Transfer Pricing alert: 11-021
U.S. IRS releases final cost sharing regulations
By Arin Mitra (Washington, DC), Keith Reams (San Francisco), Alan Shapiro (Chicago), Jacqueline Doonan (San Jose) and Lawrence Shanda (New York)
The Internal Revenue Service on December 16 released final cost sharing regulations under Treas. Reg. §1.482-7. The final regulations adopt virtually all of the provisions contained in the temporary regulations issued in January 2009 (referred to as the “2008 temporary regulations”). Most of the taxpayer-friendly changes commentators hoped would be adopted are not included in the final regulations. The changes in the final regulations are for the most part limited to clarifying a number of technical issues in the administration of the current cost sharing regime.
The final regulations continue to include the notion of platform contributions, first introduced in prior rulemaking, and maintain a broader definition of contribution beyond that traditionally understood to be intangible property (IP) within the meaning of Internal Revenue Code Section 936(h)(3)(B). According to the final regulations’ preamble, Treasury and the IRS believe that any economic contribution to a cost sharing arrangement (CSA) in the form of an existing resource, capability, or right to intangible development, whether by transfer, license, or by virtue of the contributing participant’s leveraging of such resource, capability, or right, including operating contributions, will necessitate an arm’s length payment by the receiving participants in the CSA. Operating contributions, according to the preamble, include “expertise in decision making concerning research and product development, manufacturing or marketing intangibles or services, and management oversight and direction.” By bundling traditional intellectual property and operating contributions, the IRS and Treasury are attempting to promote their view that platform contributions should be valued in the aggregate. However, such expertise is routinely provided and valued for transfer pricing purposes in settings other than cost sharing, and one could argue, as the Tax Court concluded in Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), that aggregation confuses rather than clarifies the valuation issues.
In the preamble to the final regulations, Treasury and the IRS once again discusses the period of time that an existing platform contribution is expected to contribute value to the CSA activity. Treasury and the IRS state that the duration of the CSA activity may or may not correspond to conventional concepts of useful life with respect to any of the underlying economic contributions. The statement in the preamble is at best confusing, and at worst signals a resurrection of the IRS’s notion of virtually infinite life first raised in the 2007 Coordinated Issues Paper on CSA Buy-In Adjustments.
The infinite life position was roundly criticized by the Tax Court in Veritas, as well as in other forums. The IRS had previously stated in the preamble to the temporary cost sharing regulations and in Footnote 4 of the Action on Decision in Veritas, AOD 2010-05 (2010), that the useful life should be limited to the “lift in business results” resulting from the transferred intangibles and services. One would hope that Treasury and the IRS are not attempting to reassert this clearly untenable position, but rather are merely trying to emphasize their view that conventional concepts of useful life may not take fully into consideration the length of time that certain platform contributions are likely to add value to the CSA activity. Either way, the language added in the final regulations is likely to foster robust discussion among the IRS, tax practitioners, and taxpayers regarding ideas around useful life.
The final regulations “clarify” several important issues concerning discount rates. The final regulations specifically recognize that different discount rates reflecting incremental risk can be applied in comparing the licensing alternative to the cost sharing alternative. Similarly, the final regulations recognize that it may be appropriate to apply different discount rates to different forms of payment, such as a royalty based on sales and fixed installment payments. The final regulations do not specifically address whether different discount rates can apply to different income and cost elements based on incremental risk, but such an application would appear to be consistent with the use of differential discount rates in the above circumstances.
The final regulations “clarify” that the discount rate should be applied to after-tax income when comparing the cost sharing alternative to the license alternative. In determining after-tax income, the regulations abandon long-held valuation concepts that use the “market participant” effective tax rates in favor of the CSA participant’s effective tax rate. The examples make clear that after the after-tax value of the PCT is determined, the PCT payment must be recomputed on a pre-tax basis.
In many cases, the difference between the initial projections used in computing the platform contribution transaction (PCT) and the actual results are subject to significant variation. To avoid the regulatory periodic adjustment rules and an overpayment of the PCT, some taxpayers incorporate in their agreement mechanisms to adjust PCT payments in future years. The final regulations provide new examples on how taxpayers can add adjustment clauses to their agreements that the IRS will accept as consistent with economic substance.
In addition to these “clarifying” additions, the final regulations also include changes relating to the following:
- Reasonably anticipated benefits (RAB) shares must be based on information existing during the year.
- Methods for determining PCT payments must be based on future anticipated income.
- In comparing the cost sharing and licensing alternatives, the same projections must be used.
- A taxpayer-friendly modification to the exception to the periodic adjustment rules was adopted.
- A specific mailing address for the IRS Service Center to send cost sharing statements was added to the regulations.
On balance, the final regulations preserve in the main all the provisions contained in the 2008 temporary regulations, while seeking to clarify provisions that were the subject of debate and concern among taxpayers and practitioners. Like the prior rules, the final regulations are extensive and broad in scope and make an attempt to clarify and explain Treasury’s and the IRS’s positions on many of the issues that have arisen in the intervening years since the original cost sharing provisions were adopted in the early 1990s. While the final regulations provide extensive examples and guidance, this area of taxation continues to be complex, particularly when it involves the nuanced interpretation of sometimes highly technical and even esoteric considerations of IP development, and the more elusive notions of platform contributions that Treasury and the IRS have put forward.
Cost sharing continues to provide the most practical, and in many instances the only, available method of organizing the increasingly globalized development efforts of the modern multinational. Far from closing down this vital area of tax planning, Treasury’s and the IRS’s rulemaking efforts, as reflected in these final regulations, reflect the realization that global companies face challenges in the organization of their affairs. The tax authorities, accordingly, have provided valuable guidance to taxpayers that enter into qualified CSAs. Anecdotal evidence suggests that cost sharing planning is alive and well, and that more and more companies are adopting cost sharing as a significant and fundamental part of their overall tax profiles. As a result, these companies will find it necessary to reflect on and refer to the guidance in these regulations.