[Federal Register Volume 68, Number 165 (Tuesday, August 26, 2003)]
[Rules and Regulations]
[Pages 51171-51179]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-21355]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9088]
RIN 1545-BA57


Compensatory Stock Options Under Section 482

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations that provide guidance 
regarding the application of the rules of section 482 governing 
qualified cost sharing arrangements. These regulations provide guidance 
regarding the treatment of stock-based compensation for purposes of the 
rules governing qualified cost sharing arrangements and for purposes of 
the comparability factors to be considered under the comparable profits 
method.

DATES: Effective Date: These regulations are effective August 26, 2003.
    Applicability Dates: For dates of applicability of these 
regulations, see Sec. Sec.  1.482-1(j)(5) and 1.482-7(k).

FOR FURTHER INFORMATION CONTACT: Douglas Giblen, (202) 435-5265 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507) 
under control number 1545-1794. Responses to these collections of 
information are required by the IRS to monitor compliance with the 
federal tax rules for determining stock-based compensation costs to be 
shared among controlled participants in qualified cost sharing 
arrangements.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent or recordkeeper varies 
from 2 hours to 7 hours, depending on individual circumstances, with an 
estimated average of 4 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Office of 
Management and Budget, Attn: Desk Officer for the Department of the 
Treasury, Office of Information and Regulatory Affairs, Washington, DC 
20503, with copies to the Internal Revenue Service, Attn: IRS Reports 
Clearance Officer, W:CAR:MP:T:T:SP, Washington, DC 20224.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On July 29, 2002, Treasury and the IRS published in the Federal 
Register (67 FR 48997) proposed amendments to the regulations (REG-
106359-02) under section 482 of the Internal Revenue Code (Code). These 
proposed regulations provide guidance regarding treatment of stock-
based compensation for purposes of qualified cost sharing arrangements 
(QCSAs) and the comparable profits method and clarify the coordination 
of the rules regarding QCSAs with the arm's length standard. Written 
comments responding to these proposed regulations were received, and a 
public hearing was held on November

[[Page 51172]]

20, 2002. After consideration of all the comments, the proposed 
regulations under section 482 of the Code are adopted as revised by 
this Treasury decision.

Explanation of Revisions and Summary of Comments

    These final regulations are the first in a series of regulatory 
guidance under section 482 through which Treasury and the IRS intend to 
update, clarify and improve current regulatory guidance in the transfer 
pricing area. A broader regulatory project on the treatment of QCSAs 
and a regulatory project on the transfer pricing of services are in 
progress, and Treasury and the IRS intend to issue proposed regulations 
with respect to each project in the near term.
    These final regulations set forth explicit provisions clarifying 
that stock-based compensation is taken into account in determining the 
operating expenses treated as intangible development costs of a 
controlled participant in a QCSA under Sec.  1.482-7. These final 
regulations provide rules for measuring the cost associated with stock-
based compensation; clarify that the utilization and treatment of 
stock-based compensation is appropriately taken into account as a 
comparability factor for purposes of the comparable profits method 
under Sec.  1.482-5; and provide rules that coordinate the rules of 
Sec.  1.482-7 regarding QCSAs with the arm's length standard as set 
forth in Sec.  1.482-1.
    Treasury and the IRS received comments with respect to the proposed 
regulations. Most commentators objected to the proposed regulations in 
their entirety or suggested postponement of their finalization. Some 
commentators suggested modifications to be adopted in the event that 
the proposed regulations were finalized in some form.
    After fully considering these comments, Treasury and the IRS 
continue to believe that the proposed regulations reflect a sound 
application of established principles under section 482. At the same 
time, Treasury and the IRS have concluded that certain suggested 
modifications to the administrative provisions of the proposed 
regulations are appropriate. These modifications are incorporated into 
the final regulations.

A. Stock-Based Compensation as a Cost To Be Shared and the Arm's Length 
Standard as Applied to QCSAs--Sec. Sec.  1.482-7(d)(2)(i) and (a)(3), 
and 1.482-1(a)(1), (b)(2)(i) and (c)

