IRS ATTEMPTS TO SHUT THE DOOR ON CONTROVERSIAL OPTION DEDUCTION ISSUE WITH PROPOSED REVISIONS TO NEXT DAY RULE REGULATION

Transcription

1 COMPENSATION & FRINGE BENEFITS IRS ATTEMPTS TO SHUT THE DOOR ON CONTROVERSIAL OPTION DEDUCTION ISSUE WITH PROPOSED REVISIONS TO NEXT DAY RULE REGULATION ANNE BATTER AND KAI KRAMER On March 5, 2015, Treasury and the IRS published long-awaited proposed regulations amending Reg (the 2015 Proposed Regulations ) in part to clarify the timing of stock option deductions in the acquisition context. 1 As discussed more fully below, the 2015 Proposed Regulations no longer allow use of the next day rule for extraordinary items that become deductible simultaneously with the change in control of a target company (the Target ). As the application of the 2015 Proposed Regulations to stock options is illustrated in Example 8 of Prop. Reg (b)(5), the regulations are intended to require stock option deductions to be taken on the Target s stub year return ending with the change in control. However, the premise of the regulations that the stock options cashed out on the change in control become deductible simultaneously with the change in control is questionable at best, may have repercussions outside the merger and acquisition ( M&A ) context, and makes it difficult to sort out the implications of the 2015 Proposed Regulations for other forms of equity compensation. This column describes the changes in the 2015 Proposed Regulations as applied to stock option cash outs and other compensation events that occur in an acquisition. Because the issues raised by the 2015 Proposed Regulations involve the intersection of the consolidated return rules, ANNE BATTER is a partner in Baker & McKenzie s Tax Practice Group in Washington, D.C. She focuses her practice on the tax treatment of executive compensation and fringe benefits arrangements. KAI KRAMER is an associate in the Firm s Tax Practice Group in Houston, Texas. His practice focuses on tax matters in connection with M&A transactions and international tax planning. The authors gratefully acknowledge Edward Burmeister, Jerred Blanchard, and Ross Staine for their helpful comments in the preparation of this column. the all events and economic substance tests, and special deduction timing rules applicable to compensation, this column first briefly reviews those rules. After laying the foundation, this column addresses the change in the consolidated return regulations, and what the 2015 Proposed Regulations may mean for purposes of allocating deductions related to the cash out of options (or other compensation expenses). As will be seen, while the 2015 Proposed Regulations purport to clarify the rules, because they are premised on a dubious interpretation of Section 83, they serve, instead, to muddy the waters. Background In general, when a corporation leaves or joins a consolidated group, the tax year of the Target closes at the end of the day of the transaction (the Closing Date ), and a new tax year begins on the day following the Closing Date. In the M&A context, the taxable period ending on the Closing Date is often referred to as Target s Pre-Closing Tax Period or the stub year and the taxable period beginning after the Closing Date is referred to as Target s Post-Closing Tax Period. Since 1994, the consolidated return regulations (the Current Regulations ) have contained specific rules addressing the treatment of items of income and deduction that are properly taken into account on the Target s Closing Date. Under the general rule of the Current Regulations, the Target is treated as ceasing to become a member of a consolidated group at the end of the Closing Date (the End of Day Rule ), and the Target s items properly taken into account SEPTEMBER / OCTOBER 2015 CORPORATE TAXATION 31

2 that day are typically included on the return for Target s Pre-Closing Tax Period (i.e., the stub year ending with the transaction). 2 The Current Regulations, however, provide an exception to the End of Day Rule called the Next Day Rule. The Next Day Rule. Under the Next Day Rule of the Current Regulations, if on the Closing Date a transaction occurs that is properly allocable to the portion of the Closing Date after the sale of the Target closes, the Target must treat the transaction for all federal income tax purposes as occurring at the beginning of the following day (e.g., the next day). 3 Specifically, where the Next Day Rule applies, it provides that the Target and all parties related to the Target after the change in control must treat the transaction as occurring on the beginning of the day following the Closing Date. 4 Under the Current Regulations, whether a transaction is properly allocable to the portion of the Closing Date after the sale of the Target depends on whether the allocation is reasonable and consistently applied by all parties. 5 Whether an allocation is reasonable is a factual question. Among the factors to be considered are whether the items of income, gain, deduction, loss, and credit are allocated inconsistently and whether the allocation is inconsistent with other provisions of the Internal Revenue Code. 6 Whether the allocation is consistently applied simply means that each of the selling corporation (the Seller ), the Target, and the acquiring corporation (the Acquirer ) must report the item consistently. For example, if the Target accrues an expense related to the sale of the Target, the Acquirer and the Seller cannot both take a deduction for the same expense in Target s Pre-Closing Tax Period and Target s Post-Closing Tax Period. The Next Day Rule has afforded planning opportunities for both the Seller, the Target, and the Acquirer, particularly when the Target is a loss company that would be further limited under Section 382 if deductions for expenses related to the closing of the sale of the Target must be taken in the tax return related to the Target s Pre-Closing Tax Period. Since, under the Current Regulations, a deduction is properly allocable to the next day only if each of the Seller, the Target, and the Acquirer report the item consistently under the Next Day Rule, it is possible for one party to the transaction to trump potential use of the Next Day Rule by not agreeing to its use. However, if all parties agree to apply the Next Day Rule, the deduction is allowed on the return for the Target s Post- Closing Tax Period as long as the allocation is reasonable, a standard that is subject to a wide range of interpretation. Deduction timing rules. The consolidated return rules addressing when a member joins or leaves a consolidated group are generally understood to apply in conjunction with otherwise applicable deduction timing rules. In other words, when a Target s Pre-Closing Tax Period or stub year return closes, the items taken into account that day generally include items that would otherwise be taken into account that day applying general tax principles (such as the all events and economic performance tests). Thus, for example, if an item becomes deductible under the all events and economic performance tests of Section 461 on the Closing Date, absent the application of the Next Day Rule, that item would be taken into account on the Target s stub year ending with the Closing Date. An exception exists in the case of certain items, which may be ratably allocated over the Target s entire year, but in the absence of an election to allocate such items ratably, the otherwise applicable deduction timing principles apply. 7 Special deduction timing rules for Section 83 (and deferred compensation). Sections 83 and 404(a)(5) contain special rules that, where applicable, often serve to postpone a deduction. Section 83 is a statutory regime that governs the income taxation of transfers of property in connection with services, including transfers of 1 REG , 80 Fed. Reg (March 6, 2015). For prior coverage of the 2015 Proposed Regulations, see Ley and Fleming, Proposed Next-Day Rule: Revised Rules Provide Rigid Framework, 42 Corp. Tax n 30 (July/August). 2 Reg (b)(1)(ii)(A)(1). 3 Reg (b)(1)(ii)(B). 4 Id. 5 Id. 6 Id. 7 See Reg (b)(2)(ii). 8 The preamble to the final Section 83 regulations, issued in 1978, explains the deduction provisions as follows: Subject to the requirements of sections 162 and 212, a deduction is allowed to the person for whom services were performed, in an amount equal to the amount of compensation includible in the gross income of the person who provided the services, at the time the compensation becomes includible in the gross income of the person who performed the services. TD 7554, CB 71 (emphasis added). 9 Section 83(h); Regs (a)(1) and (3). 10 See Reg (d) (treating parent s transfer of stock to employee of subsidiary as a capital contribution to the subsidiary and a payment of the compensation by the subsidiary). 11 Reg (a)(3). 12 This article addresses only compensatory, nonqualified stock options. Other options, like non-compensatory options or incentive stock options, are beyond the scope of this article. 13 Reg (a). 14 Temp. Reg (b)-1T, Q&A CORPORATE TAXATION SEPTEMBER / OCTOBER 2015 COMPENSATION & FRINGE BENEFITS

3 stock to employees. Amounts are included in gross income under Section 83(a) when property transferred to an employee becomes transferrable by the employee or no longer subject to a substantial risk of forfeiture. Section 83 is focused on income taxation of the recipient of the property, but Section 83(h) contains a rule that allows a deduction to the employer that matches in amount and timing the income to the employee. 8 In the case of a transfer of property to an employee, if the property is subject to a substantial risk of forfeiture when transferred, the compensation deduction is allowed under Section 83(h) only in the employer s year in which or with which ends the year in which the amount is includable in the employee s income. 