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October 9, 2013

2013-Issue 41—Recent headlines addressing transfer pricing (Starbucks, Google, Apple) have prompted global tax authorities and regulators to be on high alert regarding intercompany transactions. Transfer pricing remains an easy target for tax authorities seeking to increase tax revenue through adjustments and penalties. Equity arrangements used by multinational corporations are subject to scrutiny by tax authorities to ensure that costs associated with these programs satisfy transfer pricing regulations. Therefore, it is important for multinational corporations to review their current compensation policies to make sure they do not become an easy target for transfer pricing adjustments related to equity arrangements.

Financial Statements — U.S. GAAP and ASC 718

Most public multinational companies provide some form of stock compensation to their executives and employees. Under ASC 718, compensation costs for such equity grants are generally determined upfront and then expensed ratably over the vesting periods. Naturally, the amount expensed must be tax-affected. Many jurisdictions do not allow a tax deduction for equity compensation until the vesting or exercise dates. This difference in time (i.e., expense now, deduct later) results in deferred tax asset accounts. When accounting for these deferred taxes, the accountants need to know if and where a deduction will ultimately become available for the stock compensation. As discussed below, this is not always easy to determine.

A simple example involves a parent company in Country A granting stock to an employee of a Country B subsidiary. Depending on the tax rules of Country B, this basic arrangement on its own probably does not result in a tax benefit. The rationale is that the Country A company is not entitled to a deduction because it is bearing a cost on behalf of another company, and the Country B subsidiary is also not entitled to a deduction because it has not made an outlay. Certain jurisdictions have special rules that allow the employer a deduction even without an outlay (e.g., U.S. and U.K.). In other countries, it is possible to put in place intercompany agreements that compel the subsidiary to reimburse the parent, thereby creating an outlay to justify a deduction. Of course, there are often further complicating requirements in some jurisdictions, e.g., the required use of treasury shares by the parent company to secure a deduction.

Many companies have already sorted out this type of fact pattern and the resultant ASC 718 accounting. But this next example probably raises less recognized issues.

Assume instead that the same parent company grants stock to one of its own employees. This particular employee performs services that are ultimately cross-charged to a Country B subsidiary (e.g., cost-sharing or centralized service function). If the cross-border charge is based on the cost of the employee, a natural question is whether to include the cost of his/her equity compensation in the charge. Under recent transfer pricing guidance, equity compensation must be included in the calculation of services costs (e.g., management fees, cost sharing, centralized services, etc.). That leaves the accountants with an open question: if the equity compensation relating to an employee of the Country A company will ultimately be charged to a Country B subsidiary, should the ASC 718 tax effect be based on the value of the deduction in Country A or Country B?

To help resolve these kinds of questions, we discuss below some of the recent transfer pricing developments, followed by some of the mechanics of cross-border charges and ASC 718 implications.

Transfer Pricing Developments

The Ninth Circuit reversed its decision in the Xilinx Inc. v. Commissioner case on March 22, 2010, agreeing with the tax court’s previous decision and concluding that equity-based compensation need not be included in the cost base for cost sharing arrangements entered into under the previous Section 1.482-7 regulations. However, on December 16, 2011, the IRS issued final cost sharing regulations (Section 1.482-7) that supersede the previous regulations. The final cost sharing regulations require the inclusion of equity-based compensation in determining intangible development costs.

Prior to the release of the final cost sharing regulations, the IRS had issued final intercompany services regulations (Section 1.482-9) on July 31, 2009. The services regulations also require equity-based compensation as a cost that must be included in the calculation of services costs.

Implications of Including Equity Compensation in Your Intercompany Service Fee

For U.S.-based multinationals, there are two likely direct implications of including equity compensation in their service fee charges. First, such costs will likely reduce the net amount of deductions that would otherwise be applied in the United States. Second, such costs will likely shift deductions to (1) lower tax jurisdictions and/or (2) jurisdictions where the company may not be entitled to a deduction. As previously mentioned, determination of whether this equity compensation should be included in the service charge is required in performing the ASC 718 calculations. However, companies do have some options on how to determine the amount of the service fee charges as discussed below.

Equity Compensation as a Component of Your Service Charge

U.S. multinationals can choose to determine the equity component of their service charges based on either the tax deduction amount or the book expense as recorded on the financial statements. The tax deduction amount (i.e., the spread for stock options and fair market value for restricted stock) generally would not be determined until exercise for stock options and vesting for restricted stock, so this method is often referred to as the “exercise date method.” However, the book expense is determined upfront at the time of grant for financial statement purposes, so this method is often referred to as the “grant date method.” The method chosen impacts how the company handles the tax accounting in these types of situations as illustrated in the example below.

Assume a scenario in which centralized services are performed in the U.S. for the benefit of non-U.S. subsidiaries. In this example, the cost-based service charge to subsidiaries has an equity compensation component of $10 million. With the grant date method, the tax effect of the equity compensation is quantified using the U.S. statutory rate, or 35 percent. In other words, $10 million of ASC 718 expense should yield a tax effect of $3.5 million.

