[Federal Register Volume 74, Number 2 (Monday, January 5, 2009)]
[Rules and Regulations]
[Pages 340-391]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-30715]
[[Page 339]]
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Part II
Department of the Treasury
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Internal Revenue Service
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26 CFR Parts 1, 301, and 602
Section 482: Methods To Determine Taxable Income in Connection With a
Cost Sharing Arrangement; Final Rule
Federal Register / Vol. 74, No. 2 / Monday, January 5, 2009 / Rules
and Regulations
[[Page 340]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1, 301, and 602
[TD 9441]
RIN 1545-BI46
Section 482: Methods To Determine Taxable Income in Connection
With a Cost Sharing Arrangement
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final and temporary regulations.
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SUMMARY: This document contains temporary regulations that provide
further guidance and clarification regarding methods under section 482
to determine taxable income in connection with a cost sharing
arrangement in order to address issues that have arisen in
administering the current regulations. The temporary regulations affect
domestic and foreign entities that enter into cost sharing arrangements
described in the temporary regulations. The text of these temporary
regulations also serves as the text of the proposed regulations set
forth in the Proposed Rules section in this issue of the Federal
Register.
DATES: Effective Date: These regulations are effective on January 5,
2009.
Applicability Date: For dates of applicability, see Sec. Sec.
1.482-1T(j)(6)(i), 1.482-2T(f), 1.482-4T(h), 1.482-7T(l), 1.482-8T(c),
1.482-9T(n)(3), and 1.301-7701-1(f).
FOR FURTHER INFORMATION CONTACT: Kenneth P. Christman, (202) 435-5265
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
These temporary regulations are being issued without prior notice
and public procedure pursuant to the Administrative Procedure Act (5
U.S.C. 553). For this reason, the collection of information contained
in these regulations has been reviewed and pending receipt and
valuation of public comments, approved by the Office of Management and
Budget under control number 1545-1364.
The collections of information in these temporary regulations are
in Sec. 1.482-7T(b)(2) and (k). Responses to the collections of
information are required by the IRS to monitor compliance of controlled
taxpayers with the provisions applicable to 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.
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
A notice of proposed rulemaking and notice of public hearing
regarding additional guidance to improve compliance with, and
administration of, the rules in connection with a cost sharing
arrangement (CSA) were published in the Federal Register (70 FR 51116)
on (REG-144615-02) August 29, 2005 (the 2005 proposed regulations). A
correction to the notice of proposed rulemaking and notice of public
hearing was published in the Federal Register (70 FR 56611) on
September 28, 2005. A public hearing was held on December 16, 2005.
The Treasury Department and the IRS received substantial comments
on a wide range of issues addressed in the 2005 proposed regulations.
In response to these comments, these temporary regulations make several
significant changes to the rules of the 2005 proposed regulations. The
temporary regulations are generally applicable for CSAs commencing on
or after January 5, 2009, with transition rules for certain preexisting
arrangements. These regulations are being issued in temporary and
proposed form so that taxpayers and the IRS may apply the new cost
sharing rules while maintaining the opportunity for further input and
refinements before the issuance of final rules.
Explanation of Provisions
A. Overview
The temporary regulations generally provide guidance regarding the
application of section 482 and the arm's length method to cost sharing
arrangements. Several comments on the proposed regulations questioned
whether and how the proposed regulations conform to the arm's length
standard, as well as its corollary, the commensurate with income (CWI)
requirement added by the Tax Reform Act of 1986. In response, the
temporary regulations provide further guidance on the evaluation of the
arm's length results of cost sharing transactions (CSTs) and platform
contribution transactions (PCTs). The regulations address the material
functional and risk allocations in the context of a CSA, including the
reasonably anticipated duration of the commitments, the intended scope
of the intangible development, the degree and uncertainty of profit
potential of the intangibles to be developed, and the extent of
platform and other contributions of resources, capabilities, and rights
to the development and exploitation of cost shared intangibles (CSA
Activity).
Under the temporary regulations, if available data of uncontrolled
transactions reflect, or may be reliably adjusted to reflect, similar
facts and circumstances to a CSA, they may be the basis for application
of a comparable uncontrolled transaction method to value the CST and
PCT results. Because of the difficulty of finding data that reliably
reflects such facts and circumstances (even after adjustments), the
temporary regulations also provide for other methods. These include the
newly specified income, acquisition price, market capitalization, and
residual profit split methods. The temporary regulations also make
related changes to other sections of the regulations, including Temp.
Treas. Reg. Sec. Sec. 1.482-1T, 1.482-4T, 1.482-8T, and 1.482-9T, and
Treas. Reg. Sec. 1.6662-6.
B. Flexibility and Scope of CSA Coverage
Commentators criticized the 2005 proposed regulations for lack of
flexibility concerning the types and provisions of arrangements
eligible for CSA treatment. Some comments also addressed non-conforming
intangible development arrangements that would not be treated as CSAs.
In response to these comments, the temporary regulations provide
taxpayers with greater flexibility in designing certain aspects of
CSAs. The temporary regulations also address the treatment of non-
conforming intangible development arrangements.
1. Intangible Development Arrangements Other Than CSAs--Temp. Treas.
Reg. Sec. Sec. 1.482-1T(b)(2)(i) and (iii), 1.482-4T(g), 1.482-
7T(b)(5), and 1.482-9T(m)(3)
The 2005 proposed regulations defined the contractual terms, risk
allocations, and other material provisions of a CSA covered by the cost
sharing rules. While other intangible development arrangements might be
referred to colloquially as cost sharing arrangements, they were not to
be treated as CSAs by the 2005 proposed regulations unless either a
taxpayer
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substantially complied with the CSA administrative requirements and
reasonably concluded that its arrangement was a CSA, or a taxpayer
substantially complied with the CSA administrative requirements and the
Commissioner determined to apply the CSA rules to the arrangement.
Commentators suggested broadening the scope of intangible
development arrangements that meet the CSA definition. Some
commentators urged the regulations not to define CSA terms and
conditions but to extend CSA treatment to any arrangement that
uncontrolled parties might call a cost sharing arrangement, even though
such arrangement may involve materially different risk allocations and
provisions than addressed in the cost sharing rules. Still other
commentators, while accepting that the regulations should define the
scope of arrangements treated under the cost sharing rules, suggested
that non-conforming arrangements would be subject only to the general
principles of Treas. Reg. Sec. 1.482-1 and would not be governed by
the sections of the regulations addressed to specific transactional
types. Some commentators also expressed concern that the Commissioner
might treat a non-conforming arrangement as a CSA even in a situation
where that result was not warranted.
Because the cost sharing rules are designed to provide guidance for
specific types of transactions and arrangements, the Treasury
Department and the IRS continue to believe that the new rules set forth
for CSAs should apply only to the transactions intended. From the
standpoint of the purpose of the cost sharing rules and their
administrability, it is important that the rules be applicable only to
the defined scope of intangible development arrangements and apply no
more broadly or narrowly than intended. In recognition of taxpayer
concerns, however, the temporary regulations seek to provide taxpayers
with greater flexibility and scope in the types and provisions of
arrangements that may qualify as CSAs.
Under Treas. Reg. Sec. 1.482-1(b)(2)(ii) (Selection of category of
method applicable to transaction), non-conforming arrangements are
governed by methods provided in other sections of the regulations under
section 482, as applied in accordance with Treas. Reg. Sec. 1.482-1.
See also Treas. Reg. Sec. Sec. 1.482-2(d), 3(a), and 4(a), and Temp.
Treas. Reg. Sec. 1.482-9T(a). Thus, intangible development
arrangements, including partnerships, outside the scope of the cost
sharing rules are governed by the transfer of intangible rules of
Treas. Reg. Sec. 1.482-4(a), or the controlled services provisions of
Temp. Treas. Reg. Sec. 1.482-9T, as appropriate. The temporary
regulations make clarifying amendments to Temp. Treas. Reg. Sec. Sec.
1.482-1T(b)(2)(i) and (iii), 1.482-4T(g), and 1.482-9T(m)(3). These
amendments confirm that Treas. Reg. Sec. 1.482-1 provides principles,
not methods. For methods, reference must be made to the other sections
of the regulations under section 482. While treatment of a CSA is
governed by Temp. Treas. Reg. Sec. 1.482-7T, Temp. Treas. Reg.
Sec. Sec. 1.482-4T(g) and 1.482-9T(m)(3), as appropriate, govern
intangible development arrangements other than CSAs, including
partnerships.
Nevertheless, the methods and best method considerations under the
cost sharing rules may be adapted for purposes of the evaluation of
non-conforming intangible development arrangements. Importantly, the
temporary regulations provide that the analysis under the intangible
transfer or controlled services provisions, as applicable, should take
into account the principles, methods, comparability, and reliability
considerations set forth in Temp. Treas. Reg. Sec. 1.482-7T in
determining the best method for purposes of those provisions, including
an unspecified method, as those methods and considerations may be
appropriately adjusted in light of the differences in the facts and
circumstances between the non-conforming arrangement and a CSA.
Finally, Temp. Treas. Reg. Sec. 1.482-7(b)(5) clarifies the
circumstances under which the Commissioner may treat an arrangement as
a CSA, notwithstanding a technical failure to meet the substantive
requirements of a CSA. Namely, the Commissioner must conclude that the
taxpayer substantially complied with the CSA administrative
requirements and that application of the CSA rules to such non-
conforming arrangement will provide the most reliable measure of an
arm's length result. For these purposes, the temporary regulations also
clarify that applicable contractual provisions will be interpreted by
reference to economic substance and the parties' actual conduct, and
the Commissioner may disregard terms lacking economic substance and
impute terms consistent with the economic substance.
2. Territorial and Other Divisional Interests--Temp. Treas. Reg. Sec.
1.482-7T(b)(1)(iii) and (4)
The 2005 proposed regulations required the controlled participants
in a CSA to receive non-overlapping territorial interests that entitled
each controlled participant to the perpetual and exclusive right to the
profits in its territory attributable cost shared intangibles.
Commentators suggested that requiring territorial divisions of
interests was overly restrictive and did not align with common business
models. They also questioned the need for the non-overlapping,
perpetual, and exclusivity conditions.
To provide taxpayers with more flexibility in designing qualifying
divisional interests, the temporary regulations permit use of a new
basis--the field of use division of interests--in addition to the
territorial basis. Further, the regulations also authorize other non-
overlapping divisional interests provided that the basis used meets
four criteria: (1) The basis must clearly and unambiguously divide all
interests in cost shared intangibles among the controlled participants;
(2) the consistent use of such basis can be dependably verified from
the records maintained by the controlled participants; (3) the rights
of the controlled participants to exploit cost shared intangibles are
non-overlapping, exclusive, and perpetual; and (4) the resulting
benefits associated with each controlled participant's interest in cost
shared intangibles are predictable with reasonable reliability. The
temporary regulations illustrate instances in which divisional
interests tied to specific manufacturing facilities, as an example,
would, and would not, qualify under these criteria. See Temp. Treas.
Reg. Sec. 1.482-7T(b)(4)(v), Examples 2 and 3.
3. Platform and Other Contributions--Temp. Treas. Reg. Sec. 1.482-
7T(c) and (g)(2)(ii)
The 2005 proposed regulations described external contributions for
which compensation was due from other controlled participants, that is,
preliminary or contemporaneous transactions. A preliminary or
contemporaneous transaction corresponded to the buy-in pursuant to
Sec. 1.482-7(g) of the 1995 final regulations. Under the 2005 proposed
regulations, an external contribution generally consisted of the rights
in the reference transaction (RT) in any resource or capability
reasonably anticipated to contribute to developing cost shared
intangibles. The RT consisted of a transaction, to be designated in the
CSA documentation, affording the perpetual and exclusive rights in the
subject resource or capability. While the RT was relevant to valuing
the compensation obligation under a PCT, the controlled participants
were not required to actually enter into the RT. Although the RT
assumed
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perpetual and exclusive rights, proration was required to the extent
that the subject resource or capability was reasonably anticipated to
contribute both to the CSA Activity and other business activities.
Evaluation of the preliminary or contemporaneous transaction
compensation obligation for the subject rights could be in the
aggregate with preliminary or contemporaneous transaction compensation
obligation with respect to other external contributions, or in the
aggregate with the compensation obligations with respect to other
rights, where valuation on an aggregate basis would provide the most
reliable measure of an arm's length result for the aggregated
preliminary or contemporaneous transactions and other transactions.
Commentators objected to the RT as overbroad. Commentators further
contended that external contributions included elements such as
workforce, goodwill or going concern value, or business opportunity,
which in the commentators' view either do not constitute intangibles,
or are not being transferred, and so, in the commentators' view, are
not compensable.
The temporary regulations replace the term ``external
contribution'' with the term ``platform contribution'' and replace the
term ``preliminary or contemporaneous transaction'' with the term
``platform contribution transaction.'' The temporary regulations, like
the 2005 proposed regulations, do not limit platform contributions that
must be compensated in PCTs to the transfer of intangibles defined in
section 936(h)(3)(B). For example, to the extent a controlled
participant (the PCT Payee) contributes the services of its research
team for purposes of developing cost shared intangibles pursuant to the
CSA, the other controlled participant (the PCT Payor) would owe
compensation for the services of such team under Temp. Treas. Reg.
Sec. 1.482-9T, just as would be the case in a contract research
arrangement. Where there is a combined contribution of research
services, intangibles in process, or other resources, capabilities, or
rights, the temporary regulations provide for an aggregate valuation
where that would provide the most reliable measure of an arm's length
result for the aggregated PCTs and other transactions. The treatment
available under the cost sharing rules of the contribution of the
services of a research team as controlled services is without any
inference concerning the potential status of workforce in place as an
intangible within the meaning of section 936(h)(3)(B).
On the other hand, the temporary regulations only require the PCT
Payor to compensate the PCT Payee for platform contributions, or cross
operating contributions, reasonably anticipated to contribute to the
CSA Activity in the PCT Payor's division as defined in Temp. Treas.
Reg. Sec. 1.482-7T(j)(1)(i). A PCT Payor is not obligated to
compensate the PCT Payee for any of the PCT Payee's resources,
capabilities, or rights that are reasonably anticipated to benefit only
the PCT Payee's operations. Similarly, under the temporary regulations,
the PCT Payee is also not entitled to compensation from the PCT Payor
on account of any of the PCT Payor's own resources, capabilities, or
rights, including any goodwill or going concern value of the PCT Payor.
For example, where operations of parties involve undertaking functions
and risks of scope and duration comparable to those of the PCT Payor,
an application of the income method based on the comparable profits
method would retain for the PCT Payor the returns reasonably
anticipated to its own contributions to operations in its division,
including any goodwill or going concern value associated with those
operations, based on the returns to the comparable parties used in the
CPM analysis. Similarly, the PCT Payor retains the ability to pursue
its own business opportunities in its division, including through
operating cost contributions to maintain or develop resources,
capabilities, or rights to promote its operations.
In response to comments that the concept of the RT was unnecessary
and confusing, the temporary regulations do not use that concept.
Instead, the temporary regulations adopt a presumption that a PCT Payee
provides any resource, capability, or right to the intangible
development activity (IDA) pursuant to the CSA on an exclusive basis. A
taxpayer can rebut the presumption by showing to the satisfaction of
the Commissioner that the subject resource, capability, or right is
reasonably anticipated to contribute not just to the CSA, but to other
business activities as well. For example, if the platform resource is a
research tool, then the taxpayer could rebut the presumption of
exclusivity by establishing to the satisfaction of the Commissioner
that the tool is reasonably anticipated not only to be applied in the
IDA, but also to be licensed to an uncontrolled taxpayer. The temporary
regulations provide guidance on proration of PCT payments in cases
where the taxpayer rebuts the presumption.
4. Intangible Development Activity and Costs--Temp. Treas. Reg. Sec.
1.482-7T(d)
Some commentators suggested that taxpayers can limit the
application of the cost sharing rules by defining the IDA with
reference only to specifically listed platform contributions. Without
any inference intended as to the economic substance of such an
approach, the temporary regulations are clarified to exclude this
possibility. The scope of the IDA includes all activities that could
reasonably be anticipated to contribute to developing the reasonably
anticipated cost shared intangibles. The IDA cannot be described merely
by a list of particular resources, capabilities, or rights that will be
used in the CSA, since the IDA is a function of what are the reasonably
anticipated cost shared intangibles and such a list might not identify
reasonably anticipated cost shared intangibles. Also, the scope of the
IDA may change as the nature or identity of the reasonably anticipated
cost shared intangibles or the nature of the activities necessary for
their development become clearer. For example, the relevance of certain
ongoing work to developing reasonably anticipated cost shared
intangibles or the need for additional work may only become clear over
time.
The Treasury Department and the IRS requested in Notice 2005-99,
2005-52 CB 1214 comments regarding the valuation of stock options and
other stock-based compensation. The Treasury Department and the IRS
received comments and continue to consider the technical changes and
issues described in Notice 2005-99 and intend to address those in a
subsequent regulations project. See Treas. Reg. Sec.
601.601(d)(2)(ii)(b).
5. Changes in Participation--Temp. Treas. Reg. Sec. 1.482-7T(f)
The increased flexibility to adopt a divisional basis other than a
territorial or field of use basis entails the need for provisions to
prevent abuse and facilitate compliance. Capability fluctuations,
whether market-driven or strategic, that materially alter the
controlled participants' RAB shares as compared with their respective
divisional interests create the equivalent of a controlled transfer of
interests and should therefore equally occasion arm's length
compensation. Accordingly, the temporary regulations modify the change
of participation provision to classify such a material capability
variation, in addition to a controlled transfer of interest, as a
change in
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participation that requires arm's length consideration by the
controlled participant whose RAB share increases, to the controlled
participant whose RAB share decreases, as the result of the capability
variation.
C. Income and Other Specified and Unspecified Methods
1. Best Method Analysis Considerations--Temp. Treas. Reg. Sec. 1.482-
7T(g)(2)
The 2005 proposed regulations articulated ``general principles''--
such as the realistic alternatives principle--applicable to any method
to determine the arm's length charge in a PCT. Commentators expressed
uncertainty about the role intended for these principles. For example,
they wondered if these principles themselves dictated, or trumped,
methods or applications of methods.
The temporary regulations clarify that these principles were
intended to provide supplementary guidance on the application of the
best method rule to determine which method, or application of a method,
provides the most reliable measure of an arm's length result in the CSA
context. In other words, the principles provide best method
considerations to aid the competitive evaluation of methods or
applications, and are not themselves methods or trumping rules.
a. Consistency with upfront terms and risk allocation--the investor
model--Temp. Treas. Reg. Sec. 1.482-7T(g)(2)(ii).
The investor model is a core principle of the 2005 proposed
regulations. A PCT Payor, through cost sharing and payments made
pursuant to the PCT (PCT Payments), is investing for the term of the
CSA Activity and expects returns over time consistent with the
riskiness of that investment.
The upfront evaluation pursuant to the investor model of expected
returns to particular risks assumed in intangible development and
exploitation under the facts and circumstances is key to ensuring
consistency of the results of a CSA with the arm's length standard.
Commentators have criticized the investor model for stripping away
risky returns from the PCT Payor. The temporary regulations provide
additional guidance to explain that when the PCT Payor assumes risks,
it accordingly enjoys the returns (or suffers the detriments) that may
result from such risks.
For example, in addition to its cost contributions to developing
cost shared intangibles, a PCT Payor may also commit significant
operating contributions, such as existing marketing or manufacturing
process intangibles, to operations in its division as well as make
significant operating cost contributions towards further developing
such intangibles. To the extent parties to comparable transactions
undertake similar risks of similar scope and duration, the PCT Payor
will be appropriately awarded based on a method that relies in whole or
part on the returns in such comparable transactions (including
applications of the income method based on a CUT or the CPM). To the
extent its operating contributions are nonroutine, that is, not
reflected in available comparable transactions, then the PCT Payor may
share in nonroutine divisional profit under the application of the
residual profit split method (RPSM) provided in the temporary
regulations.
Moreover, the temporary regulations provide guidance on discount
rates and arm's length ranges, so as to further clarify the ability of
the PCT Payor to achieve results commensurate with its assumption of
risks.
b. Aggregation of transactions--Temp. Treas. Reg. Sec. 1.482-7T
(g)(2)(iv).
The temporary regulations make conforming changes to the guidance
included in the 2005 proposed regulations on aggregate evaluation of
multiple transactions. Thus, if the combined effect of transactions in
connection with a CSA involving platform, operating, and other
contributions of resources, capabilities, or rights are reasonably
anticipated to be interrelated, then determination of the arm's length
charge for PCTs and other transactions on an aggregate basis may
provide the most reliable measure of an arm's length result.
c. Discount rates--Temp. Treas. Reg. Sec. 1.482-7T(g)(2)(v).
The 2005 proposed regulations provided general guidance that, where
a present value is needed for a purpose in a cost sharing analysis, a
discount rate should be used that most reliably reflects the risk of
the particular set of activities or transactions based on all the
information potentially available at the time for which the present
value calculation is to be performed. Further, depending on the
particular facts and circumstances, the discount rate may differ among
a company's various activities and transactions. As examples, the
proposed regulations indicated that a weighted average cost of capital
(WACC) of the taxpayer, or an uncontrolled taxpayer, could provide the
most reliable basis for a discount rate if the CSA Activity involves
the same risk as projects undertaken by the taxpayer, or uncontrolled
taxpayer, as a whole. As another example, in certain appropriate
conditions, a company's internal hurdle rate for projects of comparable
risk might provide a reliable basis for a discount rate in a cost
sharing analysis.
Commentators offered several criticisms of the discount rate
guidance. Some comments concluded that the 2005 proposed regulations
placed an inappropriate emphasis on a taxpayer's WACC as a basis for
analysis. Other comments suggested a clarification be made that more
than a single discount rate may be appropriate in a cost sharing
analysis. Yet other comments addressed whether a discount rate in a
cost sharing analysis should be before, or after, tax. Some
commentators asserted that cash flows, rather than items entering into
income, analytically are the more appropriate amounts to be discounted.
The temporary regulations revise and elaborate upon the best method
analysis considerations in regard to discount rates. Guidance is
provided recognizing that the appropriate discount rate may, depending
on the facts and circumstances, vary between realistic alternatives and
forms of payment. As regards discount rate variation between realistic
alternatives, for example, licensing intangibles needed for its
operations would ordinarily be less risky for a licensee, and so
require a lower discount rate, than entering into a CSA which would
involve the licensee assuming the additional risk of funding its cost
contributions to the IDA. As regards discount rate variation between
forms of payment, for example, ordinarily a royalty computed on a
profits base would be more volatile, and so require a higher discount
rate to discount projected payments to present value, than a royalty
computed on a sales base.
The temporary regulations recognize that, in general, discount
rates inferred from the operations of the capital markets are post-tax
rates. An analysis applying post-tax discount rates would be expected
to treat taxes like any other expense. However, the equivalent result
may in certain circumstances be achieved by applying a post-tax
discount rate to pre-tax net income multiplied by the difference of one
minus the tax rate. If such an approach is adopted in applying the
income method, to the extent that the controlled participants'
respective tax rates are not materially affected by whether they enter
into the cost sharing or licensing alternative (or if reliable
adjustments may be made for varying tax rates), the mulitiplier (that
is, one minus the tax rate) may be cancelled from both sides of the
equation of the cost sharing and
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licensing alternative present values. Accordingly, in such circumstance
it is sufficient to apply post-tax discount rates to pre-tax items for
the purpose of equating the cost sharing and licensing alternatives.
See also the discussion of the income method in this preamble.
The specific reference to a WACC or to hurdle rates are eliminated
as unnecessary, but without any inference as to a WACC or a hurdle rate
being an appropriate discount rate, or an appropriate starting point in
ascertaining a discount rate, depending on the particular facts.
Certain methods in the temporary regulations (such as the income
method under Temp. Treas Reg. Sec. 1.482-7T(g)(4)) are theoretically
based on valuation techniques that use ``cash flow'' projections rather
than income projections. While use of cash flow projections is
permitted under these methods, for a number of practical and
administrative reasons, detailed guidance on the specific applications
of the methods are based on income, rather than cash flow, measures.
The Treasury Department and the IRS considered whether to provide
guidance on the use of cash flows, rather than income, as the
appropriate amounts to be discounted in a cost sharing analysis. The
Treasury Department and the IRS continue to consider, and solicit
comments, on whether and how the cost sharing rules could reliably be
administered on the basis of cash flows instead of operating income,
and whether such a basis is consistent with the second sentence of
section 482 and its CWI requirement.
d. Projections--Temp. Treas. Reg. Sec. 1.482-7T(g)(2)(vi).
The temporary regulations note that the reliability of an estimate
will often depend upon the reliability of the projections used in
making the estimate. Projections should reflect the best estimates of
the items projected (for example, reflecting a probability weighted
average of possible outcomes).
e. Arm's length range--Temp. Treas. Reg. Sec. 1.482-7T(g)(2)(ix).
The 2005 proposed regulations provided supplemental guidance on
applying arm's length methods in the cost sharing context in accordance
with the provisions of Treas. Reg. Sec. 1.482-1 including, inter alia,
the arm's length range of Treas. Reg. Sec. 1.482-1(e). The proposed
regulations did not, however, provide guidance on how to adapt an arm's
length range for cost sharing.
The temporary regulations adapt the guidance in Treas. Reg. Sec.
1.482-1(e) for use with some of the methods for computing PCT Payments
that are specified in the temporary regulation. The provisions
elaborate, where the entire range of results cannot be regarded as of
sufficient comparability and reliability, how to derive a statistically
enhanced range of arm's length charges for a PCT.
The guidance in Treas. Reg. Sec. 1.482-1(e) regarding arm's length
ranges is most easily understood in the context of a method (for
example, comparable uncontrolled price, cost plus, resale price,
comparable uncontrolled transaction, comparable profits), in which the
result of each comparable transaction directly provides an estimate for
the result of the controlled transaction. Some of the methods specified
in the temporary regulations (for example, the income method) have a
different structure, in which an arm's length result is estimated by
performing mathematical calculations that depend on two or more input
parameters (for example, a relevant discount rate, certain financial
projections, a return for routine activities) that must be determined.
The additional guidance in this section addresses the arm's length
range in the context of such methods.
The temporary regulations distinguish certain input parameters
(variable input parameters) that, for purposes of determining an arm's
length range, may be assigned more than one possible value. Such input
parameters are limited to those whose value is most reliably determined
by considering two or more observations of market data (for example,
profit levels or stock betas of two or more companies) that have, or
with adjustment can be brought to, a similar reliability and
comparability, as described in Treas. Reg. Sec. 1.482-1(e)(2)(ii). If
there are two or more variable input parameters, the narrowing effect
of the interquartile range is used twice: First, to narrow the
variation of each input parameter, and again to narrow the resulting
set of PCT Payment values. This double narrowing reflects that the use
of two or more variable input parameters normally introduces additional
unreliability into a method, even though that method may be the best
method.
Generally, Treas. Reg. Sec. 1.482-1(e)(3) governs the
Commissioner's ability to make an adjustment to a PCT Payment due to
the taxpayer's results being outside the arm's length range. Consistent
with the principles expressed there, adjustment under the temporary
regulations will normally be to the median, as defined in Treas. Reg.
Sec. 1.482-1(e)(3). Also, the Commissioner is not required to
establish an arm's length range prior to making an allocation under
section 482.
The Treasury Department and the IRS solicit comments on the design
and mechanics of the supplemental guidance on determination of an arm's
length range in paragraph (g)(2)(ix) of the temporary regulations,
including the limitation of variable input parameters to market-based
input parameters. Any alternative proposal should specify the design
and mechanics in detail, and should discuss whether such an approach
enhances the reliability of the analysis, is administrable, and is not
so manipulable as to yield unrealistic ranges.
2. Comparable Uncontrolled Transaction Method--Temp. Treas. Reg. Sec.
1.482-7T(g)(3)
The 2005 proposed regulations provided for possible use of the
comparable uncontrolled transaction (CUT) method to determine the arm's
length charge in a PCT where appropriate in accordance with the
standards of the intangibles transfer and controlled services
provisions of the regulations under section 482. Some commentators
asserted that any arrangement that uncontrolled parties might call a
cost sharing arrangement could serve as a CUT, even though such
arrangement may involve materially different risk allocations and
provisions than addressed in the cost sharing rules.
In response to these comments, the temporary regulations describe
the relevant considerations for purposes of evaluating whether a
putative CUT may, or may not, reflect the most reliable measure of an
arm's length result. Although all of the factors entering into a best
method analysis described in Treas. Reg. Sec. Sec. 1.482-1(c) and (d)
must be considered, comparability and reliability under the CUT method
in the CSA context are particularly dependent on similarity of
contractual terms, degree to which allocation of risks is proportional
to reasonably anticipated benefits from exploiting the results of
intangible development, similar period of commitment as to the sharing
of intangible development risks, and similar scope, uncertainty, and
profit potential of the subject intangible development, including a
similar allocation of the risks of any existing resources,
capabilities, or rights, as well as of the risks of developing other
resources, capabilities, or rights that would be reasonably anticipated
to contribute to exploitation within the parties' divisions, that is
consistent with the actual allocation of risks between the controlled
participants as provided in the CSA in accordance with the cost sharing
rules.
[[Page 345]]
3. Income Method--Temp. Treas. Reg. Sec. 1.482-7T(g)(4)
The 2005 proposed regulations made the income method a specified
method for purposes of evaluating the arm's length charge in a PCT.
Under the general rule, the arm's length charge was an amount that
equated a controlled participant's present value of entering into a CSA
with the present value of the controlled participant 's best realistic
alternative. Also provided were two applications of the income method.
One, based on a CUT analysis, assumed that a PCT Payee's best realistic
alternative would be to develop the cost shared intangibles on its own,
bearing all the intangible development costs (IDCs) itself, and then
license the cost shared intangibles. A second, based on a comparable
profits method (CPM) analysis, assumed that the PCT Payor's best
realistic alternative would be to acquire the rights to external
contributions (renamed platform contributions under the temporary
regulations) for payments with a present value equal to the PCT Payor's
anticipated profit, after reward for its routine contributions to its
operations, from the CSA Activity in its territory (the only division
permitted under the 2005 proposed regulations). Both income method
applications provided for a cost contribution adjustment in order to
allocate to the PCT Payor the return to its additional risk, as
compared to its realistic alternative, of bearing its reasonably
anticipated benefits (RAB) share of the IDCs. As set forth in the 2005
proposed regulations, both the CUT and CPM based applications of the
income method built in a conversion to a royalty form of payment,
either on sales or on operating profit.
Commentators offered several criticisms with reference to the
income method. As a general matter, some comments asserted that the
income method stripped away risky returns from the PCT Payor. Other
comments focused on technical aspects of the method and the
applications. In particular, comments pointed to the potential risk
differentials between cost sharing and the alternative arrangements.
For example, cost sharing would generally be more risky than licensing
for the PCT Payor as the result of its sharing with the PCT Payee the
risks of the IDA. As a corollary, cost sharing would generally be less
risky for the PCT Payee than licensing. The comments observed that
these risk differentials would ordinarily be reflected in different
discount rates being appropriate under the cost sharing and licensing
alternatives. Other comments suggested the possible use of different
discounts for different financial flows (sales, cost of sales,
operating expenses, cost contributions, etc.).
The temporary regulations provide further guidance on the income
method and its applications. In general, they provide that the best
realistic alternative of the PCT Payor to entering into the CSA would
be to license intangibles to be developed by an uncontrolled licensor
that undertakes the commitment to bear the entire risk of intangible
development that would otherwise have been shared under the CSA.
Similarly, the best realistic alternative of the PCT Payee to entering
into the CSA would be to undertake the commitment to bear the entire
risk of intangible development that would otherwise have been shared
under the CSA and license the resulting intangibles to an uncontrolled
licensee.
The licensing alternative is derived on the basis of a functional
and risk analysis of the cost sharing alternative, but with a shift of
the risk of cost contributions to the licensor. Accordingly, the PCT
Payor's licensing alternative consists of entering into a license with
an uncontrolled party, for a term extending for what would be the
duration of the CSA Activity, to license the make-or-sell rights in
subsequently to be developed resources, capabilities, or rights of the
licensor. Under such license, the licensor would undertake the
commitment to bear the entire risk of intangible development that would
otherwise have been shared under the CSA. Apart from the difference in
the allocation of the risks of the IDA, the licensing alternative
should assume contractual provisions with regard to non-overlapping
divisional intangible interests, and with regard to allocations of
other risks, that are consistent with the actual CSA in accordance with
the cost sharing rules. For example, the analysis under the licensing
alternative should assume a similar allocation of the risks of any
existing resources, capabilities, or rights, as well as of the risks of
developing other resources, capabilities, or rights that would be
reasonably anticipated to contribute to exploitation within the
parties' divisions, that is consistent with the actual allocation of
risks between the controlled participants as provided in the CSA in
accordance with the temporary regulations.
The temporary regulations, like the 2005 proposed regulations,
describe both CUT-based applications and CPM-based applications of the
Income Method. However, they differ from the applications described in
the 2005 proposed regulations by equating the cost sharing and
licensing alternatives of the PCT Payor using discount rates
appropriate to those alternatives. In circumstances where the market-
correlated risks as between the cost sharing and licensing alternatives
are not materially different, a reliable analysis may be possible by
using the same discount rate with respect to both alternatives.
Otherwise, as recognized in the best method considerations concerning
discount rates, realistic alternatives having the same reasonably
anticipated present value may nevertheless involve varying risk
exposure and, thus, generally are more reliably evaluated using
different discount rates. To the extent that the controlled
participants' respective tax rates are not materially affected by
whether they enter into the cost sharing or licensing alternative (or
reliable adjustments may be made for varying tax rates), it is
appropriate to apply post-tax discount rates to pre-tax items for
purpose of equating the cost sharing and licensing alternatives. The
discount rate for the cost sharing alternative will generally depend on
the form of PCT Payments assumed (for example, lump sum, royalty on
sales, royalty on divisional profit).
The income method may be applied to determine PCT Payments in any
form of payment (for example, lump sum, royalty on sales, royalty on
divisional profit). If an income method application is used to
determine arm's length PCT Payments in a particular form, then the PCT
Payments in that form may be converted to an alternative form in
accordance with Temp. Treas. Reg. Sec. 1.482-7(h) (Form of payment
rules).
The temporary regulations clarify the opportunities, depending on
the facts and circumstances, for the PCT Payor to assume risks and,
accordingly, to enjoy the returns (or suffer the detriments) that may
result from such risks. For example, in addition to its cost
contributions to developing cost shared intangibles, a PCT Payor may
also commit significant operating contributions, such as existing
marketing or manufacturing process intangibles, to operations in its
division as well as make significant operating cost contributions
towards further developing such intangibles. To the extent parties to
comparable transactions undertake risks of similar scope and duration,
the PCT Payor will be appropriately rewarded based on a method that
relies in whole or part on returns in such comparable transactions
under an application of the income method whether based on a CUT or the
[[Page 346]]
CPM. Where its operating contributions are nonroutine, that is, not
reflected in available comparable transactions, the PCT Payor may share
in nonroutine divisional profit under the application of the RPSM
provided in the temporary regulations. Similarly, while the income
method is limited to cases in which only one of the controlled
participants provides nonroutine platform contributions as the PCT
Payee, the RPSM in the temporary regulations addresses the situation
where more than one controlled participant furnishes nonroutine
platform contributions.
Yet other comments criticized the income method as positing an
unrealistic ``perpetual life.'' The income method is premised on the
assumption that, at arm's length, an investor will make a risky
investment (for example, in a platform for developing additional
technology) only if the investor reasonably anticipates that the
present value of its reasonably anticipated operational results will be
increased at least by a present value equal to the platform investment.
It may be, depending on the facts and circumstances, that the
technology is reasonably expected to achieve an incremental improvement
in results for only a finite period (after which period, results are
reasonably anticipated to return to the levels that would otherwise
have been expected absent the investment). The period of enhanced
results that justifies the platform investment in such circumstances
effectively would correspond to a finite, not a perpetual, life.
4. Acquisition Price and Market Capitalization Methods--Temp. Treas.
Reg. Sec. 1.482-7T(g)(5) and (6)
The 2005 proposed regulations included guidance on the acquisition
price and market capitalization methods for evaluating the arm's length
charge in a PCT. Under the acquisition price method, the arm's length
charge for a PCT is the adjusted acquisition price, that is, the
acquisition price increased by the value of the target's liabilities on
the date of acquisition, and decreased by the value on that date of
target's tangible property and any other resources and capabilities not
covered by the PCT. Under the market capitalization method, the arm's
length charge for a PCT is the adjusted average market capitalization,
that is, the average daily market capitalization over the 60 days
ending with the date of the PCT, increased by the value of the PCT
Payee's liabilities on such date, and decreased on account of tangible
property and any other resources and capabilities of the PCT Payee not
covered by the PCT.
Commentators questioned the reliability of these methods in light
of volatility of stock prices and lack of correlation between stock
price and underlying assets, for example, owing to control premiums or
economies of integration.
The Treasury Department and the IRS recognize that these comments
point to considerations that, depending on the facts and circumstances,
will need to be taken into account in a best method analysis that
compares the reliability of the results under application of these
methods as against the results under application of other methods
(which may themselves have aspects that reduce their reliability). The
temporary regulations retain the best method considerations from the
2005 proposed regulations that observe that reliability is reduced
under these methods if a substantial portion of the target's, or PCT
Payor's, nonroutine contributions to business activities is not
required to be covered by a PCT and, in the case of the market
capitalization method, if the facts and circumstances demonstrate the
likelihood of a material divergence between the PCT Payee's average
market capitalization and the value of its underlying resources,
capabilities, and rights for which reliable adjustments cannot be made.
The temporary regulations also provide that proximity in time between
the acquisition of the target and the PCT Payment is an important
comparability factor under the acquisition price method.
5. Residual Profit Split Method--Temp. Treas. Reg. Sec. 1.482-7T(g)(7)
The temporary regulations conform the modified RPSM from the
proposed regulations to the changes made to the income method.
6. Unspecified Methods--Temp. Treas. Reg. Sec. 1.482-7T(g)(8)
Under the temporary regulations in order to use an unspecified
method, a taxpayer must maintain documentation to describe and explain
the method selected to determine the arm's length payment due in a PCT.
D. Form of Payment
1. Post Formation Acquisitions
The 2005 proposed regulations generally provided taxpayers
flexibility to provide for PCT Payments either in fixed amounts
(whether in lump sums or installment payments with arm's length
interest) or in contingent amounts. PCT Payments could not be paid in
shares of stock of the PCT Payor. The form of payment selected for any
PCT, including the basis and structure of the payments, had to be
specified no later than the date of the PCT. In the case of a post
formation acquisition (PFA)--that is, an external contribution (renamed
platform contribution in the temporary regulations) that is acquired by
a controlled participant in an uncontrolled transaction (either
directly, or indirectly through the acquisition of an interest in an
entity or tier of entities)--the consideration under the PCT for a PFA
had to be paid in the same form as the consideration in the
uncontrolled transaction in which the PFA was acquired. An example
indicates that acquisitions for stock were considered to be for a fixed
form of payment. One principal rationale for the special rules for PFAs
was that PFAs stand in the place of IDCs and, therefore, reflect a risk
allocation equivalent to that in the IDC context, which requires the
sharing of outlays on a fixed form of payment basis. Another principal
rationale was the difficulty the IRS has had in examining CSAs using a
contingent form of payment for PFAs.
Commentators criticized the same form of payment requirement for
PFAs, especially the treatment of stock acquisitions as having a fixed
form of payment. The comments pointed out that a purchaser paying with
its own stock is selling a part of its business, and thus pays
consideration that is ultimately contingent on the success of its
business. Other comments objected to the timing mismatch caused by the
same form of payment rule, because fixed PCT Payments would be
immediately includable, but the PFA assets would be amortizable only
over time. Still other comments asserted that taxpayers may choose
their form of payment for PFAs, as with other external contributions,
so long as the price (taking into account the form of payment) is arm's
length.
The temporary regulations do not retain the special rules for PFAs.
Subsequent acquisitions remain an important source of platform
contributions that occasion the requirement of PCT compensation.
However, the temporary regulations no longer require a special form of
payment for such compensation. Therefore, controlled participants may
choose the form of payment for PCTs regardless of whether the PCTs
occur at the outset of the CSA or later. Removal of the special rules
for PFAs moots questions regarding whether stock consideration should
be treated as contingent or fixed payment and whether (and how) the
timing mismatch should be addressed. Nonetheless, the IRS will continue
to
[[Page 347]]
scrutinize the contractual documentation, pricing, and implementation
of contingent forms of payment for PFAs.
2. Contingent Payments--Temp. Treas. Reg. Sec. 1.482-7T(h)(2)(iv) and
(v)
The temporary regulations incorporate rules to ensure that the
contingent form for PCT Payments is applied properly by both taxpayers
and the IRS. In accordance with Treas. Reg. Sec. 1.482-
1(d)(3)(iii)(B), a CSA contractual provision that provides for payments
for a PCT (or group of PCTs) to be contingent on the exploitation of
cost shared intangibles will be respected as consistent with economic
substance only if the allocation between the controlled participants of
the risks attendant on such form of payment is determinable before the
outcomes of such allocation that would have materially affected the PCT
pricing are known or reasonably knowable. The temporary regulations
require a contingent payment provision to clearly and unambiguously
specify the basis on which the contingent payment obligations are to be
determined. In particular, the contingent payment provision must
clearly and unambiguously specify the events that give rise to an
obligation to make PCT Payments, the royalty base (such as sales or
revenues), and the computation used to determine the PCT Payments. The
royalty base specified must permit verification of its proper use by
reference to books and records maintained by the controlled
participants in the normal course of business (for example, books and
records maintained for financial accounting or business management
purposes).
The temporary regulations also provide that where a method yields a
fixed value for PCT Payments, a conversion may be made to a contingent
form of payments. Guidance is also provided on discount rates for
purposes of such conversion. Certain forms of payment may involve
different risks than others. For example, ordinarily a royalty computed
on a profits base would be more volatile, and so require a higher
discount rate to discount projected payments to present value, than a
royalty computed on a sales base.
E. Periodic Adjustments
1. Determination of Periodic Adjustments--Temp. Treas. Reg. Sec.
1.482-7T(i)(6)(v) and (vi)
The 2005 proposed regulations addressed the CWI principle of the
second sentence of section 482 in the context of cost sharing. The
Commissioner could make periodic adjustments for an open taxable year
(the Adjustment Year) and all subsequent years of the CSA Activity in
the event of a Periodic Trigger. Under the 2005 proposed regulations, a
Periodic Trigger arose if the PCT Payor realized, over the period
beginning with the earliest date on which an IDC occurred through the
end of the Adjustment Year, an actually experienced return ratio of the
present value of its total territorial operating profits divided by the
present value of its investment consisting of the sum of its cost
contributions plus PCT Payments, outside the periodic return ratio
range of between .5 and 2. In arriving at these present values, the
Commissioner would use an applicable discount rate, which in the case
of certain publicly traded entities would be their weighted average
cost of capital, unless the Commissioner determines, or the controlled
participants establish, that another discount rate better reflects the
degree of risk of the CSA Activity. Periodic adjustments would be
determined under a modified RPSM. Exceptions were provided, such as for
an effective CUT or for results due to extraordinary events beyond the
controlled participants' control and that could not have been
reasonably anticipated. In determining whether to make any periodic
adjustments, the Commissioner would consider whether the outcome as
adjusted more reliably reflects an arm's length result under all the
relevant facts and circumstances.
Commentators offered several criticisms of the periodic adjustment
rules. Some comments considered the periodic adjustment rules to be
inconsistent with the arm's length standard and, through hindsight, to
strip away returns to risk. Other comments claimed for taxpayers the
same ability as the Commissioner to make periodic adjustments to
implement the CWI principle where subsequent results diverge from
original expectations. Comments also addressed the exceptions and means
for taxpayers to demonstrate their results were arm's length so as to
avoid periodic adjustments.
The Treasury Department and the IRS reaffirm that the CWI principle
is consistent, and periodic adjustments are to be administered
consistently, with the arm's length standard. Congress adopted the CWI
principle in 1986 out of concern about related-party long-term
transfers of high-profit potential intangibles for relatively
insignificant lump sum or royalty consideration justified by reference
to putatively comparable transactions between unrelated parties that
differed significantly in terms of the division of functionality and
risks when compared to the transfers at issue. See H.R. Rep. 99-426, at
424-25 (1985). See also Notice 88-123 (the White Paper), 1988-2 CB 458,
472-74, 477-80. Congress intended that taxpayers be able to ``use
certain bona fide cost-sharing arrangements as an appropriate method of
allocating income attributable to intangibles among related parties, if
and to the extent such agreements are consistent with the purposes of
this provision that the income allocated among the parties reasonably
reflect the actual economic activity undertaken by each.'' H.R. Conf.
Rep. No. 99-841, at II-638 (1986). See Treas. Reg. Sec.
601.601(d)(2)(ii)(b).
Accordingly, the temporary regulations continue to provide for
periodic adjustments along lines similar to those in the intangible
transfer section of the regulations, as adapted for the cost sharing
context. Compare Treas. Reg. Sec. 1.482-4(f)(2)(Periodic adjustments).
The temporary regulations, however, adopt a smaller periodic return
ratio range than the 2005 proposed regulations. Setting a Periodic
Trigger to occur if the actually experienced return ratio falls outside
the periodic return ratio range of between .667 and 1.5 (or between 0.8
and 1.25, if the taxpayer has not substantially complied with the
documentation requirements of Temp. Treas. Reg. Sec. 1.482-7T(k)) is
intended to isolate situations in which actual results suggest the
potential of an absence of arm's length pricing as of the date of the
PCT. The Treasury Department and the IRS consider that the periodic
return ratio range under the temporary regulations more realistically
targets the threshold at which periodic adjustment scrutiny is
appropriate. In determining whether to make any periodic adjustments,
the Commissioner considers whether the outcome as adjusted more
reliably reflects an arm's length result under all the relevant facts
and circumstances.
The temporary regulations also make conforming changes to the
determination of periodic adjustments, in the event of a Periodic
Trigger, in light of other changes in the temporary regulations, for
example, in the RPSM and form of payment provisions.
2. Advance Pricing Agreement
In addition, the Treasury Department and the IRS intend to issue by
revenue procedure separate published guidance that provides an
exception to periodic adjustments, similar to exceptions
[[Page 348]]
provided in Temp. Treas. Reg. Sec. 1.482-7T(i)(6)(vi), in the context
of an advance pricing agreement (APA) entered into pursuant to Rev.
Proc. 2006-9, 2006-1 CB 278 (as it may be amended or superseded by
subsequent administrative pronouncement). The guidance would provide
that no periodic adjustments will be made in any year based on a
Trigger PCT that is a covered transaction under the APA. See Treas.
Reg. Sec. 601.601(d)(2)(ii)(b).
An APA process generally is contemporaneous with a taxpayer's
original transactions and involves transparency concerning a taxpayer's
upfront efforts to conform to the arm's length standard. Thus, the APA
process may overcome the asymmetry in information addressed by the
periodic adjustment provisions, eliminating a primary basis for a CWI
adjustment. See generally 70 FR 51128-51130 (preamble to 2005 proposed
regulations).
The Treasury Department and the IRS considered the possibility of a
further exception to periodic adjustments based on documentation that a
taxpayer would maintain contemporaneously with a PCT. Compare Treas.
Reg. Sec. 1.6662-6(d)(2)(iii). Such an exception was not incorporated
into the temporary regulations in light of the concern that
documentation prepared only by the taxpayer would not benefit from a
similar degree of contemporaneous transparency and explanation as
involved in an APA. The Treasury Department and the IRS continue to
consider this matter and solicit comments on whether and how a
documentation exception could be adapted to the purposes of the CWI
principle.
F. Terminology and Table of Definitions--Temp. Treas. Reg. Sec. 1.482-
7T(j)(1)
For ease of reference, a comprehensive table of terms is provided.
The table sets forth, alphabetically, technical terms used in the
regulations, any applicable abbreviations, definitions (if not
elsewhere defined in the regulations), and cross references to relevant
portions of the regulations where the terms are defined or used.
G. Administrative and Transition Rules--Temp. Treas. Reg. Sec. 1.482-
7T(m)
The 2005 proposed regulations included transition rules for
existing qualified cost sharing arrangements so as not to disturb
taxpayers' reliance on the prior regulations, while providing for
appropriate prospective application of the new regulations. Grandfather
treatment would have been terminated in certain events, including the
occasion of a Periodic Trigger as the result of a subsequent PCT
occurring after the regulations' effective date, a material change in
the scope of the arrangement, such as a material expansion of the
activities undertaken beyond the scope of the intangible development
area, or a 50 percent or greater change in the ownership of interests
in cost shared intangibles.
Commentators objected to the grandfather termination events, in
particular in the case of a subsequent Periodic Trigger or a 50 percent
change of ownership, as defeating taxpayers' legitimate expectation
under the prior regulations.
The temporary regulations do not terminate grandfather treatment
upon a 50 percent change of ownership or on account of a subsequent
Periodic Trigger or a material change in scope of the arrangement. The
temporary regulations instead adopt a targeted provision that applies
the temporary regulations' periodic adjustment rules to PCTs that occur
on or after the date of a material change in the scope of the
grandfathered CSA. A material change in scope would include a material
expansion of the activities undertaken beyond the scope of the
intangible development area, as described in former Treas. Reg. Sec.
1.482-7(b)(4)(iv). For this purpose, a contraction of the scope of a
CSA, absent a material expansion into one or more lines of research and
development beyond the scope of the intangible development area, does
not constitute a material change in scope of the CSA. Whether a
material change in scope has occurred is determined on a cumulative
basis. Therefore, a series of expansions, any one of which is not a
material expansion by itself, may collectively constitute a material
expansion.
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 been
determined also that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations. For the
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6)
refer to the Special Analyses section of the preamble to the cross-
reference notice of proposed rulemaking published in the Proposed Rules
section in this issue of the Federal Register. Pursuant to section
7805(f) of the Internal Revenue Code, these regulations will be
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 proposed regulations is Kenneth P.
Christman of the Office of Chief Counsel (International). However,
other personnel from the Treasury Department and the IRS participated
in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 301
Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income
taxes, Penalties, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Amendment to the Regulations
0
Accordingly, 26 CFR parts 1, 301, and 602 are amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by adding an
entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.482-7A also issued under 26 U.S.C. 482. * * *
0
Par. 2. Section 1.367(a)-1 is added to read as follows:
Sec. 1.367(a)-1 Transfers to foreign corporations subject to section
367(a): In general.
(a) through (d)(2) [Reserved].
(3) [Reserved] For further guidance, see Sec. 1.367(a)-1T(d)(3).
(d)(4) through (g) [Reserved].
0
Par 3. Section 1.367(a)-1T is amended by revising the second sentence
of paragraph (d)(3) to read as follows:
Sec. 1.367(a)-1T Transfers to foreign corporations subject to section
367(a): In general (temporary).
* * * * *
(d) * * *
(3) * * * A person's entering into a cost sharing arrangement under
Sec. 1.482-7T or acquiring rights to intangible property under such an
arrangement shall not be considered a transfer of property described in
section 367(a)(1). * * *
* * * * *
0
Par. 4. Section 1.482-0 is amended by adding the entries for Sec. Sec.
1.482-1(b)(2)(iii), 1.482-2(e) and (f), 1.482-4(g)
[[Page 349]]
and (h) and revising the entries for Sec. 1.482-7 to read as follows:
Sec. 1.482-0 Outline of regulations under section 482.
* * * * *
Sec. 1.482-1 Allocation of income and deductions among taxpayers.
* * * * *
(b) * * *
(2) * * *
(iii) [Reserved]. For further guidance, see Sec. 1.482-0T, the
entry for Sec. 1.482-1T(b)(2)(iii).
* * * * *
Sec. 1.482-2 Determination of taxable income in specific situations.
* * * * *
(e) and (f) [Reserved]. For further guidance, see Sec. 1.482-0T,
the entries for Sec. 1.482-2T(e) and (f).
* * * * *
Sec. 1.482-4 Methods to determine taxable income in connection with a
transfer of intangible property.
* * * * *
(g) and (h) [Reserved]. For further guidance, see Sec. 1.482-0T,
the entries for Sec. 1.482-4T(g) and (h).
* * * * *
Sec. 1.482-7 Methods to determine taxable income in connection with a
cost sharing arrangement.
[Reserved]. For further guidance, see Sec. 1.482-0T, the entries
for Sec. 1.482-7T.
* * * * *
0
Par. 5. Section 1.482-0T is amended as follows:
0
1. The entries for Sec. Sec. 1.482-1T(b)(2)(iii), (c), (d)(1), (d)(2),
(d)(3)(ii)(A), and (d)(3)(ii)(B) are revised.
0
2. A new entry for Sec. 1.482-1T(b)(2)(iii) is added.
0
3. The entries for Sec. 1.482-2T(e) are revised, and new entries for
Sec. 1.482-2T(f) are added.
0
4. The entries for Sec. 1.482-4T(f)(7) are removed, and the entries
for Sec. 1.482-4T(g) and (h) are added.
0
5. The entries for Sec. 1.482-7T are added.
0
6. The entries for Sec. 1.482-9T(m)(3) and (n) are revised.
The additions and revisions read as follows:
Sec. 1.482-0T Outline of regulations under section 482 (temporary).
* * * * *
Sec. 1.482-1T Allocation of income and deductions among taxpayers
(temporary).
* * * * *
(b) * * *
(2) * * *
(ii) [Reserved]. For further guidance, see Sec. 1.482-0, the entry
for Sec. 1.482-1(b)(2)(ii).
(iii) Coordination of methods applicable to certain intangible
development arrangements.
(c) through (d)(3)(ii)(B) [Reserved]. For further guidance, see
Sec. 1.482-0, the entries for Sec. 1.482-1(c) through (d)(3)(iii)(B).
* * * * *
Sec. 1.482-2T Determination of taxable income in specific situations
(temporary).
* * * * *
(e) Cost sharing arrangement.
(f) Effective/applicability Date.
(1) In general.
(2) Election to apply section paragraph (b) to earlier taxable
years.
(3) Expiration date.
* * * * *
Sec. 1.482-4T Methods to determine taxable income in connection with
a transfer of intangible property (temporary).
* * * * *
(g) Coordination with rules governing cost sharing arrangements.
(h) Effective/applicability date.
(1) In general.
(2) Election to apply regulation to earlier taxable years.
(3) Expiration date.
* * * * *
Sec. 1.482-7T Methods to determine taxable income in connection with
a cost sharing arrangement (temporary).
(a) In general.
(1) RAB share method for cost sharing transactions (CSTs).
(2) Methods for platform contribution transactions (PCTs).
(3) Methods for other controlled transactions.
(i) Contribution to a CSA by a controlled taxpayer that is not a
controlled participant.
(ii) Transfer of interest in a cost shared intangible.
(iii) Other controlled transactions in connection with a CSA.
(iv) Controlled transactions in the absence of a CSA.
(4) Coordination with the arm's length standard.
(b) Cost sharing arrangement.
(1) Substantive requirements.
(i) CSTs.
(ii) PCTs.
(iii) Divisional interests.
(iv) Examples.
(2) Administrative requirements.
(3) Date of a PCT.
(4) Divisional interests.
(i) In general.
(ii) Territorial based divisional interests.
(iii) Field of use based divisional interests.
(iv) Other divisional bases.
(v) Examples.
(5) Treatment of certain arrangements as CSAs.
(i) Situation in which Commissioner must treat arrangement as a
CSA.
(ii) Situation in which Commissioner may treat arrangement as a
CSA.
(iii) Examples.
(6) Entity classification of CSAs.
(c) Platform contributions.
(1) In general.
(2) Terms of platform contributions.
(i) Presumed to be exclusive.
(ii) Rebuttal of Exclusivity.
(iii) Proration of PCT Payments to the extent allocable to other
business activities.
(A) In general.
(B) Determining the proration of PCT Payments.
(3) Categorization of the PCT.
(4) Certain make-or-sell rights excluded.
(i) In general.
(ii) Examples.
(5) Examples.
(d) Intangible development costs.
(1) Determining whether costs are IDCs.
(i) Definition and scope of the IDA.
(ii) Reasonably anticipated cost shared intangible.
(iii) Costs included in IDCs.
(iv) Examples.
(2) Allocation of costs.
(3) Stock-based compensation.
(i) In general.
(ii) Identification of stock-based compensation with the IDA.
(iii) Measurement and timing of stock-based compensation IDC.
(A) In general.
(1) Transfers to which section 421 applies.
(2) Deductions of foreign controlled participants.
(3) Modification of stock option.
(4) Expiration or termination of CSA.
(B) Election with respect to options on publicly traded stock.
(1) In general.
(2) Publicly traded stock.
(3) Generally accepted accounting principles.
(4) Time and manner of making the election.
(C) Consistency.
(4) IDC share.
(5) Examples.
(e) Reasonably anticipated benefit shares.
(1) Definition.
(i) In general.
(ii) Examples.
(2) Measure of benefits.
(i) In general.
[[Page 350]]
(ii) Indirect bases for measuring anticipated benefits.
(A) Units used, produced, or sold.
(B) Sales.
(C) Operating profit.
(D) Other bases for measuring anticipated benefits.
(E) Examples.
(iii) Projections used to estimate benefits.
(A) In general.
(B) Examples.
(f) Changes in participation under a CSA.
(1) In general.
(2) Controlled transfer of interests.
(3) Capability variation.
(4) Arm's length consideration for a change in participation.
(5) Examples.
(g) Supplemental guidance on methods applicable to PCTs.
(1) In general.
(2) Best method analysis applicable for evaluation of a PCT pusuant
to a CSA.
(i) In general.
(ii) Consistency with upfront contractual terms and risk
allocations--the investor model.
(A) In general.
(B) Examples.
(iii) Consistency of evaluation with realistic alternatives.
(A) In general.
(B) Examples.
(iv) Aggregation of transactions.
(v) Discount rate.
(A) In general.
(B) Considerations in best method analysis of discount rates.
(1) Discount rate variation between realistic alternatives.
(2) Discount rate variation between forms of payment.
(3) Post-tax rate.
(C) Example.
(vi) Financial projections.
(vii) Accounting principles.
(A) In general.
(B) Examples.
(viii) Valuations of subsequent PCTs.
(A) Date of subsequent PCT.
(B) Best method analysis for subsequent PCT.
(ix) Arm's length range.
(A) In general.
(B) Methods based on two or more input parameters.
(C) Variable input parameters.
(D) Determination of arm's length PCT Payment.
(1) No variable input parameters.
(2) One variable input parameters.
(3) More than one variable input parameter.
(E) Adjustments.
(x) Valuation undertaken on a pre-tax basis.
(3) Comparable uncontrolled transaction method.
(4) Income method.
(i) In general.
(A) Equating cost sharing and licensing alternatives.
(B) Cost sharing alternative.
(C) Licensing alternative.
(D) Only one controlled participate with nonroutine platform
contributions.
(E) Income method payment forms.
(F) Discount rates appropriate to cost sharing and licensing
alternatives.
(G) The effect of taxation on determining the arm's length amount.
(ii) Evaluation of PCT Payor's cost sharing alternative.
(iii) Evaluation of PCT Payor's licensing alternatives.
(A) Evaluation based on CUT.
(B) Evaluation based on CPM.
(iv) Lump sum payment form.
(v) Best method analysis considerations.
(vi) Routine platform and operating contributions.
(vii) Examples.
(5) Acquisition Price Method.
(i) In general.
(ii) Determination of arm's length charge.
(iii) Adjusted acquisition price.
(iv) Best method analysis consideration.
(v) Examples.
(6) Market capitalization method.
(i) In general.
(ii) Determination of arm's length charge.
(iii) Average market capitalization.
(iv) Adjusted average market capitalization.
(v) Best method analysis consideration.
(vi) Examples.
(7) Residual profit split method.
(i) In general.
(ii) Appropriate share of profits and losses.
(iii) Profit split.
(A) In general.
(B) Determine nonroutine residual divisional profit or loss.
(C) Allocate nonroutine residual divisional profit or loss.
(1) In general.
(2) Relative value determination.
(3) Determination of PCT Payments.
(4) Routine platform and operating contributions.
(iv) Best method analysis considerations.
(A) In general.
(B) Comparability.
(C) Data and assumptions.
(D) Other factors affecting reliability.
(v) Examples.
(8) Unspecified methods.
(h) Form of payment rules.
(1) CST Payments.
(2) PCT Payments.
(i) In general.
(ii) No PCT Payor stock.
(iii) Specified form of payment.
(A) In general.
(B) Contingent payments.
(C) Examples.
(iv) Conversion from fixed to contingent form of payment.
(3) Coordination of best method rule and form of payment.
(i) Allocations by the Commissioner in connection with a CSA.
(1) In general.
(2) CST allocations.
(i) In general.
(ii) Adjustments to improve the reliability of projections used to
estimate RAB shares.
(A) Unreliable projects.
(B) Foreign-to-foreign adjustments.
(C) Correlative adjustments to PCTs.
(D) Examples.
(iii) Timing of CST allocations.
(3) PCT allocations.
(4) Allocations regarding changes in participation under CSA.
(5) Allocations when CSTs are consistently and materially
disproportionate to RAB shares.
(6) Periodic adjustments.
(i) In general.
(ii) PRRR.
(iii) AERR.
(A) In general.
(B) PVTP.
(C) PVI.
(iv) ADR.
(A) In general.
(B) Publicly traded companies.
(C) Publicly traded.
(D) PCT Payor WACC.
(E) Generally accepted accounting principles.
(v) Determination of periodic adjustments.
(A) In general.
(B) Adjusted RPSM as of Determination Date.
(vi) Exceptions to periodic adjustments.
(A) Controlled participants establish periodic adjustment not
warranted.
(1) Transactions involving the same platform contribution as in the
Trigger PCT.
(2) Results not reasonably anticipated.
(3) Reduced AERR does not cause Periodic Trigger.
(4) Increased AERR does not cause Periodic Trigger.
(B) Circumstances in which Periodic Trigger deemed out to occur.
(1) 10-year period.
(2) 5-year period.
(vii) Examples.
(j) Definitions and special rules.
(1) Definitions.
[[Page 351]]
(i) In general.
(ii) Examples.
(2) Special rules.
(i) Consolidated group.
(ii) Trade or business.
(iii) Partnership.
(3) Character.
(i) CST Payments.
(ii) PCT Payments.
(iii) Examples.
(k) CSA administrative requirements.
(1) CSA contractual requirements.
(i) In general.
(ii) Contractual provisions.
(iii) Meaning of contemporaneous.
(A) In general.
(B) Example.
(iv) Interpretation of contractual provisions.
(A) In general.
(B) Examples.
(2) CSA documentation requirements.
(i) In general.
(ii) Additional CSA documentation requirements.
(iii) Coordination rules and production of documents.
(A) Coordination with penalty regulations.
(B) Production of documentation.
(3) CSA accounting requirements.
(i) In general.
(ii) Reliance on financial accounting.
(4) CSA reporting requirements.
(i) CSA Statement.
(ii) Content of CSA Statement.
(iii) Time for filing CSA Statement.
(A) 90-day rule.
(B) Annual return requirement.
(1) In general.
(2) Special filing rule for annual return requirement.
(iv) Examples.
(l) Effective/applicability date.
(m) Transition rule.
(1) In general.
(2) Transitional modification of applicable provisions.
(3) Special rule for certain periodic adjustments.
(n) Expiration date.
* * * * *
Sec. 1.482-9T Methods to determine taxable income in connection with
a controlled services transaction (temporary).
* * * * *
(m) * * *
(3) Coordination with rules governing cost sharing arrangements. *
* *
(n) Effective/applicability dates.
0
Par. 6. Section 1.482-1 is amended by revising the last sentence of
paragraph (c)(1) to read as follows:
Sec. 1.482-1 Allocation of income and deductions among taxpayers.
* * * * *
(c) * * *
(1) * * * See Sec. 1.482-7T for the applicable methods in the case
of a cost sharing arrangement.
* * * * *
0
Par. 7. Section 1.482-1T is amended by:
0
1. Revising paragraphs (b)(2)(i), (b)(2)(ii), (c), (d)(1), (d)(2),
(d)(3)(i), (d)(3)(ii) and (j)(6)(iii).
0
2.Adding a new paragraph (b)(2)(iii).
0
3.Adding a new sentence to the end of paragraph (j)(6)(i).
The additions and revisions read as follows:
Sec. 1.482-1T Allocation of income and deductions among taxpayers
(temporary).
* * * * *
(b) * * *
(2) Arm's length methods--(i) Methods. Sections 1.482-2 through
1.482-6, 1.482-7T, and 1.482-9T provide specific methods to be used to
evaluate whether transactions between or among members of the
controlled group satisfy the arm's length standard, and if they do not,
to determine the arm's length result. Section 1.482-1 and this section
provide general principles applicable in determining arm's length
results of such controlled transactions, but do not provide methods,
for which reference must be made to those other sections in accordance
with paragraphs (b)(2)(ii) and (iii) of this section. Section 1.482-7T
provides the specific methods to be used to evaluate whether a cost
sharing arrangement as defined in Sec. 1.482-7T produces results
consistent with an arm's length result.
(ii) [Reserved]. For further guidance, see Sec. 1.482-1(c) through
(d)(3)(ii)(C) Example 1 and 2.
(iii) Coordination of methods applicable to certain intangible
development arrangements. Section 1.482-7T provides the specific
methods to be used to determine arm's length results of controlled
transactions in connection with a cost sharing arrangement as defined
in Sec. 1.482-7T. Sections 1.482-4 and 1.482-9T, as appropriate,
provide the specific methods to be used to determine arm's length
results of arrangements, including partnerships, for sharing the costs
and risks of developing intangibles, other than a cost sharing
arrangement covered by Sec. 1.482-7T. See also Sec. Sec. 1.482-4T(g)
(Coordination with rules governing cost sharing arrangements) and
1.482-9T(m)(3) (Coordination with rules governing cost sharing
arrangements).
(c) through (d)(3)(ii)(C) Examples 1 and 2. [Reserved]. For further
guidance, see Sec. 1.482-1(c) through (d)(3)(ii)(C) Example 1 and 2.
* * * * *
(j) * * *
(6) * * *
(i) * * * The provision of paragraph (b)(2)(iii) of this section is
generally applicable on January 5, 2009.
* * * * *
(iii) Except as noted in the succeeding sentence, the applicability
of Sec. 1.482-1T expires on or before July 31, 2009. The applicability
of paragraph (b)(2)(iii) of this section expires on or before December
30, 2011.
0
Par. 8. Section 1.482-2T is amended as follows:
0
1. Paragraph (e) is redesignated as paragraph (f) and newly-designated
paragraph (f) is revised.
0
2. New paragraph (e) is added.
The addition and revision reads as follows:
Sec. 1.482-2T Determination of taxable income in specific situations
(temporary).
* * * * *
(e) Cost sharing arrangement. For rules governing allocations under
section 482 to reflect an arm's length consideration for controlled
transactions involving a cost sharing arrangement, see Sec. 1.482-7T.
(f) Effective/applicability date--(1) In general. The provision of
paragraph (b) of this section is generally applicable for tax years
beginning after December 31, 2006. The provision of paragraph (e) of
this section is generally applicable on January 5, 2009.
(2) Election to apply paragraph (b) to earlier taxable years. A
person may elect to apply the provisions of paragraph (b) of this
section to earlier taxable years in accordance with the rules set forth
in Sec. 1.482-9T(n)(2).
(3) Expiration date. The applicability of paragraph (b) of this
section expires on or before July 31, 2009. The applicability of
paragraph (e) of this section expires on or before December 30, 2011.
0
Par. 9. Section 1.482-4T is amended as follows
0
1. Paragraph (f)(3)(i)(B) is revised.
0
2. Paragraph (f)(7) is removed.
0
3. New paragraphs (g) and (h) are added.
The additions and revision reads as follows:
Sec. 1.482-4T Methods to determine taxable income in connection with
a transfer of intangible property (temporary).
* * * * *
(f) * * *
(3) * * *
(i) * * *
(B) Cost sharing arrangements. The rules in this paragraph (f)(3)
regarding ownership with respect to cost shared intangibles and cost
sharing
[[Page 352]]
arrangements will apply only as provided in Sec. 1.482-7T.
* * * * *
(g) Coordination with rules governing cost sharing arrangements.
Section 1.482-7T provides the specific methods to be used to determine
arm's length results of controlled transactions in connection with a
cost sharing arrangement. This section provides the specific methods to
be used to determine arm's length results of a transfer of intangible
property, including in an arrangement for sharing the costs and risks
of developing intangibles other than a cost sharing arrangement covered
by Sec. 1.482-7T. In the case of such an arrangement, consideration of
the principles, methods, comparability, and reliability considerations
set forth in Sec. 1.482-7T is relevant in determining the best method,
including an unspecified method, under this section, as appropriately
adjusted in light of the differences in the facts and circumstances
between such arrangement and a cost sharing arrangement.
(h) Effective/applicability date--(1) In general. Except as
provided in the succeeding sentence, the provisions of paragraphs
(f)(3) and (4) of this section are generally applicable for taxable
years beginning after December 31, 2006. The provisions of paragraphs
(f)(3)(i)(B) and (g) of this section are generally applicable on
January 5, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraphs (f)(3) and (4) of this
section to earlier taxable years in accordance with the rules set forth
in Sec. 1.482-9T(n)(2).
(3) Expiration date. The applicability of this section expires on
or before December 30, 2011.
0
Par. 10. Section 1.482-5 is amended by revising the last sentence of
paragraph (c)(2)(iv) to read as follows:
Sec. 1.482-5 Comparable profits method.
* * * * *
(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 Sec. 1.482-7T(d)(3)(i)) among the tested party and comparable
parties.
* * * * *
0
Par. 11. Section 1.482-7 is redesignated Sec. 1.482-7A, and an
undesignated centerheading preceding Sec. 1.482-7A is added to read as
follows:
Regulations applicable on or before January 5, 2009.
0
Par. 12. Section 1.482-7T is added to read as follows:
Sec. 1.482-7T Methods to determine taxable income in connection with
a cost sharing arrangement (temporary).
(a) In general. The arm's length amount charged in a controlled
transaction reasonably anticipated to contribute to developing
intangibles pursuant to a cost sharing arrangement (CSA), as described
in paragraph (b) of this section, must be determined under a method
described in this section. Each method must be applied in accordance
with the provisions of Sec. 1.482-1, except as those provisions are
modified in this section.
(1) RAB share method for cost sharing transactions (CSTs). See
paragraph (b)(1)(i) of this section regarding the requirement that
controlled participants, as defined in section (j)(1)(i) of this
section, share intangible development costs (IDCs) in proportion to
their shares of reasonably anticipated benefits (RAB shares) by
entering into cost sharing transactions (CSTs).
(2) Methods for platform contribution transactions (PCTs). The
arm's length amount charged in a platform contribution transaction
(PCT) described in paragraph (b)(1)(ii) of this section must be
determined under the method or methods applicable under the other
section or sections of the section 482 regulations, as supplemented by
paragraph (g) of this section. See Sec. 1.482-1(b)(2)(ii) (Selection
of category of method applicable to transaction), Sec. 1.482-
1T(b)(2)(iii) (Coordination of methods applicable to certain intangible
development arrangements), and paragraph (g) of this section
(Supplemental guidance on methods applicable to PCTs).
(3) Methods for other controlled transactions--(i) Contribution to
a CSA by a controlled taxpayer that is not a controlled participant. If
a controlled taxpayer that is not a controlled participant contributes
to developing a cost shared intangible, as defined in section (j)(1)(i)
of this section, it must receive consideration from the controlled
participants under the rules of Sec. 1.482-4T(f)(4) (Contribution to
the value of an intangible owned by another). Such consideration will
be treated as an intangible development cost for purposes of paragraph
(d) of this section.
(ii) Transfer of interest in a cost shared intangible. If at any
time (during the term, or upon or after the termination, of a CSA) a
controlled participant transfers an interest in a cost shared
intangible to another controlled taxpayer, the controlled participant
must receive an arm's length amount of consideration from the
transferee under the rules of Sec. Sec. 1.482-1 and 1.482-4 through
1.482-6 as supplemented by paragraph (f)(4) of this section regarding
arm's length consideration for a change in participation. For this
purpose, a capability variation described in paragraph (f)(3) of this
section is considered to be a controlled transfer of interests in cost
shared intangibles.
(iii) Other controlled transactions in connection with a CSA.
Controlled transactions between controlled participants that are not
PCTs or CSTs (for example, provision of a cross operating contribution,
as defined in paragraph (j)(1)(i) of this section, or make-or-sell
rights) require arm's length consideration from the latter controlled
participant under the rules of Sec. Sec. 1.482-1, 1.482-4 through
1.482-6, and 1.482-9T as supplemented by paragraph (g)(2)(iv) of this
section.
(iv) Controlled transactions in the absence of a CSA. If a
controlled transaction is reasonably anticipated to contribute to
developing intangibles pursuant to an arrangement that is not a CSA
described in paragraph (b)(1) or (5) of this section, whether the
results of any such controlled transaction are consistent with an arm's
length result must be determined under the applicable rules of the
other sections of the regulations under section 482. For example, an
arrangement for developing intangibles in which one controlled
taxpayer's costs of developing the intangibles significantly exceeds
its share of reasonably anticipated benefits from exploiting the
developed intangibles would not in substance be a CSA, as described in
paragraphs (b)(1)(i) through (iii) of this section or paragraph
(b)(5)(i) of this section. In such a case, unless the rules of this
section are applicable by reason of paragraph (b)(5) of this section,
the arrangement must be analyzed under other applicable sections of
regulations under section 482 to determine whether it achieves arm's
length results, and if not, to determine any allocations by the
Commissioner that are consistent with such other regulations under
section 482. See Sec. Sec. 1.482-1(b)(2)(ii) (Selection of category of
method applicable to transaction) and 1.482-1T(b)(2)(iii) (Coordination
of methods applicable to certain intangible development arrangements).
(4) Coordination with the arm's length standard. A CSA produces
results that are consistent with an arm's length result within the
meaning of Sec. 1.482-
[[Page 353]]
1(b)(1) if, and only if, each controlled participant's IDC share (as
determined under paragraph (d)(4) of this section) equals its RAB
share, each controlled participant compensates its RAB share of the
value of all platform contributions by other controlled participants,
and all other requirements of this section are satisfied.
(b) Cost sharing arrangement. A cost sharing arrangement is an
arrangement by which controlled participants share the costs and risks
of developing cost shared intangibles in proportion to their RAB
shares. An arrangement is a CSA if and only if the requirements of
paragraphs (b)(1) through (4) of this section are met.
(1) Substantive requirements--(i) CSTs. All controlled participants
must commit to, and in fact, engage in cost sharing transactions. In
CSTs, the controlled participants make payments to each other (CST
Payments) as appropriate, so that in each taxable year each controlled
participant's IDC share is in proportion to its respective RAB share.
(ii) PCTs. All controlled participants must commit to, and in fact,
engage in platform contributions transactions to the extent that there
are platform contributions pursuant to paragraph (c) of this section.
In a PCT, each other controlled participant (PCT Payor) is obligated
to, and must in fact, make arm's length payments (PCT Payments) to each
controlled participant (PCT Payee) that provides a platform
contribution. For guidance on determining such arm's length obligation,
see paragraph (g) of this section.
(iii) Divisional interests. Each controlled participant must
receive a non-overlapping interest in the cost shared intangibles
without further obligation to compensate another controlled participant
for such interest.
(iv) Examples. The following examples illustrate the principles of
this paragraph (b)(1):
Example 1. Company A and Company B, who are members of the same
controlled group, execute an agreement to jointly develop vaccine X
and own the exclusive rights to commercially exploit vaccine X in
their respective territories, which together comprise the whole
world. The agreement provides that they will share some, but not
all, of the costs for developing Vaccine X in proportion to RAB
share. Such agreement is not a CSA because Company A and Company B
have not agreed to share all of the IDCs in proportion to their
respective RAB shares.
Example 2. Company A and Company B agree to share all the costs
of developing Vaccine X. The agreement also provides for employing
certain resources and capabilities of Company A in this program
including a skilled research team and certain research facilities,
and provides for Company B to make payments to Company A in this
respect. However, the agreement expressly provides that the program
will not employ, and so Company B is expressly relieved of the
payments in regard to, certain software developed by Company A as a
medical research tool to model certain cellular processes expected
to be implicated in the operation of Vaccine X even though such
software would reasonably be anticipated to be relevant to
developing Vaccine X and, thus, would be a platform contribution.
See paragraph (c) of this section. Such agreement is not a CSA
because Company A and Company B have not engaged in a necessary PCT
for purposes of developing Vaccine X.
Example 3. Companies C and D, who are members of the same
controlled group, enter into a CSA. In the first year of the CSA, C
and D conduct the intangible development activity, as described in
paragraph (d)(1) of this section. The total IDCs in regard to such
activity are $3,000,000 of which C and D pay $2,000,000 and
$1,000,000, respectively, directly to third parties. As between C
and D, however, their CSA specifies that they will share all IDCs in
accordance with their RAB shares (as described in paragraph (e)(1)
of this section), which are 60% for C and 40% for D. It follows that
C should bear $1,800,000 of the total IDCs (60% of total IDCs of
$3,000,000) and D should bear $1,200,000 of the total IDCs (40% of
total IDCs of $3,000,000). D makes a CST payment to C of $200,000,
that is, the amount by which D's share of IDCs in accordance with
its RAB share exceeds the amount of IDCs initially borne by D
($1,200,000-$1,000,000), and which also equals the amount by which
the total IDCs initially borne by C exceeds its share of IDCS in
accordance with its RAB share ($2,000,000-$1,800,000). As a result
of D's CST payment to C, the IDC shares of C and D are in proportion
to their respective RAB shares.
(2) Administrative requirements. The CSA must meet the requirements
of paragraph (k) of this section.
(3) Date of a PCT. The controlled participants must enter into a
PCT as of the earliest date on or after the CSA is entered into on
which a platform contribution is reasonably anticipated to contribute
to developing cost shared intangibles.
(4) Divisional interests--(i) In general. Pursuant to paragraph
(b)(1)(iii) of this section, each controlled participant must receive a
non-overlapping interest in the cost shared intangibles without further
obligation to compensate another controlled participant for such
interest. Each controlled participant must be entitled to the perpetual
and exclusive right to the profits from transactions of any member of
the controlled group that includes the controlled participant with
uncontrolled taxpayers to the extent that such profits are attributable
to such interest in the cost shared intangibles.
(ii) Territorial based divisional interests. The CSA may divide all
interests in cost shared intangibles on a territorial basis as follows.
The entire world must be divided into two or more non-overlapping
geographic territories. Each controlled participant must receive at
least one such territory, and in the aggregate all the participants
must receive all such territories. Each controlled participant will be
assigned the perpetual and exclusive right to exploit the cost shared
intangibles through the use, consumption, or disposition of property or
services in its territories. Thus, compensation will be required if
other members of the controlled group exploit the cost shared
intangibles in such territory.
(iii) Field of use based divisional interests. The CSA may divide
all interests in cost shared intangibles on the basis of all uses
(whether or not known at the time of the division) to which cost shared
intangibles are to be put as follows. All anticipated uses of cost
shared intangibles must be identified. Each controlled participant must
be assigned at least one such anticipated use, and in the aggregate all
the participants must be assigned all such anticipated uses. Each
controlled participant will be assigned the perpetual and exclusive
right to exploit the cost shared intangibles through the use or uses
assigned to it and one controlled participant must be assigned the
exclusive and perpetual right to exploit cost shared intangibles
through any unanticipated uses.
(iv) Other divisional bases. (A) In the event that the CSA does not
divide interests in the cost shared intangibles on the basis of
exclusive territories or fields of use as described in paragraphs
(b)(4)(ii) and (iii) of this section, the CSA may adopt some other
basis on which to divide all interests in the cost shared intangibles
among the controlled participants, provided that each of the following
criteria is met:
(1) The basis clearly and unambiguously divides all interests in
cost shared intangibles among the controlled participants.
(2) The consistent use of such basis for the division of all
interests in the cost shared intangibles can be dependably verified
from the records maintained by the controlled participants.
(3) The rights of the controlled participants to exploit cost
shared intangibles are non-overlapping, exclusive, and perpetual.
(4) The resulting benefits associated with each controlled
participant's interest in cost shared intangibles are predictable with
reasonable reliability.
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(B) See paragraph (f)(3) of this section for rules regarding the
requirement of arm's length consideration for changes in participation
in CSAs involving divisions of interest described in this paragraph
(b)(4)(iv).
(v) Examples. The following examples illustrate the principles of
this paragraph (b)(4):
Example 1. Companies P and S, both members of the same
controlled group, enter into a CSA to develop product Z. Under the
CSA, P receives the interest in product Z in the United States and S
receives the interest in product Z in the rest of the world, as
described in paragraph (b)(4)(ii) of this section. Both P and S have
plants for manufacturing product Z located in their respective
geographic territories. However, for commercial reasons, product Z
is nevertheless manufactured by P in the United States for sale to
customers in certain locations just outside the United States in
close proximity to P's U.S. manufacturing plant. Because S owns the
territorial rights outside the United States, P must compensate S to
ensure that S realizes all the cost shared intangible profits from
P's sales of product Z in S's territory. The pricing of such
compensation must also ensure that P realizes an appropriate return
for its manufacturing efforts. Benefits projected with respect to
such sales will be included for purposes of estimating S's, but not
P's, RAB share.
Example 2. The facts are the same as in Example 1 except that P
and S agree to divide their interest in product Z based on site of
manufacturing. P will have exclusive and perpetual rights in product
Z manufactured in facilities owned by P. S will have exclusive and
perpetual rights to product Z manufactured in facilities owned by S.
P and S agree that neither will license manufacturing rights in
product Z to any related or unrelated party. Both P and S maintain
books and records that allow production at all sites to be verified.
Both own facilities that will manufacture product Z and the relative
capacities of these sites are known. All facilities are currently
operating at near capacity and are expected to continue to operate
at near capacity when product Z enters production so that it will
not be feasible to shift production between P's and S's facilities.
P and S have no plans to build new facilities and the lead time
required to plan and build a manufacturing facility precludes the
possibility that P or S will build a new facility during the period
for which sales of Product Z are expected. Based on these facts,
this basis for the division of interests in Product Z is a division
described in paragraph (b)(4)(iv) of this section. The basis for the
division of interest is unambiguous and clearly defined and its use
can be dependably verified. P and S both have non-overlapping,
exclusive and perpetual rights in Product Z. The division of
interest results in the participant's relative benefits being
predictable with reasonable reliability.
Example 3. The facts are the same as in Example 2 except that
P's and S's manufacturing facilities are not expected to operate at
full capacity when product Z enters production. Production of
Product Z can be shifted at any time between sites owned by P and
sites owned by S, although neither P nor S intends to shift
production as a result of the agreement. The division of interests
in Product Z between P and S based on manufacturing site is not a
division described in paragraph (b)(4)(iv) of this section because
their relative shares of benefits are not predictable with
reasonable reliability. The fact that neither P nor S intends to
shift production is irrelevant.
(5) Treatment of certain arrangements as CSAs--(i) Situation in
which Commissioner must treat arrangement as a CSA. The Commissioner
must apply the rules of this section to an arrangement among controlled
taxpayers if the administrative requirements of paragraph (b)(2) of
this section are met with respect to such arrangement and the
controlled taxpayers reasonably concluded that such arrangement was a
CSA meeting the requirements of paragraphs (b)(1), (3), and (4) of this
section.
(ii) Situation in which Commissioner may treat arrangement as a
CSA. For arrangements among controlled taxpayers not described in
paragraph (b)(5)(i) of this section, the Commissioner may apply the
provisions of this section if the Commissioner concludes that the
administrative requirements of paragraph (b)(2) of this section are
met, and, notwithstanding technical failure to meet the substantive
requirements of paragraph (b)(1), (3), or (4) of this section, the
rules of this section will provide the most reliable measure of an
arm's length result. See Sec. 1.482-1(c)(1) (the best method rule).
For purposes of applying this paragraph (b)(5)(ii), any such
arrangement shall be interpreted by reference to paragraph (k)(1)(iv)
of this section.
(iii) Examples. The following examples illustrate the principles of
this paragraph (b)(5). In the examples, assume that Companies P and S
are both members of the same controlled group.
Example 1. (i) P owns the patent on a formula for a capsulated
pain reliever, P-Cap. P reasonably anticipates, pending further
research and experimentation, that the P-Cap formula could form the
platform for a formula for P-Ves, an effervescent version of P-Cap.
P also owns proprietary software that it reasonably anticipates to
be critical to the research efforts. P and S execute a contract that
purports to be a CSA by which they agree to proportionally share the
costs and risks of developing a formula for P-Ves. The agreement
reflects the various contractual requirements described in paragraph
(k)(1) of this section and P and S comply with the documentation,
accounting, and reporting requirements of paragraphs (k)(2) through
(4) of this section. Both the patent rights for P-Cap and the
software are reasonably anticipated to contribute to the development
of P-Ves and therefore are platform contributions for which
compensation is due from S as part of PCTs. Though P and S enter
into and implement a PCT for the P-Cap patent rights that satisfies
the arm's length standard, they fail to enter into a PCT for the
software.
(ii) In this case, P and S have substantially complied with the
contractual requirements of paragraph (k)(1) of this section and the
documentation, accounting, and reporting requirements of paragraphs
(k)(2) through (4) of this section and therefore have met the
administrative requirements of paragraph (b)(2) of this section.
However, because they did not enter into a PCT, as required under
paragraphs (b)(1)(ii) and (b)(3) of this section, for the software
that was reasonably anticipated to contribute to the development of
P-Ves (see paragraph (c) of this section), they cannot reasonably
conclude that their arrangement was a CSA. Accordingly, the
Commissioner is not required under paragraph (b)(5)(i) of this
section to apply the rules of this section to their arrangement.
(iii) Nevertheless, the arrangement between P and S closely
resembles a CSA. If the Commissioner concludes that the rules of
this section provide the most reliable measure of an arm's length
result for such arrangement, then pursuant to paragraph (b)(5)(ii)
of this section, the Commissioner may apply the rules of this
section and treat P and S as entering into a PCT for the software in
accordance with the requirements of paragraph (b)(1)(ii) of this
section, and make any appropriate allocations under paragraph (i) of
this section. Alternatively, the Commissioner may conclude that the
rules of this section do not provide the most reliable measure of an
arm's length result. In such case, the arrangement would be analyzed
under the methods under other sections of the 482 regulations to
determine whether the arrangement reaches an arm's length result.
Example 2. The facts are the same as Example 1 except that P and
S do enter into and implement a PCT for the software as required
under this paragraph (b). The Commissioner determines that the PCT
Payments for the software were not arm's length; nevertheless, under
the facts and circumstances at the time they entered into the CSA
and PCTs, P and S reasonably concluded their arrangement to be a
CSA. Because P and S have met the requirements of paragraph (b)(2)
of this section and reasonably concluded their arrangement is a CSA,
pursuant to paragraph (b)(5)(i) of this section, the Commissioner
must apply the rules of this section to their arrangement.
Accordingly, the Commissioner treats the arrangement as a CSA and
makes adjustments to the PCT Payments as appropriate under this
section to achieve an arm's length result for the PCT for the
software.
Example 3. (i) The facts are the same as Example 1 except that P
and S do enter into a PCT for the software as required under this
paragraph (b). The agreement entered into by P and S provides for a
fixed consideration of $50 million per year for four years, payable
at the end of each year. This agreement
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satisfies the arm's length standard. However, S actually pays P
consideration at the end of each year in the form of four annual
royalties equal to two percent of sales. While such royalties at the
time of the PCT were expected to be $50 million per year, actual
sales during the first year were less than anticipated and the first
royalty payment was only $25 million.
(ii) In this case, P and S failed to implement the terms of
their agreement. Under these circumstances, P and S could not
reasonably conclude that their arrangement was a CSA, as described
in paragraph (b)(1) of this section. Accordingly, the Commissioner
is not required under paragraph (b)(5)(i) of this section to apply
the rules of this section to their arrangement.
(iii) Nevertheless, the arrangement between P and S closely
resembles a CSA. If the Commissioner concludes that the rules of
this section provide the most reliable measure of an arm's length
result for such arrangement, then pursuant to paragraph (b)(5)(ii)
of this section, the Commissioner may apply the rules of this
section and make any appropriate allocations under paragraph (i) of
this section. Alternatively, the Commissioner may conclude that the
rules of this section do not provide the most reliable measure of an
arm's length result. In such case, the arrangement would be analyzed
under the methods under other sections of the 482 regulations to
determine whether the arrangement reaches an arm's length result.
Example 4. (i) The facts are the same as in Example 1 except
that P does not own proprietary software and P and S use a different
method for determining the arm's length amount of the PCT Payment
for the P-Cap patent rights from the method used in Example 1.
(ii) P and S determine that the arm's length amount of the PCT
Payments for the P-Cap patent is $10 million. However, the IRS
determines the best method for determining the arm's length amount
of the PCT Payments for the P-Cap patent rights and under such
method the arm's length amount is $100 million. To determine this
$10 million present value, P and S assumed a useful life of eight
years for the platform contribution, because the P-Cap patent rights
will expire after eight years. However, use of the P-Cap patent
rights in research is expected to lead to benefits attributable to
exploitation of the cost shared intangibles extending many years
beyond the expiration of the P-Cap patent, because use of the P-Cap
patent rights will let P and S bring P-Ves to market before the
competition, and because P and S expect to apply for additional
patents covering P-Ves, which would bar competitors from selling
that product for many future years. The assumption by P and S of a
useful life for the platform contribution that is less than the
anticipated period of exploitation of the cost shared intangibles is
contrary to paragraph (g)(2)(ii) of this section, and reduces the
reliability of the method used by P and S.
(iii) The method used by P and S employs a declining royalty.
The royalty starts at 8% of sales, based on an application of the
CUT method in which the purported CUTs all involve licenses to
manufacture and sell the current generation of P-Cap, and declines
to 0% over eight years, declining by 1% each year. Such make-or-sell
rights are fundamentally different from use of the P-Cap patent
rights to generate a new product. This difference raises the issue
of whether the make-or-sell rights are sufficiently comparable to
the rights that are the subject of the PCT Payment. See Sec. 1.482-
4(c). While a royalty rate for make-or-sell rights can form the
basis for a reliable determination of an arm's length PCT Payment in
the CUT-based implementation of the income method described in
paragraph (g)(4) of this section, under that method such royalty
rate does not decline to zero. Therefore, the use of a declining
royalty rate based on an initial rate for make-or-sell rights
further reduces the reliability of the method used by P and S.
(iv) Sales of the next-generation product are not anticipated
until after seven years, at which point the royalty rate will have
declined to 1%. The temporal mismatch between the period of the
royalty rate decline and the period of exploitation raises further
concerns about the method's reliability.
(v) For the reasons given in paragraphs (ii) through (iv) of
this Example 4, the method used by P and S is so unreliable and so
contrary to provisions of this section that P and S could not
reasonably conclude that they had contracted to make arm's length
PCT Payments as required by paragraphs (b)(1)(ii) and (b)(3) of this
section, and thus could not reasonably conclude that their
arrangement was a CSA. Accordingly, the Commissioner is not required
under paragraph (b)(5)(i) of this section to apply the rules of this
section to their arrangement.
(vi) Nevertheless, the arrangement between P and S closely
resembles a CSA. If the Commissioner concludes that the rules of
this section provide the most reliable measure of an arm's length
result for such arrangement, then pursuant to paragraph (b)(5)(ii)
of this section, the Commissioner may apply the rules of this
section and make any appropriate allocations under paragraph (i) of
this section. Alternatively, the Commissioner may conclude that the
rules of this section do not provide the most reliable measure of an
arm's length result. In such case, the arrangement would be analyzed
under the methods under other section 482 regulations to determine
whether the arrangement reaches an arm's length result.
(6) Entity classification of CSAs. See Sec. 301.7701-1(c) of this
chapter for the classification of CSAs for purposes of the Internal
Revenue Code.
(c) Platform contributions--(1) In general. A platform contribution
is any resource, capability, or right that a controlled participant has
developed, maintained, or acquired externally to the intangible
development activity (whether prior to or during the course of the CSA)
that is reasonably anticipated to contribute to developing cost shared
intangibles. The determination whether a resource, capability, or right
is reasonably anticipated to contribute to developing cost shared
intangibles is ongoing and based on the best available information.
Therefore, a resource, capability, or right reasonably determined not
to be a platform contribution as of an earlier point in time, may be
reasonably determined to be a platform contribution at a later point in
time. The PCT obligation regarding a resource or capability or right
once determined to be a platform contribution does not terminate merely
because it may later be determined that such resource or capability or
right has not contributed, and no longer is reasonably anticipated to
contribute, to developing cost shared intangibles. Notwithstanding the
other provisions of this paragraph (c), platform contributions do not
include rights in land or depreciable tangible property, and do not
include rights in other resources acquired by IDCs. See paragraph
(d)(1) of this section.
(2) Terms of platform contributions--(i) Presumed to be exclusive.
For purposes of a PCT, the PCT Payee's provision of a platform
contribution is presumed to be exclusive. Thus, it is presumed that the
platform resource, capability, or right is not reasonably anticipated
to be committed to any business activities other than the CSA Activity,
as defined in paragraph (j)(1)(i) of this section, whether carried out
by the controlled participants, other controlled taxpayers, or
uncontrolled taxpayers.
(ii) Rebuttal of exclusivity. The controlled participants may rebut
the presumption set forth in paragraph (c)(2)(i) of this section to the
satisfaction of the Commissioner. For example, if the platform resource
is a research tool, then the controlled participants could rebut the
presumption by establishing to the satisfaction of the Commissioner
that, as of the date of the PCT, the tool is reasonably anticipated not
only to contribute to the CSA Activity but also to be licensed to an
uncontrolled taxpayer. In such case, the PCT Payments may need to be
prorated as described in paragraph (c)(2)(iii) of this section.
(iii) Proration of PCT Payments to the extent allocable to other
business activities--(A) In general. Some transfer pricing methods
employed to determine the arm's length amount of the PCT Payments do so
by considering the overall value of the platform contributions as
opposed to, for example, the value of the anticipated use of the
platform contributions in the CSA Activity. Such a transfer pricing
method is consistent with the presumption that the platform
contribution is exclusive (that is, that the resources, capabilities or
rights that are the subject of a platform contribution are reasonably
anticipated
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to contribute only to the CSA Activity). See paragraph (c)(2)(i) of
this section (Terms of platform contributions--Presumed to be
exclusive). The PCT Payments determined under such transfer pricing
method may have to be prorated if the controlled participants can rebut
the presumption that the platform contribution is exclusive to the
satisfaction of the Commissioner as provided in paragraph (c)(2)(ii) of
this section. In the case of a platform contribution that also
contributes to lines of business of a PCT Payor that are not reasonably
anticipated to involve exploitation of the cost shared intangibles, the
need for explicit proration may in some cases be avoided through
aggregation of transactions. See paragraph (g)(2)(iv) of this section
(Aggregation of transactions).
(B) Determining the proration of PCT Payments. Proration will be
done on a reasonable basis in proportion to the relative economic
value, as of the date of the PCT, reasonably anticipated to be derived
from the platform contribution by the CSA Activity as compared to the
value reasonably anticipated to be derived from the platform
contribution by other business activities. In the case of an aggregate
valuation done under the principles of paragraph (g)(2)(iv) of this
section that addresses payment for resources, capabilities, or rights
used for business activities other than the CSA Activity (for example,
the right to exploit an existing intangible without further
development), the proration of the aggregate payments may have to
reflect the economic value attributable to such resources,
capabilities, or rights as well. For purposes of the best method rule
under Sec. 1.482-1(c), the reliability of the analysis under a method
that requires proration pursuant to this paragraph is reduced relative
to the reliability of an analysis under a method that does not require
proration.
(3) Categorization of the PCT. For purposes of Sec. 1.482-
1(b)(1)(ii) and paragraph (a)(2) of this section, a PCT must be
identified by the controlled participants as a particular type of
transaction (for example, a license for royalty payments). See
paragraph (k)(2)(ii)(I) of this section. Such designation must be
consistent with the actual conduct of the controlled participants. If
the conduct is consistent with different, economically equivalent types
of transaction, then the controlled participants may designate the PCT
as being any of such types of transaction. If the controlled
participants fail to make such designation in their documentation, the
Commissioner may make a designation consistent with the principles of
paragraph (k)(1)(iv) of this section.
(4) Certain make-or-sell rights excluded--(i) In general. Any right
to exploit an existing intangible without further development, such as
the right to make, replicate, license or sell existing products, does
not constitute a platform contribution to a CSA, and the arm's length
compensation for such rights (make-or-sell rights) does not satisfy the
compensation obligation under a PCT.
(ii) Examples. The following examples illustrate the principles of
this paragraph (c)(4):
Example 1. P and S, which are members of the same controlled
group, execute a CSA. Under the CSA, P and S will bear their RAB
shares of IDCs for developing the second generation of ABC, a
computer software program. Prior to that arrangement, P had incurred
substantial costs and risks to develop ABC. Concurrent with entering
into the arrangement, P (as the licensor) executes a license with S
(as the licensee) by which S may make and sell copies of the
existing ABC. Such make-or-sell rights do not constitute a platform
contribution to the CSA. The rules of Sec. Sec. 1.482-1 and 1.482-4
through 1.482-6 must be applied to determine the arm's length
consideration in connection with the make-or-sell licensing
arrangement. In certain circumstances, this determination of the
arm's length consideration may be done on an aggregate basis with
the evaluation of compensation obligations pursuant to the PCTs
entered into by P and S in connection with the CSA. See paragraph
(g)(2)(iv) of this section.
Example 2. (i) P, a software company, has developed and
currently exploits software program ABC. P and S enter into a CSA to
develop future generations of ABC. The ABC source code is the
platform on which future generations of ABC will be built and is
therefore a platform contribution of P for which compensation is due
from S pursuant to a PCT. Concurrent with entering into the CSA, P
licenses to S the make-or-sell rights for the current version of
ABC. P has entered into similar licenses with uncontrolled parties
calling for sales-based royalty payments at a rate of 20%. The
current version of ABC has an expected product life of three years.
P and S enter into a contingent payment agreement to cover both the
PCT Payments due from S for P's platform contribution and payments
due from S for the make-or-sell license. Based on the uncontrolled
make-or-sell licenses, P and S agree on a sales-based royalty rate
of 20% in Year 1 that declines on a straight line basis to 0% over
the 3 year product life of ABC.
(ii) The make-or-sell rights for the current version of ABC are
not platform contributions, though paragraph (g)(2)(iv) of this
section provides for the possibility that the most reliable
determination of an arm's length charge for the platform
contribution and the make-or-sell license may be one that values the
two transactions in the aggregate. A contingent payment schedule
based on the uncontrolled make-or-sell licenses may provide an arm's
length charge for the separate make-or-sell license between P and S,
provided the royalty rates in the uncontrolled licenses similarly
decline, but as a measure of the aggregate PCT and license payments
it does not account for the arm's length value of P's platform
contributions which include the rights in the source code and future
development rights in ABC.
(5) Examples. The following examples illustrate the principles of
this paragraph (c). In each example, Companies P and S are members of
the same controlled group, and execute a CSA providing that each will
have the exclusive right to exploit cost shared intangibles in its own
territory. See paragraph (b)(4)(ii) of this section (Territorial based
divisional interests).
Example 1. Company P has developed and currently markets version
1.0 of a new software application XYZ. Company P and Company S
execute a CSA under which they will share the IDCs for developing
future versions of XYZ. Version 1.0 is reasonably anticipated to
contribute to the development of future versions of XYZ and
therefore Company P's rights in version 1.0 constitute a platform
contribution from Company P that must be compensated by Company S
pursuant to a PCT. Pursuant to paragraph (c)(3) of this section, the
controlled participants designate the platform contribution as a
transfer of intangibles that would otherwise be governed by Sec.
1.482-4, if entered into by controlled parties. Accordingly,
pursuant to paragraph (a)(2) of this section, the applicable method
for determining the arm's length value of the compensation
obligation under the PCT between Company P and Company S will be
governed by Sec. 1.482-4 as supplemented by paragraph (g) of this
section. Absent a showing to the contrary by P and S, the platform
contribution in this case is presumed to be the exclusive provision
of the benefit of all rights in version 1.0, other than the rights
described in paragraph (c)(4) of this section (Certain make-or-sell
rights excluded). This includes the right to use version 1.0 for
purposes of research and the exclusive right in S's territory to
exploit any future products that incorporated the technology of
version 1.0, and would cover a term extending as long as the
controlled participants were to exploit future versions of XYZ or
any other product based on the version 1.0 platform. The
compensation obligation of Company S pursuant to the PCT will
reflect the full value of the platform contribution, as limited by
Company S's RAB share.
Example 2. Company P and Company S execute a CSA under which
they will share the IDCs for developing Vaccine Z. Company P will
commit to the project its research team that has successfully
developed a number of other vaccines. The expertise and existing
integration of the research team is a unique resource or capability
of Company P which is reasonably anticipated to contribute to the
development of Vaccine Z. Therefore, P's provision of the
capabilities of the research team constitute a platform contribution
for
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which compensation is due from Company S as part of a PCT. Pursuant
to paragraph (c)(3) of this section, the controlled parties
designate the platform contribution as a provision of services that
would otherwise be governed by Sec. 1.482-9T(a) if entered into by
controlled parties. Accordingly, pursuant to paragraph (a)(2) of
this section, the applicable method for determining the arm's length
value of the compensation obligation under the PCT between Company P
and Company S will be governed by Sec. 1.482-9T(a) as supplemented
by paragraph (g) of this section. Absent a showing to the contrary
by P and S, the platform contribution in this case is presumed to be
the exclusive provision of the benefits by Company P of its research
team to the development of Vaccine Z. Because the IDCs include the
ongoing compensation of the researchers, the compensation obligation
under the PCT is only for the value of the commitment of the
research team by Company P to the CSA's development efforts net of
such researcher compensation. The value of the compensation
obligation of Company S for the PCT will reflect the full value of
the provision of services, as limited by Company S's RAB share.
(d) Intangible development costs--(1) Determining whether costs are
IDCs. Costs included in IDCs are determined by reference to the scope
of the intangible development activity (IDA).
(i) Definition and scope of the IDA. For purposes of this section,
the IDA means the activity under the CSA of developing or attempting to
develop reasonably anticipated cost shared intangibles. The scope of
the IDA includes all of the controlled participants' activities that
could reasonably be anticipated to contribute to developing the
reasonably anticipated cost shared intangibles. The IDA cannot be
described merely by a list of particular resources, capabilities, or
rights that will be used in the CSA, because such a list would not
identify reasonably anticipated cost shared intangibles. Also, the
scope of the IDA may change as the nature or identity of the reasonably
anticipated cost shared intangibles changes or the nature of the
activities necessary for their development become clearer. For example,
the relevance of certain ongoing work to developing reasonably
anticipated cost shared intangibles or the need for additional work may
only become clear over time.
(ii) Reasonably anticipated cost shared intangible. For purposes of
this section, reasonably anticipated cost shared intangible means any
intangible, within the meaning of Sec. 1.482-4(b), that, at the
applicable point in time, the controlled participants intend to develop
under the CSA. Reasonably anticipated cost shared intangibles may
change over the course of the CSA. The controlled participants may at
any time change the reasonably anticipated cost shared intangibles but
must document any such change pursuant to paragraph (k)(2)(ii)(A)(1) of
this section. Removal of reasonably anticipated cost shared intangibles
does not affect the controlled participants' interests in cost shared
intangibles already developed under the CSA. In addition, the
reasonably anticipated cost shared intangibles automatically expand to
include the intended result of any further development of a cost shared
intangible already developed under the CSA, or applications of such an
intangible. However, the controlled participants may override this
automatic expansion in a particular case if they separately remove
specified further development of such intangible (or specified
applications of such intangible) from the IDA, and document such
separate removal pursuant to paragraph (k)(2)(ii)(A)(3) of this
section.
(iii) Costs included in IDCs. For purposes of this section, IDCs
mean all costs, in cash or in kind (including stock-based compensation,
as described in paragraph (d)(3) of this section), but excluding
acquisition costs for land or depreciable property, in the ordinary
course of business after the formation of a CSA that, based on analysis
of the facts and circumstances, are directly identified with, or are
reasonably allocable to, the IDA. Thus, IDCs include costs incurred in
attempting to develop reasonably anticipated cost shared intangibles
regardless of whether such costs ultimately lead to development of
those intangibles, other intangibles developed unexpectedly, or no
intangibles. IDCs shall also include the arm's length rental charge for
the use of any land or depreciable tangible property (as determined
under Sec. 1.482-2(c) (Use of tangible property)) directly identified
with, or reasonably allocable to, the IDA. Reference to generally
accepted accounting principles or Federal income tax accounting rules
may provide a useful starting point but will not be conclusive
regarding inclusion of costs in IDCs. IDCs do not include interest
expense, foreign income taxes (as defined in Sec. 1.901-2(a)), or
domestic income taxes.
(iv) Examples. The following examples illustrate the principles of
this paragraph (d)(1):
Example 1. A contract that purports to be a CSA provides that
the IDA to which the agreement applies consists of all research and
development activity conducted at laboratories A, B, and C but not
at other facilities maintained by the controlled participants. The
contract does not describe the reasonably anticipated cost shared
intangibles with respect to which research and development is to be
undertaken. The contract fails to meet the requirements set forth in
paragraph (k)(1)(ii)(B) of this section because it fails to
adequately describe the scope of the IDA to be undertaken.
Example 2. A contract that purports to be a CSA provides that
the IDA to which the agreement applies consists of all research and
development activity conducted by any of the controlled participants
with the goal of developing a cure for a particular disease. Such a
cure is thus a reasonably anticipated cost shared intangible. The
contract also contains a provision that the IDA will exclude any
activity that builds on the results of the controlled participants'
prior research concerning Enzyme X even though such activity could
reasonably be anticipated to contribute to developing such cure. The
contract fails to meet the requirement set forth in paragraph
(d)(1)(i) of this section that the scope of the IDA include all of
the controlled participants' activities that could reasonably be
anticipated to contribute to developing reasonably anticipated cost
shared intangibles.
(2) Allocation of costs. If a particular cost is directly
identified with, or reasonably allocable to, a function the results of
which will benefit both the IDA and other business activities, the cost
must be allocated on a reasonable basis between the IDA and such other
business activities in proportion to the relative economic value that
the IDA and such other business activities are anticipated to derive
from such results.
(3) Stock-based compensation--(i) In general. As used in this
section, the term stock-based compensation 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 with the IDA. The
determination of whether stock-based compensation is directly
identified with, or reasonably allocable to, the IDA 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 CSA
and, at date of grant, is directly identified with, or reasonably
allocable to, the IDA is included as an IDC 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
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grant of a new stock option for purposes of this paragraph (d)(3)(ii)
will be made in accordance with the rules of section 424(h) and related
regulations.
(iii) Measurement and timing of stock-based compensation IDC--(A)
In general. Except as otherwise provided in this paragraph (d)(3)(iii),
the cost 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 IDC under this section for the taxable year for which the
deduction is allowable.
(1) Transfers to which section 421 applies. Solely for purposes of
this paragraph (d)(3)(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) Deductions of foreign controlled participants. Solely for
purposes of this paragraph (d)(3)(iii)(A), an amount is treated as an
allowable deduction of a foreign controlled participant to the extent
that a deduction would be allowable to a United States taxpayer.
(3) Modification of stock option. Solely for purposes of this
paragraph (d)(3)(iii)(A), if the repricing or other modification of a
stock option is determined, under paragraph (d)(3)(ii) of this section,
to constitute the grant of a new stock option not identified with, or
reasonably allocable to, the IDA, 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)(3)(iii)(A)) to the
controlled participant upon exercise of the stock option immediately
before the modification must be taken into account as an IDC as of the
date of the modification.
(4) Expiration or termination of CSA. Solely for purposes of this
paragraph (d)(3)(iii)(A), if an item of stock-based compensation
identified with, or reasonably allocable to, the IDA is not exercised
during the term of a CSA, that item of stock-based compensation will be
treated as being exercised immediately before the expiration or
termination of the CSA, 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)(3)(iii)(A)) to the
controlled participant upon exercise of the stock-based compensation
must be taken into account as an IDC as of the date of the expiration
or termination of the CSA.
(B) Election with respect to options on publicly traded stock--(1)
In general. With respect to stock-based compensation in the form of
options on publicly traded stock, the controlled participants in a CSA
may elect to take into account all IDCs 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) Publicly traded stock. As used in this paragraph
(d)(3)(iii)(B), the term publicly traded stock 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) Generally accepted accounting principles. For purposes of this
paragraph (d)(3)(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) 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) 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) Time and manner of making the election. The election described
in this paragraph (d)(3)(iii)(B) is made by an explicit reference to
the election in the written contract required by paragraph (k)(1) of
this section or in a written amendment to the CSA entered into with the
consent of the Commissioner pursuant to paragraph (d)(3)(iii)(C) of
this section. In the case of a CSA in existence on August 26, 2003, the
election by written amendment to the CSA may be made without the
consent of the Commissioner if such amendment is entered into 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.
(C) Consistency. Generally, all controlled participants in a CSA
taking options on publicly traded stock into account under paragraph
(d)(3)(ii), (d)(3)(iii)(A), or (d)(3)(iii)(B) of this section must use
that same method of identification, measurement and timing for all
options on publicly traded stock with respect to that CSA. 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
CSA must join in requests for the Commissioner's consent under this
paragraph (d)(3)(iii)(C). Thus, for example, if the controlled
participants make the election described in paragraph (d)(3)(iii)(B) of
this section upon the formation of the CSA, 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)(3)(iii)(A) of this section, then except in cases specified in the
last sentence of paragraph (d)(3)(iii)(B)(4) of this section, the
controlled participants may make the election described in paragraph
(d)(3)(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.
(4) IDC share. A controlled participant's IDC share for a taxable
year is equal to the controlled participant's
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cost contribution for the taxable year, divided by the sum of all IDCs
for the taxable year. A controlled participant's cost contribution for
a taxable year means all of the IDCs initially borne by the controlled
participant, plus all of the CST Payments that the participant makes to
other controlled participants, minus all of the CST Payments that the
participant receives from other controlled participants.
(5) Examples. The following examples illustrate this paragraph (d):
Example 1. Foreign parent (FP) and its U.S. subsidiary (USS)
enter into a CSA to develop a better mousetrap. USS and FP share the
costs of FP's R&D facility that will be exclusively dedicated to
this research, the salaries of the researchers at the facility, and
overhead costs attributable to the project. They also share the cost
of a conference facility that is at the disposal of the senior
executive management of each company. Based on the facts and
circumstances, the cost of the conference facility cannot be
directly identified with, and is not reasonably allocable to, the
IDA. In this case, the cost of the conference facility must be
excluded from the amount of IDCs.
Example 2. U.S. parent (USP) and its foreign subsidiary (FS)
enter into a CSA to develop intangibles for producing a new device.
USP and FS share the costs of an R&D facility, the salaries of the
facility's researchers, and overhead costs attributable to the
project. Although USP also incurs costs related to field testing of
the device, USP does not include those costs in the IDCs that USP
and FS will share under the CSA. The Commissioner may determine,
based on the facts and circumstances, that the costs of field
testing are IDCs that the controlled participants must share.
Example 3. U.S. parent (USP) and its foreign subsidiary (FS)
enter into a CSA to develop a new process patent. USP assigns
certain employees to perform solely R&D to develop a new
mathematical algorithm to perform certain calculations. That
algorithm will be used both to develop the new process patent and to
develop a new design patent the development of which is outside the
scope of the CSA. During years covered by the CSA, USP compensates
such employees with cash salaries, stock-based compensation, or a
combination of both. USP and FS anticipate that the economic value
attributable to the R&D will be derived from the process patent and
the design patent in a relative proportion of 75% and 25%,
respectively. Applying the principles of paragraph (d)(2) of this
section, 75% of the compensation of such employees must be allocated
to the development of the new process patent and, thus, treated as
IDCs. With respect to the cash salary compensation, the IDC is 75%
of the face value of the cash. With respect to the stock-based
compensation, the IDC is 75% of the value of the stock-based
compensation as determined under paragraph (d)(3)(iii) of this
section.
Example 4. Foreign parent (FP) and its U.S. subsidiary (USS)
enter into a CSA to develop a new computer source code. FP has an
executive officer who oversees a research facility and employees
dedicated solely to the IDA. The executive officer also oversees
other research facilities and employees unrelated to the IDA, and
performs certain corporate overhead functions. The full amount of
the costs of the research facility and employees dedicated solely to
the IDA can be directly identified with the IDA and, therefore, are
IDCs. In addition, based on the executive officer's records of time
worked on various matters, the controlled participants reasonably
allocate 20% of the executive officer's compensation to supervision
of the facility and employees dedicated to the IDA, 50% of the
executive officer's compensation to supervision of the facilities
and employees unrelated to the IDA, and 30% of the executive
officer's compensation to corporate overhead functions. The
controlled participants also reasonably determine that the results
of the executive officer's corporate overhead functions yield equal
economic benefit to the IDA and the other business activities of FP.
Applying the principles of paragraph (d)(1) of this section, the
executive officer's compensation allocated to supervising the
facility and employees dedicated to the IDA (amounting to 20% of the
executive officer's total compensation) must be treated as IDCs.
Applying the principles of paragraph (d)(2) of this section, half of
the executive officer's compensation allocated to corporate overhead
functions (that is, half of 30% of the executive officer's total
compensation), must be treated as IDCs. Therefore, a total of 35%
(20% plus 15%) of the executive officer's total compensation must be
treated as IDCs.
(e) Reasonably anticipated benefits share--(1) Definition--(i) In
general. A controlled participant's share of reasonably anticipated
benefits is equal to its reasonably anticipated benefits divided by the
sum of the reasonably anticipated benefits, as defined in paragraph
(j)(1)(i) of this section, of all the controlled participants. RAB
shares must be updated to account for changes in economic conditions,
the business operations and practices of the participants, and the
ongoing development of intangibles under the CSA. For purposes of
determining RAB shares at any given time, reasonably anticipated
benefits must be estimated over the entire period, past and future, of
exploitation of the cost shared intangibles, and must reflect
appropriate updates to take into account the most reliable data
regarding past and projected future results available at such time. A
controlled participant's RAB share must be determined by using the most
reliable estimate. In determining which of two or more available
estimates is most reliable, the quality of the data and assumptions
used in the analysis must be taken into account, consistent with Sec.
1.482-1(c)(2)(ii) (Data and assumptions). Thus, the reliability of an
estimate will depend largely on the completeness and accuracy of the
data, the soundness of the assumptions, and the relative effects of
particular deficiencies in data or assumptions on different estimates.
If two estimates are equally reliable, no adjustment should be made
based on differences between the estimates. The following factors will
be particularly relevant in determining the reliability of an estimate
of RAB shares:
(A) The basis used for measuring benefits, as described in
paragraph (e)(2)(ii) of this section.
(B) The projections used to estimate benefits, as described in
paragraph (e)(2)(iii) of this section.
