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Final regs. clarify cost sharing of R & D expenditures.

In Dec. 19, 1995(1) and May 9, 1996(2) final regulations were issued governing qualified cost-sharing arrangements (QCSAs) under Sec. 482. The May 1996 final regulations made technical changes to the controlled participant qualification requirements contained in the December 1995 final regulations. The regulations bring closure to an area of regulatory unrest that has spanned a decade. This article reviews the final regulations and provides a checklist to prompt conformation of existing CSAs with the new standards.

CSAs are used to share the costs and benefits of research and development (R&D) activities between and among domestic and/for foreign parties, whether related or unrelated. Under a CSA, two or more participants contract to share R&D costs in exchange for an ownership interest in the intangibles developed through the collaboration.

Background

CSAs have existed for several decades. The Tax Reform Act of 1986 (TRA), Section 1231(e)(1), amended Sec. 482 to require that consideration for intangible property transferred in a controlled transaction be commensurate the income attributable to it. The TRA Conference Committee Report(3) indicated that in revising Sec. 482, Congress did not intend to preclude the use of R&D CSAs. Congress directed the IRS to conduct a comprehensive study and consider whether then-existing Sec. 482 regulations (issued in 1968) should be modified.

In 1988, the IRS and Treasury issued "A Study Of Intercompany Pricing"(4) (the "White Paper") which suggested that, to be valid, most CSAs must contain certain provisions. For example, most participants should be assigned exclusive geographic rights in developed intangibles,(5) and marketing intangibles should be excluded from bona fide CSAs.(6), Comments on the White Paper indicated that, in practice, there was great variety in the terms of CSAs.(7)

The IRS issued proposed cost-sharing regulations in January 1992.(8) In generally, they allowed more flexibility than had been anticipated and did not require CSAs to contain standard cost-sharing provisions. Although those rules were generally well-received, there were five areas of particular concern:

1. The mechanical use of cost-to-operating-income (cost/income) ratios as a standard for measuring the reasonableness of an effort to share costs in proportion to anticipated benefits.

2. The eligible participant requirement. Commenters argued that separate research entities (with no separate active trade or business) should be allowed to participate in CSAs, as should marketing affiliates.

3.. The regulations, requirement that every participant be able to benefit from every intangible developed under a CSA. Commenters stated that the regulations should allow both single-product CSAs and unibrena CSAs (i.e., CSAs under which a broad category of a controlled group's R&D would be covered).

4. The buy-in.buy-out rules. Commenters urged that one participant's abandonment of its rights did not necessarily confer benefits on the remaining participants and that a new participant need not always make a buy-in payment when joining a CSA.

5. Commenters viewed the administrative requirements as burdensome.

In addition, commenters noted that there should be more guidance as to when the IRS would deem a CSA to exist and argued that existing CSAs should be grandfathered or there should be a longer transition period. Finally, commenters asked that the regulations clarify that a CSA would not be deemed to create a partnership or a U.S. trade or business.(9)

Without fundamentally altering the policies of the proposed regulations, the final regulations reflect numerous modifications in response to these comments. They also reflect the approach

of the Sec. 482 regulations relating to transfers of tangible and intangible property.

The final regulations do not specify whether marketing activities can be included in a QCSA. Although the White Paper expressly excluded marketing intangibles from CSAs, no such exclusion is contained in the final regulations or their preamble. Moreover, broad definitional language is used to describe covered intangibles. Therefore, it would not be unreasonable to conclude that marketing intangibles can be cost shared under the final regulations.

What is a CSA?

Generally, transfers of intangible property are governed by Regs. Sec. 1.482-4. According to Regs. Sec. 1.482-4(f)(3)(ii), only one person can be the developer or true economic owner of an undivided interest in intangible property. Thus, only the developer is entitled to profit from commercial exploitation of such property. Under Regs. Sec.1.482-4(f)(5), profits must meet a "commensurate with income" standard that requires that the original developer receive (1) payments equal to what an unrelated party would have received in the open market and (2) all (or almost all of the profit (or loss) resulting from the commercial exploitation of the property. Although Regs. Sec. 1.482-4(f)(3)(ii) states that there is only one developer of an intangible, Regs. Sec. 1.482-4(f)(3)(ii) acknowledges that more than one entity may assist in its creation. An "assister" may receive arm's-length compensation for the services it provides.