    A QCSA subject to the rules of Sec.  1.482-7 is an arrangement to 
develop intangibles which meets certain administrative and other 
requirements and in which the participants to the arrangement share 
intangible development costs in proportion to their shares of 
reasonably anticipated benefits attributable to the intangibles 
developed under the arrangement. In the case of a QCSA, Sec.  1.482-
7(a)(2) limits the ability of the Commissioner to make allocations, 
except to the extent necessary to make each controlled participant's 
share of the costs equal its share of reasonably anticipated benefits. 
An arrangement in which significant intangible development costs are 
not shared in proportion to reasonably anticipated benefits (or are not 
shared at all) would not in substance constitute an arrangement to 
which the rules of Sec.  1.482-7 are applicable.
    The proposed regulations address the treatment of stock-based 
compensation under a QCSA, and the interaction between the rules 
applicable to QCSAs and the arm's length standard. The proposed 
regulations provide that stock-based compensation related to the 
covered intangible development area must be taken into account in 
determining the costs to be shared by participants in a QCSA. The 
proposed regulations further provide that a QCSA produces results 
consistent with an arm's length result if, and only if, all costs 
related to the intangible development, as determined in accordance with 
the specific guidance in Sec.  1.482-7(d), are shared in proportion to 
reasonably anticipated benefits.
    Commentators objected to this rule on the basis of interpretations 
of the arm's length standard and on other grounds.
1. Comments Relating to Arm's Length Standard
    Commentators asserted that taking stock-based compensation into 
account in the QCSA context would be inconsistent with the arm's length 
standard unless there is evidence that parties at arm's length take 
stock-based compensation into account in similar circumstances. 
Commentators asserted that third-party evidence, such as the 
government's own procurement contracting practices and agreements 
between unrelated parties with some characteristics similar to QCSAs, 
would show that parties at arm's length do not take stock-based 
compensation into account in determining costs to be reimbursed.
    Treasury and the IRS continue to believe that requiring stock-based 
compensation to be taken into account for purposes of QCSAs is 
consistent with the legislative intent underlying section 482 and with 
the arm's length standard (and therefore with the obligations of the 
United States under its income tax treaties and with the OECD transfer 
pricing guidelines). The legislative history of the Tax Reform Act of 
1986 expressed Congress's intent to respect cost sharing arrangements 
as consistent with the commensurate with income standard, and therefore 
consistent with the arm's length standard, if and to the extent that 
the participants' shares of income ``reasonably reflect the actual 
economic activity undertaken by each.'' See H.R. Conf. Rep. No. 99-481, 
at II-638 (1986). The regulations relating to QCSAs implement that 
legislative intent by using costs incurred by each controlled 
participant with respect to the intangible development as a proxy for 
actual economic activity undertaken by each, and by requiring each 
controlled participant to share these costs in proportion to its 
anticipated economic benefit from intangibles developed pursuant to the 
arrangement. In order for the costs incurred by a participant to 
reasonably reflect its actual economic activity, the costs must be 
determined on a comprehensive basis. Therefore, in order for a QCSA to 
reach an arm's length result consistent with legislative intent, the 
QCSA must reflect all relevant costs, including such critical elements 
of cost as the cost of compensating employees for providing services 
related to the development of the intangibles pursuant to the QCSA. 
Treasury and the IRS do not believe that there is any basis for 
distinguishing between stock-based compensation and other forms of 
compensation in this context.
    Treasury and the IRS do not agree with the comments that assert 
that taking stock-based compensation into account in the QCSA context 
would be inconsistent with the arm's length standard in the absence of 
evidence that parties at arm's length take stock-based compensation 
into account in similar circumstances. Section 1.482-1(b)(1) provides 
that a ``controlled transaction meets the arm's length standard if the 
results of the transaction are consistent with the results that would 
have been realized if uncontrolled taxpayers had engaged in the same 
transaction under the same circumstances.'' (Emphasis added). While the 
results actually realized in similar transactions under

[[Page 51173]]

similar circumstances ordinarily provide significant evidence in 
determining whether a controlled transaction meets the arm's length 
standard, in the case of QCSAs such data may not be available. As 
recognized in the legislative history of the Tax Reform Act of 1986, 
there is little, if any, public data regarding transactions involving 
high-profit intangibles. H.R. Rep. No. 99-426, at 423-25 (1985). The 
uncontrolled transactions cited by commentators do not share enough 
characteristics of QCSAs involving the development of high-profit 
intangibles to establish that parties at arm's length would not take 
stock options into account in the context of an arrangement similar to 
a QCSA. Government contractors that are entitled to reimbursement for 
services on a cost-plus basis under government procurement law assume 
substantially less entrepreneurial risk than that assumed by service 
providers that participate in QCSAs, and therefore the economic 
relationship between the parties to such an arrangement is very 
different from the economic relationship between participants in a 
QCSA. The other agreements highlighted by commentators establish 
arrangements that differ significantly from QCSAs in that they provide 
for the payment of markups on cost or of non-cost-based service fees to 
service providers within the arrangement or for the payment of 
royalties among participants in the arrangement. Such terms, which may 
have the effect of mitigating the impact of using a cost base to be 
shared or reimbursed that is less than comprehensive, would not be 
permitted by the QCSA regulations. Further, the QCSA regulations would 
not allow the Commissioner to impose such terms in the context of a 
QCSA.
    The regulations relating to QCSAs have as their focus reaching 
results consistent with what parties at arm's length generally would do 
if they entered into cost sharing arrangements for the development of 
high-profit intangibles. These final regulations reflect that at arm's 
length the parties to an arrangement that is based on the sharing of 
costs to develop intangibles in order to obtain the benefit of an 
independent right to exploit such intangibles would ensure through 
bargaining that the arrangement reflected all relevant costs, including 
all costs of compensating employees for providing services related to 
the arrangement. Parties dealing at arm's length in such an arrangement 
based on the sharing of costs and benefits generally would not 
distinguish between stock-based compensation and other forms of 
compensation.
    For example, assume that two parties are negotiating an arrangement 
similar to a QCSA in order to attempt to develop patentable 
pharmaceutical products, and that they anticipate that they will 
benefit equally from their exploitation of such patents in their 
respective geographic markets. Assume further that one party is 
considering the commitment of several employees to perform research 
with respect to the arrangement. That party would not agree to commit 
employees to an arrangement that is based on the sharing of costs in 
order to obtain the benefit of independent exploitation rights unless 
the other party agrees to reimburse its share of the compensation costs 
of the employees. Treasury and the IRS believe that if a significant 
element of that compensation consists of stock-based compensation, the 
party committing employees to the arrangement generally would not agree 
to do so on terms that ignore the stock-based compensation.
    An arrangement between controlled taxpayers for the development of 
intangible assets in which one taxpayer's share of significant costs 
exceeds its share of reasonably anticipated benefits from the 
exploitation of the developed intangibles would not in substance be a 
QCSA and therefore would be subject to analysis under the other section 
482 regulations. For example, as in the transactions cited by 
commentators, a controlled taxpayer might agree at the outset of an 
arrangement to bear a disproportionate share of costs in an arrangement 
in which it receives a service fee or a contingent royalty from the 
exploitation of the developed intangibles. More generally, controlled 
taxpayers might agree at the outset of an arrangement to determine the 
compensation of one party based on a subset of that taxpayer's costs or 
on a basis that does not take that taxpayer's costs into account at all 
(e.g., based on an amount determined with reference to a comparable 
uncontrolled price or transaction). In either case, such an arrangement 
between controlled taxpayers would not in substance constitute an 
arrangement to which the rules of Sec.  1.482-7 would apply. Indeed, 
the limitations contained in Sec.  1.482-7(a)(2) could produce results 
inconsistent with an arm's length result if applied to such an 
arrangement because the Commissioner would be precluded from making 
allocations that could be necessary to ensure that each controlled 
taxpayer is compensated appropriately. Rather, such an arrangement 
should be analyzed under the other section 482 regulations (in 
particular, sections 1.482-1, 1.482-2(b), and 1.482-4) to determine 
whether it reaches results consistent with the arm's length standard, 
and any allocations by the Commissioner should be consistent with such 
other section 482 regulations.
2. Other Comments
    Commentators offered various other reasons for not taking stock-
based compensation into account in the context of QCSAs. Commentators 
expressed the view that stock-based compensation should not be taken 
into account because it does not constitute an economic cost or require 
a cash outlay, or, to the extent such compensation does constitute a 
cost, because the cost is borne by shareholders whose share value is 
diluted when additional shares are issued on exercise. Commentators 
also noted that the treatment of stock-based compensation for financial 
reporting purposes should not mandate that stock-based compensation be 
taken into account in the context of QCSAs.
    In response to such views, and as discussed above, Treasury and the 
IRS continue to believe that requiring stock-based compensation to be 
taken into account for in the context of QCSAs is appropriate. The 
final regulations provide that stock-based compensation must be taken 
into account in the context of QCSAs because such a result is 
consistent with the arm's length standard. Treasury and the IRS agree 
that the disposition of financial reporting issues does not mandate a 
particular result under these regulations.
    One commentator suggested that even if stock-based compensation 
generates a cost to a participant, there is precedent within the 
regulations relating to QCSAs for excluding certain costs, notably 
interest and taxes. Treasury and the IRS believe that the technical 
treatment under the regulations relating to QCSAs of interest, taxes 
and other expenses not related to the intangible development area does 
not warrant failing to take into account an element of employee 
compensation that is clearly related to the intangible development 
area. Treasury and the IRS believe that in order for the costs incurred 
by a participant to reasonably reflect its actual economic activity 
consistent with the legislative intent in this area, those costs must 
be determined on a comprehensive basis and so must take into account 
all relevant costs, in particular critical elements such as employee 
compensation. As noted above, Treasury and the IRS do not believe that 
there is a basis for

[[Page 51174]]

distinguishing between stock-based compensation and other forms of 
compensation in this context.
    One commentator also claimed that the historical administrative 
practice of the IRS has been not to challenge the failure to take 
stock-based compensation into account in other transfer pricing 
contexts in which the determination of cost is relevant. Treasury and 
the IRS believe that such perceived practices of the IRS with respect 
to other section 482 contexts are not relevant to determining the 
appropriate regulatory rule applicable to QCSAs.
    As an alternate approach, one commentator suggested that rather 
than requiring stock-based compensation to be taken into account in the 
QCSA context, Treasury and the IRS should promulgate a ``stock-based 
compensation safe harbor'' applicable to QCSAs. This suggested ``safe 
harbor'' has not been adopted in the final regulations. As noted above, 
Treasury and the IRS believe that in order for the costs incurred by a 
participant to reasonably reflect its actual economic activity, those 
costs must be determined on a comprehensive basis and so must take into 
account all relevant costs, in particular critical elements such as 
employee compensation. The final regulations therefore require employee 
compensation to be taken into account, rather than provide for a safe 
harbor under which such compensation could be ignored.

B. Grant-Date Identification Rule--Sec.  1.482-7(d)(2)(ii)

    The proposed regulations identify the stock-based compensation to 
be included in the cost pool based on whether the compensation is 
related to the intangible development area on the date the option is 
granted.
    One commentator noted that this identification rule is inconsistent 
with the IRS treatment of stock-based compensation in other tax areas 
such as sourcing, where IRS rulings trace the compensation to the 
entire period over which the employee performed the services 
compensated by the option.
    The grant-date identification rule has been retained in the final 
regulations. As noted in the preamble of the proposed regulations, it 
is desirable in the QCSA context to select a single date for 
identification of covered stock-based compensation. The grant of 
compensation generally is the single economic event most closely 
associated with the services being compensated.

C. Provision of Specific Methods of Measurement and Timing

    The proposed regulations prescribe two alternative methods for 
determining the operating expenses attributable to stock-based 
compensation. The default rule under Sec.  1.482-7(d)(2)(iii)(A) 
provides that the costs attributable to stock-based compensation 
generally are included as intangible development costs upon the 
exercise of the option and measured by the spread between the option 
strike price and the price of the underlying stock. An elective rule 
under Sec.  1.482-7(d)(2)(iii)(B) provides that the costs attributable 
to stock options are taken into account in certain cases in accordance 
with the ``fair value'' of the option, as reported for financial 
accounting purposes either as a charge against income or in footnoted 
disclosures.
    Commentators claimed that parties at arm's length would not use 
either of the alternatives prescribed in the proposed regulations 
because they would produce results that are too speculative or not 
sufficiently related to the employee services that are compensated. One 
commentator suggested that the final regulations should not limit 
taxpayers to the two prescribed measurement methods but rather should 
codify the current IRS administrative practice of permitting any 
reasonable method. In the commentator's view, a standard based on any 
reasonable method should permit the intrinsic-value method, which 
measures the difference between strike price and underlying stock value 
at date of grant, exclusive of time value. However, the commentator 
suggested that if Treasury and the IRS consider an element of time 
value indispensable, an alternative would be to require the use of the 
``minimum value'' method, which accounts for the time value of stock 
options by assuming the underlying stock will grow at the risk-free 
interest rate.
    These suggestions were not adopted. Treasury and the IRS believe 
that it is appropriate for regulations to prescribe guidance in this 
context that is consistent with the arm's length standard and that also 
is objective and administrable. As long as the measurement method is 
determined at or before grant date, either of the prescribed 
measurement methods can be expected to result in an appropriate 
allocation of costs among QCSA participants and therefore would be 
consistent with the arm's length standard. The results under the 
default measurement rule are consistent with what would occur under an 
arm's length agreement at or before the grant date to take stock-based 
compensation into account at the date of exercise when more facts are 
known and therefore to share the risks associated with such 
compensation between the date of grant and the date of exercise. The 
results under the elective measurement rule are consistent with what 
would occur under an alternative arm's length agreement at or before 
the grant date to determine the value of the compensation up front and 
take such compensation into account at that time. With respect to the 
specific methods proposed by commentators, Treasury and the IRS believe 
that ``intrinsic value'' ignores significant elements of the economic 
value of stock-based compensation and ``minimum value'' ignores the 
important variable of volatility that enters into the economic pricing 
models used for financial reporting purposes.
    The prescribed measurement methods are objective and administrable 
because they rely on valuations or measurements of stock-based 
compensation prepared for other purposes. The prescribed measurement 
methods do not require or permit valuations of stock-based compensation 
specifically for QCSA purposes. A standard under which the validity of 
the taxpayer's method would have to be analyzed on a case-by-case basis 
would be unduly difficult to administer and potentially could lead to 
significant disputes.

D. General Rule of Measurement--Sec.  1.482-7(d)(2)(iii)(A)

    Under the default measurement rule, the amount taken into account 
for QCSA purposes generally is the amount allowable as a federal income 
tax deduction on exercise of the stock-based compensation. This amount 
generally is the ``spread'' between the option price and the fair 
market value of the underlying stock at the date of exercise.
    One commentator suggested that this method would be improved if the 
amount taken into account for QCSA purposes were limited to the portion 
of the spread that accrued between date of grant and full vesting, as 
further prorated to reflect only the time during which the employee was 
engaged in cost-shared activities.
    This suggestion has not been adopted in the final regulations. 
Treasury and the IRS believe that the grant-date identification rule 
already limits in an appropriate way the stock-based compensation taken 
into account. The purpose of the default measurement rule is to measure 
the amount attributable to stock-based compensation that must be taken 
into account under the grant-date identification rule. Accordingly, the 
default measurement rule does not

[[Page 51175]]

require further refinement through proration. Further, additional 
recordkeeping and analysis necessary to identify relevant time periods 
and employee activities involving the covered intangibles and to 
perform proration calculations are not warranted.
    The proposed regulations set forth special rules for the 
application of the general rule of measurement in the event of 
modification of a stock option and expiration or termination of a QCSA. 
The final regulations retain these rules with technical modifications.

E. Treatment of Statutory Stock Options--Sec.  1.482-7(d)(2)(iii)(A)(1)

    Under the default measurement rule in the proposed regulations, a 
special rule applies to statutory stock options (also referred to as 
incentive and employee stock purchase plan stock options). Under this 
special rule, the spread on statutory stock options generally is taken 
into account for QCSA purposes on exercise, even though section 421 
denies a deduction with respect to statutory stock options unless and 
until there is a disqualifying disposition of the underlying stock by 
the employee.
    One commentator suggested that the special rule for statutory stock 
options should be removed because it imposes an unnecessary 
administrative burden on taxpayers to apply different rules for 
different purposes. This suggestion was not adopted in the final 
regulations. Treasury and the IRS believe that the more important 
concern is consistent treatment of statutory and nonstatutory stock 
options for this purpose. This consistency is achieved only if the 
spread on both statutory and nonstatutory options is included in the 
cost pool on exercise.

F. Elective Method of Measurement--Sec.  1.482-7(d)(2)(iii)(B)

    The proposed regulations permit an elective method of measurement 
and timing with respect to options on publicly traded stock of 
companies subject to financial reporting under U.S. generally accepted 
accounting principles (U.S. GAAP), provided that the stock is traded on 
a U.S. securities market. Under the election, the amount taken into 
account for QCSA purposes associated with compensatory stock options is 
their ``fair value,'' generally measured by reference to economic 
pricing models as of the date of grant, as reflected either as a charge 
against income or as a footnote disclosure in the company's audited 
financial statements, in compliance with current U.S. GAAP.
    One commentator proposed that the elective measurement method be 
made available to all taxpayers. The commentator further suggested that 
controlled participants should be permitted to use any reasonable 
method to measure stock-based compensation in the form of options on 
stock of foreign corporations as long as that method is consistent with 
international accounting standards or with accounting principles that 
are prevalent in the home country of the controlled participant. In the 
commentator's view, the limitations in the proposed regulations are not 
justified by difficulty of valuation and may be vulnerable to 
challenges under anti-discrimination clauses in U.S. income tax 
treaties.
    Treasury and the IRS agree that the elective method should be more 
broadly available and have modified these rules in the final 
regulations. Specifically, the final regulations extend the 
availability of the elective method to options on the stock of certain 
companies that prepare their financial statements in accordance with 
accounting principles other than U.S. GAAP, while continuing to limit 
the availability of the elective method to options on stock that is 
publicly traded on a U.S. securities market. Thus, the availability of 
the elective method is not extended to options on stock of privately 
held companies or companies whose stock is traded only on foreign 
securities markets.
    Treasury and the IRS believe that objectivity and ease of 
administration are important features of any method of measuring costs 
attributable to stock-based compensation for purposes of QCSAs. The 
elective method should be available only for options on stock whose 
value is readily determinable and for companies that are required to 
determine the fair value of stock options for a non-tax purpose. 
Treasury and the IRS recognize that foreign-based companies whose stock 
is traded on a U.S. securities market (directly or through the use of 
American Depository Receipts) are required to determine the fair value 
of options on their stock even though they do not necessarily prepare 
financial statements in accordance with U.S. GAAP. Companies satisfy 
that requirement by preparing financial statements in accordance with a 
comprehensive body of generally accepted accounting principles (GAAP) 
that is consistent with the U.S. GAAP requirement of determining the 
fair value of stock options, or by preparing reconciliations of their 
financial statements with U.S. GAAP in a manner that reflects the fair 
value of stock options.
    Accordingly, the final regulations provide that in determining 
eligibility for the elective method, financial statements prepared in 
accordance with GAAP other than U.S. GAAP are considered as prepared in 
accordance with U.S. GAAP in two circumstances. First, financial 
statements are considered as prepared in accordance with U.S. GAAP 
where the fair value of stock options is reflected in a legally 
required reconciliation between the applicable GAAP and U.S. GAAP. In 
such a case, the fair value of stock options for purposes of the 
elective method of measurement will be the fair value reflected in such 
reconciliation. Second, financial statements are considered as prepared 
in accordance with U.S. GAAP where, under the applicable GAAP, the fair 
value of stock options is reflected as a charge against income in 
audited financial statements or is disclosed in footnotes to such 
statements. In such a case, the fair value of stock options for 
purposes of the elective method of measurement will be the fair value 
reflected in such audited financial statements.
    Treasury and the IRS continue to believe that the elective method 
should be available only for options on stock whose value is readily 
determinable and for companies that are required to determine the fair 
value of stock options for a non-tax purpose. Accordingly, the final 
regulations do not extend the availability of the elective method to 
options on stock of privately held companies or companies whose stock 
is traded only on foreign securities markets.
    One commentator suggested that the election to use the elective 
method should be made on the taxpayer's return rather than evidenced in 
the written cost sharing agreement. In the view of the commentator, 
such a procedure would be more practical from an enforcement 
perspective.
    This suggestion was not adopted. Treasury and the IRS continue to 
believe that the most effective way to ensure that all participants are 
bound by the election is to incorporate it within the written cost 
sharing agreement.

G. Modification of Comparable Profits Method--Sec.  1.482-5(c)(2)(iv)

    The proposed regulations provide that in applying the comparable 
profits method, if there are material differences among the tested 
party and uncontrolled comparables with respect to the utilization or 
treatment of stock-based compensation, such material differences are an 
appropriate basis for comparability adjustments. One commentator 
expressed the view that

[[Page 51176]]

this provision contradicts the arm's length coordination rules for 
QCSAs because the treatment of stock-based compensation by unrelated 
parties is considered relevant for purposes of the comparable profits 
method but not relevant for purposes of QCSAs.
    No revision was made in response to this comment. Treasury and the 
IRS believe that the rule provided in the proposed regulations with 
respect to the application of the comparable profits method is 
appropriate because the financial data with respect to similar business 
activities that generally is used as a reference point for that method 
is subject to adjustment to ensure comparability.

H. Effective Date and Transition Rules--Sec.  1.482-7(k) and 
(d)(2)(iii)(B)(2)

    The provisions of the proposed regulations applicable to QCSAs 
would apply to stock-based compensation granted in taxable years 
beginning on or after publication of final regulations. Participants in 
a QCSA in existence on the effective date may, on a one-time basis, 
amend their agreement to elect the grant-date method of measurement 
without the Commissioner's consent. The election with respect to 
existing QCSAs must be made not later than the latest due date, without 
regard to extensions, for an income tax return of a controlled 
participant for the first taxable year beginning after the effective 
date of final regulations.
    One commentator stated that the prospective effective date does not 
afford taxpayers a reasonable time to amend their cost sharing 
agreements or restructure complex international operations. A 
transition period of two years after the publication of final 
regulations was suggested.
    This suggestion was not adopted. Treasury and the IRS consider the 
period stated in the proposed regulations adequate for the initial 
planning and recordkeeping that may be occasioned by the final 
regulations.
    With respect to the special transition rule permitting taxpayers to 
elect the grant-date method of measurement by amendment of an existing 
written cost sharing agreement no later than the latest due date of an 
income tax return of a controlled participant, one commentator 
suggested that the due date should not disregard filing extensions. The 
commentator maintained that fairness dictates affording taxpayers this 
extra time for the analysis needed to make this significant decision.
    In response to this comment, the final regulations provide that the 
due date for amendments to existing cost sharing agreements is 
determined with regard to filing extensions.
    Some commentators urged Treasury and the IRS to postpone 
finalization of the proposed regulations until the OECD completes its 
ongoing consideration of the treatment of stock options for transfer 
pricing purposes and an international consensus begins to form so that 
the potential for international disputes and resulting negative effects 
on U.S. business can be minimized. Similarly, a commentator suggested 
that the effects of applying the principles of the proposed regulations 
to other areas of transfer pricing should be thoroughly studied and 
harmonized before finalizing the regulations to avoid creating traps 
for the unwary or other unforeseen consequences.
    These suggestions were not implemented. Treasury and the IRS do not 
believe that international discussion of issues compels the suspension 
of the regulatory process. Also, Treasury and the IRS believe that it 
is important to provide timely guidance on issues such as those 
addressed by the proposed and final regulations.
    Finally, the preamble to the proposed regulations states that the 
proposed regulations clarify that stock-based compensation must be 
taken into account in the QCSA context. Several commentators 
interpreted this language as in effect requiring the new rules to be 
applied retroactively. These commentators urged that the final 
regulations contain further assurances of prospective intent and 
explicitly recognize that these regulations represent a fundamental 
change to the traditional approach to section 482.
    No revisions were made in light of these comments. As noted 
earlier, Treasury and the IRS believe that requiring stock-based 
compensation to be taken into account in the QCSA context is consistent 
with the arm's length standard and long-standing policies underlying 
section 482. The final regulations, like the proposed regulations, 
clearly specify that the specific rules provided therein are 
prospective in application. Moreover, as stated in the proposed 
regulations, while taxpayers may rely on the proposed regulations until 
the effective date of the final regulations, no inference is intended 
with respect to the treatment of stock-based compensation granted in 
taxable years beginning before the effective date of these final 
regulations.

I. Paperwork Reduction Act and Regulatory Flexibility Act

    One commentator expressed the view that the compliance burden 
imposed by the proposed regulations on each taxpayer will significantly 
exceed the two to seven hours estimated under the Paperwork Reduction 
Act. The commentator also asserted that the estimated number of 
taxpayers affected by the rules was too low.
    The burden estimates as stated in the final regulations reflect no 
change. Treasury and the IRS reviewed the estimates made in the 
proposed regulations and concluded that they are reasonable.
    Similarly, with respect to the Regulatory Flexibility Act, the 
commentator challenged the statement in the preamble of the proposed 
regulations that the new regulatory requirements will not have a 
significant economic impact on a substantial number of small entities. 
Upon review of available information, Treasury and the IRS found no 
basis for a change in the statement or in the operative finding that 
the economic impact of the collections of information in the proposed 
regulations is not significant with respect to small entities.

J. Documentation Requirements and Other Provisions on Which No Comments 
Received

    Section 1.482-7(j)(2)(i)(F) of the proposed regulations requires 
that controlled participants maintain specific documentation to 
establish the amount attributable to stock-based compensation that is 
taken into account in determining the costs to be shared, including the 
method of measurement and timing used with respect to that amount. No 
comments were received on this particular provision, and it is retained 
in the final regulations.
    Treasury and the IRS intend that this provision will require 
controlled participants that use the elective method of measurement to 
maintain documentation establishing compliance with the requirements of 
Sec.  1.482-7(d)(2)(iii)(B). For example, documentation should 
establish that applicable financial statements reflecting the value of 
stock options with respect to which the elective method is used, as 
well as applicable accounting principles under which such financial 
statements are prepared, are in conformity with the fair-value and 
reconciliation requirements adopted in the final regulations with 
respect to GAAP other than U.S. GAAP.
    Several other provisions of the proposed regulations similarly were 
not commented upon and have been adopted without modification in the 
final regulations. These provisions include Sec.  1.482-
7(d)(2)(iii)(A)(2), relating to deductions of foreign

[[Page 51177]]

controlled participants; the last sentence of Sec.  1.482-7(d)(2)(ii), 
relating to repricing and other modifications of stock options; and 
Sec.  1.482-7(d)(2)(iii)(C), providing consistency rules for 
measurement and timing of stock-based compensation.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that few small 
entities are expected to enter into QCSAs involving stock-based 
compensation, and that for those who do, the burdens imposed under 
Sec.  1.482-7(d)(2)(iii)(B) and (j)(2)(i)(F) will be minimal. 
Therefore, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f), the proposed regulations preceding these regulations 
were submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is Douglas Giblen of the 
Office of Associate Chief Counsel (International). However, other 
personnel from Treasury and the IRS participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Sections 1.482-1, 1.482-5 and 1.482-7 also issued under 26 U.S.C. 482. 
* * *
0
Par. 2. Section 1.482-0 is amended by:
0
1. Redesignating the entry for Sec.  1.482-7(a)(3) as the entry for 
Sec.  1.482-7(a)(4).
0
2. Adding a new entry for Sec.  1.482-7(a)(3).
0
3. Redesignating the entry for Sec.  1.482-7(d)(2) as the entry for 
Sec.  1.482-7(d)(3).
0
4. Adding new entries for Sec.  1.482-7(d)(2).
    The additions and redesignation read as follows:


Sec.  1.482-0  Outline of regulations under section 482.

* * * * *


Sec.  1.482-7  Sharing of costs.

