IRS Memo on 482 Adjustments for CSAs with Reverse Claw-Back Provisions

After Altera’s victory in Tax Court in 2015,[1] many companies with cost sharing arrangements (“CSA”) ceased sharing stock-based compensation (“SBC”) costs. To address the possibility of a reversal on appeal, many of these companies added reverse claw-back provisions to their CSAs. Under these provisions, in the year a reversal of Altera becomes final, the US participant typically “claws back” from the foreign participants the amount of SBC costs not shared in prior years (the “claw-back true-up”). The effect is a large inclusion of SBC costs into the US participant’s income in the year the reversal becomes final.

These reverse claw-back provisions were revisited by companies in 2019, when the Ninth Circuit reversed the Tax Court, and in 2020, when the U.S. Supreme Court declined to hear Altera’s appeal.[2] Companies were concerned about whether the IRS would respect the provisions or insist that adjustments be made year-by-year. Should taxpayers report the claw-back amount in 2020, or amend prior year returns to include the SBC costs in the cost pool for each open year, or modify the CSA to defer or cancel the payment pending IRS guidance? On July 13, 2021, the IRS provided guidance on these questions, in the form of a Chief Counsel Memorandum, AM-2021-004 (the “CCM”).

The CCM declares the IRS’s position on the appropriate year for a section 482 adjustment to include SBC costs in the cost pool for a CSA that contains a reverse claw-back provision. The IRS will make the allocation in the year in which the intangible development costs (“IDCs”) – including the SBC costs – were incurred (i.e., as year-by-year adjustments). The IRS cites as authority the rule in Treas. Reg. §1.482-7(i)(2) permitting the Commissioner to make allocations to adjust the results of a cost-sharing transaction so that the results are consistent with an arm’s length result, including allocations to each participant’s IDC share. The IRS prefers year-by-year adjustments over one claw-back true-up amount in 2020, the year Altera became final.[3]

The CCM also addressed the pressing question of what becomes of the reverse claw-back obligation triggered in 2020 under the reverse claw-back provision. Many advisors believed that if the IRS sought adjustments for prior years, then the IRS would not also seek a duplicate payment in 2020 under the reverse claw-back provision, as doing so would not be arm’s-length. The CCM affirmed this belief, concluding that any prior year adjustments (either IRS initiated or through filing an amended return) should be treated as reducing the amount of the reverse claw-back obligation by a corresponding amount, thereby avoiding an overpayment of the SBC costs.

While the IRS prefers year-by-year adjustments in lieu of the reverse claw-back provision, the CCM warns the IRS will use the provision if an adjustment in a prior year is not possible (e.g., the statute of limitations closed). This is an issue for taxpayers with closed years for which the IRS is precluded from making an adjustment for those years. If such taxpayers disregard the reverse claw-back provision (or modify the provision to modify, defer or remove the payment obligation), the CCM warns the IRS may make allocations in the year the claw-back true-up is or (but for the modification) would have been triggered to produce results consistent with the unmodified provision or otherwise to reflect an arm’s-length result. The CCM also invokes the authority in Treas. Reg. §1.482-7(i)(5) to make allocations when cost-sharing transactions are consistently and materially disproportionate to reasonably anticipated benefits (“RAB”) shares. Further, the CCM invokes the tax benefit rule, which the IRS strains by portraying the SBC exclusion in prior years as deductions taken in prior years that must be included into income upon a triggering event.

While the CCM has provided much anticipated guidance on the IRS’s position, taxpayers must determine how to interpret the guidance in their particular circumstances. Taxpayers already under audit may wish to wait for the Exam team to propose the adjustments for audit years. Taxpayers not under audit should consider filing amended returns for open years. Taxpayers with closed years should evaluate the authorities cited in the CCM and, more importantly, the specific wording of their reverse claw-back provisions. As is typically the case, the specific facts matter when interpreting non-taxpayer-specific transfer-pricing advice.

[1] 145 T.C. 91 (2015).

[2] Altera Corp. & Subs. v. Comm’r, 926 F.3d 1061 (9th Cir. 2019), rev’g 145 T.C. 91 (2015), cert. denied, 141 S. Ct. 131 (2020).

[3] Id.

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