(ii) Example. The following example illustrates the principles of
this paragraph (e)(1):
Example. (i) USP and FS plan to conduct research to develop
Product Lines A and B. USP and FS reasonably anticipate respective
benefits from Product Line A of 100X and 200X and respective
benefits from Product Line B, respectively, of 300X and 400X. USP
and FS thus reasonably anticipate combined benefits from Product
Lines A and B of 400X and 600X, respectively.
(ii) USP and FS could enter into a separate CSA to develop
Product Line A with respective RAB shares of 33\1/3\ percent and
66\2/3\ percent (reflecting a ratio of 100X to 200X), and into a
separate CSA to develop Product Line B with respective RAB shares of
42\6/7\ percent and 57\1/7\ percent (reflecting a ratio of 300X to
400X). Alternatively, USP and FS could enter into a single CSA to
develop both Product Lines A and B with respective RAB shares of 40
percent and 60 percent (in the ratio of 400X to 600X). If the
separate CSAs are chosen, then any costs for activities that
contribute to developing both Product Line A and Product Line B will
constitute IDCs of the respective CSAs as required by paragraphs
(d)(1) and (d)(2) of this section.
(2) Measure of benefits--(i) In general. In order to estimate a
controlled participant's RAB share, the amount of each controlled
participant's reasonably anticipated benefits must be measured on a
basis that is consistent for all such participants. See paragraph
(e)(2)(ii)(E) Example 9 of this section. If a controlled participant
transfers a cost shared intangible to another controlled taxpayer,
other than by way of a transfer described in paragraph (f) of this
section, that controlled participant's benefits from the transferred
intangible must be measured by reference to the transferee's benefits,
disregarding any consideration paid by the transferee to the controlled
participant (such as a royalty pursuant to a license agreement).
Reasonably anticipated benefits are measured either on a direct basis,
by reference to estimated benefits to be generated by the use of cost
shared
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intangibles (generally based on additional revenues plus cost savings
less any additional costs incurred), or on an indirect basis, by
reference to certain measurements that reasonably can be assumed to
relate to benefits to be generated. Such indirect bases of measurement
of anticipated benefits are described in paragraph (e)(2)(ii) of this
section. A controlled participant's reasonably anticipated benefits
must be measured on the basis, whether direct or indirect, that most
reliably determines RAB shares. In determining which of two bases of
measurement is most reliable, the factors set forth in Sec. 1.482-
1(c)(2)(ii) (Data and assumptions) must be taken into account. It
normally will be expected that the basis that provided the most
reliable estimate for a particular year will continue to provide the
most reliable estimate in subsequent years, absent a material change in
the factors that affect the reliability of the estimate. Regardless of
whether a direct or indirect basis of measurement is used, adjustments
may be required to account for material differences in the activities
that controlled participants undertake to exploit their interests in
cost shared intangibles. See Examples 4 and 7 of paragraph
(e)(2)(ii)(E) of this section.
(ii) Indirect bases for measuring anticipated benefits. Indirect
bases for measuring anticipated benefits from participation in a CSA
include the following:
(A) Units used, produced, or sold. Units of items used, produced,
or sold by each controlled participant in the business activities in
which cost shared intangibles are exploited may be used as an indirect
basis for measuring its anticipated benefits. This basis of measurement
will more reliably determine RAB shares to the extent that each
controlled participant is expected to have a similar increase in net
profit or decrease in net loss attributable to the cost shared
intangibles per unit of the item or items used, produced, or sold. This
circumstance is most likely to arise when the cost shared intangibles
are exploited by the controlled participants in the use, production, or
sale of substantially uniform items under similar economic conditions.
(B) Sales. Sales by each controlled participant in the business
activities in which cost shared intangibles are exploited may be used
as an indirect basis for measuring its anticipated benefits. This basis
of measurement will more reliably determine RAB shares to the extent
that each controlled participant is expected to have a similar increase
in net profit or decrease in net loss attributable to cost shared
intangibles per dollar of sales. This circumstance is most likely to
arise if the costs of exploiting cost shared intangibles are not
substantial relative to the revenues generated, or if the principal
effect of using cost shared intangibles is to increase the controlled
participants' revenues (for example, through a price premium on the
products they sell) without affecting their costs substantially. Sales
by each controlled participant are unlikely to provide a reliable basis
for measuring RAB shares unless each controlled participant operates at
the same market level (for example, manufacturing, distribution, etc.).
(C) Operating profit. Operating profit of each controlled
participant from the activities in which cost shared intangibles are
exploited, as determined before any expense (including amortization) on
account of IDCs, may be used as an indirect basis for measuring
anticipated benefits. This basis of measurement will more reliably
determine RAB shares to the extent that such profit is largely
attributable to the use of cost shared intangibles, or if the share of
profits attributable to the use of cost shared intangibles is expected
to be similar for each controlled participant. This circumstance is
most likely to arise when cost shared intangibles are closely
associated with the activity that generates the profit and the activity
could not be carried on or would generate little profit without use of
those intangibles.
(D) Other bases for measuring anticipated benefits. Other bases for
measuring anticipated benefits may in some circumstances be
appropriate, but only to the extent that there is expected to be a
reasonably identifiable relationship between the basis of measurement
used and additional income generated or costs saved by the use of cost
shared intangibles. For example, a division of costs based on employee
compensation would be considered unreliable unless there were a
relationship between the amount of compensation and the expected
additional income generated or costs saved by the controlled
participants from using the cost shared intangibles.
(E) Examples. The following examples illustrate this paragraph
(e)(2)(ii):
Example 1. Controlled parties A and B enter into a CSA to
develop product and process intangibles for already existing Product
P. Without such intangibles, A and B would each reasonably
anticipate revenue, in present value terms, of $100M from sales of
Product P until it becomes obsolete. With the intangibles, A and B
each reasonably anticipate selling the same number of units each
year, but reasonably anticipate that the price will be higher.
Because the particular product intangible is more highly regarded in
A's market, A reasonably anticipates an increase of $20M in present
value revenue from the product intangible, while B reasonably
anticipates an increase of only $10M in present value from the
product intangible. Further, A and B each reasonably anticipate
spending an additional amount equal to $5M in present value in
production costs to include the feature embodying the product
intangible. Finally, A and B each reasonably anticipate saving an
amount equal to $2M in present value in production costs by using
the process intangible. A and B reasonably anticipate no other
economic effects from exploiting the cost shared intangibles. A's
reasonably anticipated benefits from exploiting the cost shared
intangibles equal its reasonably anticipated increase in revenue
($20M) plus its reasonably anticipated cost savings ($2M) less its
reasonably anticipated increased costs ($5M), which equals $17M.
Similarly, B's reasonably anticipated benefits from exploiting the
cost shared intangibles equal its reasonably anticipated increase in
revenue ($10M) plus its reasonably anticipated cost savings ($2M)
less its reasonably anticipated increased costs ($5M), which equals
$7M. Thus A's reasonably anticipated benefits are $17M and B's
reasonably anticipated benefits are $7M.
Example 2. Foreign Parent (FP) and U.S. Subsidiary (USS) both
produce a feedstock for the manufacture of various high-performance
plastic products. Producing the feedstock requires large amounts of
electricity, which accounts for a significant portion of its
production cost. FP and USS enter into a CSA to develop a new
process that will reduce the amount of electricity required to
produce a unit of the feedstock. FP and USS currently both incur an
electricity cost of $2 per unit of feedstock produced and rates for
each are expected to remain similar in the future. The new process,
if it is successful, will reduce the amount of electricity required
by each company to produce a unit of the feedstock by 50%. Switching
to the new process would not require FP or USS to incur significant
investment or other costs. Therefore, the cost savings each company
is expected to achieve after implementing the new process are $1 per
unit of feedstock produced. Under the CSA, FP and USS divide the
costs of developing the new process based on the units of the
feedstock each is anticipated to produce in the future. In this
case, units produced is the most reliable basis for measuring RAB
shares and dividing the IDCs because each controlled participant is
expected to have a similar $1 (50% of current charge of $2) decrease
in costs per unit of the feedstock produced.
Example 3. The facts are the same as in Example 2, except that
currently USS pays $3 per unit of feedstock produced for electricity
while FP pays $6 per unit of feedstock produced. In this case, units
produced is not the most reliable basis for measuring RAB shares and
dividing the IDCs because the participants do not expect to have a
similar decrease in costs per unit of the feedstock produced. The
Commissioner
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determines that the most reliable measure of RAB shares may be based
on units of the feedstock produced if FP's units are weighted
relative to USS's units by a factor of 2. This reflects the fact
that FP pays twice as much as USS for electricity and, therefore,
FP's savings of $3 per unit of the feedstock (50% reduction of
current charge of $6) would be twice USS's savings of $1.50 per unit
of feedstock (50% reduction of current charge of $3) from any new
process eventually developed.
Example 4. The facts are the same as in Example 3, except that
to supply the particular needs of the U.S. market USS manufactures
the feedstock with somewhat different properties than FP's
feedstock. This requires USS to employ a somewhat different
production process than does FP. Because of this difference, USS
would incur significant construction costs in order to adopt any new
process that may be developed under the cost sharing agreement. In
this case, units produced is not the most reliable basis for
measuring RAB shares. In order to reliably determine RAB shares, the
Commissioner measures the reasonably anticipated benefits of USS and
FP on a direct basis. USS's reasonably anticipated benefits are its
reasonably anticipated total savings in electricity costs, less its
reasonably anticipated costs of adopting the new process. FS's
reasonably anticipated benefits are its reasonably anticipated total
savings in electricity costs.
Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a CSA to develop new anesthetic drugs. USP obtains the right to
market any resulting drugs in the United States and FS obtains the
right to market any resulting drugs in the rest of the world. USP
and FS determine RAB shares on the basis of their respective total
anticipated operating profit from all drugs under development. USP
anticipates that it will receive a much higher profit than FS per
unit sold because the price of the drugs is not regulated in the
United States, whereas the price of the drugs is regulated in many
non-U.S. jurisdictions. In both controlled participants'
territories, the anticipated operating profits are almost entirely
attributable to the use of the cost shared intangibles. In this
case, the controlled participants' basis for measuring RAB shares is
the most reliable.
Example 6. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)
manufacture and sell fertilizers. They enter into a CSA to develop a
new pellet form of a common agricultural fertilizer that is
currently available only in powder form. Under the CSA, USS obtains
the rights to produce and sell the new form of fertilizer for the
U.S. market while FP obtains the rights to produce and sell the new
form of fertilizer in the rest of the world. The costs of developing
the new form of fertilizer are divided on the basis of the
anticipated sales of fertilizer in the controlled participants'
respective markets.
(ii) If the research and development is successful, the pellet
form will deliver the fertilizer more efficiently to crops and less
fertilizer will be required to achieve the same effect on crop
growth. The pellet form of fertilizer can be expected to sell at a
price premium over the powder form of fertilizer based on the
savings in the amount of fertilizer that needs to be used. This
price premium will be a similar premium per dollar of sales in each
territory. If the research and development is successful, the costs
of producing pellet fertilizer are expected to be approximately the
same as the costs of producing powder fertilizer and the same for
both FP and USS. Both FP and USS operate at approximately the same
market levels, selling their fertilizers largely to independent
distributors.
(iii) In this case, the controlled participants' basis for
measuring RAB shares is the most reliable.
Example 7. The facts are the same as in Example 6, except that
FP distributes its fertilizers directly while USS sells to
independent distributors. In this case, sales of USS and FP are not
the most reliable basis for measuring RAB shares unless adjustments
are made to account for the difference in market levels at which the
sales occur.
Example 8. Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a CSA to develop materials that will be used to train all new
entry-level employees. FP and USS determine that the new materials
will save approximately ten hours of training time per employee.
Because their entry-level employees are paid on differing wage
scales, FP and USS decide that they should not measure benefits
based on the number of entry-level employees hired by each. Rather,
they measure benefits based on compensation paid to the entry-level
employees hired by each. In this case, the basis used for measuring
RAB shares is the most reliable because there is a direct
relationship between compensation paid to new entry-level employees
and costs saved by FP and USS from the use of the new training
materials.
Example 9. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and
Foreign Subsidiary 2 (FS2) enter into a CSA to develop computer
software that each will market and install on customers' computer
systems. The controlled participants measure benefits on the basis
of projected sales by USP, FS1, and FS2 of the software in their
respective geographic areas. However, FS1 plans not only to sell but
also to license the software to unrelated customers, and FS1's
licensing income (which is a percentage of the licensees' sales) is
not counted in the projected benefits. In this case, the basis used
for measuring the benefits of each controlled participant is not the
most reliable because all of the benefits received by controlled
participants are not taken into account. In order to reliably
determine RAB shares, FS1's projected benefits from licensing must
be included in the measurement on a basis that is the same as that
used to measure its own and the other controlled participants'
projected benefits from sales (for example, all controlled
participants might measure their benefits on the basis of operating
profit).
(iii) Projections used to estimate benefits--(A) In general. The
reliability of an estimate of RAB shares also depends upon the
reliability of projections used in making the estimate. Projections
required for this purpose generally include a determination of the time
period between the inception of the research and development activities
under the CSA and the receipt of benefits, a projection of the time
over which benefits will be received, and a projection of the benefits
anticipated for each year in which it is anticipated that the cost
shared intangible will generate benefits. A projection of the relevant
basis for measuring anticipated benefits may require a projection of
the factors that underlie it. For example, a projection of operating
profits may require a projection of sales, cost of sales, operating
expenses, and other factors that affect operating profits. If it is
anticipated that there will be significant variation among controlled
participants in the timing of their receipt of benefits, and
consequently benefit shares are expected to vary significantly over the
years in which benefits will be received, it normally will be necessary
to use the present value of the projected benefits to reliably
determine RAB shares. See paragraph (g)(2)(v) of this section for best
method considerations regarding discount rates used for this purpose.
If it is not anticipated that benefit shares will significantly change
over time, current annual benefit shares may provide a reliable
projection of RAB shares. This circumstance is most likely to occur
when the CSA is a long-term arrangement, the arrangement covers a wide
variety of intangibles, the composition of the cost shared intangibles
is unlikely to change, the cost shared intangibles are unlikely to
generate unusual profits, and each controlled participant's share of
the market is stable.
(B) Examples. The following examples illustrate the principles of
this paragraph (e)(2)(iii):
Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a CSA to develop a new car model. The controlled
participants plan to spend four years developing the new model and
four years producing and selling the new model. USS and FP project
total sales of $4 billion and $2 billion, respectively, over the
planned four years of exploitation of the new model. The controlled
participants determine RAB shares for each year of 66\2/3\% for USS
and 33\1/3\% for FP, based on projected total sales.
(ii) USS typically begins producing and selling new car models a
year after FP begins producing and selling new car models. In order
to reflect USS's one-year lag in introducing new car models, a more
reliable projection of each participant's RAB share would be based
on a projection of all four years of sales for each participant,
discounted to present value.
Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a CSA to develop new and improved household cleaning
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products. Both controlled participants have sold household cleaning
products for many years and have stable worldwide market shares. The
products under development are unlikely to produce unusual profits
for either controlled participant. The controlled participants
determine RAB shares on the basis of each controlled participant's
current sales of household cleaning products. In this case, the
controlled participants' RAB shares are reliably projected by
current sales of cleaning products.
Example 3. The facts are the same as in Example 2, except that
FS's market share is rapidly expanding because of the business
failure of a competitor in its geographic area. The controlled
participants' RAB shares are not reliably projected by current sales
of cleaning products. FS's benefit projections should take into
account its growth in market share.
Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a CSA to develop synthetic fertilizers and insecticides. FP and
USS share costs on the basis of each controlled participant's
current sales of fertilizers and insecticides. The market shares of
the controlled participants have been stable for fertilizers, but
FP's market share for insecticides has been expanding. The
controlled participants' projections of RAB shares are reliable with
regard to fertilizers, but not reliable with regard to insecticides;
a more reliable projection of RAB shares would take into account the
expanding market share for insecticides.
(f) Changes in participation under a CSA--(1) In general. A change
in participation under a CSA occurs when there is either a controlled
transfer of interests or a capability variation. A change in
participation requires arm's length consideration under paragraph
(a)(3)(ii) of this section, and as more fully described in this
paragraph (f).
(2) Controlled transfer of interests. A controlled transfer of
interests occurs when a participant in a CSA transfers all or part of
its interests in cost shared intangibles under the CSA in a controlled
transaction, and the transferee assumes the associated obligations
under the CSA. After the controlled transfer of interests occurs, the
CSA will still exist if at least two controlled participants still have
interests in the cost shared intangibles. In such a case, the
transferee will be treated as succeeding to the transferor's prior
history under the CSA as pertains to the transferred interests,
including the transferor's cost contributions, benefits derived, and
PCT Payments attributable to such rights or obligations. A transfer
that would otherwise constitute a controlled transfer of interests for
purposes of this paragraph (f)(2) shall not constitute a controlled
transfer of interests if it also constitutes a capability variation for
purposes of paragraph (f)(3) of this section.
(3) Capability variation. A capability variation occurs when, in a
CSA in which interests in cost shared intangibles are divided as
described in paragraph (b)(4)(iv) of this section, the controlled
participants' division of interests or their relative capabilities or
capacities to benefit from the cost shared intangibles are materially
altered. For purposes of paragraph (a)(3)(ii) of this section, a
capability variation is considered to be a controlled transfer of
interests in cost shared intangibles, in which any controlled
participant whose RAB share decreases as a result of the capability
variation is a transferor, and any controlled participant whose RAB
share thus increases is the transferee of the interests in cost shared
intangibles.
(4) Arm's length consideration for a change in participation. In
the event of a change in participation, the arm's length amount of
consideration from the transferee, under the rules of Sec. Sec. 1.482-
1 and 1.482-4 through 1.482-6 and paragraph (a)(3)(ii) of this section,
will be determined consistent with the reasonably anticipated
incremental change in the returns to the transferee and transferor
resulting from such change in participation. Such changes in returns
will themselves depend on the reasonably anticipated incremental
changes in the benefits from exploiting the cost shared intangibles,
IDCs borne, and PCT Payments (if any). However, any arm's length
consideration required under this paragraph (f)(4) with respect to a
capability variation shall be reduced as necessary to prevent
duplication of an adjustment already performed under paragraph
(i)(2)(ii)(A) of this section that resulted from the same capability
variation. If an adjustment has been performed already under this
paragraph (f)(4) with respect to a capability variation, then for
purposes of any adjustment to be performed under paragraph
(i)(2)(ii)(A) of this section, the controlled participants' projected
benefit shares referred to in paragraph (i)(2)(ii)(A) of this section
shall be considered to be the controlled participants' respective RAB
shares after the capability variation occurred.
(5) Examples. The following examples illustrate the principles of
this paragraph (f):
Example 1. X, Y, and Z are the only controlled participants in a
CSA. The CSA divides interests in cost shared intangibles on a
territorial basis as described in paragraph (b)(4)(ii) of this
section. X is assigned the territories of the Americas, Y is
assigned the territory of the UK and Australia, and Z is assigned
the rest of the world. When the CSA is formed, X has a platform
contribution T. Under the PCTs for T, Y, and Z are each obligated to
pay X royalties equal to five percent of their respective sales.
Aside from T, there are no platform contributions. Two years after
the formation of the CSA, Y transfers to Z its interest in cost
shared intangibles relating to the UK territory, and the associated
obligations, in a controlled transfer of interests described in
paragraph (f)(2) of this section. At that time the reasonably
anticipated benefits from exploiting cost shared intangibles in the
UK have a present value of $11M, the reasonably anticipated IDCs to
be borne relating to the UK territory have a present value of $3M,
and the reasonably anticipated PCT Payments to be made to X relating
to sales in the UK territory have a present value of $2M. As arm's
length consideration for the change in participation due to the
controlled transfer of interests, Z must pay Y compensation with an
anticipated present value of $11M, less $3M, less $2M, which equals
$6M.
Example 2. As in Example 2 of paragraph (b)(4)(v) of this
section, companies P and S, both members of the same controlled
group, enter into a CSA to develop product Z. P and S agree to
divide their interest in product Z based on site of manufacturing. P
will have exclusive and perpetual rights in product Z manufactured
in facilities owned by P. S will have exclusive and perpetual rights
to product Z manufactured in facilities owned by S. P and S agree
that neither will license manufacturing rights in product Z to any
related or unrelated party. Both P and S maintain books and records
that allow production at all sites to be verified. Both own
facilities that will manufacture product Z and the relative
capacities of these sites are known. All facilities are currently
operating at near capacity and are expected to continue to operate
at near capacity when product Z enters production so that it will
not be feasible to shift production between P's and S's facilities.
P and S have no plans to build new facilities and the lead time
required to plan and build a manufacturing facility precludes the
possibility that P or S will build a new facility during the period
for which sales of Product Z are expected. When the CSA is formed, P
has a platform contribution T. Under the PCT for T, S is obligated
to pay P sales-based royalties according to a certain formula. Aside
from T, there are no other platform contributions. Two years after
the formation of the CSA, owing to a change in plans not reasonably
foreseeable at the time the CSA was entered into, S acquires
additional facilities F for the manufacture of Product Z. Such
acquisition constitutes a capability variation described in
paragraph (f)(3) of this section. Under this capability variation,
S's RAB share increases from 50% to 60%. Accordingly, there is a
compensable change in participation under paragraph (f)(3) of this
section.
(g) Supplemental guidance on methods applicable to PCTs--(1) In
general. This paragraph (g) provides supplemental guidance on applying
the methods listed in this paragraph (g)(1) for purposes of evaluating
the arm's length amount charged in a PCT. Each method will yield a
value for the
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compensation obligation of each PCT Payor consistent with the product
of the combined pre-tax value to all controlled participants of the
platform contribution that is the subject of the PCT and the PCT
Payor's RAB share. The methods are--
(i) The comparable uncontrolled transaction method described in
Sec. 1.482-4(c), or the comparable uncontrolled services price method
described in Sec. 1.482-9T(c), as further described in paragraph
(g)(3) of this section;
(ii) The income method, described in paragraph (g)(4) of this
section;
(iii) The acquisition price method, described in paragraph (g)(5)
of this section;
(iv) The market capitalization method, described in paragraph
(g)(6) of this section;
(v) The residual profit split method, described in paragraph (g)(7)
of this section; and
(vi) Unspecified methods, described in paragraph (g)(8) of this
section.
(2) Best method analysis applicable for evaluation of a PCT
pursuant to a CSA--(i) In general. Each method must be applied in
accordance with the provisions of Sec. 1.482-1, including the best
method rule of Sec. 1.482-1(c), the comparability analysis of Sec.
1.482-1(d), and the arm's length range of Sec. 1.482-1(e), except as
those provisions are modified in this paragraph (g).
(ii) Consistency with upfront contractual terms and risk
allocation--the investor model--(A) In general. Although all of the
factors entering into a best method analysis described in Sec. 1.482-
1(c) and (d) must be considered, specific factors may be particularly
relevant in the context of a CSA. In particular, the relative
reliability of an application of any method depends on the degree of
consistency of the analysis with the applicable contractual terms and
allocation of risk under the CSA and this section among the controlled
participants as of the date of the PCT, unless a change in such terms
or allocation has been made in return for arm's length consideration.
In this regard, a CSA involves an upfront division of the risks as to
both reasonably anticipated obligations and reasonably anticipated
benefits over the reasonably anticipated term of the CSA Activity.
Accordingly, the relative reliability of an application of a method
also depends on the degree of consistency of the analysis with the
assumption that, as of the date of the PCT, each controlled
participant's aggregate net investment in the CSA Activity
(attributable to platform contributions, operating contributions, as
such term is defined in paragraph (j)(1)(i) of this section, operating
cost contributions, as such term is defined in paragraph (j)(1)(i) of
this section, and cost contributions) is reasonably anticipated to earn
a rate of return equal to the appropriate discount rate for the
controlled participant's CSA Activity over the entire period of such
CSA Activity. If the cost shared intangibles themselves are reasonably
anticipated to contribute to developing other intangibles, then the
period described in the preceding sentence includes the period,
reasonably anticipated as of the date of the PCT, of developing and
exploiting such indirectly benefited intangibles.
(B) Example. The following example illustrates the principles of
this paragraph (g)(2)(ii):
Example. (i) P, a U.S. corporation, has developed a software
program, DEF, which applies certain algorithms to reconstruct
complete DNA sequences from partially-observed DNA sequences. S is a
wholly-owned foreign subsidiary of P. On the first day of Year 1, P
and S enter into a CSA to develop a new generation of genetic tests,
GHI, based in part on the use of DEF. DEF is therefore a platform
contribution of P for which compensation is due from S pursuant to a
PCT. S makes no platform contributions to the CSA. Sales of GHI are
projected to commence two years after the inception of the CSA and
then to continue for eight more years. Based on industry experience,
P and S are confident that GHI will be replaced by a new type of
genetic testing based on technology unrelated to DEF or GHI and
that, at that point, GHI will have no further value. P and S project
that that replacement will occur at the end of Year 10.
(ii) For purposes of valuing the PCT for P's platform
contribution of DEF to the CSA, P and S apply a type of residual
profit split method that is not described in paragraph (g)(7) of
this section and which, accordingly, constitutes an unspecified
method. See paragraph (g)(7)(i) (last sentence) of this section. The
principles of this paragraph (g)(2) apply to any method for valuing
a PCT, including the unspecified method used by P and S.
(iii) Under the method employed by P and S, in each year, a
portion of the income from sales of GHI in S's territory is
allocated to certain routine contributions made by S. The residual
of the profit or loss from GHI sales in S's territory after the
routine allocation step is divided between P and S pro rata to their
capital stocks allocable to S's territory. Each controlled
participant's capital stock is computed by capitalizing, applying a
capital growth factor to, and amortizing its historical expenditures
regarding DEF allocable to S's territory (in the case of P), or its
ongoing cost contributions towards developing GHI (in the case of
S). The amortization of the capital stocks is effected on a
straight-line basis over an assumed four-year life for the relevant
expenditures. The capital stocks are grown using an assumed growth
factor that P and S consider to be appropriate.
(iv) The assumption that all expenditures amortize on a
straight-line basis over four years does not appropriately reflect
the principle that as of the date of the PCT regarding DEF, every
contribution to the development of GHI, including DEF, is reasonably
anticipated to have value throughout the entire period of
exploitation of GHI which is projected to continue through Year 10.
Under this method as applied by P and S, the share of the residual
profit in S's territory that is allocated to P as a PCT Payment from
S will decrease every year. After Year 4, P's capital stock in DEF
will necessarily be $0, so that P will receive none of the residual
profit or loss from GHI sales in S's territory after Year 4 as a PCT
Payment.
(v) As a result of this limitation of the PCT Payments to be
made by S, the anticipated return to S's aggregate investment in the
CSA, over the whole period of S's CSA Activity, is at a rate that is
significantly higher than the appropriate discount rate for S's CSA
Activity (as determined by a reliable method). This discrepancy is
not consistent with the investor model principle that S should
anticipate a rate of return to its aggregate investment in the CSA,
over the whole period of its CSA Activity, equal to the appropriate
discount rate for its CSA Activity. The inconsistency of the method
with the investor model materially lessens its reliability for
purposes of a best method analysis. See Sec. 1.482-1(c)(2)(ii)(B).
(iii) Consistency of evaluation with realistic alternatives--(A) In
general. The relative reliability of an application of a method also
depends on the degree of consistency of the analysis with the
assumption that uncontrolled taxpayers dealing at arm's length would
have evaluated the terms of the transaction, and only entered into such
transaction, if no alternative is preferable. This condition is not
met, therefore, where for any controlled participant the total
anticipated present value of its income attributable to its entering
into the CSA, as of the date of the PCT, is less than the total
anticipated present value of its income that could be achieved through
an alternative arrangement realistically available to that controlled
participant. In principle, this comparison is made on a post-tax basis
but, in many cases, a comparison made on a pre-tax basis will yield
equivalent results. See also paragraph (g)(2)(v)(B)(1) of this section
(Discount rate variation between realistic alternatives).
(B) Examples. The following examples illustrate the principles of
this paragraph (g)(2)(iii):
Example 1. (i) P, a corporation, and S, a wholly owned
subsidiary of P, enter into a CSA to develop a personal
transportation device (the product). Under the arrangement, P will
undertake all of the R&D, and manufacture and market the product in
Country X. S will make CST Payments to P for its appropriate share
of P's R&D costs, and
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manufacture and market the product in the rest of the world. P owns
existing patents and trade secrets that are reasonably anticipated
to contribute to the development of the product. Therefore the
rights in the patents and trade secrets are platform contributions
for which compensation is due from S as part of a PCT.
(ii) S's manufacturing and distribution activities under the CSA
will be routine in nature, and identical to the activities it would
undertake if it alternatively licensed the product from P.
(iii) Reasonably reliable estimates indicate that P could
develop the product without assistance from S and license the
product outside of Country X for a royalty of 20% of sales. Based on
reliable financial projections that include all future development
costs and licensing revenue that are allocable to the non-Country X
market, and using a discount rate appropriate for the riskiness of
P's role as a licensor (see paragraph (g)(2)(v) of this section),
the post-tax present value of this licensing alternative to P for
the non-Country X market (measured as of the date of the PCT) would
be $500 million. Thus, based on this realistic alternative, the
anticipated post-tax present value under the CSA to P in the non-
Country X market (measured as of the date of the PCT), taking into
account anticipated development costs allocable to the non-Country X
market, and anticipated CST Payments and PCT Payments from S, and
using a discount rate appropriate for the riskiness of P's role as a
participant in the CSA, should not be less than $500 million.
Example 2. (i) The facts are the same as in Example 1, except
that there are no reliable estimates of the value to P from the
licensing alternative to the CSA. Further, reasonably reliable
estimates indicate that an arm's length return for S's routine
manufacturing and distribution activities is a 10% mark-up on total
costs of goods sold plus operating expenses related to those
activities. Finally, the Commissioner determines that the respective
activities undertaken by P and S (other than licensing payments, CST
Payments, and PCT Payments) would be identical regardless of whether
the arrangement was undertaken as a CSA (CSA Scenario) or as a long-
term licensing arrangement (Licensing Scenario). In particular, in
both Scenarios, P would perform all research activities and S would
undertake routine manufacturing and distribution activities
associated with its territory.
(ii) P undertakes an economic analysis that derives S's cost
contributions under the CSA, based on reliable financial
projections. Based on this and further economic analysis, P
determines S's PCT Payment as a certain lump sum amount to be paid
as of the date of the PCT (Date D).
(iii) Based on reliable financial projections that include S's
cost contributions and that incorporate S's PCT Payment, as computed
by P, and using a discount rate appropriate for the riskiness of S's
role as a CSA participant (see paragraph (g)(2)(v) of this section),
the anticipated post-tax net present value to S in the CSA Scenario
(measured as of Date D) is $800 million. Further, based on these
same reliable projections (but incorporating S's licensing payments
instead of S's cost contributions and PCT Payment), and using a
discount rate appropriate for the riskiness of S's role as a long-
term licensee, the anticipated post-tax net present value to S in
the Licensing Scenario (measured as of Date D) is $100 million.
Thus, S's anticipated post-tax net present value is $700 million
greater in the CSA Scenario than in the Licensing Scenario. This
result suggests that P's anticipated post-tax present value must be
significantly less under the CSA Scenario than under the Licensing
Scenario. This means that the reliability of P's analysis as
described in paragraph (ii) of this Example 2 is reduced, since P
would not be expected to enter into a cost sharing arrangement if
its alternative of being a long-term licensor is preferable.
Example 3. (i) The facts are the same as in paragraphs (i) and
(ii) of Example 2. In addition, based on reliable financial
projections that include S's cost contributions and S's PCT Payment,
and using a discount rate appropriate for the riskiness of S's role
as a CSA participant, the anticipated post-tax net present value to
S under the CSA (measured as of the date of the PCT) is $50 million.
Also, instead of entering the CSA, S has the realistic alternative
of manufacturing and distributing product Z unrelated to the
personal transportation device, with the same anticipated 10% mark-
up on total costs that it would anticipate for its routine
activities in Example 2. Under its realistic alternative, at a
discount rate appropriate for the riskiness of S's role with respect
to product Z, S anticipates a present value of $100 million.
(ii) Because the lump sum PCT Payment made by S results in S
having a considerably lower anticipated net present value than S
could achieve through an alternative arrangement realistically
available to it, the reliability of P's calculation of the lump sum
PCT Payment is reduced.
(iv) Aggregation of transactions. The combined effect of multiple
contemporaneous transactions, consisting either of multiple PCTs, or of
one or more PCT and one or more other transactions in connection with a
CSA that are not governed by this section (such as transactions
involving cross operating contributions or make-or-sell rights), may
require evaluation in accordance with the principles of aggregation
described in Sec. 1.482-1(f)(2)(i). In such cases, it may be that the
multiple transactions are reasonably anticipated, as of the date of the
PCT(s), to be so interrelated that the method that provides the most
reliable measure of an arm's length charge is a method under this
section applied on an aggregate basis for the PCT(s) and other
transactions. A section 482 adjustment may be made by comparing the
aggregate arm's length charge so determined to the aggregate payments
actually made for the multiple transactions. In such a case, it
generally will not be necessary to allocate separately the aggregate
arm's length charge as between various PCTs or as between PCTs and such
other transactions. However, such an allocation may be necessary for
other purposes, such as applying paragraph (i)(6) (Periodic
adjustments) of this section. An aggregate determination of the arm's
length charge for multiple transactions will often yield a payment for
a controlled participant that is equal to the aggregate value of the
platform contributions and other resources, capabilities, and rights
covered by the multiple transactions multiplied by that controlled
participant's RAB share. Because RAB shares only include benefits from
cost shared intangibles, the reliability of an aggregate determination
of payments for multiple transactions may be reduced to the extent that
it includes transactions covering resources, capabilities, and rights
for which the controlled participants' expected benefit shares differ
substantially from their RAB shares.
(v) Discount rate--(A) In general. The best method analysis in
connection with certain methods or forms of payment may depend on a
rate or rates of return used to convert projected results of
transactions to present value, or to otherwise convert monetary amounts
at one or more points in time to equivalent amounts at a different
point or points in time. For this purpose, a discount rate or rates
should be used that most reliably reflect the market-correlated risks
of activities or transactions and should be applied to the best
estimates of the relevant projected results, based on all the
information potentially available at the time for which the present
value calculation is to be performed. Depending on the particular facts
and circumstances, the market-correlated risk involved and thus, the
discount rate, may differ among a company's various activities or
transactions. Normally, discount rates are most reliably determined by
reference to market information.
(B) Considerations in best method analysis of discount rate--(1)
Discount rate variation between realistic alternatives. Realistic
alternatives may involve varying risk exposure and, thus, may be more
reliably evaluated using different discount rates. In some
circumstances, a party may have less risk as a licensee of intangibles
needed in its operations, and so require a lower discount rate, than it
would have by entering into a CSA to develop such intangibles, which
may involve the party's assumption of additional risk in funding its
cost contributions to the
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IDA. Similarly, self-development of intangibles and licensing out may
be riskier for the licensor, and so require a higher discount rate,
than entering into a CSA to develop such intangibles, which would
relieve the licensor of the obligation to fund a portion of the IDCs of
the IDA.
(2) Discount rate variation between forms of payment. Certain forms
of payment may involve different risks than others. For example,
ordinarily a royalty computed on a profits base would be more volatile,
and so require a higher discount rate to discount projected payments to
present value, than a royalty computed on a sales base.
(3) Post-tax rate. In general, discount rate estimates that may be
inferred from the operations of the capital markets are post-tax
discount rates. Therefore, an analysis would in principle apply post-
tax discount rates to income net of expense items including taxes
(post-tax income). However, in certain circumstances the result of
applying a post-tax discount rate to post-tax income is equivalent to
the product of--
(i) The result of applying a post-tax discount rate to income net
of expense items other than taxes (pre-tax income); and
(ii) The difference of one minus the tax rate.
Therefore, in such circumstances, calculation of pre-tax income,
rather than post-tax income, may be sufficient. See, for example,
paragraph (g)(4)(i)(G) of this section.
(C) Example. The following example illustrates the principles of
this paragraph (g)(2)(v):
Example. (i) P and S form a CSA to develop intangible X, which
will be used in product Y. P will develop X, and S will make CST
Payments as its cost contributions. At the start of the CSA, P has a
platform contribution, for which S commits to make a PCT Payment of
5% of its sales of product Y. As part of the evaluation of whether
that PCT Payment is arm's length, the Commissioner considers whether
P had a more favorable realistic alternative (see paragraph
(g)(2)(iii) of this section). Specifically, the Commissioner
compares P's anticipated post-tax discounted present value of the
financial projections under the CSA (taking into account S's PCT
Payment of 5% of its sales of product Y) with P's anticipated post-
tax discounted present value of the financial projections under a
reasonably available alternative Licensing Arrangement that consists
of developing intangible X on its own and then licensing X to S or
to an uncontrolled party similar to S. In undertaking the analysis,
the Commissioner determines that, because it would be funding the
entire development of the intangible, P undertakes greater risks in
the licensing scenario than in the cost sharing scenario (in the
cost sharing scenario P would be funding only part of the
development of the intangible).
(ii) The Commissioner determines that, as between the two
scenarios, all of the components of P's anticipated financial flows
are identical, except for the CST and PCT Payments under the CSA,
compared to the licensing payments under the Licensing Alternative.
Accordingly, the Commissioner concludes that the differences in
market-correlated risks between the two scenarios, and therefore the
differences in discount rates between the two scenarios, relate to
the differences in these components of the financial projections.
(vi) Financial projections. The reliability of an estimate of the
value of a platform or operating contribution in connection with a PCT
will often depend upon the reliability of projections used in making
the estimate. Such projections should reflect the best estimates of the
items projected (normally reflecting a probability weighted average of
possible outcomes). Projections necessary for this purpose may include
a projection of sales, IDCs, costs of developing operating
contributions, routine operating expenses, and costs of sales. Some
method applications directly estimate projections of items attributable
to separate development and exploitation by the controlled participants
within their respective divisions. Other method applications indirectly
estimate projections of items from the perspective of the controlled
group as a whole, rather than from the perspective of a particular
participant, and then apportion the items so estimated on some assumed
basis. For example, in some applications, sales might be directly
projected by division, but worldwide projections of other items such as
operating expenses might be apportioned among divisions in the same
ratio as the divisions' respective sales. Which approach is more
reliable depends on which provides the most reliable measure of an
arm's length result, considering the competing perspectives under the
facts and circumstances in light of the completeness and accuracy of
the underlying data, the reliability of the assumptions, and the
sensitivity of the results to possible deficiencies in the data and
assumptions. For these purposes, projections that have been prepared
for non-tax purposes are generally more reliable than projections that
have been prepared solely for purposes of meeting the requirements in
this paragraph (g).
