Sharing intellectual property with affiliates in China: status of Chinese cost-sharing rules and other observations.

Cost-sharing arrangements represent a good approach to the inherent tension of the low marginal cost of sharing innovation and the need for arm s-length transfer pricing. Cost-sharing arrangements may reduce withholding taxes and business taxes. As multinational corporations (MNCs) move more high-value activities to China, many MNCs may consider implementing cost-sharing arrangements in China. Unfortunately, China has yet to draft formal guidance on cost sharing, and Chinese tax authorities have evinced reluctance to accept cost-sharing proposals from MNCs before the planned release of cost-sharing rules in the not too distant future.

This article provides background on cost-sharing arrangements with regard to the Organisation for Economic Co-operation and Development (OECD) guidelines (the Guidelines) and China, touches on key issues China's tax authorities should consider when implementing cost-sharing rules, and describes possible options MNCs operating in China may follow when sharing technology, until China's tax authorities establish cost-sharing rules.

The Challenge

MNCs with operations in different parts of the world typically own various types of intellectual property (IP) that are used by their affiliates in different tax jurisdictions. In some cases, the IP may represent the "crown jewels" of the company--valuable pharmaceutical patents, proprietary semiconductor chip technology, or brands for a consumer products company. The value of IP can vary by market; for example, a brand that is well known in some countries may not gain the same acceptance in another. Difficulties in IP protection and piracy can make IP less valuable in certain markets. IP also can be less valuable simply because the IP that is being shared may be more mundane--for example, internal software that produces incremental improvement in rolling mill operations or proprietary knowledge that leads to modest reductions in the energy consumption of a chemical process.

Typically, MNCs are very interested in making sure that IP developed by one member of the corporate group be shared with other members of the corporate group that can benefit from the use of that innovation. If, for example, the U.S. affiliate of a chemical manufacturer develops an enhanced set of controls that reduce energy consumption by 10 percent, a rational corporate policy would encourage its China affiliate to adopt that innovation and realize similar savings. This is particularly true given that, once developed, the cost of sharing the innovation may be very minor.

The transfer pricing regulations in effect in most countries require an arm's-length payment for any transfer of IP. In the simple example given above, the U.S. Internal Revenue Service (IRS) would expect the China affiliate to pay an arm's-length price for access to the energy saving innovation developed by the U.S. affiliate. China's tax authorities, however, may take a very different position as their current tendency is to limit their view of IP to those items legally protected by trademarks and patents.

This is a much more limited definition than is used in the United States, for example, and may suggest systematically lower IP values. As China works through its views on IP, the expectation is that its view on IP will become similar to that of the rest of the world. Before that occurs, allowing several affiliates to share in the use of IP that is owned by one affiliate presents serious challenges since there is a fundamental disconnect between the optimal price to generate the efficient use of IP and the arm's-length price required under transfer pricing rules. The optimal price from a business standpoint is the marginal cost incurred in transferring the IP to the China affiliate. This incremental cost is often very low and may even be close to zero. (For example, once developed, the cost of copying software to a new disc is trivial. The same principle applies to a wide variety of IP transfers.) Transfer pricing rules, however, require that prices be set at arm's-length levels.

Such a payment may make the transfer of IP very costly. If the payment is based on the total cost of developing the innovation, it may exceed the benefits realized by the China affiliate, for example, if the China affiliate is much smaller than the affiliate that developed the transferred IP. If the payment is set to equal the benefits realized by the China affiliate, then there is little incentive for the affiliate to adopt the new process. Even if the business decision-making is completely separate from the transfer pricing used for tax compliance, it may be difficult and costly to develop an accurate measure of the arm's-length price of the innovation.

The effect of this underlying economic issue is aggravated by the difficulty of determining the magnitude of payments for intangibles, often one of the most difficult problems confronting MNCs. The very nature of the IP often makes it unique and "one of kind." Under such circumstances, there are no reliable market benchmarks that can be used to set prices.

