Cost-sharing arrangement may change stock compensation methods

Plain-English summary

A domestic corporation with a cost-sharing arrangement had used the default tax-deduction method to measure stock-based compensation included in intangible development costs. After its stock became publicly traded, it sought to use audited-financial-statement fair value for eligible options, restricted shares, and restricted share units. It also sought to identify compensation related to intangible development period by period rather than only on the grant date. The IRS gave prospective consent to both changes, provided the taxpayer amended its written cost-sharing agreement within 60 days and followed its detailed representations.

Ruling snapshot

• Question: May the taxpayer prospectively change how its cost-sharing arrangement measures, times, and identifies stock-based compensation costs?
• Outcome: Approved
• Key authorities: 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: 201552008 Third Party Communication: None
Release Date: 12/24/2015 Date of Communication: Not Applicable
Index Number: 482.11-13
Person To Contact:
------------------------------ ------------------------, ID No. ------------------
------------------------------- ----------------------------------------------------
-------------------------------------------- Telephone Number:
------------------------------ ----------------------
Refer Reply To:
In Re: ------------------------------- CC:INTL:B06
PLR-116732-15
Date:
September 21, 2015

                                                           TY: -------

Legend

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

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

This responds to a letter dated May 1, 2015, submitted by your representative. The
letter requests 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 tax years subsequent to Year 1.

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.
PLR-116732-15 2

                                    FACTS

Taxpayer, a domestic corporation, was incorporated in Year 2. On Date 1 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). Since
the onset of the CSA, Taxpayer has granted stock-based compensation ("SBC") in the
form of stock options with respect to Taxpayer's common stock and restricted stock to
its employees and employees of its affiliates. The CSA defines IDCs as including SBC
granted on or after Date 1 in Year 3 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 2 in Year 4, Taxpayer had an initial public offering and its common stock was
listed on an established U.S. securities market.

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) The SBC with respect to which Taxpayer requests to use the elective method of
measurement and timing and period-by-period identification as provided in Treas. Reg.
§ 1.482-7(d)(3)(iii)(B)(1) and Notice 2005-99 are based on publicly traded stock within
the meaning of Treas. Reg. § 1.482-7(d)(3)(iii)(B)(2).

(3) Taxpayer's SBC is not subject to market conditions or significant post-vesting
restrictions within the meaning of Statement of Financial Accounting Standards No. 123,
“Share-Based Payment,” Financial Accounting Standards Board (rev. 2004) (“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")
PLR-116732-15 3

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 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
period-by-period identification as 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 on or
after the first day of the first taxable year following receipt of the Service’s consent that
are: a) nonvested equity shares or nonvested equity share units within the meaning of
SFAS 123R, and b) 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 amend its CSA to elect the elective method of measurement and
timing and specify the use of period-by-period identification within 60 days of receiving
the Commissioner’s consent to change methods as requested.

(11) 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).
PLR-116732-15 4

                                       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

PLR-116732-15 5

    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

    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
    section 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
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. § 1.482-7(d)(3) that are applicable in the present case.
PLR-116732-15 6

   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 section
   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 section 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
   section 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)(B)(4) and (C), 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.

PLR-116732-15 7

                                    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.

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

                                Sincerely,


                                _____________________________________
                                Robert Z. Kelley
                                Acting Assistant to the Branch Chief, Branch 6
                                Office of Associate Chief Counsel (International)

cc: