I. Introduction
Inclusion or deduction of stock-based compensation (“SBC”)[1], to be defined herein, in a cost base when applying the Transactional Net Margin Method (“TNMM”)[2] / Comparable Profits Method (“CPM”)[3] has been an ongoing transfer pricing (“TP”) discussion in recent years. As will be detailed in this article, several countries have attempted to publish legislation to address this issue and the Organization for Economic Co-operation and Development (“OECD”) has similarly issued broad guidance; however, many of the said laws and court decisions are under appeal and have yet to be proven dispositive or conclusive.
This matter was addressed in a recent Supreme Court ruling in Israel, as further detailed below. On April 22, 2018, the Israeli Supreme Court ruled on appeals brought by Kontera Technologies Ltd. and Finisar Israel Ltd. and counter-appeals by the respective Assessing Officers (“AO”) with regards to the inclusion of SBC in the cost base for cost plus arrangements.[4] U.S. Treasury has also issued a rule with this regard in 2003, but a 2015 U.S. Tax Court petition had this rule overturned. While this ruling was under appeal, the internal revenue service (“IRS”) has instructed it examiners, as of January 12, 2018, to halt any new examination of SBC transfer pricing issues until the appeal is decided.[5] The 2015 ruling was once again reversed in a July 24, 2018 Ninth Circuit Court decision that will be detailed later in this article.
As tax and transfer pricing practitioners in Israel, our motivation for this article is due to the relevancy of the Israeli rulings as well as the appeal of the U.S. rulings, representing the most common outbound jurisdiction for Israeli corporations (in particular for advanced technology companies).
II. What is Stock-based Compensation?
Companies frequently offer SBC plans at favorable conditions as an incentive to drive and retain key employees. In this way, corporations may reward their employees, even if there is insufficient cash on hand to pay competitive wages. A common example would be a startup company that may be low on cash but high on potential earnings. In certain circumstances, even well-established multinational enterprises may provide stock options to employees of subsidiaries in other tax jurisdictions in order to convey the influence that employees of a local subsidiary may have on the parent company’s bottom line, facilitating dialogue with its employees, and to recognize and reward the employees’ achievements.
Various forms of equity-based compensation include:
(i) Restricted stock plans are actual shares of stock paid as compensation;
(ii) Stock option plans grant the right (as compensation) to purchase a number of shares at a fixed price (the “exercise price”) over a specified period of time;
(iii) Performance-based stock shares; and
(iv) Purchase rights under employee stock purchase plan (qualified and non-qualified).
Offering compensation that is commensurate with the success of the company helps to align the interests of the company with its internal stakeholders (i.e. the employees). More significantly, key employees, top management and executives of such companies tend to receive a significant portion of restricted stock plans.[6] As high-level executives’ decision-making may directly influence the success or failure of the company (and thereby impact the stock price), SBC may spur said executives towards corporate goals and shareholders’ interests. To establish long-term working relationships and to ensure that the SBC recipients would not dump the stock and leave the company, SBC typically includes a “vesting period” of one to three years, before they may be fully exercised.
III. SBC: Accounting vs. Tax
The debate and rulings surrounding the accounting of stock options dates back to 1972, when the Accounting Principles Board, issued APB Opinion No. 25,[7] specifying that the costs of options at the grant date should be measured by the difference between the current fair market value and the exercise price. Though there is no actual cash outlay while stock options are not exercised, both the IFRS 2 Share-based Payment standard of the International Accounting Standards Board (“IASB”)[8] as well as the FAS123 Statement of the Financial Accounting Standards Board (“FASB”)[9] view SBC as a form of compensation, which is provided in order to generate revenue and is therefore considered a cost of doing business or an expense for accounting purposes.
In addition to legislation, the theoretical concept of expensing options is discussed in an article in the Harvard Business Review, dismissing the common arguments against it. Most importantly, in contrast to these arguments, the authors of the cited article demonstrate that stock option grants have real cash-flow implications that should be reported (and not merely with a footnote disclosure) and that such implications are quantifiable.[10]
Though the classification as an expense itself was the subject of controversy for over twenty years in the U.S. and all implications of such had been cautiously deliberated during this time, it has been concluded by the aforementioned accounting standards as the correct accounting classification to treat SBC as an expense going forward. For U.S. purposes, SBC falls within the Sales, General & Administrative expense section of the income statement, as it is considered part of wages (and would be tax deductible). On the statement of cash flows, SBC would be added back in the operational expense categories. Finally, on the balance sheet, SBC would be added into the shareholder’s equity section.[11]
It is important to note that in most cases, from a tax perspective, a stock option only has value in the event that the price of the stock increases over time. The inherent value would be the difference between the current share price and the exercise price. However, in the event that the share value decreases, or even stays the same, then the option expires with zero value. In their DLA Piper publication, Joy Dasgupta and Dean Fealk explain that in the event of a divergence between the grant-date value and the value at exercise, a deferred tax asset (“DTA”) is recorded in order to recognize the future tax benefit that will arise upon exercise. The DTA serves to reconcile the time and valuation differences between accounting performed at the grant date and tax consequences at the exercise date.[12] With that in mind, a simple example of tax implications of the value of a SBC is as follows:
Value at grant date: $30 per share[13]
Exercise price: $25 per share
Actual price on exercise date: $40 per share
Profit: $15 per share
In the above example, a $25 per share stock increases over time to $40 per share at the time that the employee exercises that option. In this case, the profit of $15 per share will appear on the employee’s tax return and is considered taxable income. The reciprocal of the employee side, is that the company may claim $15 per share as a tax deduction, and the tax savings is considered a ‘Cash from Financing’.[14]
It should be noted that some countries have preferential stock option rules that state that the gain on options are taxed at capital gains tax rates and the date of taxation is delayed until the employee sells the shares. As will be detailed later in this article, the capital gains track under section 102(D)(2) of the Israeli Income Tax Ordinance allows for a preferred tax rate at the employee’s level while denying the deduction of such cost at the employer’s level for tax purposes.
IV. The Arm’s Length Principle and Relevant Transfer Pricing Methodologies
The arm’s length principle is espoused by most accepted TP standards, including the OECD Guidelines[15] as well as Section 482[16] and, as pertinent to the present article, Section 85A of the Israeli Tax Ordinance.[17] This principle states that transactions between related parties must be conducted at prices, terms and conditions that would have been agreed upon by uncontrolled parties at fair market value.
As mentioned, this article addresses the inclusion or deduction of SBC in a cost base of a transfer pricing model. Therefore, we present the context of the relevant transfer pricing methodology and common profit level indicator (“PLI”).[18] A Net Cost Plus (“NCP”) margin (also referred to as “markup on total costs”) PLI entails the calculation of remuneration to a related entity with a fee equaling its direct and indirect costs associated with the transaction (the “cost base”) plus a markup (usually, a percentage of the cost base). The margin is calculated by dividing operating profit by the sum of total costs, illustrated as follows:
This PLI is often used for low-risk routine activities such as manufacturing and provision of services (e.g. headquarter services, technical services, or as pertinent to the Israeli examples found in this article, contract research & development [“R&D”] services). An example of applying this PLI is as follows: Company A is a software company that maintains a wholly owned subsidiary, Company B, in a foreign jurisdiction. Company B is engaged in contract R&D services on behalf of Company A with regards to its software technologies. All intellectual property (“IP”) associated with these contract R&D services are solely owned by Company A. The expenses (direct and indirect costs) incurred by Company B during a given year in its provision of these services amount to $1 million.
In order to identify a range of NCP margins, a set of companies operating within a similar market and with a similar functional and risk profile to those of Company B must be procured. After a thorough benchmark analysis, applying qualitative criteria for transfer pricing purposes, a set of eight companies was identified as comparable. For the purposes of this example, the range[19] of NCP margins span from 5.3% to 8.8% with a median of 7.3%. See the set of companies below.
Let’s assume that the parties apply an 8% markup, falling within the listed range, and apply such to the $1m of direct and indirect costs (not including SBC), equaling $80,000 as the transfer pricing margin.
