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Proposed Regulations

Compensatory Stock Options Under Section 482


[Federal Register: July 29, 2002 (Volume 67, Number 145)]
[Proposed Rules]
[Page 48997-49003]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr29jy02-7]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106359-02]
RIN 1545-BA57


Compensatory Stock Options Under Section 482

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations that provide
guidance regarding the application of the rules of section 482
governing qualified cost sharing arrangements. These proposed
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. This document also
provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by October 28,
2002. Requests to speak and outlines of topics to be discussed at the
public hearing scheduled for November 20, 2002, must be received by
October 30, 2002.

ADDRESSES: Send submissions to: CC:ITA:RU (REG-106359-02), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand-delivered between the hours of 8 a.m.
and 5 p.m. to CC:ITA:RU (REG-106359-02), Courier's Desk, Internal
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC.
Alternatively, taxpayers may submit comments electronically directly to
the IRS Internet site at http://www.irs.gov/regs. The public hearing
will be held in Room 4718, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Douglas
Giblen, (202) 874-1490; concerning submissions of comments, the
hearing, and/or to be placed on the building access list to attend the
hearing, LaNita Van Dyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

    The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collection of information 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:FP:S,
Washington, DC 20224. Comments on the collection of information should
be received by September 27, 2002. Comments are specifically requested
concerning:

    Whether the proposed collection of information is necessary for the
proper performance of the functions of the Internal Revenue Service,
including whether the information will have practical utility;

    The accuracy of the estimated burden associated with the proposed
collection of information (see below);

    How the quality, utility, and clarity of the information to be
collected may be enhanced;

    How the burden of complying with the proposed collection of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and

    Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.

    The collection of information requirements are in proposed
Secs. 1.482-7(d)(2)(iii)(B) and 1.482-7(j)(2)(i)(F). This information
is required by the IRS to monitor compliance with the federal tax rules
for determining stock-based compensation costs related to intangible
development to be shared among controlled participants in qualified
cost sharing arrangements. The likely respondents are taxpayers who
enter into these arrangements. Responses to this collection of
information are required to determine these taxpayers' proper shares of
stock-based compensation costs incurred with respect to these
arrangements.

    Section 1.482-7(d)(2)(iii)(B) of the proposed regulations provides
that controlled participants may elect an alternative method of
measurement of certain stock-based compensation by clearly referring to
the election in the written cost sharing agreement required under
existing regulations or by amending a cost sharing agreement already in
effect to refer to the election. Section 1.482-7(j)(2)(i)(F) requires
controlled participants to maintain documentation necessary to
establish the amount taken into account as operating expenses
attributable to stock-based compensation, including the method of
measurement and timing used in computing that amount, and the data, as
of the date of grant, used to identify stock-based compensation related
to the development of intangibles.

    Estimated total annual reporting and/or recordkeeping burden: 2,000
hours.

    Estimated average annual burden hours per respondent and/or
recordkeeper: The estimated annual burden per respondent varies from 2
hours to 7 hours, depending on individual circumstances, with an
estimated average of 4 hours.

    Estimated number of respondents and/or recordkeepers: 500.

    Estimated frequency of responses: Annually.

    An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control

[[Page 48998]]

number assigned by the Office of Management and Budget.

    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

    Section 482 of the Internal Revenue Code generally provides that
the Secretary may allocate gross income, deductions and credits between
or among two or more taxpayers owned or controlled by the same
interests in order to prevent evasion of taxes or clearly to reflect
income. On July 8, 1994, Treasury and the IRS published in the Federal
Register (59 FR 34988) final regulations (T.D. 8552, 1994-2 C.B. 93)
under section 482 in areas other than cost sharing. On December 20,
1995, Treasury and the IRS published in the Federal Register (60 FR
65553) final cost sharing regulations (T.D. 8632, 1996-1 C.B. 85),
effective for taxable years beginning on or after January 1, 1996.
Amendments to T.D. 8632 were published in the Federal Register on May
13, 1996, at 61 FR 21955 (T.D. 8670, 1996-1 C.B. 99), and on January 3,
2001, at 66 FR 280 (T.D. 8930, 2001-1 I.R.B. 433).

    The 1994 final regulations under section 482 contain general
provisions at Sec. 1.482-1 describing the arm's length standard and the
best method rule. The final cost sharing regulations at Sec. 1.482-7
generally require that controlled participants in a qualified cost
sharing arrangement share intangible development costs in proportion to
their shares of the reasonably anticipated benefits attributable to the
development of the intangibles covered by the arrangement. These
proposed regulations clarify that stock-based compensation is taken
into account in determining the operating expenses treated as a
controlled participant's intangible development costs for purposes of
the cost sharing provisions; 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 clarify the coordination of the
cost sharing rules of Sec. 1.482-7 with the arm's length standard as
set forth in Sec. 1.482-1.

Explanation of Provisions

Overview

    The Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 2085, 2561
et seq. (reprinted at 1986-3 C.B. (Vol. 1) 1, 478) (the Act), amended
section 482 to require that consideration for intangible property
transferred in a controlled transaction be commensurate with the income
attributable to the intangible. The legislative history of the Act
indicated that in adding this commensurate with income standard to
section 482, Congress did not intend to preclude the use of bona fide
research and development cost sharing arrangements as an appropriate
method of allocating income attributable to intangibles among related
parties, ``if and to the extent such agreements are consistent with the
purpose of this provision that the income allocated among the parties
reasonably reflect the actual economic activity undertaken by each.
Under such a bona fide cost-sharing arrangement, the cost-sharer would
be expected to bear its portion of all research and development costs *
* *.'' H.R. Rep. No. 99-841, at II-638 (1986) (the Conference Report).

    The Conference Report recommended that the IRS conduct a
comprehensive study and consider whether the regulations under section
482 (issued in 1968) should be modified in any respect. In response to
this directive, on October 18, 1988, Treasury and the IRS issued a
study of intercompany pricing (the White Paper), published as Notice
88-123, 1988-2 C.B. 458. With respect to cost sharing arrangements, the
White Paper observed that Congress intended such arrangements to
produce results consistent with the purposes of the commensurate with
income standard in section 482, and in particular that allocations of
income among the participants reasonably reflect the participants'
respective economic activity. 1988-2 C.B. at 459, 495. The White Paper
further observed that Congress intended that Treasury and the IRS apply
and interpret the commensurate with income standard consistently with
the arm's length standard. 1988-2 C.B. at 458, 477.

    Section 1.482-1 of the 1994 final regulations 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. A method selected under the best method
rule is used to determine whether a controlled transaction produces an
arm's length result. The regulations reference Secs. 1.482-2 through
1.482-6 as providing specific methods to be used in this determination.

    Section 1.482-7 of the 1995 final regulations implements the
commensurate with income standard in the context of cost sharing
arrangements. The final cost sharing regulations require that
controlled participants in a qualified cost sharing arrangement share
all costs incurred that are related to the development of intangibles
in proportion to their shares of the reasonably anticipated benefits
attributable to that development. Section 1.482-7(d)(1) defines these
intangible development costs as including operating expenses as defined
in Sec. 1.482-5(d)(3), other than depreciation or amortization, plus an
arm's length rental charge determined under Sec. 1.482-2(c) for the use
of any tangible property made available to the qualified cost sharing
arrangement. Section 1.482-5(d)(3) defines operating expenses, for
purposes of the comparable profits method under section 482, as
including all expenses not included in cost of goods sold except for
interest expense, foreign and domestic income taxes, and any other
expenses not related to the operation of the relevant business
activity. In the context of cost sharing, the relevant business
activity is the development of intangibles covered by the cost sharing
arrangement.

    Since the promulgation of the final cost sharing regulations in
1995, the issue has been raised whether operating expenses within the
meaning of Sec. 1.482-7(d)(1) include compensation provided by a
controlled participant in the form of stock options. Related questions
have been posed in this context regarding the interaction between the
arm's length standard and the cost sharing regulations.

    These proposed regulations amend the final regulations to clarify
that stock-based compensation must be taken into account in determining
operating expenses under Sec. 1.482-7(d)(1) and to provide rules for
measuring stock-based compensation costs. These proposed regulations
also clarify that stock-based compensation should be taken into account
in comparability determinations pursuant to the comparable profits
method under Sec. 1.482-5. Finally, the proposed regulations amend the
final regulations to include express provisions to coordinate the cost
sharing rules of Sec. 1.482-7 with the arm's length standard as set
forth in Sec. 1.482-1.

[[Page 48999]]

Inclusion of Stock-Based Compensation in Intangible Development Costs

    The proposed regulations provide that in determining a controlled
participant's operating expenses within the meaning of Sec. 1.482-
7(d)(1), all compensation, including stock-based compensation, must be
taken into account. The proposed regulations also provide rules for
measuring the operating expenses attributable to stock-based
compensation.

    The definition of stock-based compensation for purposes of these
proposed regulations is broad, comprising any compensation provided by
a controlled participant to an employee or independent contractor in
the form of equity instruments, stock options, or rights in (or
determined by reference to) such instruments or options, regardless of
whether the compensation ultimately is settled in the form of cash,
stock, or other property. Thus, these proposed regulations are intended
to reach such forms of compensation as restricted stock, nonstatutory
stock options, statutory stock options (incentive stock options
described in section 422(b) and options granted under an employee stock
purchase plan described in section 423(b)), stock appreciation rights,
and phantom stock. Statutory stock options are within the scope of the
definition regardless of whether the employer is entitled to an income
tax deduction with respect to those options.

    The proposed regulations provide that the determination of whether
stock-based compensation is related to the development of intangibles
covered by the qualified cost sharing arrangement is to be made as of
the date the stock-based compensation is granted. For example,
controlled participants must share the costs attributable to stock-
based compensation that is granted to an employee who, at the time of
grant, is performing research services related to the qualified cost
sharing arrangement. Treasury and the IRS believe that this rule
appropriately identifies the stock-based compensation to be shared
because the grant of compensation generally is the economic event most
closely associated in time with the services being compensated. Because
a controlled participant may choose whether to provide stock-based or
cash compensation, this rule also promotes neutrality of treatment as
among various forms of compensation. Finally, because the grant-date
identification rule applies irrespective of the method used by the
controlled participant to measure or determine the timing of inclusion
of stock-based compensation in the intangible development costs to be
shared, the rule ensures that the same items of stock-based
compensation will be taken into account under any method, thus
promoting neutrality in the choice of measurement method afforded by
the proposed regulations.

    In applying the grant-date identification rule in cases where a
stock option is repriced or otherwise modified, the rules of section
424(h) and related regulations will be used to determine whether the
grant of a new stock option has occurred.

    Treasury and the IRS recognize that tax and other accounting
principles permit the cost associated with stock-based compensation to
be measured and taken into account as of different points in time and
under various methodologies for different purposes. For example, for
general income tax purposes, the amount of compensation taxed to an
employee and deductible by an employer upon exercise of a stock option
not governed by sections 421-424 (commonly referred to as a
nonstatutory stock option) generally is measured by the ``spread''
between the option price and the fair market value of the underlying
stock at the date of exercise. See Secs. 83(a), 83(h), 1.83-1(a)(1),
1.83-6(a)(1).

    For various other tax purposes, however, the IRS has adopted
modified versions of economic pricing models, such as the Black-Scholes
model, for valuing stock options at specific points in time prior to
exercise. See Rev. Proc. 98-34, 1998-1 C.B. 983 (estate and gift tax
valuation); Rev. Proc. 2002-13, 2002-8 I.R.B. 549, as modified by Rev.
Proc. 2002-45, 2002-27 I.R.B. 40 (measurement of stock-option-based
golden parachute payments under sections 280G and 4999). Pricing models
also have been adopted in the context of financial accounting. The
Financial Accounting Standards Board (FASB) refers to pricing models
for measurement of the stock-based compensation expense that a company
is required to report at ``fair value,'' either as a charge to income
or, at the company's option, in a pro forma footnote disclosure. See
FASB Statement 123, Accounting for Stock-Based Compensation (October
1995).

    Generally accepted pricing models can be applied at the date of
grant to estimate the economic cost of a stock option to the issuer.
General support for the use of economic measures of cost in the
transfer pricing context may be found in the legislative history of the
commensurate with income standard and in the White Paper, which state
that to be consistent with the commensurate with income standard, cost
sharing arrangements must ``reflect the actual economic activity'' of
participants. Conference Report at II-638 and White Paper at 1988-2
C.B. 495.