(vii) Accounting principles--(A) In general. Allocations or other
valuations done for accounting purposes may provide a useful starting
point but will not be conclusive for purposes of the best method
analysis in evaluating the arm's length charge in a PCT, particularly
where the accounting treatment of an asset is inconsistent with its
economic value.
(B) Examples. The following examples illustrate the principles of
this paragraph (g)(2)(vii):
Example 1. (i) USP, a U.S. corporation and FSub, a wholly owned
foreign subsidiary of USP, enter into a CSA in Year 1 to develop
software programs with application in the medical field. Company X
is an uncontrolled software company located in the United States
that is engaged in developing software programs that could
significantly enhance the programs being developed by USP and FSub.
Company X is still in a startup phase, so it has no currently
exploitable products or marketing intangibles and its workforce
consists of a team of software developers. Company X has negligible
liabilities and tangible property. In Year 2, USP purchases Company
X as part of an uncontrolled transaction in order to acquire its in-
process technology and workforce for purposes of the development
activities of the CSA. USP files a consolidated return that includes
Company X. For accounting purposes, $50 million of the $100 million
acquisition price is allocated to the in-process technology and
workforce, and the residual $50 million is allocated to goodwill.
(ii) The in-process technology and workforce of Company X
acquired by USP are reasonably anticipated to contribute to
developing cost shared intangibles and therefore the rights in the
in-process technology and workforce of Company X are platform
contributions for which FSub must compensate USP as part of a PCT.
In determining whether to apply the acquisition price or another
method for purposes of evaluating the arm's length charge in the
PCT, relevant best method analysis considerations must be weighed in
light of the general principles of paragraph (g)(2) of this section.
The allocation for accounting purposes raises an issue as to the
reliability of using the acquisition price method in this case
because it suggests that a significant portion of the value of
Company X's nonroutine contributions to USP's business activities is
allocable to goodwill, which is often difficult to value reliably
and which, depending on the facts and circumstances, might not be
attributable to platform contributions that are to be compensated by
PCTs. See paragraph (g)(5)(iv)(A) of this section.
(iii) This paragraph (g)(2)(vii) provides that accounting
treatment may be a starting point, but is not determinative for
purposes of assessing or applying methods to evaluate the arm's
length charge in a PCT. The facts here reveal that Company X has
nothing of economic value aside from its in-process technology and
assembled workforce. The $50 million of the acquisition price
allocated to goodwill for accounting purposes, therefore, is
economically attributable to either of, or both, the in-process
technology and the workforce. That moots the potential issue under
the acquisition price method of the reliability of valuation of
assets not to be
[[Page 366]]
compensated by PCTs, since there are no such assets. Assuming the
acquisition price method is otherwise the most reliable method, the
aggregate value of Company X's in-process technology and workforce
is the full acquisition price of $100 million (subject to possible
adjustment for differences in tax liabilities of the type described
in paragraph (g)(5)(ii) of this section). Accordingly, the aggregate
value of the arm's length PCT Payments due from FSub to USP for the
platform contributions consisting of the rights in Company X's in-
process technology and workforce will equal $100 million (subject to
adjustment as per paragraph (g)(5)(ii) of this section) multiplied
by FSub's RAB share.
Example 2. (i) The facts are the same as in Example 1, except
that Company X is a mature software business in the United States
with a successful current generation of software that it markets
under a recognized trademark, in addition to having the research
team and new generation software in process that could significantly
enhance the programs being developed under USP's and FSub's CSA. USP
continues Company X's existing business and integrates the research
team and the in-process technology into the efforts under its CSA
with FSub. For accounting purposes, the $100 million price for
acquiring Company X is allocated $50 million to existing software
and trademark, $25 million to in-process technology and research
workforce, and the residual $25 million to goodwill and going
concern value.
(ii) In this case an analysis of the facts indicates a
likelihood that, consistent with the allocation under the accounting
treatment (although not necessarily in the same amount), a
significant amount of the nonroutine contributions to the USP's
business activities consist of goodwill and going concern value
economically attributable to the existing U.S. software business
rather than to the platform contributions consisting of the rights
in the in-process technology and research workforce. In addition, an
analysis of the facts indicates that a significant amount of the
nonroutine contributions to USP's business activities consist of the
make-or-sell rights under the existing software and trademark, which
are not platform contributions and might be difficult to value.
Accordingly, further consideration must be given to the extent to
which these circumstances reduce the relative reliability of the
acquisition price method in comparison to other potentially
applicable methods for evaluating the PCT Payment.
Example 3. (i) USP, a U.S. corporation, and FSub, a wholly-owned
foreign subsidiary of USP, enter into a CSA in Year 1 to develop
Product A. Company Y is an uncontrolled corporation that owns
Technology X, which is critical to the development of Product A.
Company Y currently markets Product B, which is dependent on
Technology X. USP is solely interested in acquiring Technology X,
but is only able to do so through the acquisition of Company Y in
its entirety for $200 million in an uncontrolled transaction in Year
2. For accounting purposes, the acquisition price is allocated as
follows: $120 million to Product B and the underlying Technology X,
$30 million to trademark and other marketing intangibles, and the
residual $50 million to goodwill and going concern value. After the
acquisition of Company Y, Technology X is used to develop Product A.
No other part of Company Y is used in any manner. Immediately after
the acquisition, product B is discontinued, and, therefore, the
accompanying marketing intangibles become worthless. None of the
previous employees of Company Y is retained.
(ii) The Technology X of Company Y acquired by USP is reasonably
anticipated to contribute to developing cost shared intangibles and
is therefore a platform contribution for which FSub must compensate
USP as part of a PCT. Although for accounting purposes a significant
portion of the acquisition price of Company Y was allocated to items
other than Technology X, the facts demonstrate that USP had no
intention of using and therefore placed no economic value on any
part of Company Y other than Technology X. If USP was willing to pay
$200 million for Company Y solely for purposes of acquiring
Technology X, then assuming the acquisition price method is
otherwise the most reliable method, the value of Technology X is the
full $200 million acquisition price. Accordingly, the value of the
arm's length PCT Payment due from FSub to USP for the platform
contribution consisting of the rights in Technology X will equal the
product of $200 million (subject to adjustment as described in
paragraph (g)(5)(ii) of this section) and FSub's RAB share.
(viii) Valuations of subsequent PCTs--(A) Date of subsequent PCT.
The date of a PCT may occur subsequent to the inception of the CSA. For
example, an intangible initially developed outside the IDA may only
subsequently become a platform contribution because that later time is
the earliest date on which it is reasonably anticipated to contribute
to developing cost shared intangibles within the IDA. In such case, the
date of the PCT, and the analysis of the arm's length amount charged in
the subsequent PCT, is as of such later time.
(B) Best method analysis for subsequent PCT. In cases where PCTs
occur on different dates, the determination of the arm's length amount
charged, respectively, in the prior and subsequent PCTs must be
coordinated in a manner that provides the most reliable measure of an
arm's length result. In some circumstances, a subsequent PCT may be
reliably evaluated independently of other PCTs, as may be possible for
example, under the acquisition price method. In other circumstances,
the results of prior and subsequent PCTs may be interrelated and so a
subsequent PCT may be most reliably evaluated under the residual profit
split method of paragraph (g)(7) of this section. In those cases, for
purposes of allocating the present value of nonroutine residual
divisional profit or loss, and so determining the present value of the
subsequent PCT Payments, in accordance with paragraph (g)(7)(iii)(C) of
this section, the PCT Payor's interest in cost shared intangibles, both
already developed and in process, are treated as additional PCT Payor
operating contributions as of the date of the subsequent PCT.
(ix) Arm's length range--(A) In general. The guidance in Sec.
1.482-1(e) regarding determination of an arm's length range, as
modified by this section, applies in evaluating the arm's length amount
charged in a PCT under a transfer pricing method provided in this
section (applicable method). Section 1.482-1(e)(2)(i) provides that the
arm's length range is ordinarily determined by applying a single
pricing method selected under the best method rule to two or more
uncontrolled transactions of similar comparability and reliability
although use of more than one method may be appropriate for the
purposes described in Sec. 1.482-1(c)(2)(iii). The rules provided in
Sec. 1.482-1(e) and this section for determining an arm's length range
shall not override the rules provided in paragraph (i)(6) of this
section for periodic adjustments by the Commissioner. The provisions in
paragraphs (g)(2)(ix)(C) and (D) of this section apply only to
applicable methods that are based on two or more input parameters as
described in paragraph (g)(2)(ix)(B) of this section. For an example of
how the rules of this section for determining an arm's length range of
PCT Payments are applied, see paragraph (g)(4)(vii) of this section.
(B) Methods based on two or more input parameters. An applicable
method may determine PCT Payments based on calculations involving two
or more parameters whose values depend on the facts and circumstances
of the case (input parameters). For some input parameters (market-based
input parameters), the value is most reliably determined by reference
to data that derives from uncontrolled transactions (market data). For
example, the value of the return to a controlled participant's routine
contributions, as such term is defined in paragraph (j)(1)(i) of this
section, to the CSA Activity (which value is used as an input parameter
in the income method described in paragraph (g)(4) of this section) may
in some cases be most reliably determined by reference to the profit
level of a company with rights, resources, and capabilities comparable
to those routine contributions. See Sec. 1.482-5. As another example,
the value for the discount rate that reflects the riskiness of a
controlled participant's role in the CSA (which
[[Page 367]]
value is used as an input parameter in the income method described in
paragraph (g)(4) of this section) may in some cases be most reliably
determined by reference to the stock beta of a company whose overall
risk is comparable to the riskiness of the controlled participant's
role in the CSA.
(C) Variable input parameters. For some market-based input
parameters (variable input parameters), the parameter's value is most
reliably determined by considering two or more observations of market
data that have, or with adjustment can be brought to, a similar
reliability and comparability, as described in Sec. 1.482-1(e)(2)(ii)
(for example, profit levels or stock betas of two or more companies).
See paragraph (g)(2)(ix)(B) of this section.
(D) Determination of arm's length PCT Payment. For purposes of
applying this paragraph (g)(2)(ix), each input parameter is assigned a
single most reliable value, unless it is a variable input parameter as
described in paragraph (g)(2)(ix)(C) of this section. The determination
of the arm's length payment depends on the number of variable input
parameters.
(1) No variable input parameters. If there are no variable input
parameters, the arm's length PCT Payment is a single value determined
by using the single most reliable value determined for each input
parameter.
(2) One variable input parameter. If there is exactly one variable
input parameter, then under the applicable method, the arm's length
range of PCT Payments is the interquartile range, as described in Sec.
1.482-1(e)(2)(iii)(C), of the set of PCT Payment values calculated by
selecting--
(i) Iteratively, the value of the variable input parameter that is
based on each observation as described in paragraph (g)(2)(ix)(C) of
this section; and
(ii) The single most reliable values for each other input
parameter.
(3) More than one variable input parameter. If there are two or
more variable input parameters, then under the applicable method, the
arm's length range of PCT Payments is the interquartile range, as
described in Sec. 1.482-1(e)(2)(iii)(C), of the set of PCT Payment
values calculated iteratively using every possible combination of
permitted choices of values for the input parameters. For input
parameters other than a variable input parameter, the only such
permitted choice is the single most reliable value. For variable input
parameters, such permitted choices include any value that is--
(i) Based on one of the observations described in paragraph
(g)(2)(ix)(C) of this section; and
(ii) Within the interquartile range (as described in Sec. 1.482-
1(e)(2)(iii)(C)) of the set of all values so based.
(E) Adjustments. Section 1.482-1(e)(3), applied as modified by this
paragraph (g)(2)(ix), determines when the Commissioner may make an
adjustment to a PCT Payment due to the taxpayer's results being outside
the arm's length range. Adjustment will be to the median, as defined in
Sec. 1.482-1(e)(3). Thus, the Commissioner is not required to
establish an arm's length range prior to making an allocation under
section 482.
(x) Valuation undertaken on a pre-tax basis. PCT Payments in
general may increase the PCT Payee's tax liability and decrease the PCT
Payor's tax liability. The arm's length amount of a PCT Payment
determined under the methods in this paragraph (g) is the value of the
PCT Payment itself, without regard to such tax effects. Therefore, the
methods under this section must be applied, with suitable adjustments
if needed, to determine the PCT Payments on a pre-tax basis. See
paragraphs (g)(2)(v)(B)(3), (g)(4)(i)(G), (g)(5)(ii), and (g)(6)(ii) of
this section.
(3) Comparable uncontrolled transaction method. The comparable
uncontrolled transaction (CUT) method described in Sec. 1.482-4(c),
and the comparable uncontrolled services price (CUSP) method described
in Sec. 1.482-9T(c), may be applied to evaluate whether the amount
charged in a PCT is arm's length by reference to the amount charged in
a comparable uncontrolled transaction. Although all of the factors
entering into a best method analysis described in Sec. 1.482-1(c) and
(d) must be considered, comparability and reliability under this method
are particularly dependent on similarity of contractual terms, degree
to which allocation of risks is proportional to reasonably anticipated
benefits from exploiting the results of intangible development, similar
period of commitment as to the sharing of intangible development risks,
and similar scope, uncertainty, and profit potential of the subject
intangible development, including a similar allocation of the risks of
any existing resources, capabilities, or rights, as well as of the
risks of developing other resources, capabilities, or rights that would
be reasonably anticipated to contribute to exploitation within the
parties' divisions, that is consistent with the actual allocation of
risks between the controlled participants as provided in the CSA in
accordance with this section. When applied in the manner described in
Sec. 1.482-4(c) or 1.482-9T(c), the CUT or CUSP method will typically
yield an arm's length total value for the platform contribution that is
the subject of the PCT. That value must then be multiplied by each PCT
Payor's respective RAB share in order to determine the arm's length PCT
Payment due from each PCT Payor. The reliability of a CUT or CUSP that
yields a value for the platform contribution only in the PCT Payor's
division will be reduced to the extent that value is not consistent
with the total worldwide value of the platform contribution multiplied
by the PCT Payor's RAB share.
(4) Income method--(i) In general--(A) Equating cost sharing and
licensing alternatives. The income method evaluates whether the amount
charged in a PCT is arm's length by reference to a controlled
participant's best realistic alternative to entering into a CSA. Under
this method, the arm's length charge for a PCT Payment will be an
amount such that a controlled participant's present value, as of the
date of the PCT, of its cost sharing alternative of entering into a CSA
equals the present value of its best realistic alternative. In general,
the best realistic alternative of the PCT Payor to entering into the
CSA would be to license intangibles to be developed by an uncontrolled
licensor that undertakes the commitment to bear the entire risk of
intangible development that would otherwise have been shared under the
CSA. Similarly, the best realistic alternative of the PCT Payee to
entering into the CSA would be to undertake the commitment to bear the
entire risk of intangible development that would otherwise have been
shared under the CSA and license the resulting intangibles to an
uncontrolled licensee. Paragraphs (g)(4)(ii) through (iv) of this
section describe specific applications of the income method, but do not
exclude other possible applications of this method.
(B) Cost sharing alternative. The PCT Payor's cost sharing
alternative corresponds to the actual CSA in accordance with this
section, with the PCT Payor's obligation to make the PCT Payments to be
determined and its commitment for the duration of the IDA to bear cost
contributions.
(C) Licensing alternative. The licensing alternative is derived on
the basis of a functional and risk analysis of the cost sharing
alternative, but with a shift of the risk of cost contributions to the
licensor. Accordingly, the PCT Payor's licensing alternative consists
of entering into a license with an uncontrolled party, for a term
extending for what would be the duration of the CSA Activity, to
license the make-or-sell
[[Page 368]]
rights in to-be-developed resources, capabilities, or rights of the
licensor. Under such license, the licensor would undertake the
commitment to bear the entire risk of intangible development that would
otherwise have been shared under the CSA. Apart from any difference in
the allocation of the risks of the IDA, the licensing alternative
should assume contractual provisions with regard to non-overlapping
divisional intangible interests, and with regard to allocations of
other risks, that are consistent with the actual CSA in accordance with
this section. For example, the analysis under the licensing alternative
should assume a similar allocation of the risks of any existing
resources, capabilities, or rights, as well as of the risks of
developing other resources, capabilities, or rights that would be
reasonably anticipated to contribute to exploitation within the
parties' divisions, that is consistent with the actual allocation of
risks between the controlled participants as provided in the CSA in
accordance with this section.
(D) Only one controlled participant with nonroutine platform
contributions. This method involves only one of the controlled
participants providing nonroutine platform contributions as the PCT
Payee. For a method under which more than one controlled participant
may be a PCT Payee, see the application of the residual profit method
pursuant to paragraph (g)(7) of this section.
(E) Income method payment forms. The income method may be applied
to determine PCT Payments in any form of payment (for example, lump
sum, royalty on sales, or royalty on divisional profit). For converting
to another form of payment, see generally Sec. 1.482-7(h) (Form of
payment rules).
(F) Discount rates appropriate to cost sharing and licensing
alternatives.
(1) The present value of the cost sharing and licensing
alternatives, respectively, should be determined using the appropriate
discount rates in accordance with paragraph (g)(2)(v) of this section.
See, for example, Sec. 1.482-7(g)(2)(v)(B)(1) (Discount rate variation
between realistic alternatives). In circumstances where the market-
correlated risks as between the cost sharing and licensing alternatives
are not materially different, a reliable analysis may be possible by
using the same discount rate with respect to both alternatives.
(2) The discount rate for the cost sharing alternative will
generally depend on the form of PCT Payments assumed (for example, lump
sum, royalty on sales, royalty on divisional profit).
(G) The effect of taxation on determining the arm's length amount.
In principle, the present values of the cost sharing and licensing
alternatives should be determined by applying post-tax discount rates
to post-tax income (including the post-tax value to the controlled
participant of the PCT Payments). If such approach is adopted, then the
post-tax value of the PCT Payments must be appropriately adjusted in
order to determine the arm's length amount of the PCT Payments on a
pre-tax basis. See paragraph (g)(2)(x) of this section. In certain
circumstances, post-tax income may be derived as the product of the
result of applying a post-tax discount rate to pre-tax income, and a
factor equal to one minus the tax rate. See paragraph (g)(2)(v)(B)(3)
of this section. Moreover, to the extent that a controlled
participant's tax rate is not materially affected by whether it enters
into the cost sharing or licensing alternative (or reliable adjustments
may be made for varying tax rates), the factor (that is, one minus the
tax rate) may be cancelled from both sides of the equation of the cost
sharing and licensing alternative present values. Accordingly, in such
circumstance it is sufficient to apply post-tax discount rates to
projections of pre-tax income for the purpose of equating the cost
sharing and licensing alternatives. The specific applications of the
income method described in paragraphs (g)(4)(ii) through (iv) of this
section and the examples set forth in paragraph (g)(4)(vii) of this
section assume that such circumstance applies.
(ii) Evaluation of PCT Payor's cost sharing alternative. The
present value of the PCT Payor's cost sharing alternative is the
present value of the stream of the reasonably anticipated residuals
over the duration of the CSA Activity of divisional profits or losses,
minus operating cost contributions, minus cost contributions, minus PCT
Payments.
(iii) Evaluation of PCT Payor's licensing alternative--(A)
Evaluation based on CUT. The present value of the PCT Payor's licensing
alternative may be determined using the comparable uncontrolled
transaction method, as described in Sec. 1.482-4(c)(1) and (2). In
this case, the present value of the PCT Payor's licensing alternative
is the present value of the stream, over what would be the duration of
the CSA Activity under the cost sharing alternative, of the reasonably
anticipated residuals of the divisional profits or losses that would be
achieved under the cost sharing alternative, minus operating cost
contributions that would be made under the cost sharing alternative,
minus the licensing payments as determined under the comparable
uncontrolled transaction method.
(B) Evaluation based on CPM. The present value of the PCT Payor's
licensing alternative may be determined using the comparable profits
method, as described in Sec. 1.482-5. In this case, the present value
of the licensing alternative is determined as in paragraph
(g)(4)(iii)(A) of this section, except that the PCT Payor's licensing
payments, as defined in paragraph (j)(1)(i) of this section, are
determined to be a lump sum, as of the date of the PCT, equal to the
present value (using the discount rate appropriate for the licensing
alternative) of the stream, over what would be the duration of the CSA
Activity under the cost sharing alternative, of the reasonably
anticipated residuals of the divisional profits or losses that would be
achieved under the cost sharing alternative, minus operating cost
contributions that would be made under the cost sharing alternative,
minus market returns for routine contributions, as defined in paragraph
(j)(1)(i) of this section.
(iv) Lump sum payment form. Where the form of PCT Payment is a lump
sum as of the date of the PCT, then, based on paragraphs (g)(4)(i)
through (iii) of this section, the PCT Payment equals the difference
between--
(A) The present value, using the discount rate appropriate for the
cost sharing alternative, of the stream of the reasonably anticipated
residuals over the duration of the CSA Activity of divisional profits
or losses, minus cost contributions and operating cost contributions;
and
(B) The present value of the licensing alternative.
(v) Best method analysis considerations. (A) Whether results
derived from this method are the most reliable measure of an arm's
length result is determined using the factors described under the best
method rule in Sec. 1.482-1(c). Thus, comparability and the quality of
data, the reliability of the assumptions, and the sensitivity of the
results to possible deficiencies in the data and assumptions, must be
considered in determining whether this method provides the most
reliable measure of an arm's length result.
(B) This method will be more reliable to the extent that the
controlled participants' respective tax rates are not materially
affected by whether they enter into the cost sharing or licensing
alternative. Even if this assumption of invariant tax rates across
alternatives does not hold, this method may still be
[[Page 369]]
reliable to the extent that reliable adjustments can be made to reflect
the variation in tax rates.
(C) If the licensing alternative is evaluated using the comparable
uncontrolled transactions method, as described in paragraph
(g)(4)(iii)(A) of this section, any additional comparability and
reliability considerations stated in Sec. 1.482-4(c)(2) may apply.
(D) If the licensing alternative is evaluated using the comparable
profits method, as described in paragraph (g)(4)(iii)(B) of this
section, any additional comparability and reliability considerations
stated in Sec. 1.482-5(c) may apply.
(E) This method may be used even if the PCT Payor furnishes
significant operating contributions, or commits to assume the risk of
significant operating cost contributions, to the PCT Payor's division.
However, in such a case, any comparable uncontrolled transactions
described in paragraph (g)(4)(iii)(A) of this section, and any
comparable transactions used under Sec. 1.482-5(c) as described in
paragraphs (g)(4)(iii)(B) of this section, should be consistent with
such contributions (or reliable adjustments must be made for material
differences).
(vi) Routine platform and operating contributions. For purposes of
this paragraph (g)(4), any routine contributions that are platform or
operating contributions, the valuation and PCT Payments which are
determined and made independently of the income method, are treated
similarly to cost contributions and operating cost contributions,
respectively. Accordingly, wherever used in this paragraph, the term
``routine contributions'' shall not include routine platform or
operating contributions, and wherever the terms ``cost contributions''
and ``operating cost contributions'' appear in this paragraph, they
shall include net routine platform contributions and net routine
operating contributions, respectively. Net routine platform
contributions are the value of a controlled participant's total
reasonably anticipated routine platform contributions, plus its
reasonably anticipated PCT Payments to other controlled participants in
respect of their routine platform contributions, minus the reasonably
anticipated PCT Payments it is to receive from other controlled
participants in respect of its routine platform contributions. Net
routine operating contributions are the value of a controlled
participant's total reasonably anticipated routine operating
contributions, plus its reasonably anticipated arm's length
compensation to other controlled participants in respect of their
routine operating contributions, minus the reasonably anticipated arm's
length compensation it is to receive from other controlled participants
in respect of its routine operating contributions.
(vii) Examples. The following examples illustrate the principles of
this paragraph (g)(4):
Example 1. (i) USP, a software company, has developed version
1.0 of a new software application that it is currently marketing. In
Year 1 USP enters into a CSA with its wholly-owned foreign
subsidiary, FS, to develop future versions of the software
application. Under the CSA, USP will have the rights to exploit the
future versions in the United States, and FS will have the rights to
exploit them in the rest of the world. The future rights in version
1.0, and USP's development team, are reasonably anticipated to
contribute to the development of future versions and therefore the
rights in version 1.0 are platform contributions for which
compensation is due from FS as part of a PCT. USP does not transfer
the current exploitation rights in version 1.0 to FS. FS does not
furnish any platform contributions nor does it control any operating
intangibles at the inception of the CSA that would be relevant to
the exploitation of version 1.0 or future versions of the software.
FS agrees to make PCT payments in the form of a single lump sum
payment as of the date of the PCT.
(ii) In evaluating the CSA, the Commissioner concludes that the
cost sharing alternative represents a riskier alternative for FS
than the licensing alternative because, in cost sharing, FS will
take on the additional risks associated with CST Payments and of
making the PCT payments as a single lump sum. Consequently, the
Commissioner concludes that the appropriate discount rate to apply
in assessing the licensing alternative, based on discount rates of
comparable uncontrolled companies undertaking comparable licensing
transactions, would be 13% per year, whereas the appropriate
discount rate to apply in assessing the cost sharing alternative
would be 15% per year. FS undertakes financial projections and
anticipates making no sales during the first two years of the CSA in
its territory with sales in Years 3 through Year 8 rapidly
increasing to $200 million, $400 million, $600 million, $650
million, $700 million and $750 million, respectively. After year 8,
sales in the rest of the world are expected to remain at $750
million per annum for the foreseeable future. Costs including
routine costs and operating cost contributions are anticipated to
equal 60% of gross sales from Year 3, onwards. FS anticipates its
cost contributions will equal $50 million per year for the first
four years of the CSA and equal 10% of gross sales in each year,
thereafter. The Commissioner accepts the financial projections
undertaken by FS. The Commissioner determines that the arm's length
rate USP would have charged an uncontrolled licensee for a license
of future versions of the software had USP further developed version
1.0 on its own is 35% of the sales price, as determined under the
comparable uncontrolled transaction method in Sec. 1.482-4(c). FS
also determines that the tax rate applicable to it will be the same
in the licensing alternative as in the CSA.
(iii) Based on these projections and applying the appropriate
discount rate, the Commissioner determines that under the cost
sharing alternative, the present value of its divisional profits
(after subtracting the present value of the anticipated operating
cost contributions and cost contributions) would be $867 million
(for simplicity of calculation in this example, all financial flows
are assumed to occur at the beginning of each period). Under the
licensing alternative, the present value of the divisional profits
and losses minus the operating cost contributions would be $1.592
billion, and the present value of the licensing payments would be
$1.393 billion. Therefore, the total value of the licensing
alternative would be $199 million. In order for the present value of
the cost sharing alternative to equal the present value of the
licensing alternative, the present value of the PCT payments must
equal $668 million; the arm's length lump sum PCT payment therefore
equals $668 million.
Example 2. Arm's length range. (i) The facts are the same as in
Example 1. The licensing discount rate (13%) and the CUT licensing
rate (35%) used by the Commissioner as input parameters in applying
the income method are the median values of comparable uncontrolled
discount rates and license rates, respectively. The observations
that are in the interquartile range of the respective input
parameters are as follows:
------------------------------------------------------------------------
Comparable
uncontrolled
Observations that are within interquartile range discount rate
(percent)
------------------------------------------------------------------------
1....................................................... 11
2....................................................... 12
3 (Median).............................................. 13
4....................................................... 15
5....................................................... 17
------------------------------------------------------------------------
------------------------------------------------------------------------
Comparable
uncontrolled
Observations that are within interquartile range licensing rate
(percent)
------------------------------------------------------------------------
1....................................................... 30
2....................................................... 32
3 (Median).............................................. 35
4....................................................... 37
5....................................................... 40
------------------------------------------------------------------------
(ii) The Commissioner concludes that these estimates of the
appropriate arm's length discount rates and licensing rates are
independent of each other. Accordingly, the Commissioner undertakes
25 different applications of the income method, using each
combination of the discount rate and licensing rate parameters. In
undertaking this analysis, the Commissioner assumes that the ratio
of the median discount rate for the cost sharing alternative to the
median discount rate for the licensing alternative (that is, 15% to
13%) is maintained. The results of the 25 applications of the income
method, sorted in
[[Page 370]]
ascending order of calculated PCT payment, are as follows:
----------------------------------------------------------------------------------------------------------------
Comparable
uncontrolled Comparable Comparable Calculated Interquartile
Income method application licensing uncontrolled uncontrolled lump sum PCT range of PCT
no.: discount rate CSA discount licensing rate payment payments
(percent) rate (percent) (percent)
----------------------------------------------------------------------------------------------------------------
1............................ 17 19.6 30 291
2............................ 17 19.6 32 347
3............................ 15 17.3 30 367
4............................ 17 19.6 35 431
5............................ 15 17.3 32 433
6............................ 13 15 30 469
7............................ 17 19.6 37 487 LQ = 487
8............................ 15 17.3 35 532
9............................ 12 13.8 30 535
10........................... 13 15 32 549
11........................... 17 19.6 40 571
12........................... 15 17.3 37 598
13........................... 11 12.7 30 614 Median = 614
14........................... 12 13.8 32 623
15........................... 13 15 35 668
16........................... 15 17.3 40 697
17........................... 11 12.7 32 712
18........................... 13 15 37 748
19........................... 12 13.8 35 755 UQ = 755
20........................... 12 13.8 37 844
21........................... 11 12.7 35 860
22........................... 13 15 40 867
23........................... 11 12.7 37 959
24........................... 12 13.8 40 976
25........................... 11 12.7 40 1,107
----------------------------------------------------------------------------------------------------------------
(iii) Accordingly, the Commissioner determines that a taxpayer
will not be subject to adjustment if its initial (ex ante)
determination of the PCT payment is between $487 million and $755
million. In the event that the taxpayer's determination of the
appropriate PCT payment falls outside this range, the adjustment
made by the Commissioner will ordinarily be to $614.
Example 3. (i) USP, a U.S. software company, has developed
version 1.0 of a new software application, employed to store and
retrieve complex data sets in certain types of storage media.
Version 1.0 is currently being marketed. In Year 1, USP enters into
a CSA with its wholly owned foreign subsidiary, FS, to develop
future versions of the software application. Under the CSA, USP will
have the exclusive rights to exploit the future versions in the
U.S., and FS will have the exclusive rights to exploit them in the
rest of the world. USP's rights in version 1.0, and its development
team, are reasonably anticipated to contribute to the development of
future versions of the software application and, therefore, the
rights in version 1.0 are platform contributions for which
compensation is due from FS as part of a PCT. USP also transfers the
current exploitation rights in version 1.0 to FS and the arm's
length amount of the compensation for such transfer is determined in
the aggregate with the arm's length PCT Payments in this Example 3.
FS does not furnish any platform contributions to the CSA nor does
it control any operating intangibles at the inception of the CSA
that would be relevant to the exploitation of version 1.0 or future
versions of the software. It is reasonably anticipated that FS will
have gross sales of $1000X in its territory for 5 years attributable
to its exploitation of version 1.0 and the cost shared intangibles,
after which time the software application will be rendered obsolete
and unmarketable by the obsolescence of the storage medium
technology to which it relates. FS's costs reasonably attributable
to the CSA, other than cost contributions and operating cost
contributions, are anticipated to be $250X per year. Certain
operating cost contributions that will be borne by FS are reasonably
anticipated to equal $200X per annum for 5 years. In addition, FS is
reasonably anticipated to pay cost contributions of $200X per year
as a controlled participant in the CSA.
(ii) FS concludes that its realistic alternative would be to
license software from an uncontrolled licensor that would undertake
the commitment to bear the entire risk of software development.
Applying CPM using the profit levels experienced by uncontrolled
licensees with contractual provisions and allocations of risk that
are comparable to those of FS's licensing alternative, FS determines
that it could, as a licensee, reasonably expect a (pre-tax) routine
return equal to 14% of gross sales or $140X per year for 5 years.
The remaining net revenue would be paid to the uncontrolled licensor
as a license fee of $410X per year. FS determines that the discount
rate that would be applied to determine the present value of income
and costs attributable to its participation in the licensing
alternative would be 12.5% as compared to the 15% discount rate that
would be applicable in determining the present valuable of the net
income attributable to its participation in the CSA (reflecting the
increased risk borne by FS in bearing a share of the R&D costs in
the cost sharing alternative and the fact that FS intends to pay the
PCT payment as a single lump sum). FS also determines that the tax
rate applicable to it will be the same in the licensing alternative
as in the CSA.
(iii) On these facts, the present value to FS of entering into
the cost sharing alternative equals the present value of the
divisional profits ($1,000X minus $250X) minus operating cost
contributions ($200X) minus cost contributions ($200X) minus PCT
Payments, determined over 5 years by discounting at a discount rate
of 15% (for simplicity of calculation in this example, all financial
flows are assumed to occur at the beginning of each period). Thus,
the present value of the residuals, prior to subtracting the value
of the PCT Payments, is $1349X.
(iv) On these facts, the present value to FS of entering into
the licensing alternative would be $561X determined by discounting,
over 5 years, divisional profits ($1,000X minus $250X) minus
operating cost contributions ($200X) and licensing payments ($410X)
at a discount rate of 12.5% per annum. The present value of the cost
sharing alternative must also equal $561X but equals $1349X prior to
subtracting the present value of the PCT payments. Consequently, the
PCT payments must have a present value of $788X. Thus, the arm's
length lump sum PCT payment made at the time of the PCT will equal
$788X.
(5) Acquisition price method--(i) In general. The acquisition price
method applies the comparable uncontrolled transaction method of Sec.
1.482-4(c), or the comparable uncontrolled services price method
described in Sec. 1.482-9T(c), to evaluate whether the amount charged
in a PCT, or group of PCTs, is arm's length by reference to the amount
charged (the acquisition price) for the stock or asset purchase of an
entire organization or portion thereof (the target) in an uncontrolled
transaction. The acquisition price method is
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ordinarily used where substantially all the target's nonroutine
contributions, as such term is defined in paragraph (j)(1)(i) of this
section, made to the PCT Payee's business activities are covered by a
PCT or group of PCTs.
(ii) Determination of arm's length charge. Under this method, the
arm's length charge for a PCT or group of PCTs covering resources,
capabilities, and rights of the target is equal to the adjusted
acquisition price, as divided among the controlled participants
according to their respective RAB shares. However, an additional
adjustment may be necessary to reflect the fact that PCT Payee's tax
liability attributable to the purchase from target may differ from the
tax liability attributable to the PCT Payments. See paragraph (g)(2)(x)
of this section.
(iii) Adjusted acquisition price. The adjusted acquisition price is
the acquisition price of the target increased by the value of the
target's liabilities on the date of the acquisition, other than
liabilities not assumed in the case of an asset purchase, and decreased
by the value of the target's tangible property on that date and by the
value on that date of any other resources, capabilities, and rights not
covered by a PCT or group of PCTs.
(iv) Best method analysis considerations. The comparability and
reliability considerations stated in Sec. 1.482-4(c)(2) apply.
Consistent with those considerations, the reliability of applying the
acquisition price method as a measure of the arm's length charge for
the PCT Payment normally is reduced if--
(A) A substantial portion of the target's nonroutine contributions
to the PCT Payee's business activities is not required to be covered by
a PCT or group of PCTs, and that portion of the nonroutine
contributions cannot reliably be valued;
(B) A substantial portion of the target's assets consists of
tangible property that cannot reliably be valued; or
(C) The date on which the target is acquired and the date of the
PCT are not contemporaneous.
(v) Example. The following example illustrates the principles of
this paragraph (g)(5):
Example. USP, a U.S. corporation, and its newly incorporated,
wholly-owned foreign subsidiary (FS) enter into a CSA at the start
of Year 1 to develop Group Z products. Under the CSA, USP and FS
will have the exclusive rights to exploit the Group Z products in
the U.S. and the rest of the world, respectively. At the start of
Year 2, USP acquires Company X for cash consideration worth $110
million. At this time USP's RAB share is 60% and FS's RAB share is
40%. Company X joins in the filing of a U.S. consolidated income tax
return with USP. Under paragraph (j)(2)(i) of this section, Company
X and USP are treated as one taxpayer for purposes of this section.
Accordingly, the rights in any of Company X's resources and
capabilities that are reasonably anticipated to contribute to the
development activities of the CSA will be considered platform
contributions furnished by USP. Company X's resources and
capabilities consist of its workforce, certain technology
intangibles, $15 million of tangible property and other assets and
$5 million in liabilities. The technology intangibles, as well as
Company X's workforce, are reasonably anticipated to contribute to
the development of the Group Z products under the CSA and,
therefore, the rights in the technology intangibles and the
workforce are platform contributions for which FS must make a PCT
Payment to USP. None of Company X's existing intangible assets or
any of its workforce are anticipated to contribute to activities
outside the CSA. For purposes of this example, it is assumed that no
additional adjustment on account of tax liabilities (as described in
paragraph (g)(5)(ii) of this section) is needed. Applying the
acquisition price method, the value of USP's platform contributions
is the adjusted acquisition price of $100 million ($110 million
acquisition price plus $5 million liabilities less $15 million
tangible property and other assets). FS must make a PCT Payment to
USP for these platform contributions with a reasonably anticipated
present value of $40 million, which is the product of $100 million
(the value of the platform contributions) and 40% (FS's RAB share at
the time of the PCT).
(6) Market capitalization method--(i) In general. The market
capitalization method applies the comparable uncontrolled transaction
method of Sec. 1.482-4(c), or the comparable uncontrolled services
price method described in Sec. 1.482-9T(c), to evaluate whether the
amount charged in a PCT, or group of PCTs, is arm's length by reference
to the average market capitalization of a controlled participant (PCT
Payee) whose stock is regularly traded on an established securities
market. The market capitalization method is ordinarily used where
substantially all of the PCT Payee's nonroutine contributions to the
PCT Payee's business are covered by a PCT or group of PCTs.
(ii) Determination of arm's length charge. Under the market
capitalization method, the arm's length charge for a PCT or group of
PCTs covering resources, capabilities, and rights of the PCT Payee is
equal to the adjusted average market capitalization, as divided among
the controlled participants according to their respective RAB shares.
An increase to reflect the fact that a PCT Payment may increase the PCT
Payee's tax liability and decrease the PCT Payor's tax liability may be
warranted. See paragraph (g)(2)(x) of this section.
(iii) Average market capitalization. The average market
capitalization is the average of the daily market capitalizations of
the PCT Payee over a period of time beginning 60 days before the date
of the PCT and ending on the date of the PCT. The daily market
capitalization of the PCT Payee is calculated on each day its stock is
actively traded as the total number of shares outstanding multiplied by
the adjusted closing price of the stock on that day. The adjusted
closing price is the daily closing price of the stock, after
adjustments for stock-based transactions (dividends and stock splits)
and other pending corporate (combination and spin-off) restructuring
transactions for which reliable arm's length adjustments can be made.