9 For this purpose, the employer is the entity that directly employs the employee (not the parent company that issues the stock). 10 By contrast, under the Section 83 regulations, if the property when transferred is not subject to a substantial risk of forfeiture, the in which or with which ends rule does not apply, and the compensation deduction is allowed in accordance with [the taxpayer s] method of accounting (in conformity with sections 446 and 461). 11 In the case of nonqualified stock options, where the stock transferred at option exercise is not subject to a risk of forfeiture, but is vested, this rule allows the deduction under the normal method of accounting, rather than under the in which or with which ends rule. 12 However, whether or not the in which or with which rule applies, the overriding principle under Section 83(h) is for the compensation deduction to occur only once there is a transfer of property, and for the deduction to match in amount and timing the income to the employee. As discussed below in more detail, for Section 83 purposes, a transfer occurs when a person acquires a beneficial ownership interest in the property. 13 Similar to the general in which or with which ends rule under Section 83(h), deferred compensation is subject to an in which or with which ends deduction timing rule under the Section 404(a)(5) regulations. 14 Deferred compensation subject to the Section 404(a)(5) deduction timing rule generally is defined to include any compensation the employee receives more than a brief period of time after the end of the employer s year in which the employee performed the services that created the right to the compensation. Since certain forms of equity compensation, such as restricted stock units, can qualify as deferred compensation if paid in the year after the services are performed, the in which or with which ends rule under Section 404(a)(5) potentially applies to those forms of equity compensation as well to property transferred under Section 83. Overlaying Sections 446, 461, and 83(h). Most corporate employers whose employees hold options and other forms of equity compensation will be accrual method taxpayers, such that deductions generally will be taken only when the all events and economic performance tests are met under Section 461 and the regulations thereunder. Often, the accrual method of accounting results in more favorable deduction timing than the in which or with which ends rule of Section 83. In the case of a fiscal year employer, the in which or with which ends deduction timing rule causes a delay in the employer s ability to take a compensation deduction under Section 83(h). For example, if an employer with a June 30 fiscal year issues to employees restricted stock that vests December 15, Year 1, the deduction will not be allowed under Section 83(h) until the employer s June 30, Year 2 fiscal year ends because the employee s year of income inclusion (calendar year December 31, Year 1) falls in the fiscal year of the employer that ends June 30, Year 2. As a result of the application of the in which or with which ends rule of Section 83(h) (and the similar rule in Section 404(a)(5)), in the acquisition context, compensation deductions subject to that timing rule generally are thrown out to a later year and taken on the Target s return at a time when Target is part of the Acquirer s consolidated group. Thus, in the case of a Target whose employees have outstanding restricted stock that vests on a change in control, the deduction for that restricted stock will almost always be pushed into the Acquirer s consolidated return. Take, for example, an acquiring company that is part of a group acquiring a Target where that Target is also part of a consolidated group. Both the Acquirer and the Target group have calendar-year tax years, and the acquisition occurs on November 30. There is no question, under this scenario, that the timing of the deduction for outstanding Target restricted stock that vests on the change in control will be pushed out under the in which or with which ends rule such that it is deductible to the Target, under Section 83(h), during the tax year that the Target is included in the acquiring group s consolidated return. The same is true of deferred compensation that vests and is paid on a change in control. The key to this treatment is COMPENSATION & FRINGE BENEFITS SEPTEMBER / OCTOBER 2015 CORPORATE TAXATION 33