    In establishing rules for measurement of the operating expenses
attributable to stock-based compensation for cost sharing purposes,
Treasury and the IRS believe that due regard must be given to the
emphasis placed on economic factors in the legislative history of the
commensurate with income standard and in the White Paper. Treasury and
the IRS also recognize the importance of providing rules that are
administrable.

    The proposed regulations prescribe a general rule of measurement
based primarily on the amount and timing of the income tax deduction
associated with stock-based compensation, while in certain cases
permitting controlled participants in a qualified cost sharing
arrangement to elect a rule of measurement with respect to stock
options based on the amount and timing of the fair value of the option
that is required to be computed for purposes of financial accounting in
accordance with United States generally accepted accounting principles
(U.S. GAAP).

    To provide for uniform measurement of the cost associated with both
statutory and nonstatutory stock options, the general deduction-based
measurement rule is applied as if section 421 did not apply upon the
exercise of a statutory stock option. Thus, although section 421
generally disallows compensation deductions with respect to the
exercise of statutory stock options except in the case of certain
disqualifying dispositions, the proposed regulations treat the exercise
of a statutory stock option as giving rise to a deduction for purposes
of the deduction-based measurement rule. Consequently, the operating
expense with respect to all stock options, whether statutory or
nonstatutory, generally will be measured by the ``spread'' and taken
into account as of the date the stock option is exercised.

    To place a foreign controlled participant on an equal footing with
a United States controlled participant, an amount is treated as
deductible by a foreign controlled participant, solely for purposes of
the general deduction-based measurement rule, as if the amount were
paid or incurred by a United States taxpayer, even if the foreign
controlled participant is not subject to United States taxing
jurisdiction and so would not otherwise be entitled to a deduction
under United States income tax law.

    Solely for purposes of the general deduction-based measurement
rule, any item of stock-based compensation that is eligible to be
exercised and that remains

[[Page 49000]]

outstanding on the expiration or termination of a qualified cost
sharing arrangement will be treated as being exercised immediately
before the expiration or termination, provided that the fair market
value of the underlying stock at that time exceeds the price at which
the stock-based compensation is exercisable. The result of this
treatment is that the excess of the fair market value of the underlying
stock over the price at which the stock-based compensation is
exercisable is taken into account as an operating expense for the
taxable year in which the qualified cost sharing arrangement expires or
terminates. This special rule would apply, for example, in the case of
a currently exercisable statutory stock option or a substantially
vested nonstatutory stock option where the fair market value of the
underlying stock exceeds the option price at the time the qualified
cost sharing arrangement is terminated. The rule ensures that
controlled participants take into account for cost sharing purposes all
stock-based compensation that is attributable to the development of
intangibles and has become exercisable during the term of the cost
sharing arrangement. In cases where significant amounts of stock-based
compensation have been granted, but are not exercisable at the time of
the termination of the arrangement, the IRS anticipates that factual
issues regarding the termination of the qualified cost sharing
arrangement will arise if the arrangement is reinstated.

    A similar rule applies if, during the term of the qualified cost
sharing arrangement, a newly granted stock option is determined to
result from a repricing or other modification of another stock option
and is not related to the development of intangibles at the time of the
modification. In this situation, an amount is taken into account for
purposes of the general deduction-based measurement rule as if the
original stock option had been exercised immediately before the
modification.

    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. GAAP, provided that
the stock is traded on a United States securities market.

    Under the election, the amount of the operating expense 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. Where the election is made with respect to
stock in a company that does not take stock-based compensation expense
as a charge against income for financial accounting purposes but rather
chooses, as permitted by current U.S. GAAP (for example, FASB Statement
123), to disclose such compensation in a footnote to the financial
statements, stock-based compensation is taken into account in the same
amount, and as of the same time, as the pro forma fair value figures
reflected in the footnote.

    The election to measure the operating expense associated with
compensatory stock options in accordance with financial accounting
rules must be clearly referenced in the written cost sharing agreement
required under Sec. 1.482-7(b)(4) and must bind all controlled
participants. A transition rule permits controlled participants to
amend pre-existing cost sharing agreements 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 incorporating this rule.