This problem is compounded by the economic attributes of IP, for while it may be very expensive to develop initially, the success or lack of success of the IP may not be known until after the investment needed to develop the IP has been completed. Moreover, the incremental cost of having two affiliates use the IP rather than just one may be essentially zero. In short, the close relationship between cost and price that underlie the most widely used transfer pricing methods (resale price method, cost plus method, transactional net margin methods) often does not exist in the case of intangible transactions.

Finally, especially in the case of high-value IP that supports high residual profits, tax authorities and taxpayers may have very different views about what is the most appropriate price, and tax authorities may suggest very high transfer pricing adjustments upon audit. (1)

The transfer of IP from one affiliate to another gives rise to other tax issues as well. In particular, royalty payments are subject to withholding taxes under many tax treaties. Such withholding taxes add yet another layer of cost, and therefore present another barrier to the sharing of IP across affiliates operating in different tax jurisdictions. This is particularly true when different tax jurisdictions have a different view of IP attributes. Major differences between the United States and China include the following:

* China's definition of IP is limited to legally protected IP whereas the U.S. view is broader;

* China's tax authorities are likely to take a more narrow view of the value of global trademarks; and

* China's tax authorities tend to focus on local product enhancements and IP.

Enforcement is another key issue particularly in China as the tax authorities have devoted considerable energies to examining IP transfers into China, but have less experience analyzing IP transfers from the perspective of the IP owner. The expectation is that China will enhance its view as companies in China continue to broaden the scope and scale of their market activities into more high value-added ones such as research and development and to create local IP by building on partners' existing IP by tailoring it for local tastes.

Cost Sharing

OECD Guidelines

Cost contribution arrangements (CCAs) can provide a very effective alternative tool for addressing the underlying economic issue in jurisdictions where such arrangements are recognized. (2) Under the OECD Guidelines: (3)

   A CCA is a framework agreed among business enterprises to
   share the costs and risks of developing, producing or obtaining
   assets, services, or rights, and to determine the nature and extent
   of the interests of each participant in those assets, services,
   or rights. A CCA is a contractual arrangement rather than
   necessarily a distinct juridical entity or permanent establishment
   of all the participants. In a CCA, each participant's proportionate
   share of the overall contributions to the arrangement will
   be consistent with the participant's proportionate share of the
   overall expected benefits to be received under the arrangement,
   bearing in mind that transfer pricing is not an exact science.
   Further, each participant in a CCA would be entitled to
   exploit its interest in the CCA separately as an effective owner
   thereof and not as a licensee, and so without paying a royalty
   or other consideration to any party for that interest. Conversely,
   any other party would be required to provide a participant
   proper consideration (e.g., a royalty), for exploiting some or all
   of that participant's interest.

Thus, under a CCA the various participants to the CCA share in the cost of developing IP in proportion to their expected benefits from using the IP. (4) As a simple example, take the case in which Affiliates A and B are both engaged in the manufacture and sale of the same chemical product, each serving markets of essentially equal size. Affiliate A and B would pool their R&D costs and then share them on the basis of their expected benefits, or 50:50 in this case. If Affiliate A conducted 60 percent of all R&D and Affiliate B conducted 40 percent of their joint R&D, Affiliate B would make a payment to Affiliate A equal to 10 percent of total R&D expenditures.

The use of a CCA can make it much easier to share access to IP among affiliates operating in different tax jurisdictions. Each participant to the CCA has in effect joint ownership rights to the IP developed under the CCA and can therefore exploit the IP without making additional transfer pricing payments. (5) Therefore, under a CCA the tax cost associated with transferring IP from one jurisdiction to another may often essentially replicate the marginal cost incurred by the business--only costs associated with the transfer have to be paid for, and not the costs or value of the IP itself. The cost of transferring IP developed by one affiliate for use in other affiliates is often effectively de minimis.

The use of a CCA may result in additional benefits including:

* limiting the likely magnitude of potential transfer pricing adjustments;

* eliminating certain ancillary transfer pricing issues such as developing an arm's-length profit markup on R&D costs since IP development costs within CCAs are most commonly shared with no profit element;

* reducing withholding and business taxes;

* providing protection, at least in the United States, from permanent establishment concerns, the concern about being recharacterized as a partnership, and from commensurate with income (CWI) adjustments.

