Allocation of employee stock options to cost-sharing agreement.

• Author: O'Driscoll, David

P is in the business of researching, developing, manufacturing, marketing and selling field-programmable logic devices, integrated circuit devices and other development software systems. P entered into a cost-sharing agreement to develop intangibles with X, its foreign subsidiary.

The Agreement

Under the cost-sharing agreement, all new technology developed by either P or X would be jointly owned. Each party was required to pay a percentage of the total research and development (R&D) costs, based on its anticipated benefits from the intangibles. P issued stock options to its employees performing R&D. However, for purposes of determining the cost allocation under the agreement, P did not include the cost of issuance or exercise of such options in R&D costs.

In deficiency notices, the IRS determined that for cost-sharing purposes under Regs. Sec. 1.482-7(d), the spread (i.e., the stock's market price on the exercise date over the exercise price) or, in the alternative, the grant date value of the options, should have been included as an R&D cost.

Analysis

Sec. 482 provides "[i]n the case of any transfer ... of intangible property ... the income with respect to such transfer ... shall be commensurate with the income attributable to the intangible" Participants in a qualified cost-sharing agreement relinquish exclusive ownership of all exploitation rights in new intangibles they individually develop and agree to share ownership of (and costs associated with) such intangibles. For Sec. 482 purposes, this relinquishment is a transfer of specified future exploitation rights; see Regs. Sec. 1.482-7(a)(3) and (g).

Regs. Sec. 1.482-7(a)(1) requires participants "to share the costs of development of one or more intangibles in proportion to their ... [respective] shares of reasonably anticipated benefits." Under Regs. Sec. 1.482-7(e)(1), anticipated benefits are defined as "additional income generated or costs saved by the use of covered intangibles." If parties fail to share such costs in proportion to their benefits, the IRS is authorized to make allocations "to the extent necessary to make each controlled participant's share of the costs ... equal to its share of reasonably anticipated benefits"; see Regs. Sec. 1.482-7 (a) (2).

Sec. 482 gives the Service wide latitude in allocating income and deductions between controlled parties, to ensure they report their true taxable income. This broad grant of authority, however, is constrained by Regs. Sec...