Treasury Issues Final, Temporary and Proposed Regulations on Cost Sharing Agreements
In December, 2011, the Treasury promulgated final, temporary, and proposed regulations to cost-sharing agreements (CSAs) which are effective on December 16, 2011. The final regulations adopt the effective date and transaction date rules under the 2009 temporary regulations (T.D. 9441) so that they are generally applicable for all CSAs, with transition rules for some arrangements which existed prior to January 5, 2009. The newly minted regulations substantially reflect the positions contained in the temporary and proposed regulations that had been issued in 2009 and adopt the “comparable uncontrolled transaction method” . The regulations addressed concerns and issues that were reflected in two Tax Court decisions, Veritas Software Corp., v. Commissioner, 133 T.C. 297 (2009) and Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005).
Cost Sharing Agreements In General: Section 482
Section 482 attempts to prevent income tax evasion by transactional allocations of value and cost made by controlled entities to ensure that taxpayers clearly reflect income relating to transactions between controlled entities. Section 482 allows the Commissioner to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among controlled entities if he determines that such distribution, apportionment, or allocation is necessary to prevent evasion of taxes or to clearly reflect the income of such entities. In determining the true taxable income, "the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer." Treas. Reg. §. 1.482-1(b)(1).
Section 482 provides that in the case of any transfer of intangible property the income with respect to the transfer shall be commensurate with the income attributable to the intangible. In a qualified cost-sharing arrangement (CSA), controlled participants share the cost of developing one or more items of intangible property. Treas Reg. §1.482-7(a)(1). When a controlled participant makes preexisting intangible property available to a qualified CSA, that participant is deemed to have transferred interests in the property to the other participant and the other participant must make a buy-in payment as consideration for the transferred intangibles. Treas. Regs. §§1.482-7(g)(1) and (2). The buy-in payment, which can be made in the form of a lump-sum payment, installment payments, or royalties, is the arm's-length charge for the use of the transferred intangibles. Treas. Regs. §§1.482 7(g)(2), (7) requires buy-in payments to be determined in accordance with Treas. Regs. §§1.482-1 and 1.482-4 through 1.482-6, and Treas. Reg. §1.482-4(a).
Section 1.482-4(a).
This provision requires that, in general, the arm's length amount charged in a controlled transfer of intangible property must be determined under one of the four methods listed in this paragraph (a). Each of the methods must be applied in accordance with all of the provisions of Treas. Reg. § 1.482-1, including the best method rule of Treas. Reg. § 1.482-1(c), the comparability analysis of Treas. Reg. § 1.482-1(d), and the arm's length range of Treas. Reg. § 1.482-1(e). The arm's length consideration for the transfer of an intangible determined under this section must be commensurate with the income attributable to the intangible. Treas. Reg. § 1.482-4(f)(2) (Periodic adjustments). The available methods are -- (1) The comparable uncontrolled transaction method, described in paragraph (c) of this section; (2) The comparable profits method, described in Treas. Reg. § 1.482-5; (3) The profit split method, described in Treas. Reg. § 1.482-6; and (4) Unspecified methods described in paragraph (d) of this section.
If the recipient of the intangibles fails to make an arm's-length buy-in payment, the Commissioner is authorized to make appropriate allocations to reflect an arm's-length payment for the transferred intangibles. Treas. Reg. §1.482-7(g)(1). Still, Commissioner's authority to make section 482 allocations is limited to situations where it is necessary to make each participant's share of costs equal to its share of reasonably anticipated benefits or situations where it is necessary to ensure an arm's-length buy-in payment for transferred preexisting intangibles. Treas. Reg. §1.482-7(a)(2).
Applicable Legal Standard for Judicial Review
When the Commissioner maintains a legal action against controlled entities in a Section 482 case, its 2 allocation will be sustained absent a showing of abuse of discretion. Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 353 (1991); Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582 (1989), affd. 933 F.2d 1084 (2d Cir. 1991).
For the taxpayer to prevail it must first demonstrate that the Commissioner’s section 482 allocation is arbitrary, capricious, or unreasonable. Sundstrand Corp. & Subs. v. Commissioner, supra at 353-354 (citing G.D. Searle & Co. v. Commissioner, 88 T.C. 252, 359 (1987), and Eli Lilly & Co. v. Commissioner, 84 T.C. 996, 1131 (1985), affd. in part, revd. in part and remanded 856 F.2d 855 (7th Cir. 1988)). If petitioner proves that respondent's allocation is arbitrary, capricious, or unreasonable but fails to prove that the allocation it proposes meets the arm's-length standard, the Court must determine the proper allocation for the buy-in payment. Sundstrand Corp. & Subs. v. Commissioner, supra at 354.Respondent's determination as set forth in the notice of deficiency is presumptively correct. Id. at 353.
