Effect of Ninth Circuit Decision For IRS on Shifting Of Income To Tax Havens

Effect of Ninth Circuit Decision For IRS on Shifting Of Income To Tax Havens

Issues relating to Stock-Based Compensation

You will often see articles showing the number of companies "pay" in federal income tax. Those articles inevitably make use of the "provision for income taxes" rather than the amount paid, which is more challenging to find and not broken down by jurisdiction.  The tax deduction gotten by companies when non-qualified options are exercised or qualified options are used and the sold stock in less than a year is not measured in computing the tax provision added to income.  The benefit of tax is considered a donation on capital.

Companies are documenting as part of their provision income tax that they will not pay and not laying out cash.  More to that, they pick up money when the option is exercised and get an income tax deduction.  Their aim, in this case, is to have that entire deduction charged against the taxable income of US operations and not their foreign subsidiary operating in a tax-preferred jurisdiction.

Why the Cayman Islands?

At the core of the case is a transaction that is not economically sensible other than as a tax dodge. In May of 1997, Altera got into a cost-sharing agreement with one of its subsidiaries, Altera International Inc, a Cayman Islands corporation (“Altera International”), which is integrated earlier that year. Altera granted to Altera International a license make use of and exploit Altera’s preexisting intangible property all over the world except the United States and Canada. In exchange for that, Altera International paid royalties to Altera. Both parties agreed to pool together their resources to bear R&D costs in proportion to the profits expected from new technologies.

What is the business aim for creating a subsidiary in the Cayman Islands?

The islands have a fascinating history according to the official website. There were no indigenous people like Bermuda.  Columbus discovered the islands when he was blown off course and ships began stopping there for the turtle meat.

However, the earliest settlers got to the islands around 1658 as absconders from the British Army in Jamaica. The first colonists were called Bodden and Watler – with sailors, fishers, slaves, and refugees from the Spanish Inquisition following.

So what has occurred here is that an American company created an intangible property.  Much of it was likely R&D expense, for which there might have been credits.  An asset has been created with, a minimum to an extent, deductible dollars that protected other income from corporate tax.  Just it was ready to start producing it gets moved to the Cayman Islands, where none of the profit has to be used to aid the world order that makes it possible to get the benefits of intangible assets done in America and deployed all over the world.

The Issue

For the IRS to honor the allocation of income between the Cayman subsidiary and the parent, the cost-sharing arrangement to maintain and better the intangible assets requires to pass regulatory muster.  One of the prerequisites of the regulations is that stock-based compensation comprises of one of the costs.  The taxpayers argued, well enough to persuade the Tax Court and one of the three judges on the panel that in an arm’s length deal parties would not include stock-based compensation.  The IRS didn’t deny that instead argued that the regulations could never repeat comparable transactions among unrelated parties, as they don't happen enough.

You generally do not have somebody thinking they want to find somebody in a small country to purchase the right to their intellectual property which will then be license back for use in other parts of the world.  Furthermore, there will be a cost-revenue split on upcoming developments.  You only do that sort of thing with related parties to save taxes or possibly for protection of asset or some other regulatory concern.  In an arm’s length deal you couldn’t consider stock-based compensation since there is a chance of other party's stock taking off.

The court agreed to the IRS, but it was a close thing. One of the votes was from Stephen Reinhardt, who died on March 29, 2018. He may not get a vote if the matter goes to the full panel.

How Relevant Is This?

TCJA changed the way corporations are taxed on foreign operations and substantially reduced the corporate rate. As earlier stated, there will be an even lower rate (13.125%) for income resulting from foreign income from goods and services with the use of patents and several intellectual properties.

The inference is meant to induce companies having large U.S. operations and significant foreign income from patent royalties to make the U.S a base for most of their asset. Such companies, especially in technology and pharmaceutical areas, often have international rights for their IP in a company established in a low-tax country.

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