Research Memo
Fait Pattern #2
Issue: Whether the allocation of employee stock compensation costs between Smartbucks and Trader Jobs in the R&D cost sharing agreement satisfies the arm’s length standard and is therefore valid for tax purposes.
The facts: Smartbucks is a U.S.-based corporation that conducts a large part of its coffee business via its international wholly owned subsidiary, Trader Jobs. Trader Jobs is located in the Turks and Caicos Islands. Smartbucks and Trader Jobs entered into a research and development (R&D) cost-sharing agreement, in which Trader Jobs was given the authority to license a new latte coffee recipe internationally. Smartbucks received substantial tax savings on more than $100 million of income due to the fact that the costs of some employee stock options were not shared. The IRS has reviewed the transaction and asserts that the allocation of stock compensation costs between the companies must be appropriate to reflect economic reality and that the allocation in the R&D cost sharing agreement fails the arm’s length standard. Smartbucks claims that the IRS exceeded its authority within the arm’s length standard due to the cost-sharing methodology that was used in the agreement establishing “parity among uncontrolled taxpayers”, and the fact that actual results or economic realities are irrelevant.
Analysis:
An arm’s distance standard determines whether the terms of transactions between related parties match what could have been reached by other parties in similar circumstances. This standard prevents related parties from engaging transactions that artificially shift profits and losses among them to lower their tax liability.
Under the Internal Revenue Code (IRC), related parties are required to use the arm’s length standard in determining the allocation of income and expenses between them (IRC §482). The IRS has the authority to allocate income and expenses between related parties if it determines that a transaction does not meet the arm’s length standard (IRC §482(a)).
In this case, the IRS asserts that the allocation of employee stock compensation costs between Smartbucks and Trader Jobs in the R&D cost sharing agreement fails the arm’s length standard because it does not reflect economic reality. Smartbucks claims that the IRS exceeded its authority within the arm’s length rule because it used a cost-sharing methodology that established “parity among uncontrolled taxpayers”. According to the arm’s length standard, the actual results and economic reality are irrelevant.
Although the IRC doesn’t define “parity” as such, it generally means that income and expense allocations between related parties must be compatible with those that would have been made if they were not subject to similar circumstances. Some case law supports the idea that arm’s-length is met if income or expenses are allocated in a way that is compatible with that which would be agreed on by uncontrolled taxpayers.
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