Overview of the Newly Issued CSA Regulations
The newly issued final regulations are intended to provide guidance to and determination of and compensation for economic contributions made by all controlled entities involved in a CSA under the arm’s length standard. This begins with the with the factual and functional analysis of the actual transaction or transactions among the controlled taxpayers. In a CSA, the controlled participants make economic contributions of two types:(i) mutual commitments to prospectively share intangible development costs in proportion to their reasonably anticipated benefits from exploitation of the cost shared intangibles (“cost contributions”); and (ii) to provide any existing resources, capabilities, or rights that are reasonably anticipated to contribute to developing cost shared intangibles (“platform contributions”). CSAs also involve economic contributions by the controlled participants of other existing resources, capabilities, or rights related to the exploitation of cost shared intangibles (“operating contributions”). The concepts of platform and operating contributions are intended to encompass any existing inputs that are reasonably anticipated to facilitate developing or exploiting cost shared intangibles at any time, including resources, capabilities, or rights, such as expertise in decision-making concerning research and product development, manufacturing or marketing intangibles or services, and management oversight and direction. Other prospective economic contributions consist of costs incurred to develop or acquire resources, capabilities, and rights that facilitate the exploitation of cost shared intangibles (operating cost contributions). The new regulations provide guidance in determining the arm's length charge for all such contributions to clearly reflect the incomes of the controlled participants.
The regulations attempts to facilitate the determination of the most reliable measure of arm's length results for the categories of economic contributions over the duration of the activity of developing and exploiting cost shared intangibles (CSA Activity). The combined effect of multiple contributions, potentially including controlled transactions outside of the CSA (e.g.,make-or-sell licenses, or intangible transfers governed by section 367(d)), may need to be evaluated on an aggregate basis, where that approach provides the most reliable measure of an arm's length result.
Suppose a taxpayer transfers, in a section 367(d) transaction, intangibles as part of a CSA, then the pricing of the intangibles under section 367(d) may need to be evaluated along with the pricing of all contributions in connection with the CSA on an aggregate basis, where that approach provides the most reliable measure of an arm's length result.
Under the principles of the investor model, the reliability of the analysis required must account for the degree of consistency of the valuation with the expectation that each controlled participant's net investment attributable to cost contributions, platform contributions, operating contributions, and operating cost contributions, is reasonably anticipated to earn a rate of return (which might be reflected in a discount rate used in applying a method) appropriate to the riskiness of the controlled participant's CSA Activity over the entire period of the CSA Activity. The duration of the CSA Activity may, or may not, correspond to the conventional concept of useful life with respect to any of the underlying economic contributions; it represents the period over which the controlled participants reasonably anticipate returns from the CSA Activity.
In determining the best method of measuring the arm's length results of a CSA, and any related controlled transactions, the regulations adopt the guidance included in the 2008 temporary regulations on assessing the potential applicability of the “comparable uncontrolled transaction” (CUT) method. The arm's length standard attempts to identify the results that would obtain had uncontrolled taxpayers engaged in the same transaction under the same circumstances. It is immaterial whether the arrangement among uncontrolled taxpayers is denominated as a "cost sharing arrangement," so long as the arrangement involves the same circumstances (or similar circumstances, assuming that reliable adjustments can be made to account for any differences). Thus, long-term licenses or research and development services contracts may provide CUTs, provided and to the extent they involve the same or similar scope and contractual terms, uncertainty of outcomes, profit potential, allocation of intangible development and exploitation risks, including allocation of the risks of existing contributions and the risks of developing future contributions, consistent with the actual allocation of risks under the CSA and through related controlled transactions.
