\[4830-01-p\]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

\[TD 9088\]

RIN 1545-BA57

Compensatory Stock Options Under Section 482

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that provide guidance
regarding the application of the rules of section 482 governing
qualified cost sharing arrangements. These regulations provide guidance
regarding the treatment of stock-based compensation for purposes of the
rules governing qualified cost sharing arrangements and for purposes of
the comparability factors to be considered under the comparable profits
method. .

DATES: [Effective Date]{.underline}: These regulations are effective
August 26, 2003.

[Applicability Dates]{.underline}: For dates of applicability of these
regulations, see §§1.482-1(j)(5) and 1.482-7(k).

FOR FURTHER INFORMATION CONTACT: Douglas Giblen, (202) 435-5265 (not a
toll-free number).

SUPPLEMENTARY INFORMATION

**Paperwork Reduction Act**

The collections of information contained in these final regulations have
been reviewed and approved by the Office of Management and Budget in
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507)
under control number 1545-1794. Responses to these collections of
information are required by the IRS to monitor compliance with the
federal tax rules for determining stock-based compensation costs to be
shared among controlled participants in qualified cost sharing
arrangements.

An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless the collection of
information displays a valid control number assigned by the Office of
Management and Budget.

The estimated annual burden per respondent or recordkeeper varies from 2
hours to 7 hours, depending on individual circumstances, with an
estimated average of 4 hours.

Comments concerning the accuracy of this burden estimate and suggestions
for reducing this burden should be sent to the **Office of Management
and Budget**, Attn: Desk Officer for the Department of the Treasury,
Office of Information and Regulatory Affairs, Washington, DC 20503, with
copies to the **Internal Revenue Service**, Attn: IRS Reports Clearance
Officer, W:CAR:MP:T:T:SP, Washington, DC 20224.

Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.

**Background**

On July 29, 2002, Treasury and the IRS published in the **Federal
Register** (67 FR 48997) proposed amendments to the regulations
(REG-106359-02) under section 482 of the Internal Revenue Code (Code).
These proposed regulations provide guidance regarding treatment of
stock-based compensation for purposes of qualified cost sharing
arrangements (QCSAs) and the comparable profits method and clarify the
coordination of the rules regarding QCSAs with the arm's length
standard. Written comments responding to these proposed regulations were
received, and a public hearing was held on November 20, 2002. After
consideration of all the comments, the proposed regulations under
section 482 of the Code are adopted as revised by this Treasury
decision.

**Explanation of Revisions** **and Summary of Comments**

These final regulations are the first in a series of regulatory guidance
under section 482 through which Treasury and the IRS intend to update,
clarify and improve current regulatory guidance in the transfer pricing
area. A broader regulatory project on the treatment of QCSAs and a
regulatory project on the transfer pricing of services are in progress,
and Treasury and the IRS intend to issue proposed regulations with
respect to each project in the near term.

These final regulations set forth explicit provisions clarifying that
stock-based compensation is taken into account in determining the
operating expenses treated as intangible development costs of a
controlled participant in a QCSA under §1.482-7. These final regulations
provide rules for measuring the cost associated with stock-based
compensation; clarify that the utilization and treatment of stock-based
compensation is appropriately taken into account as a comparability
factor for purposes of the comparable profits method under §1.482-5; and
provide rules that coordinate the rules of §1.482-7 regarding QCSAs with
the arm's length standard as set forth in §1.482-1.

Treasury and the IRS received comments with respect to the proposed
regulations. Most commentators objected to the proposed regulations in
their entirety or suggested postponement of their finalization. Some
commentators suggested modifications to be adopted in the event that the
proposed regulations were finalized in some form.

After fully considering these comments, Treasury and the IRS continue to
believe that the proposed regulations reflect a sound application of
established principles under section 482. At the same time, Treasury and
the IRS have concluded that certain suggested modifications to the
administrative provisions of the proposed regulations are appropriate.
These modifications are incorporated into the final regulations.

[A. Stock-Based Compensation as a Cost to Be Shared and the Arm\'s
Length Standard as Applied to QCSAs \-- §§1.482-7(d)(2)(i) and (a)(3),
and 1.482-1(a)(1), (b)(2)(i) and (c)]{.underline}

A QCSA subject to the rules of §1.482-7 is an arrangement to develop
intangibles which meets certain administrative and other requirements
and in which the participants to the arrangement share intangible
development costs in proportion to their shares of reasonably
anticipated benefits attributable to the intangibles developed under the
arrangement. In the case of a QCSA, §1.482-7(a)(2) limits the ability of
the Commissioner to make allocations, except to the extent necessary to
make each controlled participant's share of the costs equal its share of
reasonably anticipated benefits. An arrangement in which significant
intangible development costs are not shared in proportion to reasonably
anticipated benefits (or are not shared at all) would not in substance
constitute an arrangement to which the rules of §1.482-7 are applicable.

The proposed regulations address the treatment of stock-based
compensation under a QCSA, and the interaction between the rules
applicable to QCSAs and the arm's length standard. The proposed
regulations provide that stock-based compensation related to the covered
intangible development area must be taken into account in determining
the costs to be shared by participants in a QCSA. The proposed
regulations further provide that a QCSA produces results consistent with
an arm\'s length result if, and only if, all costs related to the
intangible development, as determined in accordance with the specific
guidance in §1.482-7(d), are shared in proportion to reasonably
anticipated benefits.

Commentators objected to this rule on the basis of interpretations of
the arm's length standard and on other grounds.

[1. Comments relating to arm's length standard]{.underline}

Commentators asserted that taking stock-based compensation into account
in the QCSA context would be inconsistent with the arm\'s length
standard unless there is evidence that parties at arm\'s length take
stock-based compensation into account in similar circumstances.
Commentators asserted that third-party evidence, such as the
government\'s own procurement contracting practices and agreements
between unrelated parties with some characteristics similar to QCSAs,
would show that parties at arm\'s length do not take stock-based
compensation into account in determining costs to be reimbursed.

Treasury and the IRS continue to believe that requiring stock-based
compensation to be taken into account for purposes of QCSAs is
consistent with the legislative intent underlying section 482 and with
the arm's length standard (and therefore with the obligations of the
United States under its income tax treaties and with the OECD transfer
pricing guidelines). The legislative history of the Tax Reform Act of
1986 expressed Congress's intent to respect cost sharing arrangements as
consistent with the commensurate with income standard, and therefore
consistent with the arm's length standard, if and to the extent that the
participants\' shares of income \"reasonably reflect the actual economic
activity undertaken by each.\" See H.R. Conf. Rep. No. 99-481, at II-638
(1986). The regulations relating to QCSAs implement that legislative
intent by using costs incurred by each controlled participant with
respect to the intangible development as a proxy for actual economic
activity undertaken by each, and by requiring each controlled
participant to share these costs in proportion to its anticipated
economic benefit from intangibles developed pursuant to the arrangement.
In order for the costs incurred by a participant to reasonably reflect
its actual economic activity, the costs must be determined on a
comprehensive basis. Therefore, in order for a QCSA to reach an arm's
length result consistent with legislative intent, the QCSA must reflect
all relevant costs, including such critical elements of cost as the cost
of compensating employees for providing services related to the
development of the intangibles pursuant to the QCSA. Treasury and the
IRS do not believe that there is any basis for distinguishing between
stock-based compensation and other forms of compensation in this
context.

Treasury and the IRS do not agree with the comments that assert that
taking stock-based compensation into account in the QCSA context would
be inconsistent with the arm's length standard in the absence of
evidence that parties at arm's length take stock-based compensation into
account in similar circumstances. Section 1.482-1(b)(1) provides that a
"controlled transaction meets the arm's length standard if the results
of the transaction are consistent with the results that [would have been
realized]{.underline} if uncontrolled taxpayers [had
engaged]{.underline} in the same transaction under the same
circumstances." (Emphasis added). While the results actually realized in
similar transactions under similar circumstances ordinarily provide
significant evidence in determining whether a controlled transaction
meets the arm's length standard, in the case of QCSAs such data may not
be available. As recognized in the legislative history of the Tax Reform
Act of 1986, there is little, if any, public data regarding transactions
involving high-profit intangibles. H.R. Rep. No. 99-426, at 423-25
(1985). The uncontrolled transactions cited by commentators do not share
enough characteristics of QCSAs involving the development of high-profit
intangibles to establish that parties at arm's length would not take
stock options into account in the context of an arrangement similar to a
QCSA. Government contractors that are entitled to reimbursement for
services on a cost-plus basis under government procurement law assume
substantially less entrepreneurial risk than that assumed by service
providers that participate in QCSAs, and therefore the economic
relationship between the parties to such an arrangement is very
different from the economic relationship between participants in a QCSA.
The other agreements highlighted by commentators establish arrangements
that differ significantly from QCSAs in that they provide for the
payment of markups on cost or of non-cost-based service fees to service
providers within the arrangement or for the payment of royalties among
participants in the arrangement. Such terms, which may have the effect
of mitigating the impact of using a cost base to be shared or reimbursed
that is less than comprehensive, would not be permitted by the QCSA
regulations. Further, the QCSA regulations would not allow the
Commissioner to impose such terms in the context of a QCSA.

The regulations relating to QCSAs have as their focus reaching results
consistent with what parties at arm's length generally would do if they
entered into cost sharing arrangements for the development of
high-profit intangibles. These final regulations reflect that at arm's
length the parties to an arrangement that is based on the sharing of
costs to develop intangibles in order to obtain the benefit of an
independent right to exploit such intangibles would ensure through
bargaining that the arrangement reflected all relevant costs, including
all costs of compensating employees for providing services related to
the arrangement. Parties dealing at arm's length in such an arrangement
based on the sharing of costs and benefits generally would not
distinguish between stock-based compensation and other forms of
compensation.

For example, assume that two parties are negotiating an arrangement
similar to a QCSA in order to attempt to develop patentable
pharmaceutical products, and that they anticipate that they will benefit
equally from their exploitation of such patents in their respective
geographic markets. Assume further that one party is considering the
commitment of several employees to perform research with respect to the
arrangement. That party would not agree to commit employees to an
arrangement that is based on the sharing of costs in order to obtain the
benefit of independent exploitation rights unless the other party agrees
to reimburse its share of the compensation costs of the employees.
Treasury and the IRS believe that if a significant element of that
compensation consists of stock-based compensation, the party committing
employees to the arrangement generally would not agree to do so on terms
that ignore the stock-based compensation.

An arrangement between controlled taxpayers for the development of
intangible assets in which one taxpayer\'s share of significant costs
exceeds its share of reasonably anticipated benefits from the
exploitation of the developed intangibles would not in substance be a
QCSA and therefore would be subject to analysis under the other section
482 regulations. For example, as in the transactions cited by
commentators, a controlled taxpayer might agree at the outset of an
arrangement to bear a disproportionate share of costs in an arrangement
in which it receives a service fee or a contingent royalty from the
exploitation of the developed intangibles. More generally, controlled
taxpayers might agree at the outset of an arrangement to determine the
compensation of one party based on a subset of that taxpayer\'s costs or
on a basis that does not take that taxpayer\'s costs into account at all
(e.g., based on an amount determined with reference to a comparable
uncontrolled price or transaction). In either case, such an arrangement
between controlled taxpayers would not in substance constitute an
arrangement to which the rules of §1.482-7 would apply. Indeed, the
limitations contained in §1.482-7(a)(2) could produce results
inconsistent with an arm\'s length result if applied to such an
arrangement because the Commissioner would be precluded from making
allocations that could be necessary to ensure that each controlled
taxpayer is compensated appropriately. Rather, such an arrangement
should be analyzed under the other section 482 regulations (in
particular, sections 1.482-1, 1.482-2(b), and 1.482-4) to determine
whether it reaches results consistent with the arm\'s length standard,
and any allocations by the Commissioner should be consistent with such
other section 482 regulations.

[2. Other comments]{.underline}

Commentators offered various other reasons for not taking stock-based
compensation into account in the context of QCSAs. Commentators
expressed the view that stock-based compensation should not be taken
into account because it does not constitute an economic cost or require
a cash outlay, or, to the extent such compensation does constitute a
cost, because the cost is borne by shareholders whose share value is
diluted when additional shares are issued on exercise. Commentators also
noted that the treatment of stock-based compensation for financial
reporting purposes should not mandate that stock-based compensation be
taken into account in the context of QCSAs.

In response to such views, and as discussed above, Treasury and the IRS
continue to believe that requiring stock-based compensation to be taken
into account for in the context of QCSAs is appropriate. The final
regulations provide that stock-based compensation must be taken into
account in the context of QCSAs because such a result is consistent with
the arm's length standard. Treasury and the IRS agree that the
disposition of financial reporting issues does not mandate a particular
result under these regulations.

One commentator suggested that even if stock-based compensation
generates a cost to a participant, there is precedent within the
regulations relating to QCSAs for excluding certain costs, notably
interest and taxes. Treasury and the IRS believe that the technical
treatment under the regulations relating to QCSAs of interest, taxes and
other expenses not related to the intangible development area does not
warrant failing to take into account an element of employee compensation
that is clearly related to the intangible development area. Treasury and
the IRS believe that in order for the costs incurred by a participant to
reasonably reflect its actual economic activity consistent with the
legislative intent in this area, those costs must be determined on a
comprehensive basis and so must take into account all relevant costs, in
particular critical elements such as employee compensation. As noted
above, Treasury and the IRS do not believe that there is a basis for
distinguishing between stock-based compensation and other forms of
compensation in this context.

One commentator also claimed that the historical administrative practice
of the IRS has been not to challenge the failure to take stock-based
compensation into account in other transfer pricing contexts in which
the determination of cost is relevant. Treasury and the IRS believe that
such perceived practices of the IRS with respect to other section 482
contexts are not relevant to determining the appropriate regulatory rule
applicable to QCSAs.

As an alternate approach, one commentator suggested that rather than
requiring stock-based compensation to be taken into account in the QCSA
context, Treasury and the IRS should promulgate a "stock-based
compensation safe harbor" applicable to QCSAs. This suggested \"safe
harbor\" has not been adopted in the final regulations. As noted above,
Treasury and the IRS believe that in order for the costs incurred by a
participant to reasonably reflect its actual economic activity, those
costs must be determined on a comprehensive basis and so must take into
account all relevant costs, in particular critical elements such as
employee compensation. The final regulations therefore require employee
compensation to be taken into account, rather than provide for a safe
harbor under which such compensation could be ignored.

[B. Grant-Date Identification Rule \-- §1.482-7(d)(2)(ii)]{.underline}

The proposed regulations identify the stock-based compensation to be
included in the cost pool based on whether the compensation is related
to the intangible development area on the date the option is granted.

One commentator noted that this identification rule is inconsistent with
the IRS treatment of stock-based compensation in other tax areas such as
sourcing, where IRS rulings trace the compensation to the entire period
over which the employee performed the services compensated by the
option.

The grant-date identification rule has been retained in the final
regulations. As noted in the preamble of the proposed regulations, it is
desirable in the QCSA context to select a single date for identification
of covered stock-based compensation. The grant of compensation generally
is the single economic event most closely associated with the services
being compensated.

[C. Provision of Specific Methods of Measurement and Timing]{.underline}

The proposed regulations prescribe two alternative methods for
determining the operating expenses attributable to stock-based
compensation. The default rule under §1.482-7(d)(2)(iii)(A) provides
that the costs attributable to stock-based compensation generally are
included as intangible development costs upon the exercise of the option
and measured by the spread between the option strike price and the price
of the underlying stock. An elective rule under §1.482-7(d)(2)(iii)(B)
provides that the costs attributable to stock options are taken into
account in certain cases in accordance with the "fair value" of the
option, as reported for financial accounting purposes either as a charge
against income or in footnoted disclosures.

Commentators claimed that parties at arm's length would not use either
of the alternatives prescribed in the proposed regulations because they
would produce results that are too speculative or not sufficiently
related to the employee services that are compensated. One commentator
suggested that the final regulations should not limit taxpayers to the
two prescribed measurement methods but rather should codify the current
IRS administrative practice of permitting any reasonable method. In the
commentator's view, a standard based on any reasonable method should
permit the intrinsic-value method, which measures the difference between
strike price and underlying stock value at date of grant, exclusive of
time value. However, the commentator suggested that if Treasury and the
IRS consider an element of time value indispensable, an alternative
would be to require the use of the "minimum value" method, which
accounts for the time value of stock options by assuming the underlying
stock will grow at the risk-free interest rate.

These suggestions were not adopted. Treasury and the IRS believe that it
is appropriate for regulations to prescribe guidance in this context
that is consistent with the arm's length standard and that also is
objective and administrable. As long as the measurement method is
determined at or before grant date, either of the prescribed measurement
methods can be expected to result in an appropriate allocation of costs
among QCSA participants and therefore would be consistent with the arm's
length standard. The results under the default measurement rule are
consistent with what would occur under an arm's length agreement at or
before the grant date to take stock-based compensation into account at
the date of exercise when more facts are known and therefore to share
the risks associated with such compensation between the date of grant
and the date of exercise. The results under the elective measurement
rule are consistent with what would occur under an alternative arm's
length agreement at or before the grant date to determine the value of
the compensation up front and take such compensation into account at
that time. With respect to the specific methods proposed by
commentators, Treasury and the IRS believe that "intrinsic value"
ignores significant elements of the economic value of stock-based
compensation and \"minimum value\" ignores the important variable of
volatility that enters into the economic pricing models used for
financial reporting purposes.

The prescribed measurement methods are objective and administrable
because they rely on valuations or measurements of stock-based
compensation prepared for other purposes. The prescribed measurement
methods do not require or permit valuations of stock-based compensation
specifically for QCSA purposes. A standard under which the validity of
the taxpayer\'s method would have to be analyzed on a case-by-case basis
would be unduly difficult to administer and potentially could lead to
significant disputes.

[D. General Rule of Measurement \-- §1.482-7(d)(2)(iii)(A)]{.underline}

Under the default measurement rule, the amount taken into account for
QCSA purposes generally is the amount allowable as a federal income tax
deduction on exercise of the stock-based compensation. This amount
generally is the "spread" between the option price and the fair market
value of the underlying stock at the date of exercise.

One commentator suggested that this method would be improved if the
amount taken into account for QCSA purposes were limited to the portion
of the spread that accrued between date of grant and full vesting, as
further prorated to reflect only the time during which the employee was
engaged in cost-shared activities.

This suggestion has not been adopted in the final regulations. Treasury
and the IRS believe that the grant-date identification rule already
limits in an appropriate way the stock-based compensation taken into
account. The purpose of the default measurement rule is to measure the
amount attributable to stock-based compensation that must be taken into
account under the grant-date identification rule. Accordingly, the
default measurement rule does not require further refinement through
proration. Further, additional recordkeeping and analysis necessary to
identify relevant time periods and employee activities involving the
covered intangibles and to perform proration calculations are not
warranted.

The proposed regulations set forth special rules for the application of
the general rule of measurement in the event of modification of a stock
option and expiration or termination of a QCSA. The final regulations
retain these rules with technical modifications.

[E. Treatment of Statutory Stock Options \--
§1.482-7(d)(2)(iii)(A)(1)]{.underline}

Under the default measurement rule in the proposed regulations, a
special rule applies to statutory stock options (also referred to as
incentive and employee stock purchase plan stock options). Under this
special rule, the spread on statutory stock options generally is taken
into account for QCSA purposes on exercise, even though section 421
denies a deduction with respect to statutory stock options unless and
until there is a disqualifying disposition of the underlying stock by
the employee.

One commentator suggested that the special rule for statutory stock
options should be removed because it imposes an unnecessary
administrative burden on taxpayers to apply different rules for
different purposes. This suggestion was not adopted in the final
regulations. Treasury and the IRS believe that the more important
concern is consistent treatment of statutory and nonstatutory stock
options for this purpose. This consistency is achieved only if the
spread on both statutory and nonstatutory options is included in the
cost pool on exercise.

[F. Elective Method of Measurement \--
§1.482-7(d)(2)(iii)(B)]{.underline}

The proposed regulations permit an elective method of measurement and
timing with respect to options on publicly traded stock of companies
subject to financial reporting under U.S. generally accepted accounting
principles (U.S. GAAP), provided that the stock is traded on a U.S.
securities market. Under the election, the amount taken into account for
QCSA purposes associated with compensatory stock options is their "fair
value," generally measured by reference to economic pricing models as of
the date of grant, as reflected either as a charge against income or as
a footnote disclosure in the company's audited financial statements, in
compliance with current U.S. GAAP.

One commentator proposed that the elective measurement method be made
available to all taxpayers. The commentator further suggested that
controlled participants should be permitted to use any reasonable method
to measure stock-based compensation in the form of options on stock of
foreign corporations as long as that method is consistent with
international accounting standards or with accounting principles that
are prevalent in the home country of the controlled participant. In the
commentator's view, the limitations in the proposed regulations are not
justified by difficulty of valuation and may be vulnerable to challenges
under anti-discrimination clauses in U.S. income tax treaties.

Treasury and the IRS agree that the elective method should be more
broadly available and have modified these rules in the final
regulations. Specifically, the final regulations extend the availability
of the elective method to options on the stock of certain companies that
prepare their financial statements in accordance with accounting
principles other than U.S. GAAP, while continuing to limit the
availability of the elective method to options on stock that is publicly
traded on a U.S. securities market. Thus, the availability of the
elective method is not extended to options on stock of privately held
companies or companies whose stock is traded only on foreign securities
markets.

Treasury and the IRS believe that objectivity and ease of administration
are important features of any method of measuring costs attributable to
stock-based compensation for purposes of QCSAs. The elective method
should be available only for options on stock whose value is readily
determinable and for companies that are required to determine the fair
value of stock options for a non-tax purpose. Treasury and the IRS
recognize that foreign-based companies whose stock is traded on a U.S.
securities market (directly or through the use of American Depository
Receipts) are required to determine the fair value of options on their
stock even though they do not necessarily prepare financial statements
in accordance with U.S. GAAP. Companies satisfy that requirement by
preparing financial statements in accordance with a comprehensive body
of generally accepted accounting principles (GAAP) that is consistent
with the U.S. GAAP requirement of determining the fair value of stock
options, or by preparing reconciliations of their financial statements
with U.S. GAAP in a manner that reflects the fair value of stock
options.

Accordingly, the final regulations provide that in determining
eligibility for the elective method, financial statements prepared in
accordance with GAAP other than U.S. GAAP are considered as prepared in
accordance with U.S. GAAP in two circumstances. First, financial
statements are considered as prepared in accordance with U.S. GAAP where
the fair value of stock options is reflected in a legally required
reconciliation between the applicable GAAP and U.S. GAAP. In such a
case, the fair value of stock options for purposes of the elective
method of measurement will be the fair value reflected in such
reconciliation. Second, financial statements are considered as prepared
in accordance with U.S. GAAP where, under the applicable GAAP, the fair
value of stock options is reflected as a charge against income in
audited financial statements or is disclosed in footnotes to such
statements. In such a case, the fair value of stock options for purposes
of the elective method of measurement will be the fair value reflected
in such audited financial statements.

Treasury and the IRS continue to believe that the elective method should
be available only for options on stock whose value is readily
determinable and for companies that are required to determine the fair
value of stock options for a non-tax purpose. Accordingly, the final
regulations do not extend the availability of the elective method to
options on stock of privately held companies or companies whose stock is
traded only on foreign securities markets.

One commentator suggested that the election to use the elective method
should be made on the taxpayer\'s return rather than evidenced in the
written cost sharing agreement. In the view of the commentator, such a
procedure would be more practical from an enforcement perspective.

This suggestion was not adopted. Treasury and the IRS continue to
believe that the most effective way to ensure that all participants are
bound by the election is to incorporate it within the written cost
sharing agreement.

[G. Modification of Comparable Profits Method \--
§1.482-5(c)(2)(iv)]{.underline}

The proposed regulations provide that in applying the comparable profits
method, if there are material differences among the tested party and
uncontrolled comparables with respect to the utilization or treatment of
stock-based compensation, such material differences are an appropriate
basis for comparability adjustments. One commentator expressed the view
that this provision contradicts the arm\'s length coordination rules for
QCSAs because the treatment of stock-based compensation by unrelated
parties is considered relevant for purposes of the comparable profits
method but not relevant for purposes of QCSAs.

No revision was made in response to this comment. Treasury and the IRS
believe that the rule provided in the proposed regulations with respect
to the application of the comparable profits method is appropriate
because the financial data with respect to similar business activities
that generally is used as a reference point for that method is subject
to adjustment to ensure comparability.

[H. Effective Date and Transition Rules \-- §1.482-7(k) and
(d)(2)(iii)(B)(2)]{.underline}

The provisions of the proposed regulations applicable to QCSAs would
apply to stock-based compensation granted in taxable years beginning on
or after publication of final regulations. Participants in a QCSA in
existence on the effective date may, on a one-time basis, amend their
agreement to elect the grant-date method of measurement without the
Commissioner\'s consent. The election with respect to existing QCSAs
must be made not later than the latest due date, without regard to
extensions, for an income tax return of a controlled participant for the
first taxable year beginning after the effective date of final
regulations.

One commentator stated that the prospective effective date does not
afford taxpayers a reasonable time to amend their cost sharing
agreements or restructure complex international operations. A transition
period of two years after the publication of final regulations was
suggested.

This suggestion was not adopted. Treasury and the IRS consider the
period stated in the proposed regulations adequate for the initial
planning and recordkeeping that may be occasioned by the final
regulations.

With respect to the special transition rule permitting taxpayers to
elect the grant-date method of measurement by amendment of an existing
written cost sharing agreement no later than the latest due date of an
income tax return of a controlled participant, one commentator suggested
that the due date should not disregard filing extensions. The
commentator maintained that fairness dictates affording taxpayers this
extra time for the analysis needed to make this significant decision.

In response to this comment, the final regulations provide that the due
date for amendments to existing cost sharing agreements is determined
with regard to filing extensions.

Some commentators urged Treasury and the IRS to postpone finalization of
the proposed regulations until the OECD completes its ongoing
consideration of the treatment of stock options for transfer pricing
purposes and an international consensus begins to form so that the
potential for international disputes and resulting negative effects on
U.S. business can be minimized. Similarly, a commentator suggested that
the effects of applying the principles of the proposed regulations to
other areas of transfer pricing should be thoroughly studied and
harmonized before finalizing the regulations to avoid creating traps for
the unwary or other unforeseen consequences.

These suggestions were not implemented. Treasury and the IRS do not
believe that international discussion of issues compels the suspension
of the regulatory process. Also, Treasury and the IRS believe that it is
important to provide timely guidance on issues such as those addressed
by the proposed and final regulations.

Finally, the preamble to the proposed regulations states that the
proposed regulations clarify that stock-based compensation must be taken
into account in the QCSA context. Several commentators interpreted this
language as in effect requiring the new rules to be applied
retroactively. These commentators urged that the final regulations
contain further assurances of prospective intent and explicitly
recognize that these regulations represent a fundamental change to the
traditional approach to section 482.

No revisions were made in light of these comments. As noted earlier,
Treasury and the IRS believe that requiring stock-based compensation to
be taken into account in the QCSA context is consistent with the arm\'s
length standard and long-standing policies underlying section 482. The
final regulations, like the proposed regulations, clearly specify that
the specific rules provided therein are prospective in application.
Moreover, as stated in the proposed regulations, while taxpayers may
rely on the proposed regulations until the effective date of the final
regulations, no inference is intended with respect to the treatment of
stock-based compensation granted in taxable years beginning before the
effective date of these final regulations.

[I. Paperwork Reduction Act and Regulatory Flexibility Act]{.underline}

One commentator expressed the view that the compliance burden imposed by
the proposed regulations on each taxpayer will significantly exceed the
two to seven hours estimated under the Paperwork Reduction Act. The
commentator also asserted that the estimated number of taxpayers
affected by the rules was too low.

The burden estimates as stated in the final regulations reflect no
change. Treasury and the IRS reviewed the estimates made in the proposed
regulations and concluded that they are reasonable.

Similarly, with respect to the Regulatory Flexibility Act, the
commentator challenged the statement in the preamble of the proposed
regulations that the new regulatory requirements will not have a
significant economic impact on a substantial number of small entities.
Upon review of available information, Treasury and the IRS found no
basis for a change in the statement or in the operative finding that the
economic impact of the collections of information in the proposed
regulations is not significant with respect to small entities.

[J. Documentation Requirements and Other Provisions on Which No Comments
Received]{.underline}

Section 1.482-7(j)(2)(i)(F) of the proposed regulations requires that
controlled participants maintain specific documentation to establish the
amount attributable to stock-based compensation that is taken into
account in determining the costs to be shared, including the method of
measurement and timing used with respect to that amount. No comments
were received on this particular provision, and it is retained in the
final regulations.

Treasury and the IRS intend that this provision will require controlled
participants that use the elective method of measurement to maintain
documentation establishing compliance with the requirements of
§1.482-7(d)(2)(iii)(B). For example, documentation should establish that
applicable financial statements reflecting the value of stock options
with respect to which the elective method is used, as well as applicable
accounting principles under which such financial statements are
prepared, are in conformity with the fair-value and reconciliation
requirements adopted in the final regulations with respect to GAAP other
than U.S. GAAP.

Several other provisions of the proposed regulations similarly were not
commented upon and have been adopted without modification in the final
regulations. These provisions include
§1.482-7(d)(2)(iii)(A)([2]{.underline}), relating to deductions of
foreign controlled participants; the last sentence of
§1.482-7(d)(2)(ii), relating to repricing and other modifications of
stock options; and §1.482-7(d)(2)(iii)(C), providing consistency rules
for measurement and timing of stock-based compensation.

**Special Analyses**

It has been determined that this Treasury decision is not a significant
regulatory action as defined in Executive Order 12866. Therefore, a
regulatory assessment is not required. It has also been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations. It is hereby certified that the
collection of information in these regulations will not have a
significant economic impact on a substantial number of small entities.
This certification is based upon the fact that few small entities are
expected to enter into QCSAs involving stock-based compensation, and
that for those who do, the burdens imposed under §1.482-7(d)(2)(iii)(B)
and (j)(2)(i)(F) will be minimal. Therefore, a Regulatory Flexibility
Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is
not required. Pursuant to section 7805(f), the proposed regulations
preceding these regulations were submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact
on small business.

**Drafting Information**

The principal author of these regulations is Douglas Giblen of the
Office of Associate Chief Counsel (International). However, other
personnel from Treasury and the IRS participated in their development.

**List of Subjects**

[26 CFR Part 1]{.underline}

Income taxes, Reporting and recordkeeping requirements.

[26 CFR Part 602]{.underline}

Reporting and recordkeeping requirements.

**Adoption of Amendments to the Regulations**

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 \-- INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part
as follows:

Authority: 26 U.S.C. 7805 \* \* \*

Sections 1.482-1, 1.482-5 and 1.482-7 also issued under 26 U.S.C. 482.
\* \* \*

Par. 2. Section 1.482-0 is amended by:

1\. Redesignating the entry for §1.482-7(a)(3) as the entry for
§1.482-7(a)(4).

2\. Adding a new entry for §1.482-7(a)(3).

3\. Redesignating the entry for §1.482-7(d)(2) as the entry for
§1.482-7(d)(3).

4\. Adding new entries for §1.482-7(d)(2).

The additions and redesignation read as follows:

[§1.482-0 Outline of regulations under section 482]{.underline}.

\* \* \* \* \*

[§1.482-7 Sharing of costs]{.underline}.

\(a\) In general.

\* \* \* \* \*

\(3\) Coordination with §1.482-1.

\(4\) Cross references.

\* \* \* \* \*

\(d\) Costs.

\* \* \* \* \*

\(2\) Stock-based compensation.

\(i\) In general.

\(ii\) Identification of stock-based compensation related to intangible
development.

\(iii\) Measurement and timing of stock-based compensation expense.

\(A\) In general.

([1]{.underline}) Transfers to which section 421 applies.

([2]{.underline}) Deductions of foreign controlled participants.

([3]{.underline}) Modification of stock option.

([4]{.underline}) Expiration or termination of qualified cost sharing
arrangement.

\(B\) Election with respect to options on publicly traded stock.

([1]{.underline}) In general.

([2]{.underline}) Publicly traded stock.

([3]{.underline}) Generally accepted accounting principles.

([4]{.underline}) Time and manner of making the election.

\(C\) Consistency.

\(3\) Examples.

\* \* \* \* \*

Par. 3. Section 1.482-1 is amended by:

1\. Removing the sixth sentence of paragraph (a)(1) and adding two
sentences in its place.

2\. Adding a sentence at the end of paragraph (b)(2)(i).

3\. Adding a sentence at the end of paragraph (c)(1).

4\. Adding paragraph (j)(5).

The additions read as follows:

[§1.482-1 Allocation of income and deductions among
taxpayers]{.underline}.

\(a\) \* \* \*

\(1\) \* \* \* Section 1.482-7T sets forth the cost sharing provisions
applicable to taxable years beginning on or after October 6, 1994, and
before January 1, 1996. Section 1.482-7 sets forth the cost sharing
provisions applicable to taxable years beginning on or after January 1,
1996. \* \* \*

\* \* \* \* \*

\(b\) \* \* \*

\(2\) \* \* \*

\(i\) \* \* \* Section 1.482-7 provides the specific method to be used
to evaluate whether a qualified cost sharing arrangement produces
results consistent with an arm\'s length result.