An exception to the foregoing reflects congressional intent that has existed since the 1960. Reg. Sec. 1.482-7(a)(1) permits two or more intangible property, and to benefit from the commercial exploitation of the intangibles developed under the CSA. If two or more parties enter into a QCSA (as defined under Regs. Sec. 1.482-7(b)), they are not subject to Regs. Sec. 1.482-4.

According to Regs. Sec. 1.482-7(a)(1) a CSA is an agreement under which the parties agree to share development costs of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement. A taxpayer may claim that a CSA is a QCSA only if certain requirements under Regs. Sec. 1.482-7(b)(b) are met. However, the district director may apply the cost-sharing rules to any arrangement that in substance constitutes a CSA, notwithstanding any failure to satisfy particular regulatory requirements.

A CSA differs from both traditional licensing arrangements and from partnership structures. Under a CSA, the costs and risks of R&D are shared up front. Consequently, participants are not required to pay royalties for the subsequent use of any intangibles developed under the arrangement, as in the case of traditional licensing arrangements. Unlike a partnership, CSA participants are not required to pool profits earned through exploitation of developed intangibles. Regs. Sec. 1.482-7(a)(1) clarifies that a QCSA will not be treated as a partnership, nor will a foreign participant be treated as engaged in a trade or business within the U.S., solely by virture of its participation in a QCSA.

One of the primary advantages of a CSA is to reduce transfer pricing disputes with the IRS. However, use of a QCSA does not eliminate all transfer pricing issues; in effect, it substitutes one set of issues for another. Nevertheless, the scope of an IRS examination of a CSA should be limited to the appropriateness of the cost-sharing methodology used and the amount of any buy-in/buy-out payments (discussed below). Under Regs. Sec. 1.482-7(a)(2), the IRS may make allocations, but only to the extent necessary to make each controlled participant's share of intangible development costs (IDCs) equal to its share of reasonably anticipated benefits. If a controlled taxpayer acquires an interest in intangible property from another controlled taxpayer other than in consideration for bearing a share of the costs of the intangible's development), the district director may make appropriate allocatlons to reflect an arm's-length charge for the acquisition of the interest.

Reg. Sec. 1.482-7(a)(1) and (2) indicate that if a CSA is not a QCSA, the IRS may disregard it. The net result is that the transfer of the underlying technology is potentially subject to the Sec. 367(d) superroyalty provisions and to the Sec. 482 deemed royalty, provisions. In addition, there may be an exposure to a finding of partnership status for tax purposes, as well as a taxable U.S. trade or business presence in the case of a foreign participant. Partnership classification may lead to other unintended results. As a practical matter, a CSA which probably be respected, but the IRS is likely to impose reallocations.

Structuring a QCSA

Any two or more entities, controlled or uncontrolled,(10) may enter into a CSA. When uncontrolled participants are involved, it is assumed that they will bargain at arm's length. Consequently, it is rather easy for two uncontrolled participants to enter into a QCSA - they must comply only with the contemporaneous documentation requirements contained in Regs. Sec. 1.482-7(b)(4).

However, transfers between related parties are assumed not to be at arms length. Regs. Sec. 1.482-7(c)(1)(ii) provides that a controlled participant must meet the administrative and reporting requirements of Regs. Sec. 1.482-7(j) and must reasonably anticipate that it will derive benefits from the use of covered intangibles.

According to Regs. Sec. 1.482-7(b)(1)-(4), a QCSA must:

1. Include two or more participants.

2. Provide a method to calculate each controlled participants share of IDCs, based on factors that can reasonably be expected to reflect each participant's share of anticipated benefits.

3. Provide for adjustment to the controlled participants, shares of IDCs to account for changes in economic conditions, the participants, business operations and practices and the ongoing development of intangibles under the arrangement.

4. Be recorded in a document that is contemporaneous with the formation (and any revision) of the CSA that includes:

* A list of the arrangements participants, and any other member of the controlled group that will benefit from the use of intangibles developed under the CSA.

* A description of the method used to calculate each controlled participants share of IDCs, based on factors that can reasonably be expected to reflect that participants share of anticipated benefits.

* A description of the method used to adjust the controlled participants, share of IDCs to account for changes in economic conditions, the participants, business operations and practices and the ongoing development of intangibles under the arrangement.

* A description of the scope of R&D to be undertaken, including the intangible or class of intangibles intended to be developed.