A CSA may benefit from, and contribute to, a controlled group's own set of competitive advantages. Therefore, there may be no uncontrolled transactions that reliably reflects the same contributions by the parties, over a similar period of commitment, and with the same risk profile and profit potential. The arm's length standard requires application of the method that most reliably reflects the results that would have been realized had uncontrolled taxpayers engaged in the same transaction. Where comparable uncontrolled transactions are unavailable, these regulations, like other regulations under section 482, allow for reference to the results the controlled taxpayers could have realized by choosing a realistic alternative. The regulations adopt a specified income method included in the 2008 temporary regulations that represents an application of the realistic alternatives principle. These regulations adopt the 2008 temporary regulations' provision of a licensing alternative to the CSA that closely aligns with the economics of the CSA, but takes account of the licensor's commitment to bear the entire risk of the intangible development that would otherwise have been shared. The realistic alternatives analysis effectively constructs a comparable uncontrolled transaction that, depending on the facts and circumstances, may more reliably reflect the economics of the actual contributions to the CSA than can be derived from third party transactions. For cases where more than one controlled participant makes significant contributions to residual profits (including platform or operating contributions), the regulations adopt the guidance included in the 2008 temporary regulations on a specified residual profit split method (RPSM), which is also an application of the realistic alternatives principle.
The regulations further adopt guidance on the application of two other specified methods included in the 2008 temporary regulations -- the acquisition price method and the market capitalization method. The guidance regarding unspecified methods adopted from the 2008 temporary regulations reemphasizes that any such method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and enter into a particular transaction only if none of the alternatives is clearly preferable to it.
The newly issued regulations resolve issues that related back to the 1995 regulations. been raised under the 1995 regulations. Thus, where a controlled participant devotes, in whole or part, any existing resource, capability, or right to intangible development for the benefit of another controlled participant, whether by transfer or license to the other controlled participant, or by leveraging such resource, capability, or right within the context of the CSA, then the regulations require an arm's length charge for such platform contribution, in addition to the funding of intangible development costs.
The Preamble to the regulations recites that the regulations require an arm's length charge for one controlled participant's platform contribution commitment of a particular research team's experience and expertise to intangible development under a CSA, in addition to the controlled participants' sharing of the ongoing intangible development costs of the salaries of such researchers. To limit the arm's length charge in these circumstances to sharing the ongoing salary costs would ignore the value of having the particular research team already in place to undertake the intangible development with the benefit of its particular know-how. See Treas Reg. § 1.482-7(c)(5), Example 2. As another example, the contribution of core entrepreneurial functions such as product selection, market positioning, research strategy, and risk determinations and management requires an arm's length charge under these regulations. To omit charges for these or any other significant economic contributions one controlled taxpayer makes for another's benefit would fail to clearly reflect the incomes of such controlled taxpayers.
A unifying underpinning of the 482 regulations is that controlled transactions reflecting similar economics, regardless of the type of transaction (such as transfer of intangibles or provision of services), should be valued in accordance with similar principles and methods. See Treas.Reg. §§1.482-1(b)(2)(ii), 1.482-7, 1.482-4(g) and 1.482-9(m)(3). Under these provisions, the principles and methods for valuing platform and operating contributions under a CSA may also apply for purposes of determining the best method, which may be an unspecified method, for valuing similar contributions in connection with controlled transfers of intangibles or provisions of services.
Some Early Reflections on the New CSA Regulations
Perhaps one aspect of the new regulations that is controversial is the set of rules on when to compute a buy-in payment. These rules, as reflected in the final regulations, have been widened beyond normal cost-sharing applications. Another observation is that taxpayers who enter into ordinary or normal course licensing agreements may be unaware of the complexity of the new rules.
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Contractual clauses in CSAs may allow the parties to make future adjustments. Such types of provisions are common. The final regulations, however, allows the IRS to ignore those clauses in valuing the transferred intangibles, especially where the provisions are vague or indefinite.
The regulations clarify the manner in which projections for financial benefits when valuing a buy-in payment are to be derived. The rules call for a single probability-weighted projection. The regulations also set forth rules regarding the use of pretax and post-tax calculations in applying specified valuation methods. Another provision proscribes making a retroactive adjustment of reasonably anticipated benefit shares for prior years based on new or updated information on expected benefits that wasn't available during the prior year, thus adopting a year-by-year approach. This provision was not included in the prior set of temporary regulations. Finally guidance is contained in the temporary and proposed regulations on the relationship between the discount rate used for the cost-sharing alternative and the discount rate for the licensing alternative. The temporary regulations, in general, test the reasonableness of the implied discount rate by comparing discount rates from CUPs with similar risk profiles.
The temporary regulations seek to police some of the ways that taxpayers have employed. The proposed regulations include a new specified application of the income method using the differential income stream in Treas. Reg. 1.482-7(g)(4)(v).
The regulations are quite detailed and complex as one would only expect.