4 the combination of the in which or with which ends rule and the consolidated return regulations, described above, governing members who join and/or leave the group. GLAM GLAM (the GLAM ) was examined at length in a previous column (the Prior Column ). 15 As discussed in the Prior Column, the IRS issued guidance in the GLAM which addressed, among other things, the application of the Next Day Rule to nonqualified stock options and stock appreciation rights ( SARs ) that are required to be cashed out on a change of control. The facts of the GLAM are similar to an example in the 2015 Proposed Regulations, discussed below, which is typical in acquisitions. The acquirer was the parent of a consolidated group that acquired the Target, a C corporation. The Target became a member of the acquiring group on the day of the acquisition. Before the acquisition in the GLAM, the Target issued options and SARs to its employees, and those options and SARs were required, by their terms, to be cashed out in the event of a change in control of the Target. When the Acquirer bought all of the Target s stock, the Target s obligation to pay its employees holding outstanding options and SARs was triggered. Within several days of the acquisition, the Target satisfied its obligation (with its own cash or cash received from the Acquirer) to pay its employees the option and SAR cash out amounts. The GLAM concluded that the Next Day Rule was inapplicable to the options and SARs cashed out in connection with a change in control, where the obligation to pay and the amount of liability became fixed and determinable upon closing, because such deductions were not reasonably allocable to the part of the Closing Date after the transaction. Accordingly, since the Next Day Rule did not apply, the deductions were available only in Target s Pre-Closing Period return. The IRS reached its conclusion that the option deductions were not reasonably allocable to the day after the change (and the Next Day Rule did not apply) on the following basis: (1) the Target s obligation to pay the option cash out became fixed on the date of the change of control; (2) the options related to the performance of services by employees for the Target before the acquisition; (3) the cash out was not a transaction separate from the change in control; and (4) the transaction was not under the buyer s control, but was required under the terms of the options and SARs. As discussed in the Prior Column, these conclusions are questionable for a number of reasons, including the following: (1) the Next Day Rule under the Current Regulations applies to items that are otherwise deductible on the date of the change, and thus, the fact that the cash payment obligation became fixed on the date of the change of control is of no relevance to whether the Next Day Rule should apply; (2) option deductions are not required to be matched to when the services are performed, and the deduction on option exercise often occurs in a year after the options are fully earned; and (3) Section 83 should not apply, in the first instance, until the transfer of property (or cash out) occurs several days after the transaction. The latter point is critical since the 2015 Proposed Regulations raise this concern again by premising their analysis of the Next Day Rule s application to stock options on the questionable assumption that the stock option compensation becomes deductible simultaneously with the change of control. The 2015 Proposed Regulations In an effort to reduce the controversy and uncertainty under the Next Day Rule as to whether deductions should be allocated to Target s Pre-Closing Tax Period or Target s Post-Closing Tax Period, Treasury and the IRS issued the 2015 Proposed Regulations, which clarify the period in which the Target must report certain tax items by replacing the current rule with a revised, more narrowly tailored version of the Next Day Rule (the Proposed Next Day Rule ). The application of the Proposed Next Day Rule does not depend on all parties consistently reporting the item and, thus, the elective nature of the Current Regulations is removed. Instead, the Proposed Next Day Rule mandatorily applies to extraordinary items that result from a transaction that occurs on the Closing Date, but after the event resulting in the change. However, the Proposed Next Day Rule is not applicable to any extraordinary item that becomes deductible or includable simultaneously with the event that caused the Target s change in status (e.g., the closing of the transaction). The definition of an extraordinary item continues to include bonus, severance, and option cancellation payments made in connection with Target s change in status. 16 Example 8. Example 8 of the 2015 Proposed Regulations addresses stock options cashed out on the change in control and essentially tracks the stock option facts from the GLAM. 17 In Example 8, the Target is a stand-alone accrual method C corporation with outstanding nonqualified options. Under the original option agreements, the 34 CORPORATE TAXATION SEPTEMBER / OCTOBER 2015 COMPENSATION & FRINGE BENEFITS