* A description of each participants interest in any covered intangibles. A "covered intangible" is any intangible property developed as a result of the R&D undertaken under the CSA (intangible development area).

* A description of the duration of the arrangement.

* A description of the conditions under which the arrangement may be modified or terminated and the consequences of such modification or termination (e.g., the interest that each participant will receive in any covered intangibles).

Administrative Requirements

CSA administrative requirements are contained in Regs. Sec. 1.482-7(j)(2). Under Regs. Sec. 1.482-7(c)(1)(iii), a controlled participant in a CSA must maintain sufficient documentation to:

* Establish the total costs incurred under the CSA.

* Establish the costs borne by each controlled participant.

* Describe the method used to determine each controlled participant's share of IDCs, including the projections used to estimate benefits and an explanation of why that method was selected.

* Describe the accounting method used to determine the costs and benefits of intangible development (including the method used to translate foreign currencies), and, to the extent that such method materially differs from generally accepted accounting principles (GAAP), an explanation of such material differences.

* Describe prior research (if any) undertaken in the intangible development area, any tangible or intangible property made available for use in the arrangement by each controlled participant and any information used to establish the value of preexisting and covered intangibles.

In addition, Regs. Sec. 1.482-7(j)(3) provides that a controlled participant must attach to its Federal income tax return a statement indicating that it is a participant in a QCSA and list other controlled participants to the arrangement. Controlled participants not required to file a return must ensure that such a statement is attached to Schedule M of any Form 5471, Foreign Corporation Controlled by a U.S. Person, or Form 5472, Information Return of a Foreign Owned Corporation (under Sec. 6038A), filed with respect to that participant.

All of the foregoing documentation must be available within 30 days of an IRS request, according to Regs. Sec. 1.482-7(j)(2)(i). The preamble to the December 1995 final regulations anticipates that many of the required background documents will be kept in any event for purposes of the Sec. 6662(e) recordkeeping requirements. Regs. Sec. 1.492-7(j)(2), issued

issued in May 1996, provides that documentation maintained under the cost-sharing regulations win satisfy the principal documents requirement of Regs. Sec. 1.6662-6(d)(2)(iii)(B) with respect to a QCSA.

Reasonable Anticipation of Benefits Limitation

Probably the most important limitation on cost sharing pertains to the types of controlled entities that qualify for participation in CSAs. The limitation is based on the requirement in Regs. Sec. 1.482-7(c)(1)(i) that a controlled participant must reasonably anticipate that it will derive benefits from the use of covered intangibles.

The December 1995 version of Regs. Sec.1.482-7(c)(1)(i) required that controlled participants use, reasonably expect to use or be deemed to use the intangibles created under the CSA in the active conduct of a trade or business. This requirement created a two-pronged test for qualified participation: "use" of intangibles and "active conduct" of a trade or business. The May 1996 regulations eliminated this test. In the preamble to those regulations, the IRS explained that the active conduct rule was intended to ensure that a controlled participant stands to benefit from the use of covered intangibles in a manner that can be reliably measured. The IRS concluded that such purpose "can be accomplished without the active conduct rule." Further, there is no need for distinctions based on the nature of a participants use of covered intangibles, "so long as its benefits from such use (whether from directly exploiting the intangibles or from transferring or licensing them to others) can be reliably measured."

Additional rules ensure that benefits to group members are measured consistently. Regs. Sec. 1.482-7(f)(3)(ii) provides that if a controlled participant transfers covered intangibles to another controlled taxpayer, such participant's benefits from the transferred intangibles must be measured by reference to the transferee's benefits, disregarding any consideration paid (e.g., a royalty pursuant to a license agreement) by the transferee to the controlled participant.

Regs. Sec. 1.482-7(c)(1) permits a controlled taxpayer to be a controlled participant in a CSA only if it reasonably anticipates that it will derive benefits from the use of covered intangibles. An entity cannot be a qualified participant if the primary reason for its participation in the CSA is to transfer or license the intangibles developed under the arrangement to related or unrelated parties, rather than to use the developed intangibles in its own trade or business.

Example 1:(11) Foreign parent FP is a foreign corporation engaged in the extraction of a natural resource. FP sells supplies of this resource to its U.S. subsidiary (USS) for sale in the U.S. 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 win be patented in the U.S. and in other countries. The CSA provides that USS will receive the rights to use the machine in the extraction of the natural resource in the U.S., and FP will receive the rights in the rest of the world. This resource does not, however, exist in the U.S. Despite the fact that USS has received the right to use this process in the U.S., USS is not a qualified participant because it will not derive a benefit from the use of the intangible developed under the CSA.