Below is a snapshot demonstration of Company B’s Profit & Loss Statement:
V. Stock-based Compensation within the Context of the Arm’s Length Principle
In light of the above definition of ‘arm’s length’, it is imperative to determine how unrelated parties would construct their cost base.
One of the many tax consequences of SBC is whether such should be included in a cost base for transfer pricing purposes. In the above example, if the value of Company A’s SBC offered to Company B is $500,000 and it is determined that such should be included in the cost base, then the Total Cost Base would increase to $1.5m and the same NCP margin (8% markup) would now be $120,000 instead of $80,000.[20]
In our current example, Company B’s expenses plus markup would include:
This represents a whopping 62% of the initial cost base for tax purposes.
Although typically, the cost base should comprise all expenses, direct and indirect, that relate to the service, empirical evidence shows that unrelated parties do not take those costs into account, and the accepted standard for the arm’s length principle is what unrelated parties do. It may therefore prove to be difficult to reconcile the arm’s length principle with regards to SBC since it is extremely rare for third party transactions to include an element of SBC. Moreover, SBC may be difficult to value, as by nature they are not marketable, transferable, or even exercisable during the vesting period, though there is some consensus with regards to accepted evaluation methodologies for SBC for accounting purposes. Due to the above reasons as well as inherent risks in SBC, potential divergence of terms from comparable transactions and lack of reliable adjustments to account for such divergences, some argue that valuing SBC for transfer pricing purposes may deviate from the application of the Arm’s Length principle.[21]
On the other hand, it may be argued that it is inappropriate to ignore SBC expenses as they undeniably exist and are not equal to zero. Moreover, it cannot be denied that SBC offers at the very least potential benefits for the company issuing such to its employees. One consideration of the said benefit is to estimate the savings on wages to the company as an alternative to the granting of SBC.
VI. Global Outlook and Considerations
In 2004, the OECD released its study, “Employee Stock Option Plans: Impact on Transfer Pricing”[22] (hereinafter, the “OECD Stock TP Study”), calling attention to this issue. In considering the relevant implications, the OECD Stock TP Study considers the strengths and weaknesses of three possible approaches, detailed later in this article. Unfortunately for those hoping for a clear sanction or position of whether or not to include SBC in the cost base, the study simply outlines the various factors, recognizing the validity to each of the opposing arguments. Thus, the OECD Stock Study leaves significant uncertainty that will invariably lead to tax authorities or taxpayers to form inconsistent conclusions about the same transaction, while all claiming to be consistent with the OECD’s views.
Similarly, the U.S. government attempted to propose to amend its transfer pricing regulations to explicitly include SBC within the cost base. In July 2002, the U.S. Treasury issued a notice of proposed rule-making and invited the public to comment. Numerous commentators argued that the proposed rule would be at odds with the arm’s length principle, stating that they had exhaustively investigated databases of uncontrolled agreements between unrelated parties and could not identify any that included SBC. Other comments focused on the theoretical level that unrelated parties would not agree to include such expenses due to the highly speculative nature of the value of SBC and the fact that it may often be completely out of the control of either party. Despite these comments, the U.S. Treasury nevertheless issued a final rule (the ‘All Costs Rule’) in August 2003, explicitly requiring the inclusion of SBC in a cost base.[23]
In practice, though, this matter has already been ruled upon in U.S. Tax Courts. Notably, in the 2010 case of Xilinx, Inc. v. Commissioner, 598 F.3d 1191, the Ninth Circuit Court decided that SBC costs were not required to be shared under the prior cost-sharing regulations. The ruling in that case was based on the contention that uncontrolled parties would not share the costs of employee stock options, thereby not consistent with the arm’s length standard.[24] In 2015, a US Tax Court petition, Altera Corp. v. Commissioner, 145 T.C. 91 (2015),[25] addressed whether Treasury had adequately responded to the substantial public commentary in making the 2003 change to the rules. The 2015 ruling found that Treasury did not have a reasonable basis to conclude that the revised regulations were consistent with the arm’s length principle in light of the available evidence and therefore invalidated the 2003 All Costs Rule.
