Taxpayer may change stock-compensation methods in its cost-sharing arrangement

Plain-English summary

A domestic corporation and its subsidiary used a cost-sharing arrangement for developing intangibles. The corporation asked to replace the default tax-deduction method for measuring and timing certain stock-based compensation costs with an elective financial-statement method, and to identify the related costs period by period rather than on the grant date. Based on the taxpayer's representations, the IRS prospectively consented to both changes for qualifying stock options, restricted shares, and restricted share units. The taxpayer must make the written election in its cost-sharing arrangement within 60 days, while awards granted before the change remain under the legacy methods until exercised or lapsed.

Ruling snapshot

• Question: Could the taxpayer prospectively change the measurement, timing, and identification methods for stock-based compensation included in cost-sharing costs?
• Outcome: Approved
• Key authorities: IRC §§ 83(h) and 482; Treas. Reg. § 1.482-7(d)(3); Notice 2005-99

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201514006 Third Party Communication: None
Release Date: 4/3/2015 Date of Communication: Not Applicable
Index Number: 482.11-13
Person To Contact:
-------------------------- -----------------, ID No. ----------------
----------------------------------- Telephone Number:
---------------------------------------- --------------------
--------------------------------------- Refer Reply To:
CC:INTL:B06
PLR-121499-14
In re: -------------------------- Date:
November 25, 2014

                                                           TY: ------

Legend

Taxpayer = --------------------------
Company Z = ------------------------------------------------
Year 1 = ------
Year 2 = ------
Year 3 = ------
Year 4 = ------
Date 1 = ----------------
Date 2= --------------------------
Date 3 = ------------------------
Date 4 = ---------------------

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

This responds to a letter dated April 30, 2014, supplemented by a letter dated
November 19, 2014, both of which were submitted by your representative. The letters
request that the Internal Revenue Service (“Service”) grant Taxpayer consent to use the
methods described in Treas. Reg. § 1.482-7(d)(3)(iii)(B) and Notice 2005-99, 2005-52
C.B. 1214, for measuring, timing, and identifying employee stock options, restricted
shares, and restricted share units for purposes of determining the amount Taxpayer
must include in its cost sharing arrangement (“CSA”) as intangible development costs
(“IDCs”) for Year 1 and subsequent tax years.
PLR-121499-14 2

The rulings contained in this letter are based upon information and representations
submitted by Taxpayer 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 of the request for rulings. Verification of the factual
information, representations, and other data may be required as part of the audit
process.

                                           FACTS

Taxpayer, a domestic corporation, was incorporated in Year 2. On Date 1 in Year 2,
Taxpayer adopted a stock-based compensation (“SBC”) plan pursuant to which it issued
stock options with respect to Taxpayer’s common stock and restricted stock to its
employees, directors, and consultants (“Year 2 Plan”). On Date 2 in Year 3, Taxpayer
and its wholly-owned subsidiary, Company Z, entered into an agreement they intended
would constitute a CSA within the meaning of Treas. Reg. § 1.482-7(b). The CSA
defines IDCs as including SBC granted on or after Date 2 to the extent required by law
as measured pursuant to the method provided in Treas. Reg. § 1.482-7(d)(3)(iii)(A)
(“default method”).

On Date 3 in Year 4, Taxpayer formally registered its initial public offering of Taxpayer’s
common stock. On Date 4 in Year 4, Taxpayer’s common stock was listed on an
established U.S. securities market. Also in Year 4, Taxpayer adopted a new SBC plan
that replaced the Year 2 Plan (“Year 4 Plan”). Pursuant to the Year 4 Plan, Taxpayer is
permitted to issue, among other types of awards, stock options, restricted stock awards
(“RSAs”), and restricted stock units (“RSUs”) with respect to its common stock.

For financial reporting purposes, Taxpayer recognizes SBC expense in accordance with
Statement of Financial Accounting Standards No. 123, “Share-Based Payment,”
Financial Accounting Standards Board (rev. 2004) (“SFAS 123R”).1 Accordingly,
Taxpayer values its SBC at fair value, net of estimated forfeitures, and generally
recognizes the corresponding compensation expense over the period during which the
recipient is required to perform services in exchange for the award.

Taxpayer’s stock options generally vest over a service period set by the compensation
committee of Taxpayer’s Board of Directors. The vesting period set by Taxpayer’s
compensation committee may not exceed a maximum period of ten years (five years in
the case of incentive stock options). RSAs and RSUs granted under the Year 4 Plan
are similarly subject to a service condition that may be satisfied over a service period
specified by the compensation committee. Other SBC that Taxpayer grants may be
subject to other vesting or performance requirements as determined by the Taxpayer’s
compensation committee. Taxpayer intends to continue providing additional SBC
awards under its Year 4 Plan.
1
SFAS 123R has been re-codified as Accounting Standards Codification Topic 718, but will be referred to
herein as SFAS 123R for the sake of familiarity.
PLR-121499-14 3

Taxpayer filed this request for Commissioner consent to prospectively change its
method for measuring and timing SBC that Taxpayer must include 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
(“elective method”). Taxpayer also requested consent to prospectively change its
method for identifying SBC with the intangible development activity (“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.