This example implies that a controlled entity whose sole activity is to perform R&D may not be a qualified participant in a CSA, presumably because it fails the reasonable participation of benefits test. This example provides no real guidance in situations in which a controlled entity is not "solely" engaged in R&D. The provision appears to be designed to prevent companies from setting up foreign entities simply to participate in CSAs without performing any other significant business activities or bearing significant risks.

In summary, these changes ensure that a controlled participant must benefit from the arrangement, that the basis for measuring benefits must be consistent for all controlled participants, and that, in the event of intragroup transfers, there will be "lookthrough" treatment for reliably measuring benefits. These rules allow a participant to exploit covered intangibles itself or by transferring or licensing them to others, as long as the benefits to be derived can be consistently and reliably measured for all controlled participants.

Costs Subject to Cost Sharing

Regs. Sec. 1.482-7(d)(1) defines the costs subject to cost sharing as all costs incurred by a participant related to the intangible development area, plus aU of the cost-sharing payments it makes to other controlled and uncontrolled participants, less all of the cost-sharing payments it receives from other controlled and uncontrolled participants.

These costs include operating expenses (other than depreciation or amortization expense) plus (to the extent not included in such operating expenses) an arm's-length charge for any tangible property made available to the CSA. The expenses of intangible property contributed to a CSA cannot be shared. Costs that do not contribute to the intangible development area are not taken into account. Under the cost-sharing rules, costs of relevant R&D are shared, even if such costs are nondeductible and must be capitalized.

Regs. Sec.1.482-7(d)(1) preserves the district director's authority to adjust the pool of costs shared to properly reflect costs that relate to the intangible development area.

Cost Allocations

A key CSA issue is the cost allocation rules, which set out how a controlled participant's share of reasonably anticipated benefits is determined. Cost allocations are still problematic under the final regulations. Regs. Sec. 1.482-7(e)(1) defines "benefits" as additional income generated or costs saved by the use if covered intangibles. According to Regs. Sec. 1.482-7(e)(2), a controlled participants reasonably anticipated benefits are the aggregate benefits it reasonably anticipates it will derive from covered intangibles; it effect, cost shares must equal benefit shares.

For purposes of determining whether a cost allocation is appropriate for a tax year, Regs. Sec. 1.482-7(f)(1) states that a controlled participants share of IDCs for a CSA must equal its share of reasonably anticipated benefits. According to Regs. Sec. 1.482-7(f)(3)(ii), a share of reasonably anticipated benefits is determined using the most reliable estimate of benefits. Cost and benefit share determinations must be consistent for all participant's.

Regs. Sec. 1.482-7(f)(3)(ii) also provides that if a controlled participant transfers covered intangibles to another controlled taxpayer, such participants benefits from the transferred intangibles must be measured by reference to the transferee's benefits (disregarding any consideration paid by the transferee to the controlled participant, e.g., a royalty pursuant to a license agreement).

Example 2:(12) U.S. parent USP, foreign subsidiary 1 (FS1) and foreign subsidiary 1 (FS2) enter into a CSA to develop computer software that each will market and install on customers' computer systems. The participants divide costs 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 see 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. Here, the basis used for measuring the benefits of each participant is not the most reliable, because all of the benefits received by participants are not taken into account. To reliably determine benefit 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 participants' projected benefits from sales (e.g., all participants might measure their benefits on the basis of operating profit).

According to Regs. Sec. 1.482-7(f)(3)(i)(A) and (B), the reliability of an estimate of benefits depends on two factors: the reliability of the basis used for measuring benefits and the reliability of the projections used. The measurement basis used must be consistent for all controlled participants. The district director may make an allocation of costs or income under Regs. Sec. 1.482-7(f)(3)(iv)(B) if the taxpayer does not use the most reliable estimate of benefits (which depends on the facts and circumstances of each case).

Regs. Sec. 1.482-7(f)(3)(ii) allows anticipated benefits to be measured either on a direct or fits are measured on a direct basis by reference to estimated additional income to be generated or costs to be saved by the use of covered intangibles. Anticipated benefits are measured on an indirect basis by reference to certain measurements that can reasonably be assumed to be related to income generated or costs saved.