    (a) In general.
* * * * *
    (3) Coordination with Sec.  1.482-1.
    (4) Cross references.
* * * * *
    (d) Costs.
* * * * *
    (2) Stock-based compensation.
    (i) In general.
    (ii) Identification of stock-based compensation related to 
intangible development.
    (iii) Measurement and timing of stock-based compensation expense.
    (A) In general.
    (1) Transfers to which section 421 applies.
    (2) Deductions of foreign controlled participants.
    (3) Modification of stock option.
    (4) Expiration or termination of qualified cost sharing 
arrangement.
    (B) Election with respect to options on publicly traded stock.
    (1) In general.
    (2) Publicly traded stock.
    (3) Generally accepted accounting principles.
    (4) Time and manner of making the election.
    (C) Consistency.
    (3) Examples.
* * * * *

0
Par. 3. Section 1.482-1 is amended by:
0
1. Removing the sixth sentence of paragraph (a)(1) and adding two 
sentences in its place.
0
2. Adding a sentence at the end of paragraph (b)(2)(i).
0
3. Adding a sentence at the end of paragraph (c)(1).
0
4. Adding paragraph (j)(5).
    The additions read as follows:


Sec.  1.482-1  Allocation of income and deductions among taxpayers.

    (a) * * *
    (1) * * * Section 1.482-7T sets forth the cost sharing provisions 
applicable to taxable years beginning on or after October 6, 1994, and 
before January 1, 1996. Section 1.482-7 sets forth the cost sharing 
provisions applicable to taxable years beginning on or after January 1, 
1996. * * *
* * * * *
    (b) * * *
    (2) * * *
    (i) * * *Section 1.482-7 provides the specific method to be used to 
evaluate whether a qualified cost sharing arrangement produces results 
consistent with an arm's length result.
* * * * *
    (c) * * *
    (1) * * *See Sec.  1.482-7 for the applicable method in the case of 
a qualified cost sharing arrangement.
* * * * *
    (j) * * *
    (5) The last sentences of paragraphs (b)(2)(i) and (c)(1) of this 
section and of paragraph (c)(2)(iv) of Sec.  1.482-5 apply for taxable 
years beginning on or after August 26, 2003.

0
Par. 4. Section 1.482-5 is amended by adding a sentence at the end of 
paragraph (c)(2)(iv) to read as follows:


Sec.  1.482-5  Comparable profits method.

* * * * *
    (c) * * *
    (2) * * *
    (iv) * * *As another example, it may be appropriate to adjust the 
operating profit of a party to account for material differences in the 
utilization of or accounting for stock-based compensation (as defined 
by Sec.  1.482-7(d)(2)(i)) among the tested party and comparable 
parties.
* * * * *

0
Par. 5. Section 1.482-7 is amended by:
0
1. Redesignating paragraph (a)(3) as paragraph (a)(4).
0
2. Adding a new paragraph (a)(3).
0
3. Redesignating paragraph (d)(2) as paragraph (d)(3).
0
4. Adding a new paragraph (d)(2).
0
5. Removing the word ``and'' at the end of paragraph (j)(2)(i)(D).
0
6. Removing the period at the end of paragraph (j)(2)(i)(E) and adding 
``; and'' in its place.
0
7. Adding paragraph (j)(2)(i)(F).
0
8. Revising paragraph (k).
    The additions and revision read as follows:


Sec.  1.482-7  Sharing of costs.

    (a) * * *
    (3) Coordination with Sec.  1.482-1. A qualified cost sharing 
arrangement produces results that are consistent with an arm's length 
result within the meaning of Sec.  1.482-1(b)(1) if, and only if, each 
controlled participant's share of

[[Page 51178]]