Status in China

China's transfer pricing regulations generally follow the principles of the transfer pricing guidelines issued by the OECD. It is common, however, for there to be differences in the ways different countries implement the OECD Guidelines. China's current interpretation, which does not allow for cost sharing, differs from most other countries that follow the OECD Guidelines.

In 2004, China's State Administration of Taxation (SAT), in a departure from usual practice, issued a private ruling known as "Ruling 470," relating to the tax treatment on the cost contribution arrangement for R&D activities. This tax notice allowed the China entities of a multinational group to claim a tax deduction on expenses incurred for sharing pooled R&D costs with its overseas related company. In addition, the reimbursement of such costs to the overseas company would not be considered a royalty, as long as the China entity would also be the beneficial owner of the resultant IP. As a result, there would be no business tax or withholding income tax consequences for the cost reimbursement.

Ruling 470, however, was never implemented. The local tax bureau in Shanghai, which is the governing tax authority for entities involved in the Ruling 470, proved unwilling to execute it. Since the execution and monitoring of transfer pricing rulings lies with the governing tax authority, the consensus between the SAT and the local tax bureau is a necessary condition for implementation of the ruling. This result may reflect the fact that China's tax authorities are not ready to adopt an approach to cost sharing arrangements akin to that reflected in U.S. regulations or the OECD guidelines.

Key Issues

Although China's tax authorities have been reluctant to accept cost-sharing arrangements proposed by MNCs, the expectation is that they will develop their own cost-sharing rules in the near future, which will be more closely modeled on the OECD's rules than the U.S. rules governing cost sharing. Whatever form these rules ultimately take, there are certain critical issues that will need to be addressed. These include:

* Determining which costs have to be included in the cost-sharing pool;

* Determining how to allocate these costs among the different participants in the CCA; and

* Determining whether one or more of the participants has to "buy into" pre-existing rights owned by other participants in the CCA.

Determining the Pool of Costs to Be Shared

The OECD Guidelines provide only limited instructions on which particular costs must be shared under a CCA, reflecting in part the wide variety of different circumstances and types of costs that may be at issue. The language of the Guidelines makes it clear, however, that as a general rule the pool of costs to be shared under a CCA includes all of the costs associated with the development of the IP. Determining such costs can require a detailed evaluation of different accounting categories and this may or may not require a very specific allocation of costs that are not found elsewhere. Moreover, the OECD Guidelines indicate that the value of the contribution has to reflect market value, stating: (6)

   Under the arm's length principle, the value of each participant's
   contribution should be consistent with the value that independent
   enterprises would have assigned to that contribution
   in comparable circumstances. Therefore, in determining
   the value of contributions to a CCA the guidance in Chapters
   I through VII of these Guidelines should be followed. For example,
   as indicated in Chapter I of these Guidelines, the application
   of the arm's length principle would take into account,
   inter alia, the contractual terms and economic circumstances
   particular to the CCA, e.g., the sharing of risks and costs.

Thus, while cost is likely to be the most accurate and straightforward measure of relative value in many cases, conceptually the need to refer to arm's-length values under the traditional pricing rules can complicate the analysis. Moreover, the question of how to determine the market value of different contributions may be a substantive issue in cases in which labor costs vary significantly among the different participants to the cost-sharing agreements--does the difference in the wage costs of an engineer operating in the United States provide an accurate measure of that engineer's value when being compared with the wage cost of a similar engineer operating in China? (7)

There are clearly various situations in which questions associated with the determination of the cost pool may lead different tax authorities to take different positions. Generally, there is the question of where to draw the boundary between costs to be shared and costs that should be excluded from the pool--to what extent, for example, should costs associated with the overall corporate recruiting, accounting, etc., be included in the pool of costs that are shared?