The final regulations prescribe no direct basis for measuring benefits, but Regs. Sec. 1.482-7(f)(3)(iii)(A) - (D) include four indirect bases to measure benefits: (1) units used, produced or sold by each participant; (2) sales made or (3) operating profits earned by each participant that exploits the intangible developed under the CSA; and (4) other bases of measurement that might provide a reasonably identifiable relationship between the basis of measurement used and additional income generated or costs saved by the use of the covered intangibles under consideration. most reliable basis for measuring anticipated benefits must be used.

According to Regs. Sec. 1.482-7(f)(3)(iv)(A), a projection of the relevant basis of measurement may require concomitant projections of underlying factors (e.g., a projection of operating income may require that sales, cost of sales and operating expenses be reliably projected). Regs. Sec. 1.482-7(f)(3)(iv)(B) provides that the district director may disregard unreliable projections and make adjustments and reallocations.

If there is a significant difference between projected and actual benefit shares, Regs. Sec. 1.482-7(f)(3)(iv)(B) takes the position that the projections may not have been reliable, in such cases, the district director may then use actual benefits to allocate costs under the agreement. Projections are not unreliable based on a divergence between a controlled participants projected benefits and actual benefits if the amount of such divergence for each controlled participant is 20% or less of the participants projected benefit share. For purposes of the 20% test, all non-U.S. controlled participants are treated as a single controlled participant.

In addition, the district director will not make an allocation based on such divergence if the difference is due to an extraordinary event, beyond the control of the participants, that could not have reasonably been anticipated at the time costs were shared. If there is a significant divergence not due to an unforeseeable event, the district director may use actual benefits to allocate costs.

Buy-in/Buy-out Payments

Regs. Sec. 1.482-7(g) contains complex rules that are fairly R,consistent with the proposed regulations and require payment of arm's-length consideration by all incoming and outgoing participants for the value of intangible property made available through the CSA. In addition, under Regs. Sec. 1.482-7(g)(1), any modification of a participants interest in covered intangibles is deemed to be a transfer of intangible property for which the district director may impose an arm's-length charge under Sec. 482.

Regs. Sec. 1.482-7(g)(2) provides that when a controlled participant makes pre-existing intangible property available to a QCSA, other controlled participants are required to make a buy-in payment to the owner of the intangible property. If the buy-in payment is not made, Regs. Sec. 1.482-7(g)(1) allows the district director to make appropriate allocations under Sec. 482 to reflect an arm's-length consideration for the transferred intangible property.

According to Regs. Sec. 1.482-7(g)(2), a controlled participant's buy-in payment is netted against payments owed to it from other controlled participants. The preamble to the May 1996 final regulations notes that this netting rule does not apply in other contexts (e.g., there is no provision for netting of royalties from cross-licenses). Each payment received by a payee is treated as a pro rata payment made from all payors.

Under Regs. Sec. 1.482-7(g)(1), any change in a participant's interest in covered intangibles is a transfer of an intangible for which the district director may inipose appropriate allocations under Sec. 482 to reflect an arm's-length consideration for the transfer. Regs. Sec. 1.482-7(g)(4) states that a change in a participant's interest in a covered intangible occurs when a controlled participant either joins the arrangement or abandons, transfers or otherwise relinquishes some or all interest in covered intangibles under the CSA. If such a relinquishment takes place, the participant relinquishing the interest must receive an arm's-length consideration from the remaining controlled participant(s). When a new controlled participant enters a QCSA and acquires any interest in covered intangibles, it must pay an arm's-length consideration.

Regs. Sec. 1.482-7(g)(6) provides that any unassigned interests in a covered intangible are deemed to be owned by each controlled participant in an amount equal to its share of IDCs. Should an unassigned geographic market be ultimately exploited by one of the controlled participants or another related party, an arm's-length payment must be made to each of the deemed owners consistent with the value of the geographic rights in the intangible.

Regs. Sec. 1.482-7(g)(7) provides that the consideration for a buy-in/buy-out payment may take any of three forms: lump-sum payment, installment payments or royalties. Lump-sum payments may present problems in terms of determining the fair market value of the base technology, this results from the inherent difficulties associated with the valuation of intangibles. Payments of royalties may present problems in terms of determining how long royalties should continue and whether they should decline or phase out due to the declining value of the base technology.

