New regs for qualified cost sharing arrangements.

The Internal Revenue Service has released final regulations for qualified cost sharing arrangements under Internal Revenue Code section 482, effective for tax years beginning on or after January 1, 1996. Taxpayers in existing cost Sharing arrangements have one year to bring them into compliance with the regulations.

Section 482 requires arm's-length consideration for transactions between related entities and mandates that intangible transfers be commensurate with the income attributed to the intangible. For example, the IRS can adjust the consideration charged in each taxable year to ensure that it matches income earned as a result of a transferred intangible. Parties who wish to avoid this provision may enter into a qualified cost sharing arrangement for research and development costs related to intangibles intended for more than one entity. All of the parties who enter this arrangement would beneficially own the intangibles, and no transfer would be required.

The final regulations address taxpayer comments to proposed regulations issued in 1992. One major change in the final regulations eliminates a provision that allowed the IRS to adjust a U.S. cost sharing participant's income annually if it had a substantially disproportionate cost-to-operating income ratio. The final regulations allow adjustments in income only if, under the facts and circumstances, the taxpayer did not use the most reliable method to allocate benefits.

The IRS also may scrutinize the projections used in estimating benefits. Projections may be considered unreliable if there is a discrepancy of more than 20% between projected and actual results that is within the control of the participants. In this case, the IRS may use actual benefits as the most reliable measuring method.

Unlike the proposed regulations, the final regulations allow unrelated people to participate in cost sharing arrangements but still restrict participation to taxpayers who use developed intangibles in the active conduct of their trade or business. For this purpose, a taxpayer may be attributed the activities of a related entity over which it exercises substantial managerial and operational control.

The final regulations require all cost allocations to be reflected in the year in which the costs were incurred and also resolve some collateral issues. For example, foreign participants in a cost sharing arrangement will not be treated as having a business in the United States merely as a result of the arrangement. In addition, a qualified cost sharing arrangement will not be treated as a partnership.

Observation: The final regulations allow more flexibility in structuring cost sharing arrangements, but taxpayers should be concerned about the elimination of a subgroup rule in the proposed regulations that allowed a member involved in the active conduct of a trade or business to participate in a cost sharing arrangement on behalf of a group of companies.

--Kenneth Kral, CPA, international tax partner, Jack Serota, Esq., international tax manager, and Charles Erivona, PhD, economist, at Price Waterhouse LLP, New York City.

FYI 

* In a technical advice memorandum (letter ruling 9549002), the IRS said capital loss carryovers that reduce current capital gains must also reduce investment income for purposes of the investment interest expense limitation of section 163(d).

--submitted by Michael Lynch