Parties to Cost Sharing Agreements Must Share the Costs and Deductions of Stock-Based Compensation

On July 24, 2018, the 9th Circuit Court of Appeals reversed a prior Tax Court decision and handed the Internal Revenue Service a significant victory in its long-standing litigation with Altera as to the validity of a Treasury regulation that requires parties to a “cost sharing agreement” (“CSA”) to include the costs (and associated deductions) of stock-based compensation in the costs that must be shared pursuant to the CSA.¹

A CSA is an agreement pursuant to which related parties agree to share the costs of developing intellectual property (“IP”) in exchange for obtaining the right to exploit the developed IP in their respective territories. The parties to a typical CSA might be the US parent of a multinational group, to which the CSA would grant the right to exploit the developed IP in the US, and an offshore subsidiary (formed and structured to bear as little tax on its income as possible), to which the CSA would grant the right to exploit the developed IP in the rest of the world. Because the individuals whose compensation is partly stock-based tend to be employed by the US parent rather than by the offshore subsidiary, including this compensation in the costs to be shared pursuant to a CSA has the effect of reducing the amount of the related compensation deduction the US parent is entitled to report on its US tax returns. The amounts can be rather significant. For example, over the four years covered in the Altera litigation, the stock-based compensation at issue was just over $80 million.

It is possible that the 9th Circuit will rehear the Altera decision. But, the decision, if and once final and unless overturned by the Supreme Court (which does not appear likely to agree to hear an appeal of the decision in the first place), will constitute a judicial precedent for taxpayers resident in California, Oregon, Washington, and other western states and territories. The contrary Tax Court opinion, however, will continue to have precedential value for Tax Court cases that must be appealed to courts outside the 9th Circuit.

In light of Altera, companies, particularly those that may have relied on prior judicial precedents and excluded stock-based compensation costs from their CSAs, should review their existing CSAs and determine whether any amendments are appropriate once the Altera decision is final. More broadly, Altera sends a strong signal to all taxpayers that they need to be appropriately conservative in how they structure their intercompany arrangements.

¹See Altera Corp. v. Comm’r, 2018-2 U.S.T.C.¶50,344 (9th Cir. 2018). The prior Tax Court decision is Altera Corp. v. Comm’r, 145 T.C. 91 (2015).