CSA did not include
SBC as IDCs under the CSA. Beginning in Year 3 the controlled participants under the
CSA have included SBC as IDCs using the default method and grant date identification.
Company W has stated that it will correct any and all noncompliance with Treas. Reg.
§ 1.482-7(d)(1)(iii) (i.e., failing to include SBC as IDCs) for all years since the inception
of the CSA to the date when inclusion began in Year 3.

Company W filed this request for the Commissioner’s consent to prospectively change
the method for measuring and timing of SBC that must be included as IDCs from the
default method to the method described in Treas. Reg. § 1.482-7(d)(3)(iii)(B), which was
extended to certain restricted shares and restricted share units by Notice 2005-99 (the
“elective method”). Company W also requested consent to prospectively change the
method for identifying SBC with the IDA from grant date identification as provided in
Treas. Reg. § 1.482-7(d)(3)(ii) to period-by-period identification as provided in Notice
2005-99.

Company W has made the following representations, as stated in its submissions:

        1. With regard to the CSA, Company W will remain in compliance with all record
      keeping requirements of the Internal Revenue Code of 1986, as amended (the
      “Code”) and the regulations thereunder, including Treas. Reg. § 1.482-7(k)(2)(ii).
     Upon request, Company W will timely provide to the Commissioner records kept
     pursuant to such requirements.
    2. The SBC that is the subject of this Ruling Request is Company Z’s publicly
     traded stock within the meaning of Treas. Reg. § 1.482-7(d)(3)(iii)(B)(2).
    3. Under the terms of the SBC plan, the service and performance vesting
     restrictions of the SBC to which this election will apply will not have a substantial
     effect on the fair value of the SBC under GAAP and will not result in
     unreasonably long vesting periods within the meaning of Financial Accounting
     Standards Codification Topic No. 718, “Compensation-Stock Based
     Compensation,” Financial Accounting Standards Board (rev. 2016) (“ASC 718”).
    4. SBC granted prior to the term of the CSA is excluded from IDCs.
    5. For all SBC granted before the first day of the first taxable year following receipt
     of Service’s consent (“Legacy SBC”), all controlled participants to the CSA will
     continue to use the method of measurement and timing provided in Treas. Reg.
     § 1.482-7(d)(3)(iii)(A), as well as their existing method for identification, until all
     Legacy SBC has been exercised or lapsed.
    6. If the Commissioner grants consent for Company W to adopt the period-by-
     period identification method described in Notice 2005-99, and Company W then
     makes an election to adopt such method, then:
         a. Any SBC, the fair value of which is not reflected as a charge against
            income in audited financial statements, will be identified for purposes of
            Treas. Reg. § 1.482-7 as if the fair value of such compensation were
            reflected as a charge against income in audited financial statements.
         b. SBC granted, but not vested during the term of the CSA, must be treated
            as vesting immediately before expiration or termination of the CSA for
            purposes of Treas. Reg. § 1.482-7.
    7. All controlled participants to the CSA will apply the identification method
     consistently as required under the principles of Treas. Reg. § 1.482-
     7(d)(3)(iii)(C).
    8. For all SBC issued with respect to publicly traded stock within the meaning of
     Treas. Reg. § 1.482-7(d)(3)(iii)(B)(2) granted on or after the first day of the first
     taxable year following receipt of Service’s consent that satisfy the following
     conditions, all controlled participants to the CSA will use the method of
     measurement and timing provided in Treas. Reg. § 1.482-7(d)(3)(iii)(B)(1) and as
     expanded by Notice 2005-99:
         a. Are stock options; non-vested equity shares or non-vested equity share
            units within the meaning of Statement of Financial Accounting Standards
              No. 123, “Share-Based Payment,” Financial Accounting Standards Board
              (rev. 2004) (“FAS 123R”); or Share-Based Payments within the meaning
              of FAS 123R’s successor, ASC 718; and
          b. Are not subject to market conditions or significant post-vesting restrictions
             within the meaning of ASC 718.
                                           LAW
Measurement and Timing of SBC Related to Intangible Development
Treas. Reg. § 1.482-7(d)(3)(iii)(A) provides the default method for measurement and
timing of SBC IDCs as follows:
       Except as otherwise provided in this paragraph (d)(3)(iii), the cost attributable to
       stock-based compensation is equal to the amount allowable to the controlled
       participant as a deduction for federal income tax purposes with respect to that
       stock-based compensation (for example, under section 83(h)) and is taken into
       account as an IDC under this section for the taxable year for which the deduction
       is allowable.
Treas. Reg. § 1.482-7(d)(3)(iii)(B)(1) provides the alternative elective method for
measurement and timing of SBC IDCs with respect to options on publicly traded stock
as follows:
       With respect to stock-based compensation in the form of options on publicly
       traded stock, the controlled participants in a CSA may elect to take into account
       all IDCs attributable to those stock options in the same amount, and as of the
       same time, as the fair value of the stock options reflected as a charge against
       income in audited financial statements or disclosed in footnotes to such financial
       statements, provided that such statements are prepared in accordance with
       United States generally accepted accounting principles by or on behalf of the
       company issuing the publicly traded stock.
Treas. Reg. § 1.482-7(d)(3)(iii)(B)(4) provides for the time and manner of making the
election, in relevant part, as follows:
       The election described in this paragraph (d)(3)(iii)(B) is made by an explicit
       reference to the election in the written contract required by paragraph (k)(1) of
       this section or in a written amendment to the CSA entered into with the consent
       of the Commissioner pursuant to paragraph (d)(3)(iii)(C) of this section.
Treas. Reg. § 1.482-7(d)(3)(iii)(C) provides, in relevant part:
       [I]f controlled participants already have granted stock options that have been or
       will be taken into account under the general rule of paragraph (d)(3)(iii)(A) of this
       section, then except in cases specified in the last sentence of paragraph
        (d)(3)(iii)(B)(4) of this section, the controlled participants may make the election
        described in paragraph (d)(3)(iii)(B) of this section only with the consent of the
        Commissioner, and the consent will apply only to stock options granted in taxable
        years subsequent to the taxable year in which consent is obtained.
Notice 2005-991 extended the elective method to:
        [N]onvested equity shares or nonvested equity share units within the meaning of
        Statement of Financial Accounting Standards No. 123, “Share-Based Payment,”
        Financial Accounting Standards Board (rev. 2004) (SFAS 123R), provided that
        those shares or share units: (i) constitute or are issued with respect to publicly
        traded stock within the meaning of § 1.482-7(d)(2)(iii)(B)(2); and (ii) are not
        subject to market conditions or significant post-vesting restrictions within the
        meaning of SFAS 123R.2
Such shares and share units are referred to as “restricted shares and share units.” An
election to apply the elective method to restricted shares or share units is generally
made in the time and manner set forth in Treas. Reg. § 1.482-7(d)(3)(iii)(B)(4).
However, the consent of the Commissioner is not required to elect the elective method
for restricted shares and share units if the election is made by a written amendment to
the CSA not later than the latest due date (with regard to extensions) of a Federal
income tax return of any controlled participant for the first taxable year beginning after
December 8, 2005.
Identifying SBC Related to Intangible Development
Treas. Reg. § 1.482-7(d)(3)(ii) provides the rule for identification of SBC with the IDA
(“grant date identification”), in relevant part, as follows:
        The determination of whether stock-based compensation is directly identified
        with, or reasonably allocable to, the IDA is made as of the date that the stock-
        based compensation is granted. Accordingly, all stock-based compensation that
        is granted during the term of the CSA and, at date of grant, is directly identified
        with, or reasonably allocable to, the IDA is included as an IDC under paragraph
        (d)(1) of this section.
Notice 2005-99 provides that a taxpayer may choose to determine whether SBC
measured by the elective method is related to the IDA by analyzing the activities of the
employee recipients of the SBC by reference to financial reporting periods, identifying
the related compensation on a period-by-period basis (“period-by-period identification”),
rather than using grant date identification. Notice 2005-99 further provides:


1 Notice 2005-99 refers to the SBC rules contained in Treas. Reg. § 1.482-7(d)(2) (2003), the materially

similar predecessor of the rules in Treas. Reg. § 1.487-7(d)(3) that are applicable to the present case.
2 FAS 123R was amended after the publication of Notice 2005-99 by ASC 718.
       Taxpayers’ implementation of this identification method based on financial
       reporting periods must meet four requirements. First, the identification
       methodology must be applied consistently (under the principles of § 1.482-
       7(d)(2)(iii)(C)). Second, any stock-based compensation the fair value of which is
       not reflected as a charge against income in audited financial statements (for
       example, as in the case of certain stock options the fair value of which was
       disclosed in footnotes prior to the effective date of SFAS 123R) must be
       identified for purposes of § 1.482-7 as if the fair value of such compensation
       were reflected as a charge against income in audited financial statements. Third,
       as under the grant date identification rule, controlled participants using this
       identification methodology must exclude stock-based compensation granted prior
       to the term of the QCSA. Fourth and finally, stock-based compensation granted
       but not vested during the term of the QCSA must be treated as vesting
       immediately before expiration or termination of the QCSA for purposes of §
       1.482-7. Under this final requirement, if costs attributable to stock-based
       compensation granted during the term of the QCSA are allocable under U.S.
       GAAP to reporting periods subsequent to the term of the QCSA, the
       determination of whether these costs must be taken into account as intangible
       development costs must be based on the employee’s activities as of the financial
       reporting period during which the date of the expiration or termination of the
       QCSA occurs.
Generally, pursuant to Treas. Reg. § 1.482-7(d)(3)(iii)(C) and (B)(4), a change of
identification method may be made only by a written amendment to the CSA entered
into with the consent of the Commissioner. However, Notice 2005-99 further provides
that the consent of the Commissioner is not required to change from grant date
identification to period-by-period identification if such written amendment is “made no
later than the latest due date (with regard to extensions) of a Federal income tax return
of any controlled participant for the first taxable year beginning after December 8, 2005.”
In applying period-by-period identification, Notice 2005-99 provides:
       [A]ctivities within the intangible development area are not necessarily
       coextensive with those activities classified as “research and development” for
       financial reporting purposes. Consequently, nothing in this notice should be
       interpreted as eliminating the requirement to take into account all stock-based
       compensation costs related to the intangible development area. Controlled
       participants must identify the stock-based compensation that is related to the
       intangible development area, notwithstanding that the activities conducted to
       develop intangibles covered by the QCSA may differ from the activities classified
       as “research and development” for U.S. GAAP purposes.
                                        ANALYSIS
Based on the facts and representations Company W has made, the Service grants
Company W and the other controlled participants prospective consent to change to the
elective method and period-by-period identification for SBC covered by Treas. Reg.
§ 1.482-7(d)(3)(iii)(B) and Notice 2005-99. This consent is effective for 60 days from the
date of this letter. Therefore, if Company W chooses to adopt the elective method and
period-by-period identification, it must make the written election within 60 days from the
date of this letter.

The sole purpose of this private letter ruling is to grant consent for Company W and the
other controlled participants to use the elective method and period-by-period
identification for purposes of including SBC as an IDC that must be shared under the
CSA. Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter, including the CSA, or concerning the validity of any provisions
within the CSA.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.


                                       Sincerely,



                                       Robert Z. Kelley
                                       Senior Technical Reviewer, Branch 6
                                       (International)


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