5 Target is obligated to pay its employees in cancellation of their stock options upon a change in control of the Target, and the Target s obligation to make option cancellation payments to its employees becomes fixed and determinable upon the closing the acquisition. Several days after the closing, the Target pays its employees the amounts required under the option agreements. The example reasons that the deduction with respect to the options arises from the Target s liability to pay its employees in cancellation of their stock options in connection with the Target s change in status and, thus, involves an extraordinary item that cannot be ratably allocated. The example next concludes that the parties must apply the End of Day rule because the Target s liability to pay its employees on cash out of the options becomes deductible on the day of the Target s change in status simultaneously with the event the causes the Target s change in status. Thus, according to Example 8, the Proposed Next Day Rule does not apply, and the deduction must be allocated to the Target s Pre-Closing Tax Period and not to the Target s Post-Closing Tax Period. The example is premised on a questionable interpretation of when the Section 83(h) deduction on cash out of the options occurs. The example states that the stock option liability becomes deductible simultaneously with the change in control. This conclusion makes the Next Day Rule inapplicable and also serves to require the deduction to be taken on the return for the Target s Pre-Closing Tax Period under the End of Day Rule. However, the conclusion is a seriously questionable interpretation of Section 83. Taxation under Section 83(a) hinges on there being a transfer of property to the employee. A transfer of property occurs when a person acquires a beneficial ownership interest in such property. 18 The Section 83 regulations set forth a number of factors that indicate when no current transfer of property has occurred. These include (1) the arrangement resembles an option, (2) the transferee is not subject to risk of loss if the property declines in value, and (3) the transferee is required to resell the property at a price not approaching its fair market value. 19 In the case of stock options, once the option is exercised, it is understood that the option holder has beneficial ownership of the stock because, at option exercise, there is an unconditional obligation to deliver the stock and the option holder at that point has the risk that the stock will decline in value. 20 Thus, once the option is exercised and the stock is beneficially owned, the stock is taxable when it becomes transferrable by the employee or no longer subject to a substantial risk of forfeiture. But, this certainly cannot occur before the property is transferred. The Section 83 regulations provide that [i]n general, such property is not taxable under section 83(a) until it has been transferred to such person and become substantially vested. 21 In the case of an option exercise, sections 83(a) and 83(b) apply to the transfer of property pursuant to such exercise, and the employee realizes compensation income upon such transfer at the time and in the amount determined under section 83(a) or 83(b). 22 In the case of stock options that are disposed of, rather than exercised, the taxation occurs at the disposition of the option. In the case of a disposition of the option, such as where an option is cashed out, the clear terms of the Section 83 regulations state that sections 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as sections 83(a) and 83(b) would have applied to the transfer of property pursuant to an exercise of the option. 23 Yet, it is difficult to see how the Section 83 beneficial ownership concepts apply to give a person beneficial ownership in a promise to transfer cash in the future. The cashed out option holder certainly does not have a risk that the cash will decrease in value and is not obligated to return the cash for less than its value. Thus, the income to the employee on cash out of an option should occur when the cash is actually transferred. In Example 8, this occurs several days after the change in control. And, under Section 83(h), the deduction is meant to match in amount and timing the income to the employee. While the deduction is not required to be delayed under the in which or with which ends rule, because the property is vested at the time of transfer, it should not be allowed to be taken in the 15 Batter and Sloan, IRS Addresses Controversial Option Deduction Issue in GLAM , 40 Corp. Tax n 44 (July/August 2013). 16 Prop. Reg (b)(2)(ii)(C)(9). The Proposed Next Day Rule applies solely for purposes of determining the short period to which an item is allocated, not for other purposes (such as determining whether the item is attributable to an intercompany transaction within the meaning of Reg (b)(1)). 17 Prop. Reg (b)(5), Ex Reg (a)(1). 19 Regs (a)(2)-(6). 20 See Rev. Rul , CB Reg (a) (emphasis added). 22 Reg (a) (emphasis added). 23 Id. COMPENSATION & FRINGE BENEFITS SEPTEMBER / OCTOBER 2015 CORPORATE TAXATION 35