(iv) Adjusted average market capitalization. The adjusted average
market capitalization is the average market capitalization of the PCT
Payee increased by the value of the PCT Payee's liabilities on the date
of the PCT and decreased by the value on such date of the PCT Payee's
tangible property and of any other resources, capabilities, or rights
of the PCT Payee not covered by a PCT or group of PCTs.
(v) Best method analysis considerations. The comparability and
reliability considerations stated in Sec. 1.482-4(c)(2) apply.
Consistent with those considerations, the reliability of applying the
comparable uncontrolled transaction method using the adjusted market
capitalization of a company as a measure of the arm's length charge for
the PCT Payment normally is reduced if--
(A) A substantial portion of the PCT Payee's nonroutine
contributions to its business activities is not required to be covered
by a PCT or group of PCTs, and that portion of the nonroutine
contributions cannot reliably be valued;
(B) A substantial portion of the PCT Payee's assets consists of
tangible property that cannot reliably be valued; or
(C) Facts and circumstances demonstrate the likelihood of a
material divergence between the average market capitalization of the
PCT Payee and the value of its resources, capabilities, and rights for
which reliable adjustments cannot be made.
(vi) Examples. The following examples illustrate the principles of
this paragraph (g)(6):
Example 1. (i) USP, a publicly traded U.S. company, and its
newly incorporated wholly-owned foreign subsidiary (FS) enter into a
CSA on Date 1 to develop software. At that
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time USP has in-process software but has no software ready for the
market. Under the CSA, USP and FS will have the exclusive rights to
exploit the software developed under the CSA in the United States
and the rest of the world, respectively. On Date 1, USP's RAB share
is 70% and FS's RAB share is 30%. USP's assembled team of
researchers and its in-process software are reasonably anticipated
to contribute to the development of the software under the CSA.
Therefore, the rights in the research team and in-process software
are platform contributions for which compensation is due from FS.
Further, these rights are not reasonably anticipated to contribute
to any business activity other than the CSA Activity.
(ii) On Date 1, USP had an average market capitalization of $205
million, tangible property and other assets that can be reliably
valued worth $5 million, and no liabilities. Aside from those
assets, USP had no assets other than its research team and in-
process software. Applying the market capitalization method, the
value of USP's platform contributions is $200 million ($205 million
average market capitalization of USP less $5 million of tangible
property and other assets). The arm's length value of the PCT
Payments FS must make to USP for the platform contributions, before
any adjustment on account of tax liability as described in paragraph
(g)(2)(ii) of this section, is $60 million, which is the product of
$200 million (the value of the platform contributions) and 30% (FS's
RAB share on Date 1).
Example 2. Aggregation with make-or-sell rights. (i) The facts
are the same as in Example 1, except that on Date 1 USP also has
existing software ready for the market. USP separately enters into a
license agreement with FS for make-or-sell rights for all existing
software outside the United States. No marketing has occurred, and
USP has no marketing intangibles. This license of current make-or-
sell rights is a transaction governed by Sec. 1.482-4. However,
after analysis, it is determined that the arm's length PCT Payments
and the arm's length payments for the make-or-sell license may be
most reliably determined in the aggregate using the market
capitalization method, under principles described in paragraph
(g)(2)(iv) of this section, and it is further determined that those
principles are most reliably implemented by computing the aggregate
arm's length charge as the product of the aggregate value of the
existing and in-process software and FS's RAB share on Date 1.
(ii) Applying the market capitalization method, the aggregate
value of USP's platform contributions and the make-or-sell rights in
its existing software is $250 million ($255 million average market
capitalization of USP less $5 million of tangible property and other
assets). The total arm's length value of the PCT Payments and
license payments FS must make to USP for the platform contributions
and current make-or-sell rights, before any adjustment on account of
tax liability as described in paragraph (g)(2)(ii) of this section,
is $75 million, which is the product of $250 million (the value of
the platform contributions and the make-or-sell rights) and 30%
(FS's RAB share on Date 1).
Example 3. Reduced reliability. The facts are the same as in
Example 1 except that USP also has significant nonroutine assets
that will be used solely in a nascent business division that is
unrelated to the subject of the CSA and that cannot themselves be
reliably valued. Those nonroutine contributions are not platform
contributions and accordingly are not required to be covered by a
PCT. The reliability of using the market capitalization method to
determine the value of USP's platform contributions to the CSA is
significantly reduced in this case because that method would require
adjusting USP's average market capitalization to account for the
significant nonroutine contributions that are not required to be
covered by a PCT.
(7) Residual profit split method--(i) In general. The residual
profit split method evaluates whether the allocation of combined
operating profit or loss attributable to one or more platform
contributions subject to a PCT is arm's length by reference to the
relative value of each controlled participant's contribution to that
combined operating profit or loss. The combined operating profit or
loss must be derived from the most narrowly identifiable business
activity (relevant business activity) of the controlled participants
for which data are available that include the CSA Activity. The
residual profit split method may not be used where only one controlled
participant makes significant nonroutine contributions (including
platform or operating contributions) to the CSA Activity. The
provisions of Sec. 1.482-6 shall apply to CSAs only to the extent
provided and as modified in this paragraph (g)(7). Any other
application to a CSA of a residual profit method not described in
paragraphs (g)(7)(ii) and (iii) will constitute an unspecified method
for purposes of sections 482 and 6662(e) and the regulations under
those sections.
(ii) Appropriate share of profits and losses. The relative value of
each controlled participant's contribution to the success of the
relevant business activity must be determined in a manner that reflects
the functions performed, risks assumed, and resources employed by each
participant in the relevant business activity, consistent with the best
method analysis described in Sec. 1.482-1(c) and (d). Such an
allocation is intended to correspond to the division of profit or loss
that would result from an arrangement between uncontrolled taxpayers,
each performing functions similar to those of the various controlled
participants engaged in the relevant business activity. The profit
allocated to any particular controlled participant is not necessarily
limited to the total operating profit of the group from the relevant
business activity. For example, in a given year, one controlled
participant may earn a profit while another controlled participant
incurs a loss. In addition, it may not be assumed that the combined
operating profit or loss from the relevant business activity should be
shared equally, or in any other arbitrary proportion.
(iii) Profit split--(A) In general. Under the residual profit split
method, the present value of each controlled participant's residual
divisional profit or loss attributable to nonroutine contributions
(nonroutine residual divisional profit or loss) is allocated between
the controlled participants that each furnish significant nonroutine
contributions (including platform or operating contributions) to the
relevant business activity in that division.
(B) Determine nonroutine residual divisional profit or loss. The
present value of each controlled participant's nonroutine residual
divisional profit or loss must be determined to reflect the most
reliable measure of an arm's length result. The present value of
nonroutine residual divisional profit or loss equals the present value
of the stream of the reasonably anticipated residuals over the duration
of the CSA Activity of divisional profit or loss, minus market returns
for routine contributions, minus operating cost contributions, minus
cost contributions, using a discount rate appropriate to such residuals
in accordance with paragraph (g)(2)(v) of this section.
(C) Allocate nonroutine residual divisional profit or loss--(1) In
general. The present value of nonroutine residual divisional profit or
loss in each controlled participant's division must be allocated among
all of the controlled participants based upon the relative values,
determined as of the date of the PCTs, of the PCT Payor's as compared
to the PCT Payee's nonroutine contributions to the PCT Payor's
division. For this purpose, the PCT Payor's nonroutine contribution
consists of the sum of the PCT Payor's nonroutine operating
contributions and the PCT Payor's RAB share of the PCT Payor's
nonroutine platform contributions. For this purpose, the PCT Payee's
nonroutine contribution consists of the PCT Payor's RAB share of the
PCT Payee's nonroutine platform contributions.
(2) Relative value determination. The relative values of the
controlled participants' nonroutine contributions must be determined so
as to reflect the most reliable measure of an arm's length result.
Relative values may be measured by external market benchmarks that
reflect the fair market value of such nonroutine contributions.
Alternatively, the relative value of nonroutine
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contributions may be estimated by the capitalized cost of developing
the nonroutine contributions and updates, as appropriately grown or
discounted so that all contributions may be valued on a comparable
dollar basis as of the same date. If the nonroutine contributions by a
controlled participant are also used in other business activities (such
as the exploitation of make-or-sell rights described in paragraph
(c)(4) of this section), an allocation of the value of the nonroutine
contributions must be made on a reasonable basis among all the business
activities in which they are used in proportion to the relative
economic value that the relevant business activity and such other
business activities are anticipated to derive over time as the result
of such nonroutine contributions.
(3) Determination of PCT Payments. Any amount of the present value
of a controlled participant's nonroutine residual divisional profit or
loss that is allocated to another controlled participant represents the
present value of the PCT Payments due to that other controlled
participant for its platform contributions to the relevant business
activity in the relevant division. For purposes of paragraph (j)(3)(ii)
of this section, the present value of a PCT Payor's PCT Payments under
this paragraph shall be deemed reduced to the extent of the present
value of any PCT Payments owed to it from other controlled participants
under this paragraph (g)(7). The resulting remainder may be converted
to a fixed or contingent form of payment in accordance with paragraph
(h) (Form of payment rules) of this section.
(4) Routine platform and operating contributions. For purposes of
this paragraph (g)(7), any routine platform or operating contributions,
the valuation and PCT Payments for which are determined and made
independently of the residual profit split method, are treated
similarly to cost contributions and operating cost contributions,
respectively. Accordingly, wherever used in this paragraph (g)(7), the
term ``routine contributions'' shall not include routine platform or
operating contributions, and wherever the terms ``cost contributions''
and ``operating cost contributions'' appear in this paragraph (g)(7),
they shall include net routine platform contributions and net routine
operating contributions, respectively, as defined in paragraph
(g)(4)(vi) of this section.
(iv) Best method analysis considerations--(A) In general. Whether
results derived from this method are the most reliable measure of the
arm's length result is determined using the factors described under the
best method rule in Sec. 1.482-1(c). Thus, comparability and quality
of data, reliability of assumptions, and sensitivity of results to
possible deficiencies in the data and assumptions, must be considered
in determining whether this method provides the most reliable measure
of an arm's length result. The application of these factors to the
residual profit split in the context of the relevant business activity
of developing and exploiting cost shared intangibles is discussed in
paragraphs (g)(7)(iv)(B), (C) and (D) of this section.
(B) Comparability. The derivation of the present value of
nonroutine residual divisional profit or loss includes a carveout on
account of market returns for routine contributions. Thus, the
comparability considerations that are relevant for that purpose include
those that are relevant for the methods that are used to determine
market returns for the routine contributions.
(C) Data and assumptions. The reliability of the results derived
from the residual profit split is affected by the quality of the data
and assumptions used to apply this method. In particular, the following
factors must be considered:
(1) The reliability of the allocation of costs, income, and assets
between the relevant business activity and the controlled participants'
other activities that will affect the reliability of the determination
of the divisional profit or loss and its allocation among the
controlled participants. See Sec. 1.482-6(c)(2)(ii)(C)(1).
(2) The degree of consistency between the controlled participants
and uncontrolled taxpayers in accounting practices that materially
affect the items that determine the amount and allocation of operating
profit or loss affects the reliability of the result. See Sec. 1.482-
6(c)(2)(ii)(C)(2).
(3) The reliability of the data used and the assumptions made in
estimating the relative value of the nonroutine contributions by the
controlled participants. In particular, if capitalized costs of
development are used to estimate the relative value of nonroutine
contributions, the reliability of the results is reduced relative to
the reliability of other methods that do not require such an estimate.
This is because, in any given case, the costs of developing a
nonroutine contribution may not be related to its market value and
because the calculation of the capitalized costs of development may
require the allocation of indirect costs between the relevant business
activity and the controlled participant's other activities, which may
affect the reliability of the analysis.
(D) Other factors affecting reliability. Like the methods described
in Sec. Sec. 1.482-3 through 1.482-5 and Sec. 1.482-9T(c), the
carveout on account of market returns for routine contributions relies
exclusively on external market benchmarks. As indicated in Sec. 1.482-
1(c)(2)(i), as the degree of comparability between the controlled
participants and uncontrolled transactions increases, the relative
weight accorded the analysis under this method will increase. In
addition, to the extent the allocation of nonroutine residual
divisional profit or loss is not based on external market benchmarks,
the reliability of the analysis will be decreased in relation to an
analysis under a method that relies on market benchmarks. Finally, the
reliability of the analysis under this method may be enhanced by the
fact that all the controlled participants are evaluated under the
residual profit split. However, the reliability of the results of an
analysis based on information from all the controlled participants is
affected by the reliability of the data and the assumptions pertaining
to each controlled participant. Thus, if the data and assumptions are
significantly more reliable with respect to one of the controlled
participants than with respect to the others, a different method,
focusing solely on the results of that party, may yield more reliable
results.
(v) Examples. The following examples illustrate the principles of
this paragraph (g)(7):
Example 1. (i) USP, a U.S. electronic data storage company, has
partially developed technology for a type of extremely small compact
storage devices (nanodisks) which are expected to provide a
significant increase in data storage capacity in various types of
portable devices such as cell phone, MP3 players, laptop computers
and digital cameras. At the same time, USP's wholly-owned
subsidiary, FS, has developed significant marketing intangibles
outside the United States in the form of customer lists, ongoing
relations with various OEMs, and trademarks that are well recognized
by consumers due to a long history of marketing successful data
storage devices and other hardware used in various types of consumer
electronics. At the beginning of Year 1, USP enters into a CSA with
FS to develop nanodisk technologies for eventual commercial
exploitation. Under the CSA, USP will have the right to exploit
nanodisks in the United States, while FS will have the right to
exploit nanodisks in the rest of the world. The partially developed
nanodisk technologies owned by USP are reasonably anticipated to
contribute to the development of commercially exploitable nanodisks
and therefore the rights in the nanodisk technologies constitute
platform contributions of USP for which compensation is due under
PCTs. FS does
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not own any intangible assets that constitute platform contributions
for the CSA. Due to the fact that nanodisk technologies have yet to
be incorporated into any commercially available product, neither USP
nor FS transfers rights to make or sell current products in
conjunction with the CSA.
(ii) Because only in FS's territory do both controlled
participants make significant nonroutine contributions, USP and FS
determine that they need to determine the relative value of their
respective contributions to operating profit or loss attributable to
the CSA only in FS's territory (that is, to FS's divisional profit
or loss). FS anticipates making no nanodisk sales during the first
year of the CSA in its territory with revenues in Year 2 reaching
$200 million. Revenues through Year 5 are reasonably anticipated to
increase by 50% per year. The annual growth rate for revenues is
then expected to decline to 30% per annum in Years 6 and 7, 20% per
annum in Years 8 and 9 and 10% per annum in Year 10. Revenues are
then expected to start to decline; declining 10% in Year 11 and 5%
per annum, thereafter. The routine costs (costs other than cost
contributions, operating cost contributions, routine platform and
operating contributions, and nonroutine contributions) that are
allocable to this revenue in calculating FS's divisional profit or
loss, are anticipated to equal 45% of gross sales from Year 2,
onwards. FS undertakes routine distribution activities in its
markets that constitute routine contributions to the relevant
business activity of exploiting NanoBuild. USP and FS estimate that
the total market return on these routine contributions will amount
to 6% of the routine costs. FS anticipates that its operating cost
contributions will equal $40 million per annum for the first two
years of the CSA and $65 and $70 million in Years 3 and 4.
Thereafter, operating cost contributions are expected to equal 7% of
revenue in each year. FS expects its cost contributions to be $60
million in Year 1, rise to $100 million in Years 2 and 3, and then
decline again to $60 million. Thereafter, FS's cost contributions
are expected to equal 10% of revenues.
(iii) USP and FS determine the present value of the stream of
the reasonably anticipated residuals in FS's territory over the
duration of the CSA Activity of the divisional profit or loss
(revenues minus routine costs), minus the market returns for routine
contributions, the operating cost contributions, and the cost
contributions. USP and FS determine, based on the considerations
discussed in paragraph (g)(2)(v) of this section, that the
appropriate discount rate is 17.5% per annum (for simplicity of
calculation in this example, all financial flows are assumed to
occur at the beginning of each period). Therefore, the present value
of the nonroutine residual divisional profit is $1.319 billion.
(iv) After analysis, USP and FS determine that the relative
value of the nanodisk technologies contributed by USP to CSA (giving
effect only to its value in FS's territory) is roughly 150% of the
value of FS's marketing intangibles (which only have value in FS's
territory). Consequently, 60% of the nonroutine residual divisional
profit is attributable to USP's platform contribution. Therefore,
FS's PCT payments should have an expected present value equal to
$792 million (.6 x $1.319 billion).
Example 2. (i) USP is a U.S. automobile manufacturing company
that has completed significant research on the development of
diesel-electric hybrid engines that, if they could be successfully
manufactured, would result in providing a significant increased fuel
economy for a wide variety of motor vehicles. Successful
commercialization of the diesel-electric hybrid engine will require
the development of a new class of advanced battery that will be
light, relatively cheap to manufacture and yet capable of holding a
substantial electric charge. FS, a foreign subsidiary of USP, has
completed significant research on developing lithium-ion batteries
that appear likely to have the requisite characteristics. At the
beginning of Year 1, USP enters into a CSA with FS to further
develop diesel-electric hybrid engines and lithium-ion battery
technologies for eventual commercial exploitation. Under the CSA,
USP will have the right to exploit the diesel-electric hybrid engine
and lithium-ion battery technologies in the United States, while FS
will have the right to exploit such technologies in the rest of the
world. The partially developed diesel-electric hybrid engine and
lithium-ion battery technologies owned by USP and FS, respectively,
are reasonably anticipated to contribute to the development of
commercially exploitable automobile engines and therefore the rights
in both these technologies constitute platform contributions of USP
and of FS for which compensation is due under PCTs. At the time of
inception of the CSA, USP owns operating intangibles in the form of
self-developed marketing intangibles which have significant value in
the United States, but not in the rest of the world, and that are
relevant to exploiting the cost shared intangibles. Similarly, FS
owns self-developed marketing intangibles which have significant
value in the rest of the world, but not in the United States, and
that are relevant to exploiting the cost shared intangibles.
Although the new class of diesel-electric hybrid engine using
lithium-ion batteries is not yet ready for commercial exploitation,
components based on this technology are beginning to be incorporated
in current-generation gasoline-electric hybrid engines and the
rights to make and sell such products are transferred from USP to FS
and vice-versa in conjunction with the inception of the CSA.
(ii) USP's estimated RAB share is 66.7 percent. During Year 1,
it is anticipated that sales in USP's territory will be $1000X in
Year 1. Sales in FS's territory are anticipated to be $500X.
Thereafter, as revenue from the use of components in gasoline-
electric hybrids is supplemented by revenues from the production of
complete diesel-electric hybrid engines using lithium-ion battery
technology, anticipated sales in both territories will increase
rapidly at a rate of 50% per annum through Year 4. Anticipated sales
are then anticipated to increase at a rate of 40% per annum for
another 4 years. Sales are then anticipated to increase at a rate of
30% per annum through Year 10. Thereafter, sales are anticipated to
decrease at a rate of 5% per annum for the foreseeable future as new
automotive drivetrain technologies displace diesel-electric hybrid
engines and lithium-ion batteries. Total operating expenses
attributable to product exploitation (including operating cost
contributions) equal 40% of sales per year for both USP and FS. USP
and FS estimate that the total market return on their routine
contributions to the CSA will amount to 6% of the operating
expenses. USP is expected to bear \2/3\s of the total cost
contributions for the foreseeable future. Cost contributions are
expected to total $375X in Year 1 (of which $250X are borne by USP)
and increase at a rate of 25% per annum through Year 6. In Years 7
through 10, cost contributions are expected to increase 10% a year.
Thereafter, cost contributions are expected to decrease by 5% a year
for the foreseeable future.
(iii) USP and FS determine the present value of the stream of
the reasonably anticipated divisional profit or loss (revenues minus
operating costs), minus the market returns for routine
contributions, minus cost contributions. USP and FS determine, based
on the considerations discussed in paragraph (g)(2)(v) of this
section, that the appropriate discount rate is 12% per year.
Therefore, the present value of the nonroutine residual divisional
profit in USP's territory is $41,115X and in CFC's territory is
$20,557X (for simplicity of calculation in this example, all
financial flows are assumed to occur at the beginning of each
period).
(iv) After analysis, USP and FS determine that, in the United
States the relative value of the technologies contributed by USP and
FS to the CSA and of the operating intangibles used by USP in the
exploitation of the cost shared intangibles (reported as equaling
100 in total), equals: USP's platform contribution (59.5); FS's
platform contribution (25.5); and USP's operating intangibles (15).
Consequently, the present value of the arm's length amount of the
PCT payments that USP should pay to FS for FS's platform
contribution is $10,484X (.255 x $41,115X). Similarly, USP and FS
determine that, in the rest of the world, the relative value of the
technologies contributed by USP and FS to the CSA and of the
operating intangibles used by FS in the exploitation of the cost
shared intangibles can be divided as follows: USP's platform
contribution (63); FS's platform contribution (27); and FS's
operating intangibles (10). Consequently, the present value of the
arm's length amount of the PCT payments that FS should pay to USP
for USP's platform contribution is $12,951X (.63 x $20,557X).
Therefore, FS is required to make a net payment to USP with a
present value of $2,467X ($12,951X-10,484X).
(8) Unspecified methods. Methods not specified in paragraphs (g)(3)
through (7) of this section may be used to evaluate whether the amount
charged for a PCT is arm's length. Any method used under this paragraph
(g)(8) must be applied in accordance with the provisions of Sec.
1.482-1 and of paragraph (g)(2) of this section. Consistent with the
specified methods, an unspecified method should take into account the
[[Page 375]]
general principle that uncontrolled taxpayers evaluate the terms of a
transaction by considering the realistic alternatives to that
transaction, and only enter into a particular transaction if none of
the alternatives is preferable to it. Therefore, in establishing
whether a PCT achieved an arm's length result, an unspecified method
should provide information on the prices or profits that the controlled
participant could have realized by choosing a realistic alternative to
the CSA. See paragraph (k)(2)(ii)(J) of this section. As with any
method, an unspecified method will not be applied unless it provides
the most reliable measure of an arm's length result under the
principles of the best method rule. See Sec. 1.482-1(c) (Best method
rule). In accordance with Sec. 1.482-1(d) (Comparability), to the
extent that an unspecified method relies on internal data rather than
uncontrolled comparables, its reliability will be reduced. Similarly,
the reliability of a method will be affected by the reliability of the
data and assumptions used to apply the method, including any
projections used.
(h) Form of payment rules--(1) CST Payments. CST Payments may not
be paid in shares of stock in the payor (or stock in any member of the
controlled group that includes the controlled participants).
(2) PCT Payments--(i) In general. The consideration under a PCT for
a platform contribution may take one or a combination of both of the
following forms:
(A) Payments of a fixed amount (fixed payments), either paid in a
lump sum payment or in installment payments spread over a specified
period, with interest calculated in accordance with Sec. 1.482-2(a)
(Loans or advances).
(B) Payments contingent on the exploitation of cost shared
intangibles by the PCT Payor (contingent payments).
(ii) No PCT Payor Stock. PCT Payments may not be paid in shares of
stock in the PCT Payor (or stock in any member of the controlled group
that includes the controlled participants).
(iii) Specified form of payment--(A) In general. The form of
payment selected (subject to the rules of this paragraph (h)) for any
PCT, including, in the case of contingent payments, the contingent base
and structure of the payments as set forth in paragraph (h)(2)(iii)(B)
of this section, must be specified no later than the due date of the
applicable tax return (including extensions) for the later of the
taxable year of the PCT Payor or PCT Payee that includes the date of
that PCT.
(B) Contingent payments. In accordance with paragraph (k)(1)(iv)(A)
of this section, a provision of a written contract described in
paragraph (k)(1) of this section, or of the additional documentation
described in paragraph (k)(2) of this section, that provides for
payments for a PCT (or group of PCTs) to be contingent on the
exploitation of cost shared intangibles will be respected as consistent
with economic substance only if the allocation between the controlled
participants of the risks attendant on such form of payment is
determinable before the outcomes of such allocation that would have
materially affected the PCT pricing are known or reasonably knowable. A
contingent payment provision must clearly and unambiguously specify the
basis on which the contingent payment obligations are to be determined.
In particular, the contingent payment provision must clearly and
unambiguously specify the events that give rise to an obligation to
make PCT Payments, the royalty base (such as sales or revenues), and
the computation used to determine the PCT Payments. The royalty base
specified must be one that permits verification of its proper use by
reference to books and records maintained by the controlled
participants in the normal course of business (for example, books and
records maintained for financial accounting or business management
purposes).
(C) Examples. The following examples illustrate the principles of
this paragraph (h)(2)(iii).
Example 1. A CSA provides that PCT payments with respect to a
particular platform contribution shall be contingent payments equal
to 15% of the revenues from sales of products that incorporate cost
shared intangibles. The terms further permit (but do not require)
the controlled participants to adjust such contingent payments in
accordance with a formula set forth in the arrangement so that the
15% rate is subject to adjustment by the controlled participants at
their discretion on an after-the-fact, uncompensated basis. The
Commissioner may impute payment terms that are consistent with
economic substance with respect to the platform contribution because
the contingent payment provision does not specify the computation
used to determine the PCT Payments.
Example 2. Taxpayer, an automobile manufacturer, is a controlled
participant in a CSA that involves research and development to
perfect certain manufacturing techniques necessary to the actual
manufacture of a state-of-the-art, hybrid fuel injection system
known as DRL337. The arrangement involves the platform contribution
of a design patent covering DRL337. Pursuant to paragraph
(h)(2)(iii)(B) of this section, the CSA provides for PCT payments
with respect to the platform contribution of the patent in the form
of royalties contingent on sales of automobiles that contain the
DRL337 system. However, Taxpayer's system of book- and record-
keeping does not enable Taxpayer to track which automobile sales
involve automobiles that contain the DRL337 system. Because Taxpayer
has not complied with paragraph (h)(2)(iii)(B) of this section, the
Commissioner may impute payment terms that are consistent with
economic substance and susceptible to verification by the
Commissioner.
(iv) Conversion from fixed to contingent form of payment. With
regard to a conversion of a fixed present value to a contingent form of
payment, see paragraphs (g)(2)(v) (Discount rate) and (g)(2)(vi)
(Financial projections) of this section.
(3) Coordination of best method rule and form of payment. A method
described in paragraph (g)(1) of this section evaluates the arm's
length amount charged in a PCT in terms of a form of payment (method
payment form). For example, the method payment form for the acquisition
price method described in paragraph (g)(5) of this section, and for the
market capitalization method described in paragraph (g)(6) of this
section, is fixed payment. Applications of the income method provide
different method payment forms. See paragraphs (g)(4)(i)(E) and
(g)(4)(iv) of this section. The method payment form may not necessarily
correspond to the form of payment specified pursuant to paragraphs
(h)(2)(iii) and (k)(2)(ii)(l) of this section (specified payment form).
The determination under Sec. 1.482-1(c) of the method that provides
the most reliable measure of an arm's length result is to be made
without regard to whether the respective method payment forms under the
competing methods correspond to the specified payment form. If the
method payment form of the method determined under Sec. 1.482-1(c) to
provide the most reliable measure of an arm's length result differs
from the specified payment form, then the conversion from such method
payment form to such specified payment form will be made to the
satisfaction of the Commissioner.
(i) Allocations by the Commissioner in connection with a CSA--(1)
In general. The Commissioner may make allocations to adjust the results
of a controlled transaction in connection with a CSA so that the
results are consistent with an arm's length result, in accordance with
the provisions of this paragraph (i).
(2) CST allocations--(i) In general. The Commissioner may make
allocations to adjust the results of a CST so that the results are
consistent with an
[[Page 376]]
arm's length result, including any allocations to make each controlled
participant's IDC share, as determined under paragraph (d)(4) of this
section, equal to that participant's RAB share, as determined under
paragraph (e)(1) of this section. Such allocations may result from, for
purposes of CST determinations, adjustments to--
(A) Redetermine IDCs by adding any costs (or cost categories) that
are directly identified with, or are reasonably allocable to, the IDA,
or by removing any costs (or cost categories) that are not IDCs;
(B) Reallocate costs between the IDA and other business activities;
(C) Improve the reliability of the selection or application of the
basis used for measuring benefits for purposes of estimating a
controlled participant's RAB share;
(D) Improve the reliability of the projections used to estimate RAB
shares, including adjustments described in paragraph (i)(2)(ii) of this
section; and
(E) Allocate among the controlled participants any unallocated
interests in cost shared intangibles.
(ii) Adjustments to improve the reliability of projections used to
estimate RAB shares--(A) Unreliable projections. A significant
divergence between projected benefit shares and benefit shares adjusted
to take into account any available actual benefits to date (adjusted
benefit shares) may indicate that the projections were not reliable for
purposes of estimating RAB shares. In such a case, the Commissioner may
use adjusted benefit shares as the most reliable measure of RAB shares
and adjust IDC shares accordingly. The projected benefit shares will
not be considered unreliable, as applied in a given taxable year, based
on a divergence from adjusted benefit shares for every controlled
participant that is less than or equal to 20% of the participant's
projected benefits share. Further, the Commissioner will not make an
allocation based on such divergence if the difference is due to an
extraordinary event, beyond the control of the controlled participants,
which could not reasonably have been anticipated at the time that costs
were shared. The Commissioner generally may adjust projections of
benefits used to calculate benefit shares in accordance with the
provisions of Sec. 1.482-1. In particular, if benefits are projected
over a period of years, and the projections for initial years of the
period prove to be unreliable, this may indicate that the projections
for the remaining years of the period are also unreliable and thus
should be adjusted. For purposes of this paragraph (i)(2)(ii)(A), all
controlled participants that are not U.S. persons are treated as a
single controlled participant. Therefore, an adjustment based on an
unreliable projection of RAB shares will be made to the IDC shares of
foreign controlled participants only if there is a matching adjustment
to the IDC shares of controlled participants that are U.S. persons.
Nothing in this paragraph (i)(2)(ii)(A) prevents the Commissioner from
making an allocation if a taxpayer did not use the most reliable basis
for measuring anticipated benefits. For example, if the taxpayer
measures its anticipated benefits based on units sold, and the
Commissioner determines that another basis is more reliable for
measuring anticipated benefits, then the fact that actual units sold
were within 20% of the projected unit sales will not preclude an
allocation under this section.
(B) Foreign-to-foreign adjustments. Adjustments to IDC shares based
on an unreliable projection also may be made among foreign controlled
participants if the variation between actual and projected benefits has
the effect of substantially reducing U.S. tax.
(C) Correlative adjustments to PCTs. Correlative adjustments will
be made to any PCT Payments of a fixed amount that were determined
based on RAB shares that are subsequently adjusted on a finding that
they were based on unreliable projections. No correlative adjustments
will be made to contingent PCT Payments regardless of whether RAB
shares were used as a parameter in the valuation of those payments.
(D) Examples. The following examples illustrate the principles of
this paragraph (i)(2)(ii):
Example 1. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a CSA to develop new food products, dividing costs on the basis
of projected sales two years in the future. In Year 1, USP and FS
project that their sales in Year 3 will be equal, and they divide
costs accordingly. In Year 3, the Commissioner examines the
controlled participants' method for dividing costs. USP and FS
actually accounted for 42% and 58% of total sales, respectively. The
Commissioner agrees that sales two years in the future provide a
reliable basis for estimating benefit shares. Because the
differences between USP's and FS's adjusted and projected benefit
shares are less than 20% of their projected benefit shares, the
projection of future benefits for Year 3 is reliable.
Example 2. The facts are the same as in Example 1, except that
in Year 3 USP and FS actually accounted for 35% and 65% of total
sales, respectively. The divergence between USP's projected and
adjusted benefit shares is greater than 20% of USP's projected
benefit share and is not due to an extraordinary event beyond the
control of the controlled participants. The Commissioner concludes
that the projected benefit shares were unreliable, and uses adjusted
benefit shares as the basis for an adjustment to the cost shares
borne by USP and FS.
Example 3. U.S. Parent (USP), a U.S. corporation, and its
foreign subsidiary (FS) enter into a CSA in Year 1. They project
that they will begin to receive benefits from cost shared
intangibles in Years 4 through 6, and that USP will receive 60% of
total benefits and FS 40% of total benefits. In Years 4 through 6,
USP and FS actually receive 50% each of the total benefits. In
evaluating the reliability of the controlled participants'
projections, the Commissioner compares the adjusted benefit shares
to the projected benefit shares. Although USP's adjusted benefit
share (50%) is within 20% of its projected benefit share (60%), FS's
adjusted benefit share (50%) is not within 20% of its projected
benefit share (40%). Based on this discrepancy, the Commissioner may
conclude that the controlled participants' projections were
unreliable and may use adjusted benefit shares as the basis for an
adjustment to the cost shares borne by USP and FS.
Example 4. Three controlled taxpayers, USP, FS1, and FS2 enter
into a CSA. FS1 and FS2 are foreign. USP is a domestic corporation
that controls all the stock of FS1 and FS2. The controlled
participants project that they will share the total benefits of the
cost shared intangibles in the following percentages: USP 50%; FS1
30%; and FS2 20%. Adjusted benefit shares are as follows: USP 45%;
FS1 25%; and FS2 30%. In evaluating the reliability of the
controlled participants' projections, the Commissioner compares
these adjusted benefit shares to the projected benefit shares. For
this purpose, FS1 and FS2 are treated as a single controlled
participant. The adjusted benefit share received by USP (45%) is
within 20% of its projected benefit share (50%). In addition, the
non-U.S. controlled participant's adjusted benefit share (55%) is
also within 20% of their projected benefit share (50%). Therefore,
the Commissioner concludes that the controlled participant's
projections of future benefits were reliable, despite the fact that
FS2's adjusted benefit share (30%) is not within 20% of its
projected benefit share (20%).
Example 5. The facts are the same as in Example 4. In addition,
the Commissioner determines that FS2 has significant operating
losses and has no earnings and profits, and that FS1 is profitable
and has earnings and profits. Based on all the evidence, the
Commissioner concludes that the controlled participants arranged
that FS1 would bear a larger cost share than appropriate in order to
reduce FS1's earnings and profits and thereby reduce inclusions USP
otherwise would be deemed to have on account of FS1 under subpart F.
Pursuant to paragraph (i)(2)(ii)(B) of this section, the
Commissioner may make an adjustment solely to the cost shares borne
by FS1 and FS2 because FS2's projection of future benefits was
unreliable and the variation between adjusted and projected benefits
had the effect of substantially reducing USP's U.S. income tax
liability (on account of FS1 subpart F income).
[[Page 377]]
Example 6. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a CSA in 1996 to develop a new treatment for baldness.
USS's interest in any treatment developed is the right to produce
and sell the treatment in the U.S. market while FP retains rights to
produce and sell the treatment in the rest of the world. USS and FP
measure their anticipated benefits from the CSA based on their
respective projected future sales of the baldness treatment. The
following sales projections are used:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1......................................................... 5 10
2......................................................... 20 20
3......................................................... 30 30
4......................................................... 40 40
5......................................................... 40 40
6......................................................... 40 40
7......................................................... 40 40
8......................................................... 20 20
9......................................................... 10 10
10........................................................ 5 5
------------------------------------------------------------------------
(B) In Year 1, the first year of sales, USS is projected to have
lower sales than FP due to lags in U.S. regulatory approval for the
baldness treatment. In each subsequent year, USS and FP are
projected to have equal sales. Sales are projected to build over the
first three years of the period, level off for several years, and
then decline over the final years of the period as new and improved
baldness treatments reach the market.
(ii) To account for USS's lag in sales in the Year 1, the
present discounted value of sales over the period is used as the
basis for measuring benefits. Based on the risk associated with this
venture, a discount rate of 10 percent is selected. The present
discounted value of projected sales is determined to be
approximately $154.4 million for USS and $158.9 million for FP. On
this basis USS and FP are projected to obtain approximately 49.3%
and 50.7% of the benefit, respectively, and the costs of developing
the baldness treatment are shared accordingly.
(iii)(A) In Year 6, the Commissioner examines the CSA. USS and
FP have obtained the following sales results through Year 5:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1......................................................... 0 17
2......................................................... 17 35
3......................................................... 25 41
4......................................................... 38 41
5......................................................... 39 41
------------------------------------------------------------------------
(B) USS's sales initially grew more slowly than projected while
FP's sales grew more quickly. In each of the first three years of
the period, the share of total sales of at least one of the parties
diverged by over 20% from its projected share of sales. However, by
Year 5 both parties' sales had leveled off at approximately their
projected values. Taking into account this leveling off of sales and
all the facts and circumstances, the Commissioner determines that it
is appropriate to use the original projections for the remaining
years of sales. Combining the actual results through Year 5 with the
projections for subsequent years, and using a discount rate of 10%,
the present discounted value of sales is approximately $141.6
million for USS and $187.3 million for FP. This result implies that
USS and FP obtain approximately 43.1% and 56.9%, respectively, of
the anticipated benefits from the baldness treatment. Because these
adjusted benefit shares are within 20% of the benefit shares
calculated based on the original sales projections, the Commissioner
determines that, based on the difference between adjusted and
projected benefit shares, the original projections were not
unreliable. No adjustment is made based on the difference between
adjusted and projected benefit shares.
Example 7. (i) The facts are the same as in Example 6, except
that the actual sales results through Year 5 are as follows:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1......................................................... 0 17
2......................................................... 17 35
3......................................................... 25 44
4......................................................... 34 54
5......................................................... 36 55
------------------------------------------------------------------------
(ii) Based on the discrepancy between the projections and the
actual results and on consideration of all the facts, the
Commissioner determines that for the remaining years the following
sales projections are more reliable than the original projections:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
6......................................................... 36 55
7......................................................... 36 55
8......................................................... 18 28
9......................................................... 9 14
10........................................................ 4.5 7
------------------------------------------------------------------------
(iii) Combining the actual results through Year 5 with the
projections for subsequent years, and using a discount rate of 10%,
the present discounted value of sales is approximately $131.2
million for USS and $229.4 million for FP. This result implies that
USS and FP obtain approximately 35.4% and 63.6%, respectively, of
the anticipated benefits from the baldness treatment. These adjusted
benefit shares diverge by greater than 20% from the benefit shares
calculated based on the original sales projections, and the
Commissioner determines that, based on the difference between
adjusted and projected benefit shares, the original projections were
unreliable. The Commissioner adjusts cost shares for each of the
taxable years under examination to conform them to the recalculated
shares of anticipated benefits.
