How Are Stock Options Taxed And How A Little Tax Case Called Altera May Affect Your Paycheck
We live in tumultuous times. The COVID 19 Pandemic, murder hornets, politics, and who knows what else are occupying the headlines. Beneath it all lies an important tax case called Altera Corporation v. the Commissioner of the Internal Revenue Service (“Altera”). This case involves how stock options are taxed and its outcome may have far ranging impact on thousands of Americans who receive stock options as compensation from their employers. The US Supreme Court recently declined to hear the case, but the tax issues how stock options are taxed, and the impact on thousands of American workers may be far from settled.
There is a lot to unpack with this case. It involves administrative law issues and complex regulations that we will not elaborate too much on, but the core question for us is whether multi-national companies will recognize taxable income in the US when they issue stock options to US employees who develop technology and other intellectual property.
Transfer Pricing Regulations
To give us a starting point, Altera involves transfer pricing regulations that are created to prevent tax abuses that could occur when two related companies (like a parent company and subsidiary) have a transaction. Let us take a US Company that has a Cayman Islands subsidiary as an example. The US Company’s tax rate is much higher than the Cayman Islands subsidiary. Let us say the US Company has profits of $10 million a year. In a world without transfer pricing regulations, the US Company could rent a 200 square foot office from its own Cayman Islands subsidiary at a rate of $10 million per year. The US Company would claim a $10 million per year deduction on its US tax return and wipe out its taxable profits. The Cayman Islands subsidiary would have $10 million of income which really would not matter much because the tax rate in the Cayman Islands is zero.
Transfer pricing regulations prevent these abuses by generally providing that transactions between related companies will be treated for tax purposes as if they resembled arm’s length transactions between unrelated companies. In the above example, the transfer pricing regulations would not allow a US company to claim a $10 million per year deduction for renting a 200 square foot office from its own Cayman Island’s subsidiary. It would only be able to claim a deduction equal to the fair market value of rent would be (which is going to be far less than $10 million per year). The US Company ends up paying tax on the $10 million of income it earned (as it should).
Transfers of Intellectual Property and Other Intangibles
Things get more complicated when it comes to intellectual property and other intangibles being transferred between related companies. The Altera case involved a US Corporation (we will call it Altera US) that developed electronic components and had a Cayman Islands subsidiary (we will call it Altera CI). To lower its tax bill, Altera US transferred its worldwide rights on its electronic component technologies to Altera CI. Altera CI, not Altera US, would recognize the taxable income from the worldwide rights on the technology and thus Altera US lowered its US tax bill by lowering its taxable income.
There is potential for abuse if a company like Altera US transfers the worldwide rights to its technology or other intellectual properties to offshore subsidiaries like Altera CI. Just as a US based company should not get to claim a $10 million deduction for renting an office from itself, a US based company should not be able to give away the worldwide rights on lucrative technologies. The transfer pricing regulations include cost sharing agreement regulations which target this type of potential abuse.
The Cost Sharing Agreement regulations imagine companies like Altera US and Altera CI enter into a cost sharing agreement to share R&D costs almost as if they were unrelated companies entering into a deal to develop technology. Altera CI compensates Altera US a “reasonable” amount to develop the electronic components under the cost sharing agreement. Altera US claims income on its US tax return money it receives from Altera CI to develop the electronic components. Altera US is still better off tax wise because it is not being taxed in the United States for the worldwide income of its electronic components, but it is not completely running away without paying tax. It is still reporting income it “receives” from its Cost Sharing Agreement with Altera CI on its US tax return.
Altera Corporation v. the Commissioner of the Internal Revenue Service
The regulations that govern these cost sharing agreements are quite complicated and we will not go into them in detail, but the issue in dispute within the Altera matter is whether American companies in cost sharing agreements should include stock compensation as part of the cost sharing agreement. In other words, should Altera US get reimbursed by Altera CI under the cost sharing agreement when it gives Altera US employees stock options. The cost sharing regulations require companies like Altera US to be reimbursed by its subsidiary, which would result in companies like Altera US paying more income tax in the US when they give employees stock options.
Altera US challenged the regulation in Tax Court. The Tax Court found the regulations requiring Altera US to share the costs of employee stock options were not valid. The IRS appealed the Tax Court’s decision to the Ninth Circuit Court of Appeals (which hears appeals from California and some other western states). The Ninth Circuit Court of Appeals reversed the Tax Court decision and upheld the regulation. This means under the Ninth Circuit Court decision companies like Altera will recognize income when they grant employees stock options. Altera is now petitioning the United States Supreme Court to hear the case and settle the matter once and for all.
The Supreme Court declined to hear Altera’s case which means the ruling of the Ninth Circuit stands for Altera. This means that companies in the Ninth Circuit’s jurisdiction will have to recognize income when they grant employees stock options. It is not certain whether courts in other circuits’ jurisdiction will agree with the Ninth Circuit.
Will the Outcome of Altera Affect You?
While tax issues like transfer pricing and cost sharing agreements are arcane, the issues in this case have real world consequences for thousands of American workers who work in technology, pharmaceuticals, entertainment, and other industries that use cost sharing agreements. Workers are often compensated with company stock options.
While Altera may have lost the battle, the war over the tax treatment of stock options may not be over. As it now stands, the Tax Court (which hears cases from all over the United States) ruled that companies with cost sharing agreements do not have to pay more income tax when they issue stock options to employees. The Ninth Circuit Court ruled that companies with cost sharing agreements do have to pay income tax when they issue stock options to employees. This could possibly lead to two (or perhaps more) sets of tax laws governing different parts of the country. Companies outside the Ninth Circuit’s jurisdiction may argue the Tax Court’s decision applies to them and they should not recognize income when they issue stock options. This makes the issuance of stock options more favorable for employers.
How Are Stock Options Taxed? There are many advantages to companies offering stock options to their employees and we cannot anticipate companies completely abandoning the practice any time in the immediate future because of Altera’s defeat. However, if another court in another case rules favorably for a company like Altera, don’t be surprised if your company’s HR department contacts you about your compensation package.
Published by Joe Cole