Finally, differences in specific local requirements may lead tax authorities to take different positions on the types of costs that have to be shared. Perhaps the most obvious example of this is the U.S. cost-sharing regulations, which explicitly require the sharing of stock option costs, and the use of specific approaches to determining the value of such costs, even though it is unclear whether these will be treated as deductible expenses in other jurisdictions. (8)

While there can be issues in determining which costs should be included in the cost-haring pool, these issues are generally significantly less complex than those associated with determining the value of the resulting IP. In many cases, determining what costs should go into a cost-haring pool is essentially an accounting issue that does not require the determination of economic value. Moreover, as previously discussed, the dollar magnitude of issues relating to the allocation of costs is often much lower than for issues relating to the determination of the market value of transferred IP.

Determining How to Allocate Costs

The general concept underlying a CCA is that the participants will allocate IP development costs on the basis of expected benefits rather than allocating income/profits on the basis of expected spending on R&D and other IP development activities by the different participants to the CCA. Thus, if Affiliates A and B expect to benefit equally from ongoing R&D spending but Affiliate A carries on 60 percent of R&D while Affiliate B carries the remaining 40 percent, under a CCA Affiliate B would pay for a portion of the costs Affiliate A incurred in carrying out the required R&D, such that each would bear an equal share of expenses. This contrasts from an arrangement in which income is allocated on the basis of spending. For example, under a typical cross-licensing arrangement or a joint venture driven by contributions, Affiliate A would seek to capture 60 percent of intangible income based on relative spending levels.

While the general concept of splitting costs based on expected benefit is relatively straightforward, there are often a number of practical problems that have to be addressed in the actual implementation of the CCA. At a very basic level, it is often difficult to determine initially which CCA participants will actually realize the benefits of the R&D. Such problems can arise, for example, when the participants use a common base of technology, but operate in somewhat different product lines. Under such circumstances, the R&D may turn out to be more important for one product line than the other, or the growth of one product line may outstrip that of the other.

More generally, there are cases in which certain types of costs may provide common benefits to all members of the CCA while other costs may provide benefits to a more narrowly defined set, or even just one participant. For example, in a CCA covering technology related to an energy-intensive chemical manufacturing process, some of the participants may rely upon oil as an energy source while others rely upon natural gas.

All the participants may be expected to share in R&D that leads to an overall reduction in energy use; only certain participants, however, will share in R&D related specifically to issues concerning natural gas usage and not oil usage. Under such circumstances, different allocation keys may be required for different R&D projects, or the decision whether or not to share costs may have to be made on a project-by-project basis.

Finally, the determination of how to measure benefits can be an issue in certain cases. Conceptually, the most direct measure of benefits is probably increased profits or reduced costs. It is often very difficult, however, to develop reliable forecasts of specific profits or cost savings. Therefore, as a general rule more indirect measures are often used, with allocations based on relative sales, energy use, or raw material consumed.

Once again, these issues are generally significantly less complex than those associated with determining the value of IP. Moreover, the dollar magnitude of issues relating to the allocation of costs is often much lower than issues relating to the determination of the market value of transferred IP.

Buy-in Payment for Pre-Existing Intangibles

In many cases, the different participants to a CCA may bring very different capabilities to the table. At the extreme, one participant may own valuable pre-existing IP while the other participants lack any offsetting IP. In other cases, the different participants may both own IP, but in different shares. Under such circumstances, the OECD Guidelines call for an arm's-length determination of that pre-existing value, and appropriate offsetting payments. The valuation methods used would be the same as those in any transfer pricing analysis.

The determination of initial buy-in payments has all of the difficult intangible pricing issues discussed above. In the United States, in particular, the IRS has expressed concern about the approaches taken by taxpayers to determine buy-in payments, which in the IRS's view have led to a significant (and troublesome) shift in income from the United States to various lower-tax jurisdictions. As a result, the IRS has issued a set of proposed changes to U.S. cost-sharing rules that would treat CCAs as non-arm's-length arrangements and subject them to a special set of transfer pricing rules differing markedly from both the general OECD methods and the methods dealing with the determination of transfer prices outside of a cost-sharing agreement. (9)

There is no question that the issue of buy-in payments can be very difficult to resolve. In principle, however, it no different from the issues confronted with any transfer of intangible property. (10) Moreover, there may be cases in which the magnitude of any buy-in is mitigated because the participants to the CCA are contributing IP of their or because the initial contribution may be relatively routine.