(iii) Timing of CST allocations. If the Commissioner makes an
allocation to adjust the results of a CST, the allocation must be
reflected for tax purposes in the year in which the IDCs were incurred.
When a CST payment is owed by one controlled participant to another
controlled participant, the Commissioner may make appropriate
allocations to reflect an arm's length rate of interest for the time
value of money, consistent with the provisions of Sec. 1.482-2(a)
(Loans or advances).
(3) PCT allocations. The Commissioner may make allocations to
adjust the results of a PCT so that the results are consistent with an
arm's length result in accordance with the provisions of the applicable
sections of the regulations under section 482, as determined pursuant
to paragraph (a)(2) of this section.
(4) Allocations regarding changes in participation under a CSA. The
Commissioner may make allocations to adjust the results of any
controlled transaction described in paragraph (f) of this section if
the controlled participants do not reflect arm's length results in
relation to any such transaction.
(5) Allocations when CSTs are consistently and materially
disproportionate to RAB shares. If a controlled participant bears IDC
shares that are consistently and materially greater or lesser than its
RAB share, then the Commissioner may conclude that the economic
substance of the arrangement between the controlled participants is
inconsistent with the terms of the CSA. In such a case, the
Commissioner may disregard such terms and impute an agreement that is
consistent with the controlled participants' course of conduct, under
which a controlled participant that bore a disproportionately greater
IDC share received additional interests in the cost shared intangibles.
See Sec. 1.482-1(d)(3)(ii)(B) (Identifying contractual terms) and
Sec. 1.482-4(f)(3)(ii) (Identification of owner). Such additional
interests will consist of partial undivided interests in the other
controlled participant's interest in the cost shared intangible.
Accordingly, that controlled participant must receive arm's length
consideration from any controlled participant whose IDC share is less
than its RAB share over time, under the provisions of Sec. Sec. 1.482-
1 and 1.482-4 through 1.482-6 to provide compensation for the latter
controlled
[[Page 378]]
participants' use of such partial undivided interest.
(6) Periodic adjustments--(i) In general. Subject to the exceptions
in paragraph (i)(6)(vi) of this section, the Commissioner may make
periodic adjustments for an open taxable year (the Adjustment Year) and
for all subsequent taxable years for the duration of the CSA Activity
with respect to all PCT Payments, if the Commissioner determines that,
for a particular PCT (the Trigger PCT), a particular controlled
participant that owes or owed a PCT Payment relating to that PCT (such
controlled participant being referred to as the PCT Payor for purposes
of this paragraph (i)(6)) has realized an Actually Experienced Return
Ratio (AERR) that is outside the Periodic Return Ratio Range (PRRR).
The satisfaction of the condition stated in the preceding sentence is
referred to as a Periodic Trigger. See paragraphs (i)(6)(ii) through
(vi) of this section regarding the PRRR, the AERR, and periodic
adjustments. In determining whether to make such adjustments, the
Commissioner may consider whether the outcome as adjusted more reliably
reflects an arm's length result under all the relevant facts and
circumstances, including any information known as of the Determination
Date. The Determination Date is the date of the relevant determination
by the Commissioner. The failure of the Commissioner to determine for
an earlier taxable year that a PCT Payment was not arm's length will
not preclude the Commissioner from making a periodic adjustment for a
subsequent year. A periodic adjustment under this paragraph (i)(6) may
be made without regard to whether the taxable year of the Trigger PCT
or any other PCT remains open for statute of limitations purposes or
whether a periodic adjustment has previously been made with respect to
any PCT payment.
(ii) PRRR. Except as provided in the next sentence, the PRRR will
consist of return ratios that are not less than .667 nor more than 1.5.
Alternatively, if the controlled participants have not substantially
complied with the documentation requirements referenced in paragraph
(k) of this section, as modified, if applicable, by paragraphs (m)(2)
and (3) of this section, the PRRR will consist of return ratios that
are not less than .8 nor more than 1.25.
(iii) AERR--(A) In general. The AERR is the Present Value of Total
Profits (PVTP) divided by the Present Value of Investment (PVI). In
computing PVTP and PVI, present values are computed using the
Applicable Discount Rate (ADR), and all information available as of the
Determination Date is taken into account.
(B) PVTP. The PVTP is the present value, as of the CSA Start Date,
as defined in section (j)(1)(i) of this section, of the PCT Payor's
actually experienced divisional profits or losses from the CSA Start
Date through the end of the Adjustment Year.
(C) PVI. The PVI is the present value, as of the CSA Start Date, of
the PCT Payor's investment associated with the CSA Activity, defined as
the sum of its cost contributions and its PCT Payments, from the CSA
Start Date through the end of the Adjustment Year. For purposes of
computing the PVI, PCT Payments means all PCT Payments due from a PCT
Payor before netting against PCT Payments due from other controlled
participants pursuant to paragraph (j)(3)(ii) of this section.
(iv) ADR--(A) In general. Except as provided in paragraph
(i)(6)(iv)(B) of this section, the ADR is the discount rate pursuant to
paragraph (g)(2)(v) of this section, subject to such adjustments as the
Commissioner determines appropriate.
(B) Publicly traded companies. If the PCT Payor meets the
conditions of paragraph (i)(6)(iv)(C) of this section, the ADR is the
PCT Payor WACC as of the date of the Trigger PCT. However, if the
Commissioner determines, or the controlled participants establish to
the satisfaction of the Commissioner, that a discount rate other than
the PCT Payor WACC better reflects the degree of risk of the CSA
Activity as of such date, the ADR is such other discount rate.
(C) Publicly traded. A PCT Payor meets the conditions of this
paragraph (i)(6)(iv)(C) if--
(1) Stock of the PCT Payor is publicly traded; or
(2) Stock of the PCT Payor is not publicly traded, provided--
(i) The PCT Payor is included in a group of companies for which
consolidated financial statements are prepared; and
(ii) A publicly traded company in such group owns, directly or
indirectly, stock in PCT Payor. Stock of a company is publicly traded
within the meaning of this paragraph (i)(6)(iv)(C) if such stock is
regularly traded on an established United States securities market and
the company issues financial statements prepared in accordance with
United States generally accepted accounting principles for the taxable
year.
(D) PCT Payor WACC. The PCT Payor WACC is the WACC, as defined in
paragraph (j)(1)(i) of this section, of the PCT Payor or the publicly
traded company described in paragraph (i)(6)(iv)(C)(2)(ii) of this
section, as the case may be.
(E) Generally accepted accounting principles. For purposes of
paragraph (i)(6)(iv)(C) of this section, 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
the amounts of debt, equity, and interest expense are reflected in any
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.
(v) Determination of periodic adjustments. In the event of a
Periodic Trigger, subject to paragraph (i)(6)(vi) of this section, the
Commissioner may make periodic adjustments with respect to all PCT
Payments between all PCT Payors and PCT Payees for the Adjustment Year
and all subsequent years for the duration of the CSA Activity pursuant
to the residual profit split method as provided in paragraph (g)(7) of
this section, subject to the further modifications in this paragraph
(i)(6)(v). A periodic adjustment may be made for a particular taxable
year without regard to whether the taxable years of the Trigger PCT or
other PCTs remain open for statute of limitation purposes.
(A) In general. Periodic adjustments are determined by the
following steps:
(1) First, determine the present value, as of the date of the
Trigger PCT, of the PCT Payments under paragraph (g)(7)(iii)(C)(3) of
this section pursuant to the Adjusted RPSM as defined in paragraph
(i)(6)(v)(B) of this section (first step result).
(2) Second, convert the first step result into a stream of
contingent payments on a base of reasonably anticipated divisional
profits or losses over the entire duration of the CSA Activity, using a
level royalty rate (second step rate). See paragraph (h)(2)(iv) of this
section (Conversion from fixed to contingent form of payment). This
conversion is made based on all information known as of the
Determination Date.
(3) Third, apply the second step rate to the actual divisional
profit or loss for taxable years preceding and including the Adjustment
Year to yield a stream of contingent payments for such years, and
convert such stream to a present
[[Page 379]]
value as of the CSA Start Date under the principles of paragraph
(g)(2)(v) of this section (third step result). For this purpose, the
second step rate applied to a loss for a particular year will yield a
negative contingent payment for that year.
(4) Fourth, convert any actual PCT Payments up through the
Adjustment Year to a present value as of the CSA Start Date under the
principles of paragraph (g)(2)(v) of this section. Then subtract such
amount from the third step result. Determine the nominal amount in the
Adjustment Year that would have a present value as of the CSA Start
Date equal to the present value determined in the previous sentence to
determine the periodic adjustment in the Adjustment Year.
(5) Fifth, apply the second step rate to the actual divisional
profit or loss for each taxable year after the Adjustment Year up to
and including the taxable year that includes the Determination Date to
yield a stream of contingent payments for such years. For this purpose,
the second step rate applied to a loss will yield a negative contingent
payment for that year. Then subtract from each such payment any actual
PCT Payment made for the same year to determine the periodic adjustment
for such taxable year.
(6) For each taxable year subsequent to the year that includes the
Determination Date, the periodic adjustment for such taxable year
(which is in lieu of any PCT Payment that would otherwise be payable
for that year under the taxpayer's position) equals the second step
rate applied to the actual divisional profit or loss for that year. For
this purpose, the second step rate applied to a loss for a particular
year will yield a negative contingent payment for that year.
(7) If the periodic adjustment for any taxable year is a positive
amount, then it is an additional PCT Payment owed from the PCT Payor to
the PCT Payee for such year. If the periodic adjustment for any taxable
year is a negative amount, then it is an additional PCT Payment owed by
the PCT Payee to the PCT Payor for such year.
(B) Adjusted RPSM as of Determination Date. The Adjusted RPSM is
the residual profit split method pursuant to paragraph (g)(7) of this
section applied to determine the present value, as of the date of the
Trigger PCT, of the PCT Payments under paragraph (g)(7)(iii)(C)(3) of
this section, with the following modifications.
(1) Actual results up through the Determination Date shall be
substituted for what otherwise were the projected results over such
period, as reasonably anticipated as of the date of the Trigger PCT.
(2) Projected results for the balance of the CSA Activity after the
Determination Date, as reasonably anticipated as of the Determination
Date, shall be substituted for what otherwise were the projected
results over such period, as reasonably anticipated as of the date of
the Trigger PCT.
(3) The requirement in paragraph (g)(7)(i) of this section, that at
least two controlled participants make significant nonroutine
contributions, does not apply.
(vi) Exceptions to periodic adjustments--(A) Controlled
participants establish periodic adjustment not warranted. No periodic
adjustment will be made under paragraphs (i)(6)(i) and (i)(6)(v) of
this section if the controlled participants establish to the
satisfaction of the Commissioner that all the conditions described in
one of paragraphs (i)(6)(vi)(A)(1) through (4) of this section apply
with respect to the Trigger PCT.
(1) Transactions involving the same platform contribution as in the
Trigger PCT.
(i) The same platform contribution is furnished to an uncontrolled
taxpayer under substantially the same circumstances as those of the
relevant Trigger PCT and with a similar form of payment as the Trigger
PCT;
(ii) This transaction serves as the basis for the application of
the comparable uncontrolled transaction method described in paragraph
(g)(3) of this section, in the first year and all subsequent years in
which substantial PCT Payments relating to the Trigger PCT were
required to be paid; and
(iii) The amount of those PCT Payments in that first year was arm's
length.
(2) Results not reasonably anticipated. The differential between
the AERR and the nearest bound of the PRRR is due to extraordinary
events beyond the control of the controlled participants that could not
reasonably have been anticipated as of the date of the Trigger PCT.
(3) Reduced AERR does not cause Periodic Trigger. The Periodic
Trigger would not have occurred had the PCT Payor's divisional profits
or losses used to calculate its PVTP excluded those profits or losses
attributable to the PCT Payor's routine contributions to its
exploitation of cost shared intangibles, attributable to its operating
cost contributions, and attributable to its nonroutine contributions to
the CSA Activity.
(4) Increased AERR does not cause Periodic Trigger--(i) The
Periodic Trigger would not have occurred had the divisional profits or
losses of the PCT Payor used to calculate its PVTP included its
reasonably anticipated divisional profits or losses after the
Adjustment Year from the CSA Activity, including from its routine
contributions, its operating cost contributions, and its nonroutine
contributions to that activity, and had the cost contributions and PCT
Payments of the PCT Payor used to calculate its PVI included its
reasonably anticipated cost contributions and PCT Payments after the
Adjustment Year. The reasonably anticipated amounts in the previous
sentence are determined based on all information available as of the
Determination Date.
(ii) For purposes of this paragraph (i)(6)(vi)(A)(4), the
controlled participants may, if they wish, assume that the average
yearly divisional profits or losses for all taxable years prior to and
including the Adjustment Year, in which there has been substantial
exploitation of cost shared intangibles resulting from the CSA
(exploitation years), will continue to be earned in each year over a
period of years equal to 15 minus the number of exploitation years
prior to and including the Determination Date.
(B) Circumstances in which Periodic Trigger deemed not to occur. No
Periodic Trigger will be deemed to have occurred at the times and in
the circumstances described in paragraph (i)(6)(vi)(B)(1) or (2) of
this section.
(1) 10-year period. In any year subsequent to the 10-year period
beginning with the first taxable year in which there is substantial
exploitation of cost shared intangibles resulting from the CSA, if the
AERR determined is within the PRRR for each year of such 10-year
period.
(2) 5-year period. In any year of the 5-year period beginning with
the first taxable year in which there is substantial exploitation of
cost shared intangibles resulting from the CSA, if the AERR falls below
the lower bound of the PRRR.
(vii) Examples. The following examples illustrate the rules of this
paragraph (i)(6):
Example 1. (i) At the beginning of Year 1, USP, a publicly
traded U.S. company, and FS, its wholly-owned foreign subsidiary,
enter into a CSA to develop new technology for cell phones. USP has
a platform contribution, the rights for an in-process technology
that when developed will improve the clarity of calls, for which
compensation is due from FS. FS has no platform contributions to the
CSA, no operating contributions, and no operating cost
contributions. USP and FS agree to fixed
[[Page 380]]
PCT payments of $40 million in Year 1 and $10 million per year for
Years 2 through 10. At the beginning of Year 1, the weighted average
cost of capital of the controlled group that includes USP and FS is
15%. In Year 9, the Commissioner audits Years 5 through 7 of the CSA
and considers whether any periodic adjustments should be made. USP
and FS have substantially complied with the documentation
requirements of paragraph (k) of this section.
(ii) FS experiences the results reported in the following table
from its participation in the CSA through Year 7. In the table, all
present values (PV) are reported as of the CSA Start Date, which is
the same as the date of the PCT (and reflect a 15% discount rate as
discussed in paragraph (iii) of this Example 1). Thus, in any year
the present value of the cumulative investment is PVI and of the
cumulative divisional profit or loss is PVTP. All amounts in this
table and the tables that follow are reported in millions of dollars
and cost contributions are referred to as ``CCs'' (for simplicity of
calculation in this Example 1, all financial flows are assumed to
occur at the beginning of the year).
----------------------------------------------------------------------------------------------------------------
a b c d e f g h
----------------------------------------------------------------------------------------------------------------
AERR
Non-CC PCT Investment Divisional (PVTP/
Year Sales costs CCs payments (d+e) profit or PVI) (g/
loss (b-c) f)
----------------------------------------------------------------------------------------------------------------
1...................................... 0 0 15 40 55 0
2...................................... 0 0 17 10 27 0
3...................................... 0 0 18 10 28 0
4...................................... 680 662 20 10 30 18
5...................................... 836 718 22 10 32 118
6...................................... 1,023 680 24 10 34 343
7...................................... 1,079 747 27 10 37 332
PV through Year 5...................... 925 846 69 69 138 79 .58
PV through Year 6...................... 1,434 1,184 81 74 155 250 1.62
PV through Year 7...................... 1,900 1,507 93 78 171 393 2.31
----------------------------------------------------------------------------------------------------------------
(iii) Because USP is publicly traded in the United States and is
a member of the controlled group to which FS (the PCT Payor)
belongs, for purposes of calculating the AERR for FS, the present
values of its PVTP and PVI are determined using an ADR of 15%, the
weighted average cost of capital of the controlled group. (It is
assumed that no other rate was determined or established, under
paragraph (i)(6)(iv)(B) of this section, to better reflect the
relevant degree of risk.) At a 15% discount rate, the PVTP,
calculated as of Year 1, and based on actual profits realized by FS
through Year 7 from exploiting the new cell phone technology
developed by the CSA, is $393 million. The PVI, based on FS's cost
contributions and its PCT Payments, is $171 million. The AERR for FS
is equal to its PVTP divided by its PVI, $393 million/$171 million,
or 2.31. There is a Periodic Trigger because FS's AERR of 2.31 falls
outside the PRRR of .67 to 1.5, the applicable PRRR for controlled
participants complying with the documentation requirements of this
section.
(iv) At the time of the Determination Date, it is determined
that the first Adjustment Year in which a Periodic Trigger occurred
was Year 6, when the AERR of FS was determined to be 1.62. It is
also determined that for Year 6 none of the exceptions to periodic
adjustments described in paragraph (i)(6)(vi) of this section
applies. The Commissioner exercises its discretion under paragraph
(i)(6)(i) of this section to make periodic adjustments using Year 6
as the Adjustment Year. Therefore, the arm's length PCT Payments
from FS to USP shall be determined for each taxable year using the
adjusted residual profit split method described in paragraphs
(g)(7)(v)(B) and (i)(6)(v)(B) of this section. Periodic adjustments
will be made for each year to the extent the PCT Payments actually
made by FS differ from the PCT Payment calculation under the
adjusted residual profit split method.
(v) It is determined, as of the Determination Date, that the
cost shared intangibles will be exploited through Year 10. FS's
return for routine functions (determined by the Commissioner, based
on the return for comparable routine functions undertaken by
comparable uncontrolled companies, to be 10% of non-CC costs), and
its actual and projected results, are described in the following
table.
----------------------------------------------------------------------------------------------------------------
a b c d e f g
----------------------------------------------------------------------------------------------------------------
Divisional Residual
Year Sales Non-CC profits or CCs Routine profit (d-e-
costs loss (b-c) return f)
----------------------------------------------------------------------------------------------------------------
1............................................... 0 0 0 15 0 -15
2............................................... 0 0 0 17 0 -17
3............................................... 0 0 0 18 0 -18
4............................................... 680 662 18 20 66 -68
5............................................... 836 718 118 22 72 24
6............................................... 1,023 680 343 24 68 251
7............................................... 1,079 747 332 27 75 230
8............................................... 1,138 822 316 29 82 205
9............................................... 1,200 894 306 32 89 185
10.............................................. 1.265 974 291 35 97 159
Cumulative PV through Year 10 as of CSA Start 3,080 2,385 695 124 238 332
Date...........................................
----------------------------------------------------------------------------------------------------------------
(vi) The periodic adjustments are calculated in a series of
steps set out in paragraph (i)(6)(v)(A) of this section. First, a
lump sum for the PCT Payment is determined using the adjusted
residual profit split method. Under the method, based on the
considerations discussed in paragraph (g)(2)(v) of this section, the
appropriate discount rate is 15% per year. The non-routine residual
divisional profit or loss described in paragraph (g)(7)(iii)(B) of
this section is $332 million. Further under paragraph (g)(7)(iii)(C)
of this section, the entire nonroutine residual divisional profit
constitutes the PCT Payment because only USP has nonroutine
contributions.
(vii) In step two, the first step result ($332 million) is
converted into a level royalty rate
[[Page 381]]
based on the reasonably anticipated divisional profits or losses of
the CSA Activity, the PV of which is reported in the table above
(net PV of divisional profit or loss for Years 1 through 10 is $695
million). Consequently, the step two result is a level royalty rate
of 47.8% ($332/$694) of the divisional profit in Years 1 through 10.
(viii) In step three, the Commissioner calculates the PCT
Payments due through Year 6 by applying the step two royalty rate to
the actual divisional profits for each year and then determines the
aggregate PV of these PCT Payments as of the CSA Start Date ($120
million as reported in the following table). In step four, the PCT
Payments actually made through Year 6 are similarly converted to PV
as of the CSA Start Date ($74 million) and subtracted from the
amount determined in step three ($120 million - $74 million = $46
million). That difference of $46 million, representing a net PV as
of the CSA Start Date, is then converted to a nominal amount, as of
the Adjustment Year, of equivalent present value (again using a
discount rate of 15%). That nominal amount is $93 million (not shown
in the table), and is the periodic adjustment in Year 6.
----------------------------------------------------------------------------------------------------------------
a b c d e
----------------------------------------------------------------------------------------------------------------
Nominal
royalty due Nominal
Year Divisional Royalty under payments
profit rate adjusted made
RPSM (b*c)
----------------------------------------------------------------------------------------------------------------
Year 1...................................................... 0 47.8% $0 $40
Year 2...................................................... 0 47.8 0 10
Year 3...................................................... 0 47.8 0 10
Year 4...................................................... 18 47.8 9 10
Year 5...................................................... 118 47.8 56 10
Year 6...................................................... 343 47.8 164 10
Cumulative PV as of Year 1.................................. ........... ........... 120 74
----------------------------------------------------------------------------------------------------------------
(ix) Under step five, the royalties due from FS to USP for Year
7 (the year after the Adjustment Year) through Year 9 (the year
including the Determination Date) are determined. (These
determinations are made for Years 8 and 9 after the divisional
profit for those years becomes available.) For each year, the
periodic adjustment is a PCT Payment due in addition to the $10
million PCT Payment that must otherwise be paid under the CSA as
described in paragraph (i) of this Example 1. That periodic
adjustment is calculated as the product of the step two royalty rate
and the divisional profit, minus the $10 million that was otherwise
paid for that year. The calculations are shown in the following
table:
----------------------------------------------------------------------------------------------------------------
a b c d E f
----------------------------------------------------------------------------------------------------------------
PCT
Divisional Royalty Royalty due payments Periodic
Year profit rate (b*c) otherwise adjustment
paid (d-e)
----------------------------------------------------------------------------------------------------------------
7.............................................. 332 47.8% $159 $10 $149
8.............................................. 316 47.8 151 10 141
9.............................................. 306 47.8 146 10 136
----------------------------------------------------------------------------------------------------------------
(x) Under step six, the periodic adjustment for Year 10 (the
only exploitation year after the year containing the Determination
Date) will be determined by applying the step two royalty rate to
the divisional profit. This periodic adjustment is a PCT Payment
payable from FS to USP, and is in lieu of the $10 payment otherwise
due. The calculations are shown in the following table, based on a
divisional profit of $291 million. USP and FS experienced the
following results in Year 10.
----------------------------------------------------------------------------------------------------------------
PCT payment called for
Year Divisional Royalty Royalty due under original Periodic
profit rate agreement but not made adjustment
----------------------------------------------------------------------------------------------------------------
10.................................. 291 47.8% $139 $10 (not paid)........ $139
----------------------------------------------------------------------------------------------------------------
Example 2. The facts are the same as Example 1 (i) through
(iii). At the time of the Determination Date, it is determined that
the first Adjustment Year in which a Periodic Trigger occurred was
Year 6, when the AERR of FS was determined to be 1.62. Upon further
investigation as to what may have caused the high return in FS's
market, the Commissioner learns that, in Years 4 through 6, USP's
leading competitors experienced severe, unforeseen disruptions in
their supply chains resulting in a significant increase in USP's and
FS's market share for cell phones. Further analysis determines that
without this unforeseen occurrence the Periodic Trigger would not
have occurred. Based on paragraph (i)(6)(vi)(A)(2) of this section,
the Commissioner determines to his satisfaction that no adjustments
are warranted.
(j) Definitions and special rules--(1) Definitions--(i) In general.
For purposes of this section--
------------------------------------------------------------------------
Main cross
Term Definition references
------------------------------------------------------------------------
Acquisition price........... .................... Sec. 1.482-
7T(g)(5)(i).
Adjusted acquisition price.. .................... Sec. 1.482-
7T(g)(5)(iii).
Adjusted average market .................... Sec. 1.482-
capitalization. 7T(g)(6)(iv).
Adjusted benefit shares..... .................... Sec. 1.482-
7T(i)(2)(ii)(A).
Adjusted RPSM............... .................... Sec. 1.482-
7T(i)(6)(v)(B).
[[Page 382]]
Adjustment Year............. .................... Sec. 1.482-
7T(i)(6)(i).
ADR......................... .................... Sec. 1.482-
7T(i)(6)(iv).
AERR........................ .................... Sec. 1.482-
7T(i)(6)(iii).
Applicable Method........... .................... Sec. 1.482-
7T(g)(2)(ix)(A).
Average market .................... Sec. 1.482-
capitalization. 7T(g)(6)(iii).
Benefits.................... Benefits means the Sec. 1.482-
sum of additional 7T(e)(1)(i).
revenue generated,
plus cost savings,
minus any cost
increases from
exploiting cost
shared intangibles.
Capability variation........ .................... Sec. 1.482-
7T(f)(3).
Change in participation .................... Sec. 1.482-7T(f).
under a CSA.
Consolidated group.......... .................... Sec. 1.482-
7T(j)(2)(i).
Contingent payments......... .................... Sec. 1.482-
7T(h)(2)(i)(B).
Controlled participant...... Controlled Sec. 1.482-
participant means a 7T(a)(1).
controlled
taxpayer, as
defined under Sec.
1.482-1(i)(5),
that is a party to
the contractual
agreement that
underlies the CSA,
and that reasonably
anticipates that it
will derive
benefits, as
defined in
paragraph (e)(1)(i)
of this section,
from exploiting one
or more cost shared
intangibles.
Controlled transfer of .................... Sec. 1.482-
interests. 7T(f)(2).
Cost contribution........... .................... Sec. 1.482-
7T(d)(4).
Cost shared intangible...... Cost shared Sec. 1.482-7T(b).
intangible means
any intangible,
within the meaning
of Sec. 1.482-
4(b), that is
developed by the
IDA, including any
portion of such
intangible that
reflects a platform
contribution.
Therefore, an
intangible
developed by the
IDA is a cost
shared intangible
even though the
intangible was not
always or was never
a reasonably
anticipated cost
shared intangible.
Cost sharing alternative.... .................... Sec. 1.482-
7T(g)(4)(i)(B).
Cost sharing arrangement or .................... Sec. 1.482-7T(a),
CSA. (b).
Cost sharing transactions or .................... Sec. 1.482-
CSTs. 7T(a)(1),
(b)(1)(i).
Cross operating A cross operating Sec. 1.482-
contributions. contribution is any 7T(a)(3)(iii),
resource or (g)(2)(iv).
capability or
right, other than a
platform
contribution, that
a controlled
participant has
developed,
maintained, or
acquired prior to
the CSA Start Date
that is reasonably
anticipated to
contribute to the
CSA Activity within
another controlled
participant's
division.
CSA Activity................ CSA Activity is the Sec. 1.482-
activity of 7T(c)(2)(i).
developing and
exploiting cost
shared intangibles.
CSA Start Date.............. The earliest date Sec. 1.482-
that any IDC 7T(i)(6)(iii)(B).
described in
paragraph (d)(1) of
this section
occurred.
CST Payments................ .................... Sec. 1.482-
7T(b)(1).
Date of PCT................. .................... Sec. 1.482-
7T(b)(3).
Determination Date.......... .................... Sec. 1.482-
7T(i)(6)(i).
Division.................... Division means the See definitions of
territory or other divisional profit
division that or loss, operating
serves as the basis contribution, and
of the division of operating cost
interests under the contribution.
CSA in the cost
shared intangibles
pursuant to Sec.
1.482-7T(b)(4).
Divisional interest......... .................... Sec. 1.482-
7T(b)(1)(iii),
(b)(4).
Divisional profit or loss... Divisional profit or Sec. 1.482-
loss means the 7T(g)(4)(iii).
operating profit or
loss as separately
earned by each
controlled
participant in its
division from the
CSA Activity,
determined before
any expense
(including
amortization) on
account of cost
contributions,
operating cost
contributions,
routine platform
and operating
contributions,
nonroutine
contributions
(including platform
and operating
contributions), and
tax.
Fixed payments.............. .................... Sec. 1.482-
7T(h)(2)(i)(A).
IDC share................... .................... Sec. 1.482-
7T(d)(4).
Input parameters............ .................... Sec. 1.482-
7T(g)(2)(ix)(B).
Intangible development .................... Sec. 1.482-
activity or IDA. 7T(d)(1).
Intangible development costs .................... Sec. 1.482-
or IDCs. 7T(a)(1), (d)(1).
Licensing alternative....... .................... Sec. 1.482-
7T(g)(4)(i)(C).
Licensing payments.......... Licensing payments Sec. 1.482-
means payments 7T(g)(4)(iii).
pursuant to the
licensing
obligations under
the licensing
alternative.
[[Page 383]]
Make-or-sell rights......... .................... Sec. 1.482-
7T(c)(4),
(g)(2)(iv).
Market-based input parameter .................... Sec. 1.482-
7T(g)(2)(ix)(B).
Market returns for routine Market returns for Sec. 1.482-
contributions. routine 7T(g)(4), (g)(7).
contributions means
returns determined
by reference to the
returns achieved by
uncontrolled
taxpayers engaged
in activities
similar to the
relevant business
activity in the
controlled
participant's
division,
consistent with the
methods described
in Sec. Sec.
1.482-3, 1.482-4,
1.482-5, or Sec.
1.482-9T(c).
Method payment form......... .................... Sec. 1.482-
7T(h)(3).
Nonroutine contributions.... Nonroutine Sec. 1.482-7T(g).
contributions means
a controlled
participant's
contributions to
the relevant
business activities
that are not
routine
contributions.
Nonroutine
contributions
ordinarily include
both nonroutine
platform
contributions and
nonroutine
operating
contributions used
by controlled
participants in the
commercial
exploitation of
their interests in
the cost shared
intangibles (for
example, marketing
intangibles used by
a controlled
participant in its
division to sell
products that are
based on the cost
shared intangible).
Nonroutine residual .................... Sec. 1.482-
divisional profit or loss. 7T(g)(7)(iii).
Operating contributions..... An operating Sec. 1.482-
contribution is any 7T(g)(2)(ii),
resource or (g)(4)(v)(E),
capability or (g)(7)(iii)(A) &
right, other than a (C).
platform
contribution, that
a controlled
participant has
developed,
maintained, or
acquired prior to
the CSA Start Date
that is reasonably
anticipated to
contribute to the
CSA Activity within
the controlled
participant's
division.
Operating cost contributions Operating cost Sec. 1.482-
contributions means 7T(g)(2)(ii),
all costs in the (g)(4)(iii),
ordinary course of (g)(7)(iii)(B).
business on or
after the CSA Start
Date that, based on
analysis of the
facts and
circumstances, are
directly identified
with, or are
reasonably
allocable to,
developing
resources,
capabilities, or
rights (other than
reasonably
anticipated cost
shared intangibles)
that are reasonably
anticipated to
contribute to the
CSA Activity within
the controlled
participant's
division.
PCT Payee................... .................... Sec. 1.482-
7T(b)(1)(ii).
PCT Payment................. .................... Sec. 1.482-
7T(b)(1)(ii).
PCT Payor................... .................... Sec. 1.482-
7T(b)(1)(ii),
(i)(6)(i).
PCT Payor WACC.............. .................... Sec. 1.482-
7T(i)(6)(iv)(D).
Periodic adjustments........ .................... Sec. 1.482-
7T(i)(6)(i).
Periodic Trigger............ .................... Sec. 1.482-
7T(i)(6)(i).
Platform contribution .................... Sec. 1.482-
transaction or PCT. 7T(a)(2),
(b)(1)(ii).
Platform contributions...... .................... Sec. 1.482-
7T(c)(1).
Post-tax income............. .................... Sec. 1.482-
7T(g)(2)(v)(B)(3),
(g)(4)(i)(G).
Pre-tax income.............. .................... Sec. 1.482-
7T(g)(2)(v)(B)(3),
(g)(4)(i)(G).
Projected benefit shares.... .................... Sec. 1.482-
7T(i)(2)(ii)(A).
PRRR........................ .................... Sec. 1.482-
7T(i)(6)(ii).
PVI......................... .................... Sec. 1.482-
7T(i)(6)(iii)(C).
PVTP........................ .................... Sec. 1.482-
7T(i)(6)(iii)(B).
Reasonably anticipated A controlled Sec. 1.482-
benefits. participant's 7T(e)(1).
reasonably
anticipated
benefits means the
benefits that
reasonably may be
anticipated to be
derived from
exploiting cost
shared intangibles.
For purposes of
this definition,
benefits mean the
sum of additional
revenue generated,
plus cost savings,
minus any cost
increases from
exploiting cost
shared intangibles.
Reasonably anticipated .................... Sec. 1.482-
benefits or RAB shares. 7T(a)(1), (e)(1).
Reasonably anticipated cost .................... Sec. 1.482-
shared intangible. 7T(d)(1)(ii).
Relevant business activity.. .................... Sec. 1.482-
7T(g)(7)(i).
[[Page 384]]
Routine contributions....... Routine Sec. 1.482-
contributions means 7T(g)(4), (g)(7).
a controlled
participant's
contributions to
the relevant
business activities
that are of the
same or similar
kind to those made
by uncontrolled
taxpayers involved
in similar business
activities for
which it is
possible to
identify market
returns. Routine
contributions
ordinarily include
contributions of
tangible property,
services and
intangibles that
are generally owned
by uncontrolled
taxpayers engaged
in similar
activities. A
functional analysis
is required to
identify these
contributions
according to the
functions
performed, risks
assumed, and
resources employed
by each of the
controlled
participants.
Routine platform and .................... Sec. 1.482-
operating contributions, 7T(g)(4)(vi), 1.482-
and net routine platform 7(g)(7)(iii)(C)(4).
and operating contributions.
Specified payment form...... .................... Sec. 1.482-
7T(h)(3).
Stock-based compensation.... .................... Sec. 1.482-
7T(d)(3).
Stock options............... .................... Sec. 1.482-
7T(d)(3)(i).
Subsequent PCT.............. .................... Sec. 1.482-
7T(g)(2)(viii).
Target...................... .................... Sec. 1.482-
7T(g)(5)(i).
Trigger PCT................. .................... Sec. 1.482-
7T(i)(6)(i).
Variable input parameter.... .................... Sec. 1.482-
7T(g)(2)(ix)(C).
WACC........................ WACC means weighted Sec. 1.482-
average cost of 7T(i)(6)(iv)(D).
capital.
------------------------------------------------------------------------
(ii) Examples. The following examples illustrate certain
definitions in paragraph (j)(1)(i) of this section:
Example 1. Controlled participant. Foreign Parent (FP) is a
foreign corporation engaged in the extraction of a natural resource.
FP has a U.S. subsidiary (USS) to which FP sells supplies of this
resource for sale in the United States. FP enters into a CSA with
USS to develop a new machine to extract the natural resource. The
machine uses a new extraction process that will be patented in the
United States and in other countries. The CSA provides that USS will
receive the rights to exploit the machine in the extraction of the
natural resource in the United States, and FP will receive the
rights in the rest of the world. This resource does not, however,
exist in the United States. Despite the fact that USS has received
the right to exploit this process in the United States, USS is not a
controlled participant because it will not derive a benefit from
exploiting the intangible developed under the CSA.
Example 2. Controlled participants. (i) U.S. Parent (USP), one
foreign subsidiary (FS), and a second foreign subsidiary
constituting the group's research arm (R+D) enter into a CSA to
develop manufacturing intangibles for a new product line A. USP and
FS are assigned the exclusive rights to exploit the intangibles
respectively in the United States and the rest of the world, where
each presently manufactures and sells various existing product
lines. R+D is not assigned any rights to exploit the intangibles.
R+D's activity consists solely in carrying out research for the
group. It is reliably projected that the RAB shares of USP and FS
will be 66\2/3\% and 33\1/3\%, respectively, and the parties'
agreement provides that USP and FS will reimburse 66\2/3\% and 33\1/
3\%, respectively, of the IDCs incurred by R+D with respect to the
new intangible.
(ii) R+D does not qualify as a controlled participant within the
meaning of paragraph (j)(1)(i) of this section, because it will not
derive any benefits from exploiting cost shared intangibles.
Therefore, R+D is treated as a service provider for purposes of this
section and must receive arm's length consideration for the
assistance it is deemed to provide to USP and FS, under the rules of
paragraph (a)(3) of this section and Sec. Sec. 1.482-4(f)(3)(iii),
1.482-4T(f)(4), and 1.482-9T, as appropriate. Such consideration
must be treated as IDCs incurred by USP and FS in proportion to
their RAB shares (that is, 66\2/3\% and 33\1/3\%, respectively). R+D
will not be considered to bear any share of the IDCs under the
arrangement.
Example 3. Cost shared intangible, reasonably anticipated cost
shared intangible. U.S. Parent (USP) has developed and currently
exploits an antihistamine, XY, which is manufactured in tablet form.
USP enters into a CSA with its wholly-owned foreign subsidiary (FS)
to develop XYZ, a new improved version of XY that will be
manufactured as a nasal spray. Work under the CSA is fully devoted
to developing XYZ, and XYZ is developed. During the development
period, XYZ is a reasonably anticipated cost shared intangible under
the CSA. Once developed, XYZ is a cost shared intangible under the
CSA.
Example 4. Cost shared intangible. The facts are the same as in
Example 3, except that in the course of developing XYZ, the
controlled participants by accident discover ABC, a cure for disease
D. ABC is a cost shared intangible under the CSA.
Example 5. Reasonably anticipated benefits. Controlled parties A
and B enter into a cost sharing arrangement to develop product and
process intangibles for an already existing Product P. Without such
intangibles, A and B would each reasonably anticipate revenue, in
present value terms, of $100M from sales of Product P until it
became obsolete. With the intangibles, A and B each reasonably
anticipate selling the same number of units each year, but
reasonably anticipate that the price will be higher. Because the
particular product intangible is more highly regarded in A's market,
A reasonably anticipates an increase of $20M in present value
revenue from the product intangible, while B reasonably anticipates
only an increase of $10M. Further, A and B each reasonably
anticipate spending an extra $5M present value in production costs
to include the feature embodying the product intangible. Finally, A
and B each reasonably anticipate saving $2M present value in
production costs by using the process intangible. A and B reasonably
anticipate no other economic effects from exploiting the cost shared
intangibles. A's reasonably anticipated benefits from exploiting the
cost shared intangibles equal its reasonably anticipated increase in
revenue ($20M) plus its reasonably anticipated cost savings ($2M)
minus its reasonably anticipated increased costs ($5M), which equals
$17M. Similarly, B's reasonably anticipated benefits from exploiting
the cost shared intangibles equal its reasonably anticipated
increase in revenue ($10M) plus its reasonably anticipated cost
savings ($2M) minus its reasonably anticipated increased costs
($5M), which equals $7M. Thus A's reasonably anticipated benefits
are $17M and B's reasonably anticipated benefits are $7M.