However, if the exercise date method is used, the tax impact of the equity compensation takes into consideration the local tax circumstances. The following depiction illustrates the mechanics of the exercise date method using a tax deduction amount of $10 million.

In this example, when the exercise date method is used, it results in a lower tax impact of $2.9 million since only the U.S. portion (70 percent) of the deferred tax asset is recorded at the U.S. statutory rate. The amount charged to the other countries is tax-affected using the local tax rates and taking into account whether the company is entitled to a deduction in the respective country.

There may be many variables behind any analysis of this type affecting the deductibility of the cross-charges in the local countries that would require further examination. The overall point is that many companies have not taken the necessary time to examine the implications of cross-charges. While this example focused on the tax accounting for the equity component, there would also be tax accounting implications from the cash received from the cross-charges that would also need to be considered.

So far, we have focused much of our discussion on U.S. multinationals. It is important to note, however, that the complexities could be the same for foreign multinationals. In fact, quasi-governmental groups such as the Organisation for Economic Co-operation and Development (OECD) have strongly suggested that equity compensation must also be included in transfer pricing for services. For example, the U.K. revenue authorities agree that equity compensation should be a component of cost-sharing pools. While there seems to be growing consensus as to the inclusion of these costs, the method(s) used to determine the amounts of cost charges could differ from one jurisdiction to another.

Depending on the jurisdiction and the local transfer pricing guidelines, the determination of an allowable component of equity compensation in cross-charges can be significantly different. Thankfully, many jurisdictions have not yet established specific requirements, so some flexibility and discretion exists. For example, the transfer pricing for services regulations under Treasury Regulations Section 1.482-9 (which expressly require taxpayers to use stock-based compensation in cost-based service fees) are agnostic as to which methodology should be used for valuing that equity-based compensation.

The following methodology example might help clarify some of these points.


When using the grant date method, companies may be using U.S. GAAP – ASC 718 or the International Financial Reporting Standards (IFRS) to determine the fair value of the equity compensation. As mentioned above, the exercise date method uses the tax deductibility principles. The example below shows how these commonly used methods for determining the cost of equity compensation for cross-charges have different results. 

ASC 718: The equity compensation charge would be calculated using fair market value (FMV) at grant and would result in a deduction of $1 per year over the three-year vesting of the award. Although this amount would already have to be calculated for accounting purposes, be mindful that it may not yield the largest deduction available.

IFRS: The equity compensation charge would follow a market-to-market approach for a liability award and would result in a cumulative deduction of $5. There is a greater potential for a higher deduction than under ASC 718 since awards are more likely to received liability treatment under IFRS. However, note that this requires a separate calculation at the end of each year, and it is possible that a negative adjustment to the stock could result in a negative adjustment to the service charge, which could prove to be troublesome.

U.S. Tax Principles: The equity compensation charge would be calculated only upon exercise and would result in a deduction of $5, as calculated under Internal Revenue Code Section 83(h). There is greater potential for a higher deduction than under ASC 718, and the timing of the deduction comes upon exercise in later years. The cost is determined at exercise; therefore, there are no interim fluctuations.

Choosing the Best Method

So far, we have discussed potential issues relating only to ASC 718 and transfer pricing. However, the method employed has an effect on other aspects of your business that should be considered. The following points may not cover every aspect of your company’s profile but may help shed some light on the overall implications.

  • Anticipate the necessity of additional documentation and intercompany agreements to obtain deductions in local jurisdictions.
  • Compare the cash-flow implications of the various alternatives.
  • Evaluate the predictability and control over deductions and cash repatriation.
  • Bear in mind that obtaining deductions locally may increase the administrative burden of tracking those deductions.
  • Contemplate large fluctuations in annual service fee charges that may result from tranches of exercises in a particular year and any increased audit scrutiny that might arise.
  • Consider the implications of a bull versus a bear market. For example, consider how future unexpected movements in share value would affect your cash flow and effective tax rate under today’s market conditions.

Alvarez & Marsal Taxand Says:

Best practices require periodic examination of equity compensation entries under ASC 718, so it is important to review services charges for proper inclusion of equity compensation.

We suggest the following:

  • Take a comprehensive approach by bringing all involved professionals to the table for a discussion (e.g., transfer pricing, accounting, ASC 718 specialist, internal tax, etc.).
  • Scrutinize your transfer pricing and international tax structuring to understand your current position.
  • When choosing an equity compensation methodology, consider other factors that may affect your company’s profile, such as cash needs, ease of administration or exposure to FIN 48 (Financial Accounting Standards Board Interpretation No. 48).

By getting in front of these issues and setting company policy for charge-outs, you can increase shareholder value, improve control over your tax accounting and minimize your risk of being the next transfer pricing headline.


Brian Cumberland
Managing Director, Dallas
+1 214 438 1013

Allison Hoeinghaus, Senior Director, Gwayne Lai, Senior Director, and Andrew Scripps, Director, contributed to this article.

For More Information

J.D. Ivy
Managing Director, Dallas
+1 214 438 1028

Albert Liguori
Managing Director, New York
+1 212 763 1638

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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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