What Are Possible Options?

Given that China's tax authorities do not currently accept cost-sharing arrangements, the practical question is what options are available for taxpayers involved in joint IP development and use.

Licensing

One obvious option is simply to enter into licensing or cross-licensing arrangements. Arm's-length payments will be required under such arrangements, but in most cases the economic and business benefits resulting from the IP sharing can outweigh the tax costs of the resulting transfer pricing payments. (11) In some cases, the financial measures needed to drive management behavior may have to be separated from legal entity results to determine that the intercompany payments mandated by transfer pricing rules do not undermine the business objective of sharing IP.

China's tax authorities' tendency to limit royalty rates and payments may also reduce the incentive of the licensor to share technology with subsidiaries and joint venture partners in China. The authorities have historically followed a rule of thumb that the royalty rate should not exceed five percent of the revenue. Although the rule has now been abolished, royalty agreements with a high rate would be difficult to register with relevant government authorities and may be challenged by tax authorities. One way to address such a payment is to enter into an Advanced Pricing Agreement with the tax authorities.

Joint venture partners are common and in many cases mandatory for foreign multinationals wishing to operate in China. China's tax authorities view most of these transactions, even when the related party ownership stake is much less than 50 percent, as related party transactions. It is not uncommon for joint venture partners to use China's current posture toward the inbound licensing of IP as a lever to minimize such payments.

In cases in which multiple entities own different IP that they are cross licensing, it may be possible to argue that the most appropriate arm's-length arrangement is a cross license based on a net royalty or even on a royalty-free basis. While this type of analysis may work from a pure transfer pricing perspective, it may not fully address other tax issues. The SAT, for example, has taken the position that in such cross-licensing situations, withholding taxes should be levied on gross rather than net royalty payments.

Services

Alternatively, taxpayers can try to enter into agreements that effectively replicate at least some of the economics of a cost-sharing arrangement without having a formal arrangement. For example, taxpayers can set up contract R&D arrangements in which the entity carrying out the R&D is paid for the R&D, with the payments split among two or more taxpayers based on their relative "use" of the resulting IP. While this structure does not get IP development expenses shared at "cost"--there is generally a requirement to pay the provider of the contract R&D an arm's-length payment--it does represent a way of getting ownership interests assigned on the basis of expected benefits and therefore can mitigate the need for significant cross border royalty payments. (12)

Structuring these agreements properly will be important in China since Article 58 of the Detailed Implementation Rules on the Foreign Enterprise Income Tax (FEIT) law provides that general management fees paid to a related party are not deductible by a foreign investment enterprise for FEIT purposes. More generally, some taxpayers in lieu of formal transfers of IP, may bundle the IP transfer into a services payment. For example, when Affiliate A provides engineering services to Affiliate B, these engineering services implicitly contain IP. Therefore, the payment for the engineering service may also implicitly contain a payment for the associated IP as well. This approach probably only works, however, if the value of the IP is linked closely to costs, and even then it may raise the same transfer pricing issues as the transfer of IP on a standalone basis. Therefore, it only addresses a limited portion of the issue.

In practice, it is also common for multinational enterprises operating in China to structure the arrangements as service agreements. For the provision of services among related parties, the key assessments should be based on whether the service recipient derives real benefit from the services, whether the service charges were set at an appropriate level and whether the relevant direct and indirect costs and profit margin are reasonable.

Turnover tax and income tax implications should be considered when paying inter-company service charges. If the services are provided purely from offshore, the service charge would not be subject to People's Republic of China tax, but supporting documentation would be required by China's tax authorities to substantiate the offshore services. A mark-up of approximately 5 to 10 percent on total cost after business tax (BT) may be expected by the PRC tax authorities for the back-office service fee charge to the related party.

Finally, it may be possible to limit the choice of the business model used to limit formal IP transfers. For example, as long as a U.S. parent company buys all of the output of its manufacturing affiliate in China, the U.S. parent company should be able to effectively provide the China affiliate with access to all of the IP it needs on a royalty-free basis, as this is done for the benefit of the parent company. Such an approach (i) does not work under many circumstances (e.g., the license becomes royalty free as soon as the Chinese manufacturing affiliate sells to anyone other than the parent company) and (ii) severely limits the taxpayer's flexibility in developing alternative business structures. Finally, such arrangements may also be ignored by tax authorities.