(2) Special rules--(i) Consolidated group. For purposes of this
section, all members of the same consolidated group shall be treated as
one taxpayer. For these purposes, the term consolidated group means all
members of a group of controlled entities created
[[Page 385]]
or organized within a single country and subjected to an income tax by
such country on the basis of their combined income.
(ii) Trade or business. A participant that is a foreign corporation
or nonresident alien individual will not be treated as engaged in a
trade or business within the United States solely by reason of its
participation in a CSA. See generally Sec. 1.864-2(a).
(iii) Partnership. A CSA, or an arrangement to which the
Commissioner applies the rules of this section, will not be treated as
a partnership to which the rules of subchapter K of the Internal
Revenue Code apply. See Sec. 301.7701-1(c) of this chapter.
(3) Character--(i) CST Payments. CST Payments generally will be
considered the payor's costs of developing intangibles at the location
where such development is conducted. For these purposes, IDCs borne
directly by a controlled participant that are deductible are deemed to
be reduced to the extent of any CST Payments owed to it by other
controlled participants pursuant to the CSA. Each cost sharing payment
received by a payee will be treated as coming pro rata from payments
made by all payors and will be applied pro rata against the deductions
for the taxable year that the payee is allowed in connection with the
IDCs. Payments received in excess of such deductions will be treated as
in consideration for use of the land and tangible property furnished
for purposes of the CSA by the payee. For purposes of the research
credit determined under section 41, CST Payments among controlled
participants will be treated as provided for intra-group transactions
in Sec. 1.41-6(i). Any payment made or received by a taxpayer pursuant
to an arrangement that the Commissioner determines not to be a CSA will
be subject to the provisions of Sec. Sec. 1.482-1, 1.482-4 through
1.482-6 and 1.482-9T. Any payment that in substance constitutes a cost
sharing payment will be treated as such for purposes of this section,
regardless of its characterization under foreign law.
(ii) PCT Payments. A PCT Payor's payment required under paragraph
(b)(1)(ii) of this section is deemed to be reduced to the extent of any
payments owed to it under such paragraph from other controlled
participants. Each PCT Payment received by a PCT Payee will be treated
as coming pro rata out of payments made by all PCT Payors. PCT Payments
will be characterized consistently with the designation of the type of
transaction pursuant to paragraphs (c)(3) and (k)(2)(ii)(H) of this
section. Depending on such designation, such payments will be treated
as either consideration for a transfer of an interest in intangible
property or for services.
(iii) Examples. The following examples illustrate this paragraph
(j)(3):
Example 1. U.S. Parent (USP) and its wholly owned Foreign
Subsidiary (FS) form a CSA to develop a miniature widget, the Small
R. Based on RAB shares, USP agrees to bear 40% and FS to bear 60% of
the costs incurred during the term of the agreement. The principal
IDCs are operating costs incurred by FS in Country Z of 100X
annually, and costs incurred by USP in the United States also of
100X annually. Of the total costs of 200X, USP's share is 80X and
FS's share is 120X so that FS must make a payment to USP of 20X. The
payment will be treated as a reimbursement of 20X of USP's costs in
the United States. Accordingly, USP's Form 1120 will reflect an 80X
deduction on account of activities performed in the United States
for purposes of allocation and apportionment of the deduction to
source. The Form 5471 ``Information Return of U.S. Persons With
Respect to Certain Foreign Corporations'' for FS will reflect a 100X
deduction on account of activities performed in Country Z and a 20X
deduction on account of activities performed in the United States.
Example 2. The facts are the same as in Example 1, except that
the 100X of costs borne by USP consist of 5X of costs incurred by
USP in the United States and 95X of arm's length rental charge, as
described in paragraph (d)(1)(iii) of this section, for the use of a
facility in the United States. The depreciation deduction
attributable to the U.S. facility is 7X. The 20X net payment by FS
to USP will first be applied in reduction pro rata of the 5X
deduction for costs and the 7X depreciation deduction attributable
to the U.S. facility. The 8X remainder will be treated as rent for
the U.S. facility.
Example 3. (i) Four members A, B, C, and D of a controlled group
form a CSA to develop the next generation technology for their
business. Based on RAB shares, the participants agree to bear shares
of the costs incurred during the term of the agreement in the
following percentages: A 40%; B 15%; C 25%; and D 20%. The arm's
length values of the platform contributions they respectively own
are in the following amounts for the taxable year: A 80X; B 40X; C
30X; and D 30X. The provisional (before offsets) and final PCT
Payments among A, B, C, and D are shown in the table as follows:
[All amounts stated in X's]
------------------------------------------------------------------------
A B C D
------------------------------------------------------------------------
Payments............................ <40> <21> <37.5> <30>
Receipts............................ 48 34 22.5 24
-----------------------------------
Final........................... 8 13 <15> <6>
------------------------------------------------------------------------
(ii) The first row/first column shows A's provisional PCT
Payment equal to the product of 100X (sum of 40X, 30X, and 30X) and
A's RAB share of 40%. The second row/first column shows A's
provisional PCT receipts equal to the sum of the products of 80X and
B's, C's, and D's RAB shares (15%, 25%, and 20%, respectively). The
other entries in the first two rows of the table are similarly
computed. The last row shows the final PCT receipts/payments after
offsets. Thus, for the taxable year, A and B are treated as
receiving the 8X and 13X, respectively, pro rata out of payments by
C and D of 15X and 6X, respectively.
(k) CSA administrative requirements. A controlled participant meets
the requirements of this paragraph if it substantially complies,
respectively, with the CSA contractual, documentation, accounting, and
reporting requirements of paragraphs (k)(1), (k)(2), (k)(3), and (k)(4)
of this section.
(1) CSA contractual requirements--(i) In general. A CSA must be
recorded in writing in a contract that is contemporaneous with the
formation (and any revision) of the CSA and that includes the
contractual provisions described in this paragraph (k)(1).
(ii) Contractual provisions. The written contract described in this
paragraph (k)(1) must include provisions that--
(A) List the controlled participants and any other members of the
controlled group that are reasonably anticipated to benefit from the
use of the cost shared intangibles, including the address of each
domestic entity and the country of organization of each foreign entity;
(B) Describe the scope of the IDA to be undertaken and each
reasonably anticipated cost shared intangible or class of reasonably
anticipated cost shared intangibles;
(C) Specify the functions and risks that each controlled
participant will undertake in connection with the CSA;
(D) Divide among the controlled participants all divisional
interests in
[[Page 386]]
cost shared intangibles and specify each controlled participant's
divisional interest in the cost shared intangibles, as described in
paragraphs (b)(1)(iii) and (b)(4) of this section, that it will own and
exploit without any further obligation to compensate any other
controlled participant for such interest;
(E) Provide a method to calculate the controlled participants' RAB
shares, based on factors that can reasonably be expected to reflect the
participants' shares of anticipated benefits, and require that such RAB
shares must be updated, as described in paragraph (e)(1) of this
section (see also paragraph (k)(2)(ii)(F) of this section);
(F) Enumerate all categories of IDCs to be shared under the CSA;
(G) Specify that the controlled participant must use a consistent
method of accounting to determine IDCs and RAB shares, as described in
paragraphs (d) and (e) of this section, respectively, and must
translate foreign currencies on a consistent basis;
(H) Require the controlled participant to enter into CSTs covering
all IDCs, as described in paragraph (b)(1)(i) of this section, in
connection with the CSA;
(I) Require the controlled participants to enter into PCTs covering
all platform contributions, as described in paragraph (b)(1)(ii) of
this section, in connection with the CSA;
(J) Specify the form of payment due under each PCT (or group of
PCTs) in existence at the formation (and any revision) of the CSA,
including information and explanation that reasonably supports an
analysis of applicable provisions of paragraph (h) of this section; and
(K) Specify the date on which the CSA is entered into and the
duration of the CSA, the conditions under which the CSA may be modified
or terminated, and the consequences of a modification or termination
(including consequences described under the rules of paragraph (f) of
this section).
(iii) Meaning of contemporaneous--(A) In general. For purposes of
this paragraph (k)(1), a written contractual agreement is
contemporaneous with the formation (or revision) of a CSA if, and only
if, the controlled participants record the CSA, in its entirety, in a
document that they sign and date no later than 60 days after the first
occurrence of any IDC described in paragraph (d) of this section to
which such agreement (or revision) is to apply.
(B) Example. The following example illustrates the principles of
this paragraph (k)(1)(iii):
Example. Companies A and B, both of which are members of the
same controlled group, commence an IDA on March 1, Year 1. Company A
pays the first IDCs in relation to the IDA, as cash salaries to A's
research staff, for the staff's work during the first week of March,
Year 1. A and B, however, do not sign and date any written
contractual agreement until August 1, Year 1, whereupon they execute
a ``Cost Sharing Agreement'' that purports to be ``effective as of''
March 1 of Year 1. The arrangement fails the requirement that the
participants record their arrangement in a written contractual
agreement that is contemporaneous with the formation of a CSA. The
arrangement has failed to meet the requirements set forth in
paragraph (b)(2) of this section and, pursuant to paragraph (b) of
this section, cannot be a CSA.
(iv) Interpretation of contractual provisions--(A) In general. The
provisions of a written contract described in this paragraph (k)(1) and
of the additional documentation described in paragraph (k)(2) of this
section must be clear and unambiguous. The provisions will be
interpreted by reference to the economic substance of the transaction
and the actual conduct of the controlled participants. See Sec. 1.482-
1(d)(3)(ii)(B) (discussing interpretation of contractual terms in
assessing the comparability of controlled and uncontrolled
transactions). Accordingly, the Commissioner may impute contractual
terms in a CSA consistent with the economic substance of the CSA and
may disregard contractual terms that lack economic substance. An
allocation of risk between controlled participants after the outcome of
such risk is known or reasonably knowable lacks economic substance. See
Sec. 1.482-1(d)(3)(iii)(B). A contractual term that is disregarded due
to a lack of economic substance does not satisfy a contractual
requirement set forth in this paragraph (k)(1) or documentation
requirement set forth in paragraph (k)(2) of this section. See
paragraph (b)(5) of this section for the treatment of an arrangement
among controlled taxpayers that fails to comply with the requirements
of this section.
(B) Examples. The following examples illustrate the principles of
this paragraph (k)(1)(iv). In each example, it is assumed that the
Commissioner will exercise the discretion granted pursuant to paragraph
(b)(5)(ii) of this section to apply the provisions of this section to
the arrangement that purports to be a CSA.
Example 1. The contractual provisions recorded upon formation of
an arrangement that purports to be a CSA provide that PCT payments
with respect to a particular external contribution will consist of
payments contingent on sales. Contrary to the contractual
provisions, the PCT payments actually made are contingent on
profits. Because the controlled participants' actual conduct is
different from the contractual terms, the Commissioner may
determine, based on the facts and circumstances, that--
(i) The actual payments have economic substance and, therefore,
impute payment terms in the CSA consistent with the actual payments;
or
(ii) The contract terms reflect the economic substance of the
arrangement and, therefore, the actual payments must be adjusted to
conform to the terms.
Example 2. An arrangement that purports to be a CSA provides
that PCT payments with respect to a particular external contribution
shall be contingent payments equal to 10% of sales of products that
incorporate cost shared intangibles. The contract terms further
provide that the controlled participants must adjust such contingent
payments in accordance with a formula set forth in the terms. During
the first three years of the arrangement, the controlled
participants fail to make the adjustments required by the terms with
respect to the PCT payments. The Commissioner may determine, based
on the facts and circumstances, that--
(i) The contingent payment terms with respect to the external
contribution do not have economic substance because the controlled
participants did not act in accordance with their upfront risk
allocation; or
(ii) The contract terms reflect the economic substance of the
arrangement and, therefore, the actual payments must be adjusted to
conform to the terms.
(2) CSA documentation requirements--(i) In general. The controlled
participants must timely update and maintain sufficient documentation
to establish that the participants have met the CSA contractual
requirements of paragraph (k)(1) of this section and the additional CSA
documentation requirements of this paragraph (k)(2).
(ii) Additional CSA documentation requirements. The controlled
participants to a CSA must timely update and maintain documentation
sufficient to--
(A) Describe the current scope of the IDA and identify--
(1) Any additions or subtractions from the list of reasonably
anticipated cost shared intangibles reported pursuant to paragraph
(k)(1)(ii)(B) of this section;
(2) Any cost shared intangible, together with each controlled
participant's interest therein; and
(3) Any further development of intangibles already developed under
the CSA or of specified applications of such intangibles which has been
removed from the IDA (see paragraphs (d)(1)(ii) and (j)(1)(i) of this
section (definitions of reasonably anticipated cost shared intangible,
cost shared intangible)) and the steps (including any accounting
classifications and allocations) taken to implement such removal.
[[Page 387]]
(B) Establish that each controlled participant reasonably
anticipates that it will derive benefits from exploiting cost shared
intangibles;
(C) Describe the functions and risks that each controlled
participant has undertaken during the term of the CSA;
(D) Provide an overview of each controlled participant's business
segments, including an analysis of the economic and legal factors that
affect CST and PCT pricing;
(E) Establish the amount of each controlled participant's IDCs for
each taxable year under the CSA, including all IDCs attributable to
stock-based compensation, as described in paragraph (d)(3) of this
section (including the method of measurement and timing used in
determining such IDCs, and the data, as of the date of grant, used to
identify stock-based compensation with the IDA);
(F) Describe the method used to estimate each controlled
participant's RAB share for each year during the course of the CSA,
including--
(1) All projections used to estimate benefits;
(2) All updates of the RAB shares in accordance with paragraph
(e)(1) of this section; and
(3) An explanation of why that method was selected and why the
method provides the most reliable measure for estimating RAB shares;
(G) Describe all platform contributions;
(H) Designate the type of transaction involved for each PCT or
group of PCTs;
(I) Specify, within the time period provided in paragraph
(h)(2)(iii) of this section, the form of payment due under each PCT or
group of PCTs, including information and explanation that reasonably
supports an analysis of applicable provisions of paragraph (h) of this
section;
(J) Describe and explain the method selected to determine the arm's
length payment due under each PCT, including--
(1) An explanation of why the method selected constitutes the best
method, as described in Sec. 1.482-1(c)(2), for measuring an arm's
length result;
(2) The economic analyses, data, and projections relied upon in
developing and selecting the best method, including the source of the
data and projections used;
(3) Each alternative method that was considered, and the reason or
reasons that the alternative method was not selected;
(4) Any data that the controlled participant obtains, after the CSA
takes effect, that would help determine if the controlled participant's
method selected has been applied in a reasonable manner;
(5) The discount rate or rates, where applicable, used for purposes
of evaluating PCT Payments, including information and explanation that
reasonably supports an analysis of applicable provisions of paragraph
(g)(2)(v) of this section;
(6) The estimated arm's length values of any platform contributions
as of the dates of the relevant PCTs, in accordance with paragraph
(g)(2)(ii) of this section;
(7) A discussion, where applicable, of why transactions were or
were not aggregated under the principles of paragraph (g)(2)(iv) of
this section;
(8) The method payment form and any conversion made from the method
payment form to the specified payment form, as described in paragraph
(h)(3) of this section; and
(9) If applicable under paragraph (i)(6)(iv) of this section, the
WACC of the parent of the controlled group that includes the controlled
participants.
(iii) Coordination rules and production of documents--(A)
Coordination with penalty regulations. See Sec. 1.6662-6(d)(2)(iii)(D)
regarding coordination of the rules of this paragraph (k) with the
documentation requirements for purposes of the accuracy-related penalty
under section 6662(e) and (h).
(B) Production of documentation. Each controlled participant must
provide to the Commissioner, within 30 days of a request, the items
described in this paragraph (k)(2) and paragraph (k)(3) of this
section. The time for compliance described in this paragraph
(k)(2)(iii)(B) may be extended at the discretion of the Commissioner.
(3) CSA accounting requirements--(i) In general. The controlled
participants must maintain books and records (and related or underlying
data and information) that are sufficient to--
(A) Establish that the controlled participants have used (and are
using) a consistent method of accounting to measure costs and benefits;
(B) Permit verification that the amount of any contingent PCT
Payments due have been (and are being) properly determined;
(C) Translate foreign currencies on a consistent basis; and
(D) To the extent that the method of accounting used materially
differs from U.S. generally accepted accounting principles, explain any
such material differences.
(ii) Reliance on financial accounting. For purposes of this
section, the controlled participants may not rely solely upon financial
accounting to establish satisfaction of the accounting requirements of
this paragraph (k)(4) of this section. Rather, the method of accounting
must clearly reflect income. Thor Power Tools Co. v. Commissioner, 439
U.S. 522 (1979).
(4) CSA reporting requirements--(i) CSA Statement. Each controlled
participant must file with the Internal Revenue Service, in the manner
described in this paragraph (k)(4), a ``Statement of Controlled
Participant to Sec. 1.482-7T Cost Sharing Arrangement'' (CSA
Statement) that complies with the requirements of this paragraph
(k)(5).
(ii) Content of CSA Statement. The CSA Statement of each controlled
participant must--
(A) State that the participant is a controlled participant in a
CSA;
(B) Provide the controlled participant's taxpayer identification
number;
(C) List the other controlled participants in the CSA, the country
of organization of each such participant, and the taxpayer
identification number of each such participant;
(D) Specify the earliest date that any IDC described in paragraph
(d)(1) of this section occurred; and
(E) Indicate the date on which the controlled participants formed
(or revised) the CSA and, if different from such date, the date on
which the controlled participants recorded the CSA (or any revision)
contemporaneously in accordance with paragraphs (k)(1)(i) and (iii) of
this section.
(iii) Time for filing CSA Statement--(A) 90-day rule. Each
controlled participant must file its original CSA Statement with the
Internal Revenue Service Ogden Campus, no later than 90 days after the
first occurrence of an IDC to which the newly-formed CSA applies, as
described in paragraph (k)(1)(iii)(A) of this section, or, in the case
of a taxpayer that became a controlled participant after the formation
of the CSA, no later than 90 days after such taxpayer became a
controlled participant. A CSA Statement filed in accordance with this
paragraph (k)(4)(iii)(A) must be dated and signed, under penalties of
perjury, by an officer of the controlled participant who is duly
authorized (under local law) to sign the statement on behalf of the
controlled participant.
(B) Annual return requirement--(1) In general. Each controlled
participant must attach to its U.S. income tax return, for each taxable
year for the duration of the CSA, a copy of the original CSA Statement
that the controlled participant filed in accordance with the 90-day
rule of
[[Page 388]]
paragraph (k)(4)(iii)(A) of this section. In addition, the controlled
participant must update the information reflected on the original CSA
Statement annually by attaching a schedule that documents changes in
such information over time.
(2) Special filing rule for annual return requirement. If a
controlled participant is not required to file a U.S. income tax
return, the participant must ensure that the copy or copies of the CSA
Statement and any updates are attached to Schedule M of any Form 5471,
any Form 5472 ``Information Return of a Foreign Owned Corporation'', or
any Form 8865 ``Return of U.S. Persons With Respect to Certain Foreign
Partnerships'', filed with respect to that participant.
(iv) Examples. The following examples illustrate this paragraph
(k)(4). In each example, Companies A and B are members of the same
controlled group.
Example 1. A and B, both of which file U.S. tax returns, agree
to share the costs of developing a new chemical formula in
accordance with the provisions of this section. On March 30, Year 1,
A and B record their agreement in a written contract styled, ``Cost
Sharing Agreement.'' The contract applies by its terms to IDCs
occurring after March 1, Year 1. The first IDCs to which the CSA
applies occurred on March 15, Year 1. To comply with paragraph
(k)(4)(iii)(A) of this section, A and B individually must file
separate CSA Statements no later than 90 days after March 15, Year 1
(June 13, Year 1). Further, to comply with paragraph (k)(4)(iii)(B)
of this section, A and B must attach copies of their respective CSA
Statements to their respective Year 1 U.S. income tax returns.
Example 2. The facts are the same as in Example 1, except that a
year has passed and C, which files a U.S. tax return, joined the CSA
on May 9, Year 2. To comply with the annual filing requirement
described in paragraph (k)(4)(iii)(B) of this section, A and B must
each attach copies of their respective CSA Statements (as filed for
Year 1) to their respective Year 2 income tax returns, along with a
schedule updated appropriately to reflect the changes in information
described in paragraph (k)(4)(ii) of this section resulting from the
addition of C to the CSA. To comply with both the 90-day rule
described in paragraph (k)(4)(iii)(A) of this section and the annual
filing requirement described in paragraph (k)(4)(iii)(B) of this
section, C must file a CSA Statement no later than 90 days after May
9, Year 2 (August 7, Year 2), and must attach a copy of such CSA
Statement to its Year 2 income tax return.
(l) Effective/applicability date. This section applies on January
5, 2009.
(m) Transition rule--(1) In general. An arrangement in existence on
January 5, 2009 will be considered a CSA, as described under paragraph
(b) of this section, if, prior to such date, it was a qualified cost
sharing arrangement under the provisions of Sec. 1.482-7 (as contained
in the 26 CFR part 1 edition revised as of January 1, 1996, hereafter
referred to as ``former Sec. 1.482-7''), but only if the written
contract, as described in paragraph (k)(1) of this section, is amended,
if necessary, to conform with, and only if the activities of the
controlled participants substantially comply with, the provisions of
this section, as modified by paragraphs (m)(2) and (m)(3) of this
section, by July 6, 2009.
(2) Transitional modification of applicable provisions. For
purposes of this paragraph (m), conformity and substantial compliance
with the provisions of this section shall be determined with the
following modifications:
(i) CSTs and PCTs occurring prior to January 5, 2009 shall be
subject to the provisions of former Sec. 1.482-7 rather than this
section.
(ii) Except to the extent provided in paragraph (m)(3) of this
section, PCTs that occur under a CSA that was a qualified cost sharing
arrangement under the provisions of former Sec. 1.482-7 and remained
in effect on January 5, 2009, shall be subject to the periodic
adjustment rules of Sec. 1.482-4(f)(2) rather than the rules of
paragraph (i)(6) of this section.
(iii) Paragraphs (b)(1)(iii) and (b)(4) of this section shall not
apply.
(iv) Paragraph (k)(1)(ii)(D) of this section shall not apply.
(v) Paragraphs (k)(1)(ii)(H) and (k)(1)(ii)(I) of this section
shall be construed as applying only to transactions entered into on or
after January 5, 2009.
(vi) The deadline for recordation of the revised written
contractual agreement pursuant to paragraph (k)(1)(iii) of this section
shall be no later than July 6, 2009.
(vii) Paragraphs (k)(2)(ii)(G) through (J) of this section shall be
construed as applying only with reference to PCTs entered into on or
after January 5, 2009.
(viii) Paragraph (k)(4)(iii)(A) of this section shall be construed
as requiring a CSA Statement with respect to the revised written
contractual agreement described in paragraph (m)(3)(vi) of this section
no later than September 2, 2009.
(ix) Paragraph (k)(4)(iii)(B) of this section shall be construed as
only applying for taxable years ending after the filing of the CSA
Statement described in paragraph (m)(2)(viii) of this section.
(3) Special rule for certain periodic adjustments. The periodic
adjustment rules in paragraph (i)(6) of this section (rather than the
rules of Sec. 1.482-4(f)(2)) shall apply to PCTs that occur on or
after the date of a material change in the scope of the CSA from its
scope as of January 5, 2009. A material change in scope would include a
material expansion of the activities undertaken beyond the scope of the
intangible development area, as described in former Sec. 1.482-
7(b)(4)(iv). For this purpose, a contraction of the scope of a CSA,
absent a material expansion into one or more lines of research and
development beyond the scope of the intangible development area, does
not constitute a material change in scope of the CSA. Whether a
material change in scope has occurred is determined on a cumulative
basis. Therefore, a series of expansions, any one of which is not a
material expansion by itself, may collectively constitute a material
expansion.
(n) Expiration date. The applicability of this section expires on
or before December 30, 2011.
0
Par. 13. Section 1.482-8 is amended by revising paragraph (b) Examples
10, 11, and 12 and adding Examples 13, 14, 15, 16, 17 and 18 at the end
of paragraph (b) to read as follows:
Sec. 1.482-8 Examples of the best method rule.
* * * * *
(b) * * *
Examples 10 through 18. [Reserved]. For further guidance, see Sec.
1.482-8T(b) Examples 10 through 18.
0
Par. 14. Section 1.482-8T is amended by:
0
1. Adding Examples 13, 14, 15, 16, 17 and 18 at the end of paragraph
(b).
0
2. Revising paragraph (c).
The additions and revision reads as follows:
Sec. 1.482-8T Examples of the best method rule (temporary).
* * * * *
(b) * * *
Example 13. Preference for acquisition price method. (i) USP
develops, manufacturers, and distributes pharmaceutical products.
USP and FS, USP's wholly-owned subsidiary, enter into a CSA to
develop a new oncological drug, Oncol. Immediately prior to entering
into the CSA, USP acquires Company X, an unrelated U.S.
pharmaceutical company. Company X is solely engaged in oncological
pharmaceutical research, and its only significant resources and
capabilities are its workforce and its sole patent, which is
associated with Compound X, a promising molecular compound derived
from a rare plant, which USP reasonably anticipates will contribute
to developing Oncol. All of Company X researchers will be engaged
solely in research that is reasonably anticipated to contribute to
developing Oncol as well. The rights in the Compound X and the
commitment of Company X's researchers to the development of Oncol
are platform
[[Page 389]]
contributions for which compensation is due from FS as part of a
PCT.
(ii) In this case, the acquisition price method, based on the
lump sum price paid by USP for Company X, is likely to provide a
more reliable measure of an arm's length PCT Payment due to USP than
the application of any other method. See Sec. Sec. 1.482-4(c)(2)
and 1.482-7T(g)(5)(iv)(A).
Example 14. Preference for market capitalization method. (i)
Company X is a publicly traded U.S. company solely engaged in
oncological pharmaceutical research and its only significant
resources and capabilities are its workforce and its sole patent,
which is associated with Compound Y, a promising molecular compound
derived from a rare plant. Company X has no marketable products.
Company X enters into a CSA with FS, a newly-formed foreign
subsidiary, to develop a new oncological drug, Oncol, derived from
Compound Y. Compound Y is reasonably anticipated to contribute to
developing Oncol. All of Company X researchers will be engaged
solely in research that is reasonably anticipated to contribute to
developing Oncol under the CSA. The rights in Compound Y and the
commitment of Company X's researchers are platform contributions for
which compensation is due from FS as part of a PCT.
(ii) In this case, given that Company X's platform contributions
covered by PCTs relate to its entire economic value, the application
of the market capitalization method, based on the market
capitalization of Company X, provides a reliable measure of an arm's
length result for Company X's PCTs to the CSA. See Sec. Sec. 1.482-
4(c)(2) and 1.482-7T(g)(6)(v)(A).
Example 15. Preference for market capitalization method. (i)
MicroDent, Inc. (MDI) is a publicly traded company that developed a
new dental surgical microscope ScopeX-1, which drastically shortens
many surgical procedures. On January 1 of Year 1, MDI entered into a
CSA with a wholly-owned foreign subsidiary (FS) to develop ScopeX-2,
the next generation of ScopeX-1. In the CSA, divisional interests
are divided on a territorial basis. The rights associated with
ScopeX-1, as well as MDI's research capabilities are reasonably
anticipated to contribute to the development of ScopeX-2 and are
therefore platform contributions for which compensation is due from
FS as part of a PCT. At the time of the PCT, MDI's only product was
the ScopeX-1 microscope, although MDI was in the process of
developing ScopeX-2. Concurrent with the CSA, MDI separately
transfers exclusive and perpetual exploitation rights associated
with ScopeX-1 to FS in the same territory as assigned to FS in the
CSA.
(ii) Although the transactions between MDI and FS under the CSA
are distinct from the transactions between MDI and FS relating to
the exploitation rights for ScopeX-1, it is likely to be more
reliable to evaluate the combined effect of the transactions than to
evaluate them in isolation. This is because the combined
transactions between MDI and FS relate to all of the economic value
of MDI (that is, the exploitation rights and research rights
associated with ScopeX-1, as well as the research capabilities of
MDI). In this case, application of the market capitalization method,
based on the enterprise value of MDI on January 1 of Year 1, is
likely to provides a reliable measure of an arm's length payment for
the aggregated transactions. See Sec. Sec. 1.482-4(c)(2) and 1.482-
7T(g)(6)(v)(A).
(iii) Notwithstanding that the market capitalization method
provides the most reliable measure of the aggregated transactions
between MDI and FS, see Sec. 1.482-7T(g)(2)(iv) for further
considerations of when further analysis may be required to
distinguish between the remuneration to MDI associated with PCTs
under the CSA (for research rights and capabilities associated with
ScopeX-1) and the remuneration to MDI for the exploitation rights
associated with ScopeX-1.
Example 16. Income method (applied using CPM) preferred to
acquisition price method. The facts are the same as Example 13,
except that the acquisition occurred significantly in advance of
formation of the CSA, and reliable adjustments cannot be made for
this time difference. In addition, Company X has other valuable
molecular patents and associated research capabilities, apart from
Compound X, that are not reasonably anticipated to contribute to the
development of Oncol and that cannot be reliably valued. The CSA
divides divisional interests on a territorial basis. Under the terms
of the CSA, USP will undertake all R&D (consisting of laboratory
research and clinical testing) and manufacturing associated with
Oncol, as well as the distribution activities for its territory (the
United States). FS will distribute Oncol in its territory (the rest
of the world). FS's distribution activities are routine in nature,
and the profitability from its activities may be reliably determined
from third-party comparables. FS does not furnish any platform
contributions. At the time of the PCT, reliable (ex ante) financial
projections associated with the development of Oncol and its
separate exploitation in each of USP's and FSub's assigned
geographical territories are undertaken. In this case, application
of the income method using CPM is likely to provide a more reliable
measure of an arm's length result than application of the
acquisition price method based on the price paid by USP for Company
X. See Sec. 1.482-7T(g)(4)(v) and (g)(5)(iv)(C).
Example 17. Evaluation of alternative methods. (i) The facts are
the same as Example 13, except that the acquisition occurred
sometime prior to the CSA, and Company X has some areas of promising
research that are not reasonably anticipated to contribute to
developing Oncol. For purposes of this example, the CSA is assumed
to divide divisional interests on a territorial basis. In general,
the Commissioner determines that the acquisition price data is
useful in informing the arm's length price, but not necessarily
determinative. Under the terms of the CSA, USP will undertake all
R&D (consisting of laboratory research and clinical testing) and
manufacturing associated with Oncol, as well as the distribution
activities for its territory (the United States). FS will distribute
Oncol in its territory (the rest of the world). FS's distribution
activities are routine in nature, and the profitability from its
activities may be reliably determined from third-party comparables.
At the time of the PCT, financial projections associated with the
development of Oncol and its separate exploitation in each of USP's
and FSub's assigned geographical territories are undertaken.
(ii) Under the facts, it is possible that the acquisition price
method or the income method using CPM might reasonably be applied.
Whether the acquisition price method or the income method provides
the most reliable evidence of the arm's length price of USP's
contributions depends on a number of factors, including the
reliability of the financial projections, the reliability of the
discount rate chosen, and the extent to which the acquisition price
of Company X can be reliably adjusted to account for changes in
value over the time period between the acquisition and the formation
of the CSA and to account for the value of the in-process research
done by Company X that does not constitute platform contributions to
the CSA. See Sec. 1.482-7T(g)(4)(v) and (g)(5)(iv)(A) and (C).
Example 18. Evaluation of alternative methods. (i) The facts are
the same as Example 17, except that FS has a patent on Compound Y,
which the parties reasonably anticipate will be useful in mitigating
potential side effects associated with Compound X and thereby
contribute to the development of Oncol. The rights in Compound Y
constitute a platform contribution for which compensation is due
from USP as part of a PCT. The value of FS's platform contribution
cannot be reliably measured by market benchmarks.
(ii) Under the facts, it is possible that either the acquisition
price method and the income method together or the residual profit
split method might reasonably be applied to determine the arm's
length PCT Payments due between USP and FS. Under the first option
the PCT Payment for the platform contributions related to Company
X's workforce and Compound X would be determined using the
acquisition price method referring to the lump sum price paid by USP
for Company X. Because the value of these platform contributions can
be determined by reference to a market benchmark, they are
considered routine platform contributions. Accordingly, under this
option, the platform contribution related to Compound Y would be the
only nonroutine platform contribution and the relevant PCT Payment
is determined using the income method. Under the second option,
rather than looking to the acquisition price for Company X, all the
platform contributions are considered nonroutine and the RPSM is
applied to determine the PCT Payments for each platform
contribution. Under either option, the PCT Payments will be netted
against each other.
(iii) Whether the acquisition price method together with the
income method or the residual profit split method provides the most
reliable evidence of the arm's length price of the platform
contributions of USP and FS depends on a number of factors,
including the reliability of the determination of the relative
values of the platform
[[Page 390]]
contributions for purposes of the RPSM, and the extent to which the
acquisition price of Company X can be reliably adjusted to account
for changes in value over the time period between the acquisition
and the formation of the CSA and to account for the value of the
rights in the in-process research done by Company X that does not
constitute platform contributions to the CSA. In these
circumstances, it is also relevant to consider whether the results
of each method are consistent with each other, or whether one or
both methods are consistent with other potential methods that could
be applied. See Sec. 1.482-7T(g)(4)(v), (g)(5)(iv), and (g)(7)(iv).
(c) Effective/applicability date--(1) In general. Paragraphs (a)
and (b) Examples 10 through 12 of this section are generally applicable
for taxable years beginning after December 31, 2006. Paragraph (b)
Examples 13 through 18 of this section are generally applicable on
January 5, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraph (b) Examples 10 through
12 of this section to earlier taxable years in accordance with rules
set forth in Sec. 1.482-9T(n)(2).
(3) Expiration date. The applicability of paragraphs (a) and (b)
Examples 10 through 12 of this section expires on or before July 31,
2009. The applicability of paragraph (b) Examples 13 through 18 of this
section expires on or before December 30, 2011.
0
Par. 15. Section 1.482-9T is amended by revising paragraph (m)(3), the
heading for paragraph (n) and paragraph (n)(3) to read as follows:
Sec. 1.482-9T Methods to determine taxable income in connection with
a controlled services transaction (temporary).
* * * * *
(m) * * *
(3) Coordination with rules governing cost sharing arrangements.
Section 1.482-7T provides the specific methods to be used to determine
arm's length results of controlled transactions in connection with a
cost sharing arrangement. This section provides the specific methods to
be used to determine arm's length results of a controlled service
transaction, including in an arrangement for sharing the costs and
risks of developing intangibles other than a cost sharing arrangement
covered by Sec. 1.482-7T. In the case of such an arrangement,
consideration of the principles, methods, comparability, and
reliability considerations set forth in Sec. 1.482-7T is relevant in
determining the best method, including an unspecified method, under
this section, as appropriately adjusted in light of the differences in
the facts and circumstances between such arrangement and a cost sharing
arrangement.
* * * * *
(n) Effective/applicability dates. * * *
(3) Expiration dates. The applicability of this section expires on
July 31, 2009, except paragraph (m)(3) of this section, which expires
on December 30, 2011.
0
Par. 16. Section 1.861-17 is amended by revising paragraph (c)(3)(iv)
to read as follows:
Sec. 1.861-17 Allocation and apportionment of research and
experimental expenditures.
* * * * *
(c) * * *
(3) * * *
(iv) Effect of cost sharing arrangements. If the corporation
controlled by the taxpayer has entered into a cost sharing arrangement,
in accordance with the provisions of Sec. 1.482-7T, with the taxpayer
for the purpose of developing intangible property, then that
corporation shall not reasonably be expected to benefit from the
taxpayer's share of the research expense.
* * * * *
0
Par. 17. Section 1.6662-6 is amended by:
0
1. Removing the third and fourth sentences from paragraph (d)(2)(i).
0
2. Adding a new paragraph (d)(2)(iii)(D).
The addition reads as follows:
Sec. 1.6662-6 Transaction between persons described in section 482
and net section 482 transfer price adjustments.
* * * * *
(d) * * *
(2) * * *
(iii) * * *
(D) Satisfaction of the documentation requirements described in
Sec. 1.482-7T(k)(2) for the purpose of complying with the rules for
CSAs under Sec. 1.482-7T also satisfies all of the documentation
requirements listed in paragraph (d)(2)(iii)(B) of this section, except
the requirements listed in paragraphs (d)(2)(iii)(B)(2) and (10) of
this section, with respect to CSTs and PCTs described in Sec. 1.482-
7T(b)(1)(i) and (ii), provided that the documentation also satisfies
the requirements of paragraph (d)(2)(iii)(A) of this section.
* * * * *
PART 301--PROCEDURE AND ADMINISTRATION
0
Par. 18. The authority citation for part 301 continues to read in part
as follows:
Authority: 26 U.S.C. 7805 * * *.
0
Par. 19. Section 301.7701-1 is amended by revising paragraphs (c) and
(f) to read as follows:
Sec. 301.7701-1 Classification of organizations for Federal tax
purposes.
* * * * *
(c) Cost sharing arrangements. A cost sharing arrangement that is
described in Sec. 1.482-7T of this chapter, including any arrangement
that the Commissioner treats as a CSA under Sec. 1.482-7T(b)(5) of
this chapter, is not recognized as a separate entity for purposes of
the Internal Revenue Code. See Sec. 1.482-7T of this chapter for the
rules regarding CSAs.
* * * * *
(f) Effective/applicability dates. Except as provided in the
following sentence, the rules of this section are applicable as of
January 1, 1997. The rules of paragraph (c) of this section are
applicable on January 5, 2009.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
0
Par. 20. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
0
Par. 21. In Sec. 602.101, paragraph (b) is amended by adding the
following entry in numerical order to the table:
Sec. 602.101 OMB Control numbers.
* * * * *
(b) * * *
------------------------------------------------------------------------
CFR part or section where identified and Current OMB control
described no.
------------------------------------------------------------------------
* * * * * * *
1.482-7T........................................ 1545-1364
* * * * * * *
------------------------------------------------------------------------
[[Page 391]]
L.E. Stiff,
Deputy Commissioner for Services and Enforcement.
Approved: December 18, 2008.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E8-30715 Filed 12-31-08; 11:15 am]
BILLING CODE 4830-01-P