6 24 If the IRS, instead, is saying in Example 8 that both the transfer and income to the employee and the deduction to the employer occur on the change in control several days before the cash is received, that too would be a novel interpretation of the Section 83 regulations that should not be hidden in an example in the consolidated return regulations. year before the Section 83 transfer and income events occur. Nonetheless, Example 8 concludes (without any mention of Section 83(a), the transfer or beneficial ownership principles under Section 83, or the matching deduction principles of Section 83(h)) that the deduction occurs simultaneously with the change in control, when under Section 83(h) the deduction should occur only when the employees have income due to the transfer of cash several days after the change in control. The example thus appears to accelerate the stock option deduction to a point earlier than the point at which the transfer occurs and before there is income to the employee. This is a novel interpretation of fundamental Section 83 principles that has repercussions outside of the Next Day Rule. If this interpretation of Section 83(h) allowing a deduction ahead of the stock option income is truly the position of the IRS, it certainly should not be established in an example tucked away in a consolidated return regulation. 24 As mentioned, if it is true that the stock option compensation becomes deductible under Section 83(h) when the obligation to pay is fixed and determinable on the day of the change of control, before there is a transfer subject to Section 83, that conclusion has repercussions outside of the M&A context. If this Proposed Next Day Rule and the Section 83(h) interpretation implicit in it, is finalized, the regulation will present a myriad of opportunities for employers to make Section 83 deductions fixed and determinable well before there is a Section 83 income event to the employees and, thus, to accelerate the deduction to a point well ahead of the time the matching income will be recognized. Another issue with the Proposed Next Day rule is that its impact on other forms of equity and deferred compensation is somewhat unclear. Presumably, Example 8 purposefully addresses only compensation that would not otherwise be subject to a push out of the deduction under the in which or with which ends rules of Sections 83(h) and 404(a)(5). Where restricted stock vests on a change in control, or deferred compensation (including certain restricted stock units) is paid on a change in control, the implication is that the in which or with which rule will continue to push the deduction into the acquiring company s consolidated return that includes the Target s Post-Closing Tax Period. In the case of such a deduction delay under the in which or with which ends rule, the deduction is delayed until the Target s Post-Closing Tax Period return, without regard to the Proposed Next Day Rule. Similarly, in some cases, options and equity compensation are not cashed out immediately, but are cashed out contingent on continued services being performed for a period, such as a year, following the change in control. Under Section 83, the existence of a requirement that significant services be performed in order for the equity to be earned would postpone the deduction until the property vests at a point significantly after closing of the transaction. Presumably, the deduction timing under such a scenario also would not be impacted by the Proposed Next Day Rule. However, given the convoluted interpretation of Section 83(h) implicit in Example 8, and the 2015 Proposed Regulations failure to address scenarios involving these other Section 83 and 404(a)(5) deduction timing rules, any conclusion with regard to the timing of a Section 83 deduction in the M&A context can no longer be entirely taken for granted. Conclusion For the reasons discussed above, the analysis of the 2015 Proposed Regulations remains suspect, as it did in the GLAM. The treatment of stock options in the 2015 Proposed Regulations is premised on a novel and fundamentally unsound interpretation of Section 83(h), which has repercussions outside of the M&A context. However, it appears that the 2015 Proposed Regulations do not intend to change the impact of other deduction timing principles, such as the application of the in which or with which ends rules. The IRS should consider, if and when the 2015 Proposed Regulations are finalized, confirming the application of the in which or with which ends and other compensation deduction timing rules in the M&A context, as well as correcting or clarifying the Section 83(h) principles underlying Example 8. Going forward, and because the impact of the other deduction timing principles were not addressed in the 2015 Proposed Regulations, planning opportunities appear to remain available with respect to compensation deductions in the M&A context. However, before taking a position contrary to the 2015 Proposed Regulations, taxpayers must weigh the risk and be prepared for the issue to arise in audit. n 36 CORPORATE TAXATION SEPTEMBER / OCTOBER 2015 COMPENSATION & FRINGE BENEFITS