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

(1) With respect to its CSA, Taxpayer is in compliance, and will remain in
compliance, with all record-keeping requirements of the Internal Revenue Code
of 1986, as amended, and the regulations thereunder, including Treas. Reg.
§ 1.482-7(k)(2)(ii). Upon request, Taxpayer will timely provide to the
Commissioner records kept pursuant to such requirements.

(2) Taxpayer requests to use the elective method of measurement and timing, and
period-by-period identification with respect to SBC that it issues with respect to
its --------------------, which are now publicly traded within the meaning of Treas.
Reg. § 1.482-7(d)(3)(iii)(B)(2). The period-by-period identification methodology
will be applied consistently under the principles of Treas. Reg. § 1.482-
7(d)(2)(iii)(C).

(3) Taxpayer’s SBC issued under its Year 4 Plan will not be subject to market
conditions or significant post-vesting restrictions within the meaning of SFAS
123R.

(4) The service and performance vesting restrictions do not have a substantial effect
on the fair value of the SBC under U.S. generally accepted accounting principles
(“GAAP”) and do not result in unreasonably long vesting periods within the
meaning of SFAS 123R.

(5) With respect to any SBC the fair value of which is not reflected as a charge
against income in audited financial statements, Taxpayer will identify such SBC
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.

(6) Taxpayer will treat SBC granted, but not vested, during the term of the CSA, as
vesting immediately before expiration or termination of the CSA for purposes of
Treas. Reg. § 1.482-7, as provided for in Notice 2005-99.

(7) For all SBC granted before the first day of the first taxable year following receipt
of the Service’s consent (“Legacy SBC”), Taxpayer and all controlled participants
PLR-121499-14 4

   to the CSA will use the methods of measurement and timing provided in Treas.
   Reg. § 1.482-7(d)(3)(iii)(A) and grant date identification provided in Treas. Reg.
   § 1.482-7(d)(3)(ii) until all Legacy SBC has been exercised or lapsed.

(8) For all stock options 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 the Service’s consent, Taxpayer and
all controlled participants under the CSA will use the elective method of
measurement and timing and the period-by-period identification method provided
in Treas. Reg. § 1.482-7(d)(3)(iii)(B)(1) and Notice 2005-99.

(9) For all restricted shares and restricted share units issued with respect to publicly
traded stock within the meaning of Treas. Reg. § 1.482-7(d)(3)(iii)(B)(2) granted
in or after Year 1 that are: a) nonvested equity shares or nonvested equity share
units within the meaning of SFAS 123R, and b) are not subject to market
conditions or significant post-vesting restrictions within the meaning of SFAS
123R, Taxpayer and all controlled participants to the CSA will use the elective
method of measurement and timing and period-by-period identification.

(10) Taxpayer will apply the period-by-period identification method provided in Notice
2005-99 consistently, under the principles of Treas. Reg. § 1.482-7(d)(3)(iii)(C).

                                   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

PLR-121499-14 5

    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 2005-992 extended the elective method to

    nonvested 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.

We refer to such shares and share units hereinafter 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
2
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. § 1.482-7(d)(3) that are applicable in the present case.
PLR-121499-14 6

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:

   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.

PLR-121499-14 7

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 representations Taxpayer has made, the Service grants Taxpayer
prospective consent to change to the elective method for measurement and timing of
employee stock options, restricted shares, or restricted share units pursuant to Treas.
Reg. § 1.482-7(d)(3)(iii)(B) and Notice 2005-99 for purposes of determining the amount
Taxpayer must include as IDCs. The Service also grants Taxpayer prospective consent
to change to period-by-period identification of SBC with the IDA pursuant to Notice
2005-99. This consent is effective for 60 days from the date of this letter. Therefore, if
Taxpayer chooses to adopt the elective method and period-by-period identification, it
must make the written election in its CSA within 60 days from the date of this letter.

The sole purpose of this private letter ruling is to grant consent for Taxpayer to use the
elective method and period-by-period identification for purposes of including SBC as an
IDC that Taxpayer must share for purposes of its 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.
PLR-121499-14 8

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,


                                _____________________________________
                                Christopher J. Bello
                                Chief, Branch 6
                                Office of Associate Chief Counsel (International)

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