The 2015 Altera ruling was then appealed in the Ninth Circuit Court of Appeals (the same court as in the 2010 Xilinx case) and a reversal was filed in an interim ruling on July 24, 2018 under Tax Ct. Nos. 6253-12 \ 9963-12 (2018).[26] In this 2-1 opinion ruling, the appellate court found that Treasury had, in fact, adequately addressed the public commentary and validly require SBC to be included in cost sharing reimbursements. Moreover, the ruling further empowered the IRS to allocate income in a manner that assures income follows economic activity by endorsing “flexibility it needed to prevent cost and income shifting between related parties for the purpose of decreasing tax liability”. Needless to say, this may have much broader implications than the SBC issue, potentially allowing for constantly evolving standards in place of comparable transactions and the arm’s length principle. As this issue is extensive, it is beyond the scope of the present article. It must be noted, however, that 15 days after this ruling, the Ninth Circuit Court withdrew the ruling since the deciding vote in the 2-1 ruling was cast by the late Judge Stephen Reinhardt, who passed away in March 2018.[27] Though the ruling was issued, the court decided to withdraw in order to allow time for a reconstituted panel to confer on the appeal.
In the United Kingdom, Her Majesty’s Revenue & Customs (“HMRC”) issued an International Manual that states that the parties to intercompany services should consider all elements of the whole facility, reflecting what the parties would expect to witness in a transaction with third parties. Emphasizing the distinction between “value” and “cost” (also addressed in the OECD Stock TP Study), the HMRC notes that value would include the cost plus the markup.[28] In explaining the constitution of the cost base, HMRC insists that all relevant costs are incorporated, including the costs of the stock options.[29] The accurate capture of all costs is further accentuated herein as potentially more important than the rate of the margin. It should be mentioned, however, that the HMRC manual represents merely a publication of its position and it has no force of law. Based on its position, more information regarding arm’s length pricing of stock-based compensation can be found in the Special Commissioners’ 2001 tax ruling in Sp C 301 Waterloo Plc v. Inland Revenue Commissioners.[30]
VII. Israeli (District & Supreme) Court Judicial Decisions
The first judicial decision on transfer pricing matters by Israeli courts [case of Kontera Technologies Ltd v the Assessing Officer Tel Aviv, 2016] was a district court case that specifically considered the validity of including SBC in the cost base under a cost plus model.
Kontera Technologies Ltd. (“KT-IL”) an Israel-based company, entered into an agreement under which it would provide R&D services to its US-based parent, Kontera Technologies Inc. (“KT-US”) in exchange for payment of costs plus a 7% mark-up. However, the R&D service agreement excluded the expenses of the stock options granted by KT-US to KT-IL’s employees from the intercompany charge. Moreover, the employees of KT-IL enjoyed a tax favorable stock option plan (qualified under a capital gains track under section 102(D)(2) of the Israeli Income Tax Ordinance), which denied the Israeli employer the right to deduct any expenses in relation to the options.
The Tel Aviv District Court ruled that expenses incurred for an employee stock option plan by KT-IL must be included in the cost base when calculating reportable income. While KT-IL is not allowed to deduct expenses related to the employee stock option plan for corporate income tax purposes, the acceptance by the District Court of the tax assessor’s position resulted in a significant increase in KT-IL’s taxable income.
Similarly, Finisar Israel Ltd. (“FIL”), an Israel-based company, entered into an agreement under which it would provide R&D services to its US-based parent, Kailight Photonics Inc. (“KPI”), in exchange for payment of costs plus an 8% mark-up. KPI’s grant of stock options to FIL’s employees became the subject of a parallel District Court ruling that the employee stock option plan must be included in the cost base when calculating reportable income [case of Finisar Israel Ltd v the Assessing Officer Rehovot, 2016].
Both KT-IL and FIL had appealed these rulings, equipped with counter-arguments, emphasizing that in uncontrolled environments, third parties would not include SBC in their cost base and, in their view, can unjustly lead to economic double taxation.