\* \* \* \* \*

\(c\) \* \* \*

\(1\) \* \* \* See §1.482-7 for the applicable method in the case of a
qualified cost sharing arrangement.

\* \* \* \* \*

\(j\) \* \* \*

\(5\) The last sentences of paragraphs (b)(2)(i) and (c)(1) of this
section and of paragraph (c)(2)(iv) of §1.482-5 apply for taxable years
beginning on or after August 26, 2003.

Par. 4. Section 1.482-5 is amended by adding a sentence at the end of
paragraph (c)(2)(iv) to read as follows:

[§1.482-5 Comparable profits method]{.underline}.

\* \* \* \* \*

\(c\) \* \* \*

\(2\) \* \* \*

\(iv\) \* \* \* As another example, it may be appropriate to adjust the
operating profit of a party to account for material differences in the
utilization of or accounting for stock-based compensation (as defined by
§1.482-7(d)(2)(i)) among the tested party and comparable parties.

\* \* \* \* \*

Par. 5. Section 1.482-7 is amended by:

1\. Redesignating paragraph (a)(3) as paragraph (a)(4).

2\. Adding a new paragraph (a)(3).

3\. Redesignating paragraph (d)(2) as paragraph (d)(3).

> 4\. Adding a new paragraph (d)(2).

5\. Removing the word \"and\" at the end of paragraph (j)(2)(i)(D).

6\. Removing the period at the end of paragraph (j)(2)(i)(E) and adding
"; and" in its place.

7\. Adding paragraph (j)(2)(i)(F).

> 8\. Revising paragraph (k).

The additions and revision read as follows:

[§1.482-7 Sharing of costs]{.underline}.

\(a\) \* \* \*

\(3\) [Coordination with §1.482-1]{.underline}. A qualified cost sharing
arrangement produces results that are consistent with an arm\'s length
result within the meaning of §1.482-1(b)(1) if, and only if, each
controlled participant\'s share of the costs (as determined under
paragraph (d) of this section) of intangible development under the
qualified cost sharing arrangement equals its share of reasonably
anticipated benefits attributable to such development (as required by
paragraph (a)(2) of this section) and all other requirements of this
section are satisfied.

\* \* \* \* \*

\(d\) \* \* \*

\(2\) [Stock-based compensation]{.underline}\--(i) [In
general]{.underline}. For purposes of this section, a controlled
participant's operating expenses include all costs attributable to
compensation, including stock-based compensation. As used in this
section, the term [stock-based compensation]{.underline} means any
compensation provided by a controlled participant to an employee or
independent contractor in the form of equity instruments, options to
acquire stock (stock options), or rights with respect to (or determined
by reference to) equity instruments or stock options, including but not
limited to property to which section 83 applies and stock options to
which section 421 applies, regardless of whether ultimately settled in
the form of cash, stock, or other property.

\(ii\) [Identification of stock-based compensation related to intangible
development]{.underline}. The determination of whether stock-based
compensation is related to the intangible development area within the
meaning of paragraph (d)(1) of this section is made as of the date that
the stock-based compensation is granted. Accordingly, all stock-based
compensation that is granted during the term of the qualified cost
sharing arrangement and is related at date of grant to the development
of intangibles covered by the arrangement is included as an intangible
development cost under paragraph (d)(1) of this section. In the case of
a repricing or other modification of a stock option, the determination
of whether the repricing or other modification constitutes the grant of
a new stock option for purposes of this paragraph (d)(2)(ii) will be
made in accordance with the rules of section 424(h) and related
regulations.

\(iii\) [Measurement and timing of stock-based compensation
expense]{.underline}\--(A) [In general]{.underline}. Except as otherwise
provided in this paragraph (d)(2)(iii), the operating expense
attributable to stock-based compensation is equal to the amount
allowable to the controlled participant as a deduction for Federal
income tax purposes with respect to that stock-based compensation (for
example, under section 83(h)) and is taken into account as an operating
expense under this section for the taxable year for which the deduction
is allowable.

([1]{.underline}) [Transfers to which section 421 applies]{.underline}.
Solely for purposes of this paragraph (d)(2)(iii)(A), section 421 does
not apply to the transfer of stock pursuant to the exercise of an option
that meets the requirements of section 422(a) or 423(a).

([2]{.underline}) [Deductions of foreign controlled
participants]{.underline}. Solely for purposes of this paragraph
(d)(2)(iii)(A), an amount is treated as an allowable deduction of a
controlled participant to the extent that a deduction would be allowable
to a United States taxpayer.

([3]{.underline}) [Modification of stock option]{.underline}. Solely for
purposes of this paragraph (d)(2)(iii)(A), if the repricing or other
modification of a stock option is determined, under paragraph (d)(2)(ii)
of this section, to constitute the grant of a new stock option not
related to the development of intangibles, the stock option that is
repriced or otherwise modified will be treated as being exercised
immediately before the modification, provided that the stock option is
then exercisable and the fair market value of the underlying stock then
exceeds the price at which the stock option is exercisable. Accordingly,
the amount of the deduction that would be allowable (or treated as
allowable under this paragraph (d)(2)(iii)(A)) to the controlled
participant upon exercise of the stock option immediately before the
modification must be taken into account as an operating expense as of
the date of the modification.