the costs (as determined under paragraph (d) of this section) of 
intangible development under the qualified cost sharing arrangement 
equals its share of reasonably anticipated benefits attributable to 
such development (as required by paragraph (a)(2) of this section) and 
all other requirements of this section are satisfied.
* * * * *
    (d) * * *
    (2) Stock-based compensation--(i) In general. For purposes of this 
section, a controlled participant's operating expenses include all 
costs attributable to compensation, including stock-based compensation. 
As used in this section, the term stock-based compensation means any 
compensation provided by a controlled participant to an employee or 
independent contractor in the form of equity instruments, options to 
acquire stock (stock options), or rights with respect to (or determined 
by reference to) equity instruments or stock options, including but not 
limited to property to which section 83 applies and stock options to 
which section 421 applies, regardless of whether ultimately settled in 
the form of cash, stock, or other property.
    (ii) Identification of stock-based compensation related to 
intangible development. The determination of whether stock-based 
compensation is related to the intangible development area within the 
meaning of paragraph (d)(1) of this section 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 qualified cost 
sharing arrangement and is related at date of grant to the development 
of intangibles covered by the arrangement is included as an intangible 
development cost under paragraph (d)(1) of this section. In the case of 
a repricing or other modification of a stock option, the determination 
of whether the repricing or other modification constitutes the grant of 
a new stock option for purposes of this paragraph (d)(2)(ii) will be 
made in accordance with the rules of section 424(h) and related 
regulations.
    (iii) Measurement and timing of stock-based compensation expense--
(A) In general. Except as otherwise provided in this paragraph 
(d)(2)(iii), the operating expense 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 operating expense under this section for 
the taxable year for which the deduction is allowable.
    (1) Transfers to which section 421 applies. Solely for purposes of 
this paragraph (d)(2)(iii)(A), section 421 does not apply to the 
transfer of stock pursuant to the exercise of an option that meets the 
requirements of section 422(a) or 423(a).
    (2) Deductions of foreign controlled participants. Solely for 
purposes of this paragraph (d)(2)(iii)(A), an amount is treated as an 
allowable deduction of a controlled participant to the extent that a 
deduction would be allowable to a United States taxpayer.
    (3) Modification of stock option. Solely for purposes of this 
paragraph (d)(2)(iii)(A), if the repricing or other modification of a 
stock option is determined, under paragraph (d)(2)(ii) of this section, 
to constitute the grant of a new stock option not related to the 
development of intangibles, the stock option that is repriced or 
otherwise modified will be treated as being exercised immediately 
before the modification, provided that the stock option is then 
exercisable and the fair market value of the underlying stock then 
exceeds the price at which the stock option is exercisable. 
Accordingly, the amount of the deduction that would be allowable (or 
treated as allowable under this paragraph (d)(2)(iii)(A)) to the 
controlled participant upon exercise of the stock option immediately 
before the modification must be taken into account as an operating 
expense as of the date of the modification.
    (4) Expiration or termination of qualified cost sharing 
arrangement. Solely for purposes of this paragraph (d)(2)(iii)(A), if 
an item of stock-based compensation related to the development of 
intangibles is not exercised during the term of a qualified cost 
sharing arrangement, that item of stock-based compensation will be 
treated as being exercised immediately before the expiration or 
termination of the qualified cost sharing arrangement, provided that 
the stock-based compensation is then exercisable and the fair market 
value of the underlying stock then exceeds the price at which the 
stock-based compensation is exercisable. Accordingly, the amount of the 
deduction that would be allowable (or treated as allowable under this 
paragraph (d)(2)(iii)(A)) to the controlled participant upon exercise 
of the stock-based compensation must be taken into account as an 
operating expense as of the date of the expiration or termination of 
the qualified cost sharing arrangement.
    (B) Election with respect to options on publicly traded stock--(1) 
In general. With respect to stock-based compensation in the form of 
options on publicly traded stock, the controlled participants in a 
qualified cost sharing arrangement may elect to take into account all 
operating expenses 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.
    (2) Publicly traded stock. As used in this paragraph 
(d)(2)(iii)(B), the term publicly traded stock means stock that is 
regularly traded on an established United States securities market and 
is issued by a company whose financial statements are prepared in 
accordance with United States generally accepted accounting principles 
for the taxable year.
    (3) Generally accepted accounting principles. For purposes of this 
paragraph (d)(2)(iii)(B), a financial statement prepared in accordance 
with a comprehensive body of generally accepted accounting principles 
other than United States generally accepted accounting principles is 
considered to be prepared in accordance with United States generally 
accepted accounting principles provided that either--
    (i) The fair value of the stock options under consideration is 
reflected in the reconciliation between such other accounting 
principles and United States generally accepted accounting principles 
required to be incorporated into the financial statement by the 
securities laws governing companies whose stock is regularly traded on 
United States securities markets; or
    (ii) In the absence of a reconciliation between such other 
accounting principles and United States generally accepted accounting 
principles that reflects the fair value of the stock options under 
consideration, such other accounting principles require that the fair 
value of the stock options under consideration be reflected as a charge 
against income in audited financial statements or disclosed in 
footnotes to such statements.
    (4) Time and manner of making the election. The election described 
in this paragraph (d)(2)(iii)(B) is made by an explicit reference to 
the election in the written cost sharing agreement required by 
paragraph (b)(4) of this section or in a written amendment to the cost 
sharing agreement entered into with the consent

[[Page 51179]]

of the Commissioner pursuant to paragraph (d)(2)(iii)(C) of this 
section. In the case of a qualified cost sharing arrangement in 
existence on August 26, 2003, the election must be made by written 
amendment to the cost sharing agreement 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 
August 26, 2003, and the consent of the Commissioner is not required.
    (C) Consistency. Generally, all controlled participants in a 
qualified cost sharing arrangement taking options on publicly traded 
stock into account under paragraph (d)(2)(iii)(A) or (B) of this 
section must use that same method of measurement and timing for all 
options on publicly traded stock with respect to that qualified cost 
sharing arrangement. Controlled participants may change their method 
only with the consent of the Commissioner and only with respect to 
stock options granted during taxable years subsequent to the taxable 
year in which the Commissioner's consent is obtained. All controlled 
participants in the qualified cost sharing arrangement must join in 
requests for the Commissioner's consent under this paragraph. Thus, for 
example, if the controlled participants make the election described in 
paragraph (d)(2)(iii)(B) of this section upon the formation of the 
qualified cost sharing arrangement, the election may be revoked 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. Similarly, if controlled 
participants already have granted stock options that have been or will 
be taken into account under the general rule of paragraph 
(d)(2)(iii)(A) of this section, then except in cases specified in the 
last sentence of paragraph (d)(2)(iii)(B)(2) of this section, the 
controlled participants may make the election described in paragraph 
(d)(2)(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.
* * * * *
    (j) * * *
    (2) * * *
    (i) * * *
    (F) The amount taken into account as operating expenses 
attributable to stock-based compensation, including the method of 
measurement and timing used with respect to that amount as well as the 
data, as of date of grant, used to identify stock-based compensation 
related to the development of covered intangibles.
* * * * *
    (k) Effective date. This section applies for taxable years 
beginning on or after January 1, 1996. However, paragraphs (a)(3), 
(d)(2) and (j)(2)(i)(F) of this section apply for stock-based 
compensation granted in taxable years beginning on or after August 26, 
2003.
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 9. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805


0
Par. 10. In Sec.  602.101, paragraph (b) is amended by adding an entry 
in numerical order to the table to read in part as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                                * * * * *
1.482-7.................................................       1545-1794
 
                                * * * * *
------------------------------------------------------------------------


Robert E. Wenzel,
Deputy Commissioner for Services and Enforcement.
    Approved: August 11, 2003.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-21355 Filed 8-25-03; 8:45 am]
BILLING CODE 4830-01-P