    The proposed regulations contain consistency rules to ensure that
all controlled participants in a qualified cost sharing arrangement
normally will use the same method of measurement for all options on
publicly traded stock with respect to that arrangement. Once a method
of measurement has been adopted with respect to stock options granted
in a taxable year following the effective date of the proposed
regulations, the method of measurement may not be changed for those
stock options. With respect to subsequently granted stock options to
which the transition rule does not apply, the proposed regulations
provide that a method of measurement different from that adopted
following the effective date of the proposed regulations may be adopted
only with the consent of the Commissioner.

    To ensure that taxpayers maintain documentation supporting all
amounts taken into account as operating expenses attributable to stock-
based compensation, these proposed regulations add to the documentation
requirements of Sec. 1.482-7(j)(2)(i) an item specifically relating to
stock-based compensation.

Treatment of Stock-Based Compensation Under Other Provisions

    The treatment of stock-based compensation as a cost or operating
expense for purposes of the transfer pricing of services and for
purposes of applying the comparable profits method will be considered
by Treasury and the IRS in a separate regulation project. Accordingly,
these regulations do not propose amendments to the definitions of cost
or operating expense in Sec. 1.482-2(b) or Sec. 1.482-5(d)(3). However,
these proposed regulations amend Sec. 1.482-5(c)(2)(iv) to clarify that
in applying the comparable profits method, material differences among
the tested party and uncontrolled comparables with respect to the
utilization or treatment of stock-based compensation are an appropriate
basis for comparability adjustments.

Coordination of Cost Sharing With the Arm's Length Standard

    These proposed regulations add express provisions coordinating the
cost sharing rules of Sec. 1.482-7 with the arm's length standard as
set forth in Sec. 1.482-1. New Sec. 1.482-7(a)(3) clarifies that in
order for a qualified cost sharing arrangement to produce results
consistent with an arm's length result within the meaning of
Sec. 1.482-1(b)(1), all requirements of Sec. 1.482-7 must be met,
including the requirement that each controlled participant's share of
intangible development costs equal its share of reasonably anticipated
benefits attributable to the development of intangibles. The proposed
regulations also make amendments to Sec. 1.482-1 to clarify that
Sec. 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, and to clarify that under the
best method rule, the provisions of Sec. 1.482-7 set forth the
applicable method with respect to qualified cost sharing arrangements.

    Through these new provisions, Treasury and the IRS intend to
clarify that all of the specific rules necessary to the determination
of costs, reasonably anticipated benefits and other aspects of
qualified cost sharing arrangements are either contained or cross-
referenced within Sec. 1.482-7. Thus, for example, regarding buy-in
payments with respect to pre-existing intangibles made available to
qualified cost sharing arrangements, Secs. 1.482-7(a)(2) and 1.482-7(g)
cross-reference various other sections of the regulations under section
482. For the determination of reasonably anticipated benefits,
Sec. 1.482-7(f)(3) expressly requires that certain comparability
factors described in Sec. 1.482-1(c)(2)(ii) under the best method rule
be considered. With respect to identification of the costs to be
shared, the rules are contained within Sec. 1.482-7(d)(1), which refers
to ``all'' intangible development costs and cross-references the
definition of operating expenses in Sec. 1.482-5(d)(3) and the
provisions of

[[Page 49001]]

Sec. 1.482-2(c) governing determination of arm's length rental charges
for tangible property. The Sec. 1.482-7(d)(1) definition of intangible
development costs is supplemented by the provisions of Sec. 1.482-
7(c)(2), which cross-references the provisions of Sec. 1.482-
4(f)(3)(iii) to determine arm's length consideration for research
assistance performed by a controlled taxpayer that is not a controlled
participant.

Proposed Effective Date

    These regulations are proposed to apply to stock-based compensation
granted in taxable years beginning on or after the date these
regulations are published as a Treasury Decision promulgating final
regulations in the Federal Register. Notwithstanding this prospective
effective date, Treasury and the IRS intend that taxpayers may rely on
these 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 the final regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking 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 collections 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 qualified cost sharing arrangements
involving stock-based compensation, and that for those who do, the
burdens imposed under Secs. 1.482-7(d)(2)(iii)(B) and 1.482-
7(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), this notice of proposed
rulemaking will be submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic or written comments (a
signed original and eight (8) copies) that are submitted timely to the
IRS. Treasury and the IRS specifically request comments on the clarity
of the proposed regulations and how they may be made easier to
understand. All comments will be available for public inspection and
copying.