([4]{.underline}) [Expiration or termination of qualified cost sharing
arrangement]{.underline}. Solely for purposes of this paragraph
(d)(2)(iii)(A), if an item of stock-based compensation related to the
development of intangibles is not exercised during the term of a
qualified cost sharing arrangement, that item of stock-based
compensation will be treated as being exercised immediately before the
expiration or termination of the qualified cost sharing arrangement,
provided that the stock-based compensation is then exercisable and the
fair market value of the underlying stock then exceeds the price at
which the stock-based compensation is exercisable. Accordingly, the
amount of the deduction that would be allowable (or treated as allowable
under this paragraph (d)(2)(iii)(A)) to the controlled participant upon
exercise of the stock-based compensation must be taken into account as
an operating expense as of the date of the expiration or termination of
the qualified cost sharing arrangement.

\(B\) [Election with respect to options on publicly traded
stock]{.underline} \--([1]{.underline}) [In general]{.underline}. With
respect to stock-based compensation in the form of options on publicly
traded stock, the controlled participants in a qualified cost sharing
arrangement may elect to take into account all operating expenses
attributable to those stock options in the same amount, and as of the
same time, as the fair value of the stock options reflected as a charge
against income in audited financial statements or disclosed in footnotes
to such financial statements, provided that such statements are prepared
in accordance with United States generally accepted accounting
principles by or on behalf of the company issuing the publicly traded
stock.

([2]{.underline}) [Publicly traded stock]{.underline}. As used in this
paragraph (d)(2)(iii)(B), the term [publicly traded stock]{.underline}
means stock that is regularly traded on an established United States
securities market and is issued by a company whose financial statements
are prepared in accordance with United States generally accepted
accounting principles for the taxable year.

([3]{.underline}) [Generally accepted accounting
principles]{.underline}. For purposes of this paragraph (d)(2)(iii)(B),
a financial statement prepared in accordance with a comprehensive body
of generally accepted accounting principles other than United States
generally accepted accounting principles is considered to be prepared in
accordance with United States generally accepted accounting principles
provided that either\--

([i]{.underline}) The fair value of the stock options under
consideration is reflected in the reconciliation between such other
accounting principles and United States generally accepted accounting
principles required to be incorporated into the financial statement by
the securities laws governing companies whose stock is regularly traded
on United States securities markets; or

([ii]{.underline}) In the absence of a reconciliation between such other
accounting principles and United States generally accepted accounting
principles that reflects the fair value of the stock options under
consideration, such other accounting principles require that the fair
value of the stock options under consideration be reflected as a charge
against income in audited financial statements or disclosed in footnotes
to such statements.

([4]{.underline}) [Time and manner of making the election]{.underline}.
The election described in this paragraph (d)(2)(iii)(B) is made by an
explicit reference to the election in the written cost sharing agreement
required by paragraph (b)(4) of this section or in a written amendment
to the cost sharing agreement entered into with the consent of the
Commissioner pursuant to paragraph (d)(2)(iii)(C) of this section. In
the case of a qualified cost sharing arrangement in existence on August
26, 2003, the election must be made by written amendment to the cost
sharing agreement not later than the latest due date (with regard to
extensions) of a federal income tax return of any controlled participant
for the first taxable year beginning after August 26, 2003, and the
consent of the Commissioner is not required.

\(C\) [Consistency]{.underline}. Generally, all controlled participants
in a qualified cost sharing arrangement taking options on publicly
traded stock into account under paragraph (d)(2)(iii)(A) or (B) of this
section must use that same method of measurement and timing for all
options on publicly traded stock with respect to that qualified cost
sharing arrangement. Controlled participants may change their method
only with the consent of the Commissioner and only with respect to stock
options granted during taxable years subsequent to the taxable year in
which the Commissioner's consent is obtained. All controlled
participants in the qualified cost sharing arrangement must join in
requests for the Commissioner's consent under this paragraph. Thus, for
example, if the controlled participants make the election described in
paragraph (d)(2)(iii)(B) of this section upon the formation of the
qualified cost sharing arrangement, the election may be revoked only
with the consent of the Commissioner, and the consent will apply only to
stock options granted in taxable years subsequent to the taxable year in
which consent is obtained. Similarly, if controlled participants already
have granted stock options that have been or will be taken into account
under the general rule of paragraph (d)(2)(iii)(A) of this section, then
except in cases specified in the last sentence of paragraph
(d)(2)(iii)(B)([2]{.underline}) of this section, the controlled
participants may make the election described in paragraph (d)(2)(iii)(B)
of this section only with the consent of the Commissioner, and the
consent will apply only to stock options granted in taxable years
subsequent to the taxable year in which consent is obtained.

\* \* \* \* \*

\(j\) \* \* \*

\(2\) \* \* \*

\(i\) \* \* \*

\(F\) The amount taken into account as operating expenses attributable
to stock-based compensation, including the method of measurement and
timing used with respect to that amount as well as the data, as of date
of grant, used to identify stock-based compensation related to the
development of covered intangibles.

\* \* \* \* \*

\(k\) [Effective date]{.underline}. This section applies for taxable
years beginning on or after January 1, 1996. However, paragraphs (a)(3),
(d)(2) and (j)(2)(i)(F) of this section apply for stock-based
compensation granted in taxable years beginning on or after August 26,
2003.

\* \* \* \* \*

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 9. The authority citation for part 602 continues to read as
follows:

Authority: 26 U.S.C. 7805

Par. 10. In §602.101, paragraph (b) is amended by adding an entry in
numerical order to the table to read in part as follows :

[§602.101 OMB Control numbers]{.underline}.

\* \* \* \* \*

\(b\) \* \* \*

CFR part or section where Current OMB

[identified and described control No.]{.underline}

\* \* \* \* \*

1.482-7\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...\...1545-1794

\* \* \* \* \*

Deputy Commissioner for Services and Enforcement.

Robert E. Wenzel

Approved: August 11, 2003

Assistant Secretary of the Treasury.

Pamela F. Olson