Looking Forward

China is in the process of unifying its corporate income tax code. In the past, foreign-invested enterprises and domestic enterprises have operated under different systems. Although some senior tax officials from the SAT have stated that they are considering adopting rules governing cost sharing in the new corporate income tax rules, no official details have been made public so far.

In the long run, it may be better for China's tax authorities to adopt flexible rules allowing cost-sharing arrangements, which may benefit all parties involved. Simplifying audit issues arising from transfer pricing may allow China's tax authorities to use scarce resources more effectively and reduce the time spent on audit disputes. Moreover, from China's policy perspective, in the near term MNCs are more likely to use cost-sharing arrangements as a way of bringing IP into China than extracting IP from China. Until such a change occurs in China's tax regulations, there will be no simple answer.

(1.) For example, see GlaxoSmithKline Holdings (Americas) Inc. v. Commisioner, 9 TM TPR 335.

(2.) These are called "cost-sharing agreements" in the U.S. transfer pricing regulations. See Treas. Reg. [section] 1.482-7.

(3.) OECD Guidelines [paragraph] 8.3.

(4.) This article discusses the use of CCAs in the context of intangible property. The OECD Guidelines suggest, however, that CCAs can be used in other contexts as well, such as the use of shared services. OECD Guidelines [paragraph] 8.7.

(5.) This "shared ownership" may be shared legal rights or shared beneficial rights. The OECD Guidelines state (at [paragraph] 8.6): Perhaps the most frequently encountered type of CCA is an arrangement for the joint development of intangible property, where each participant receives a share of rights in the developed property. In such a CCA, each participant is accorded separate rights to exploit the intangible property, for example in specific geographic areas or applications. Stated more generally, a participant uses the intangible property for its own purposes rather than in a joint activity with other participants. The separate rights obtained may constitute actual legal ownership; alternatively, it may be that only one of the participants is the legal owner of the property, but economically all the participants are co-owners. In cases where a participant has an effective ownership interest in any property developed by the CCA and the contributions are in the appropriate proportions, there is no need for a royalty payment or other consideration for use of the developed property consistent with the interest that the participant has acquired.

(6.) OECD Guidelines [paragraph] 8.14.

(7.) While this may be a conceptually interesting question, tax authorities have generally taken the pragmatic view that costs are in fact an accurate measure of value in all but the most unusual of circumstances.

(8.) Treas. Reg. [section] 1.482-7 (these regulations were amended in 2003 to require expressly that the value of equity-based compensation be included in the costs shared under a cost-sharing arrangement).

(9.) Prop. Reg. [section] 1.482-7 (August 23, 2005).

(10.) New CCAs involving the United Sates represent a potential exception to this if and when the new cost-sharing regulations go into effect.

(11.) In general, under the licensing arrangements, the overseas recipient will be subject to People's Republic of China (PRC) withholding tax at 10 percent and business tax at 5 percent, but the business tax may be exempted under certain conditions.

(12.) This type of contract R&D structure may not provide some of the ancillary benefits of a CCA. For example, tax authorities may be less willing to limit any adjustments to cost, rather than the economic value of the IP, in the case of audit disputes.

Clark Chandler is a principal with the Washington National Tax practice of KPMG LLP. Sean Foley is the firm's U.S. Global Transfer Pricing Services leader, and Erik Skarstad is managing director, Washington National Tax, KPMG LLP. Steven Tseng is Global Transfer Pricing Services leader, Hong Kong & China, KPMG Huazhen. Messrs. Chandler and Foley are based in Washington, D.C.; Mr. Skarstad is located in Portland, Oregon; and Mr. Tseng is based in Shanghai. The authors may be reached at [e-mail], [e-mail], [e-mail], and [e-mail] authors thank Constance Lin, Assistant Manager, KPMG Huazhen (Shanghai), for her assistance in the preparation of this article.