    A public hearing has been scheduled for October 21, 2002, at 10
a.m., in Room 4718, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC. Because of access restrictions, visitors
will not be admitted beyond the building lobby more than 30 minutes
before the hearing starts. For information about having your name
placed on the building access list to attend the hearing, see the FOR
FURTHER INFORMATION CONTACT section of this preamble.

    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit written
comments and an outline of the topics to be discussed and the time to
be devoted to each topic (signed original and eight (8) copies) by
September 30, 2002. A period of 10 minutes will be allotted to each
person for making comments.

    An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed 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 in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR Part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

    Authority: 26 U.S.C. 7805 * * **
    Sections 1.482-1, 1.482-5 and 1.482-7 also issued under 26
U.S.C. 482. * * *

    Section 1.482-0 is amended by:
    1. Redesignating the entry for Sec. 1.482-7(a)(3) as the caption
for Sec. 1.482-7(a)(4).
    2. Adding a new entry for Sec. 1.482-7(a)(3).
    3. Redesignating the entry for Sec. 1.482-7(d)(2) as the caption
for Sec. 1.482-7(d)(3).
    4. Adding new entries for Sec. 1.482-7(d)(2).
    The additions and revisions 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.
    (C) Consistency.
    (3) Examples.
* * * * *
    Section 1.482-1 is amended by:
    1. Revising the sixth sentence of paragraph (a)(1).
    2. Adding a sentence following the sixth sentence of paragraph
(a)(1).
    3. Adding a sentence at the end of paragraph (b)(2)(i).
    4. Adding a sentence at the end of paragraph (c)(1).
    5. Adding paragraph (j)(5).
    The additions and revisions 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.
* * * * *

[[Page 49002]]

    (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 are effective for
taxable years beginning on or after the date of publication of the
Treasury Decision incorporating those sentences into final regulations
in the Federal Register.
    Section 1.482-5 is amended by adding a sentence to 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.
* * * * *
    Section 1.482-7 is amended by:
    1. Redesignating paragraph (a)(3) as paragraph (a)(4).
    2. Adding paragraph (a)(3).
    3. Redesignating paragraph (d)(2) as paragraph (d)(3).
    4. Adding paragraph (d)(2).
    5. Removing the word ``and'' at the end of paragraph (j)(2)(i)(D).
    6. Removing the period and adding a semicolon and the word ``and''
at the end of paragraph (j)(2)(i)(E).
    7. Adding paragraph (j)(2)(i)(F).
    8. Revising paragraph (k).
    The additions and revisions 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 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.
    (4) Cross references. * * *
* * * * *
    (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
deductible by a foreign controlled participant otherwise not entitled
to a deduction under United States income tax law as if the amount were
paid or incurred by 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
substantially vested within the meaning of Sec. 1.83-3(b) (or, in the
case of stock options to which section 421 applies, 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 substantially vested within the
meaning of Sec. 1.83-3(b) (or, in the case of stock options to which
section 421 applies, 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. 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

[[Page 49003]]

disclosed in footnotes to such financial statements, prepared in
accordance with United States generally accepted accounting principles
by or on behalf of the company issuing the publicly traded stock. As
used in this section, 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. 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 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 the effective date of this paragraph
(d)(2)(iii)(B), the election must be made by written amendment to the
cost sharing agreement not later than the latest due date (without
regard to extensions) of a federal income tax return of any controlled
participant for the first taxable year beginning after the effective
date of this paragraph, 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 (d)(2)(iii)(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) 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.
    (3) Examples. * * *
* * * * *
    (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 intangibles covered by the qualified cost
sharing arrangement.
* * * * *
    (k) Effective date. This section is generally effective for taxable
years beginning on or after January 1, 1996. However, paragraphs
(a)(3), (d)(2) and (j)(2)(i)(F) of this section are effective for
taxable years beginning on or after the date of publication of the
Treasury Decision adopting those rules as final regulations in the
Federal Register.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 02-19126 Filed 7-26-02; 8:45 am]
BILLING CODE 4830-01-P

Source: 67 Fed. Reg. 48997-49003 (July 29, 2002) [TEXT]   [PDF]
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