IRS Wants To Expense Stock Options In Transfer Pricing

by Mike Godfrey, Tax-News.com, New York

20 November 2002

The world-wide trend towards requiring companies to account for the issue of stock options as expense items in profit and loss accounting (in most countries they are already accounted for as an expense for tax purposes) is coming head to head with the rules for calculating expense for 'arms length' treatment under international transfer-pricing guidelines.

Seen from the perspective of most public companies, they want to deduct the cost of stock options when making their tax returns (= pay less tax) but they don't want to do so when reporting profit or loss to their shareholders (= higher share prices for their own share options). When calculating transfer price costs, managements would like to include stock option costs in those countries with low taxes, because it would increase their profits in such countries, but would prefer not to include such costs in high-tax countries, because they want to minimize income (= export prices) in such countries.

For these reasons, in the US, companies would usually prefer not to include stock option costs in transfer-pricing calculations. But after a long period of uncertainty, the IRS has proposed regulations that would include stock-based compensation as part of the expenses that must be shared in qualified cost sharing arrangements.

Historically, the IRS did not include stock option costs in its formulae for calculating transfer prices, and these costs are not mentioned in the IRS's 1995 QCSA (Qualified Cost Sharing Arrangement) regulations.

Attempts by the IRS to include stock option costs have been resisted by corporations, although so far no case has gone to a final court ruling. The IRS hopes that its regulations will settle the issue, but this seems unlikely given that there is as yet no international agreement on expensing stock option costs.

On his site www.ecommercetax.com, Professor James Hardesty says that the IRS regulations are being heavily criticized for the following reasons: (1) unrelated companies do not agree to share stock-based compensation, such as compensation resulting from the exercise of stock options; (2) requiring the inclusion of stock-based compensation is therefore a major departure from the arm’s length standard; (3) countries other than the United States may not count such compensation, opening the way to double taxation; (4) the proposals are different from the historical litigating positions of the IRS; and (5) the proposed rules will be difficult to apply.

This one will run and run, although the final outcome is predictably that stock option costs will be counted as such for all purposes, in conformity with the position of most economists, after a period of uncertainty. However, the actual basis of calculation of stock option costs is a minefield, and should give rise to a decade's worth of argument in national and international fora.

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