The Supreme Court has thoroughly reviewed these appeals and has arrived at the following binding rulings:
1. SBC is viewed as an integral part of the compensation package to the Israeli subsidiary’s employees, with the objective of improving the quality of services rendered and strengthening the bond between the company’s and employees’ cohesive goals. Therefore, it is indeed confirmed that such compensation should be included in the cost base.
2. Nevertheless, though it must be included in the cost base, the Israeli Tax Authorities (“ITA”) do not possess the right to automatic transfer pricing adjustments, unless the economic results deviate from the Arm’s Length Range.
3. The benchmarks in both cases that were identified by the tax payers included companies that prepare their financial statements based on the aforementioned U.S. standard FAS 123. Therefore, it can be assumed that if SBC were provided to these companies, they have already been included in their cost base.
4. The Israeli regulations recognize that the term “arm’s length” may be reflected in an IQR of values instead of at a singular point in the list of values from the benchmark companies. The Supreme Court concludes that the economic results of the intercompany service transactions in both cases deviate from the arm’s length principle as the effective markup in those cases, including SBC costs, is lower than the 2nd quartile of the IQR. Therefore, a TP adjustment is required. According to the Israeli regulations, if an economic result is outside of the IQR, an adjustment would be to the median point. In the Kontera case, therefore, the Supreme Court upheld the ITA counter-appeal with respect to the extent of the adjustment and ruled that such adjustment would be to the median value of the IQR (i.e. from initially reported 7% to 9.1%).
5. The Supreme Court also upheld the ruling that, although SBC expenses may generally be deductible, in both of these cases, it may not be deducted for Israeli corporate tax purposes since both Kontera and Finisar elected a “capital gains” track under section 102(D)(2) of the Israeli Income Tax Ordinance, since this section provides a specific exception to the main deductibility rule specified in Section 17 of the Income Tax Ordinance. Had they elected the “employment income” track also available under Section 102(B)(1), a deduction of the SBC expenses would have been allowed.
6. Finally, following its decision to uphold the Primary Adjustment (i.e. SBC included in cost base and no deduction), the Supreme Court espoused the District Court’s ruling to Finisar regarding Secondary Adjustment by viewing the discrepancy as an imputed loan by FIL to KPI. It can be argued that KPI had no cash benefit from the transaction since the Primary Adjustment resulted from a deemed inclusion of the SBC value in FIL’s cost base, where the SBC was contributed by KPI to begin with.
The result of these final binding rulings of the Israeli Supreme Court is that, for Israeli tax purposes, SBC is included in the cost base of cost plus arrangements, even in cases where it is not deductible for tax purposes by the service provider. This would apply even in a case that the effective tax rate may be considered as excessive since, on one hand the SBC increases the subsidiary’s tax burden, and on the other hand, is not viewed as a deductible expense.
It should be noted that the Supreme Court has mentioned as an obiter dictum that it is not analyzing the prudence of Israel’s tax policy or legislation and has rather focused its analysis on appropriate interpretation to the relevant law.
VIII. Alternative Approaches
The OECD Stock TP Study offered a few approaches to determining an arm’s length compensation for SBC:[31]
1. Fair Value: An approach based on the fair value of the stock options either by reference to the adjusted market price of comparable options or based on an option pricing model (e.g. Black-Scholes formula)[32] which would need to be adjusted.
2. Cost: An approach based on the costs associated with the establishment and provision of the stock option plan.
3. Benefit: An approach based on the value of the stock option plan from the subsidiary’s perspective.
However, the study reflects on the strengths and weaknesses of each and there remains a lack of consensus due to the practicality of applying any of the above.
As mentioned in the introduction to this article, the discussion of inclusion or deduction of SBC from a cost base is in the context of application of the TNMM / CPM methods. Though TNMM / CPM are considered to be practical and commonly applied methods to arrive at arm’s length pricing, we would like to propose alternative TP approaches that, under certain circumstances, do not require the construction of a cost base and therefore SBC would not come into play.
Related parties may establish among themselves a distinctive legal contractual arrangement, in which they agree that the engagement is based on time & materials invested in by the tested party and not on a target profit margin. Such an arrangement represents a different remuneration model as well as a different allocation of risks than those found in a typical cost plus arrangement. In order to verify that the remuneration meets the arm’s length principle, the Comparable Uncontrolled Price (“CUP”) method[33] may be applied to arrive at standard service fees. The actual hours incurred by the tested party would be multiplied by the arm’s length hourly-based service fee in addition to a charge with relation to other direct expenses (e.g. travel) relating to the service.
The CUP method compares amounts charged in controlled transactions with those charged in third-party transactions. The CUP method is considered to be the most reliable measure of arm’s length results, if transactions are identical or if only minor readily quantifiable differences exist and is even considered the preferred method in the OECD Guidelines[34] and in certain jurisdictions, including Israel, represents the top of the hierarchy of methods.[35]
However, it is fairly rare to identify internal CUPs that are identical to controlled transactions. External CUPs require high levels of comparability and significant adjustments are often needed. In practice, many potential CUPs are rejected because they cannot match one or more of the comparability criteria, such as similar markets, volumes and position in the supply chain. While adjustments to CUPs are permitted, many practitioners prefer to use an alternative method rather than apply arbitrary adjustments to a CUP, arguing that each adjustment distances the CUP from what was actually agreed in the open market.
Nevertheless, an external CUP may be obtained from reliable, published sources (e.g. government lists) and, in order to reach arm’s length pricing, a specific adjustment may be needed. If such a model is applicable, a time & material arrangement can be constructed instead of identifying the profit margins of comparable service providers through their financial statements. Since the standard service fees would not relate to cost base, the issue of SBC would not be relevant.
Another possibility is the application of a Profit Split (“PS”) method, which allocates profits/losses in proportion to the relative contributions of value made by each party. The PS Method represented one of the items remaining for further guidance of the OECD, in collaboration with the G20,[36] in their promulgation of the Base Erosion & Profit Shifting (“BEPS”) Actions 8-10 final reports.[37] As the over-arching objective of the BEPS Actions 8-10 is to ensure that TP outcomes are in line with economic value creation, a tendency towards the application of the PS has been noted as appropriate to achieving this goal. In fact, the revised guidance for such was published by the OECD in the weeks preceding this publication.[38]
In certain circumstances, applying the PS method may be appropriate. The advantage in our context is that it makes no reference to the cost base. The drawback, though, is that the profit split method creates, almost by definition, a number of uncertainties, such as variances of value contributions, complex allocation of risks, and discrepancies in splitting methods.
Finally, Transfer Pricing legislation recognizes that the list of commonly applied methods is not exhaustive and that selection of an appropriate method and PLI should be influenced by various factors, such as the nature of the activities as well as the reliability of the available unrelated party data. The regulations further state that methods that aren’t listed (i.e. unspecified methods) may be used if they provide reliable measure of arm’s length profitability.[39] Therefore, although other approaches may also be considered, they are beyond the scope of our current article.
IX. Conclusion
The result of this final binding ruling of the Israeli Supreme Court is that, for Israeli tax purposes, SBC is included in the cost base of cost plus arrangements, even in cases where it is not deductible for tax purposes by the service provider, which may render the effective tax rate excessive. While this article addresses both the best practice standards in other major tax jurisdictions as well as the conceptual practicality of the inclusion of SBC (including the advantages and disadvantages of such), more significantly, we offer alternative methods. As suggested above, due to the extensive tax effect of the aforementioned court rulings, taxpayers and their advisors are increasingly evaluating various alternative contractual arrangements and resulting transfer pricing economic analysis approaches in order to address this practical hurdle. Consideration should be dedicated to external (modified) CUPs, a carefully executed PS, if applicable, or other unspecified methods and PLI.
Authors: Shlomo Hubscher, MBA, is a partner at JH Consulting Ltd. Jacky Houlie, LL.M, is founder & managing partner at JH & Co. Law Office. Both are the current authors of the Israel section on the IBFD Global Transfer Pricing Explorer.
Shlomo can be reached at shlomo@jhconsulting.co.il or +972-52-600-6804
Jacky can be reached at jacky@jh-law.co.il or +972-52-851-2569