When research projects in question are still in a relatively early stage, it may be possible to satisfy the buy-in requirement by making a "catch up" time-valued payment that reimburses prior R&D costs and includes a premium for risk and going concern value (or, more properly, a type of "assembled work force" valuation). Cost-based buy-in payments may be limited by the IRS to early-stage cost-sharing projects.

Tax Treatment of Payments

According to Regs. Sec. 1.482-7(h)(1), cost-sharing payments (other than buy-in/buy-out payments, previously discussed) are treated as cost reimbursements to the payee and as R&D expenses to the payor. Thus, such payments are not generally subject to withholding (as are royalty payments). Cost-sharing payments received by a domestic party from an offshore affiliate are not treated as foreign-source income for Federal tax purposes; instead, such payments reduce R&D expenses that would otherwise be deducted by the domestic affiliate and subject to allocation under Regs. Sec. 1.861-8.

Effective Date; Transition Rule

The final regulations are effective for tax years beginning after 1995. Regs. Sec. 1.482-7(k) and (1) allow a one-year transition period for taxpayers to amend existing CSAs to conform with the final regulations.

Benefits and Burdens of Cost Sharing

Benefits

Avoidance of superroyalty provisions: Offshore ownership of intangibles developed through a QCSA can avoid application of the Sec. 367(d) superroyalty provisions, and should serve to narrow the range of Sec. 482 disputes (Regs. Sec. 1.482-7(a)(2)).

Research credit unaffected: Cost sharing does not adversely affect the R&D credit determination under Sec. 41(f), as intercompany payments are disregarded for purposes of the R&D credit under Regs. Sec. 1.41-8(e) (Regs. Sec. 1.482-7(h)(1)).

Increase active assets: Offshore ownership of intangibles should provide overall substance to an offshore manufacturing affiliate by increasing the amount of active assets held by the affiliate. In turn, this could permit avoidance of passive foreign investment company status and application of Sec. 956A.(13) Under Sec. 1.1297-(e), the adjusted basis of the total assets of the offshore affiliate is increased by the unreimbursed research expenses incurred (as determined under Sec. 174) during the tax year and the preceding two tax years.

Increase foreign sales corporation benefits: Use of a CSA can increase foreign sales corporation (FSC) income, at least in the short term, because cost-sharing receipts reduce the domestic corporation's research expenses. Lower research expenses result in a reduced charge against combined taxable benefits. In the long term, there would be no FSC benefit with respect to the intangibles developed under a CSA, because the situs of manufacturing would have shifted away from the US.

Avoid multiple withholding taxes: Payments made from U.S. entities are cost reimbursements and would not be subject to 30% withthholding (critical in the case of cascading royalty structures).

Burdens

Reduce current Sec. 174 deduction: Cost sharing reduces current R&D expense deductions to the extent costs are allocated to foreign participants, thereby increasing current taxable income.

Reduce foreign-source income: Cost sharing may not be preffered by US. multinationals with excess foreign tax credits, as it reduces foreign-source royalty income that potentially could be included in general basket income under Sec. 904.

Withholding tax implications: In some countries, issues may arise regarding both the deductibility of cost-sharing payments and liability for foreign withholding tax. Regs. Sec. 1.482-7(h)(1) provides that any payment that in substance constitutes a cost-sharing payment will be treated as such, regardless of its characterization under foreign law. This rule is intended to enable foreign entities to participate in CSAs with U.S. controlled participants even if foreign law does not recognize cost sharing. The extent to which foreign tax jurisdictions will accept the US. government's tax treatment of intangible transfers among related parties remains uncertain. Obviously, the risk of double taxation is reduced when foreign jurisdictions accept cost sharing as an alternative.

Advantages and Disadvantages

of the Final Regulations

The cost-sharing regulations contain some improvements over the proposed regulations, but continue to contain some limitations that may jeopardize certain existing CSAs.

Advantages

* By comparison with the proposed cost-sharing regulations the final regulations offer some advantages: * They clarify that CSAs alone will not be deemed to be partnerships (Regs. Sec. 1.482-7(a)(1)). * They clarify that CSAs alone will not give rise to permanent establishments in the U.S. (Regs. Sec. 1.482-7(a)(1)). * They permit unrelated parties to be participants in CSAs (Regs. Sec. 1.482-7(c)(1)). * The district director's ability to make adjustments to QCSAs is limited to putting the controlled participants' cost shares in line with their shares of reasonably anticipated benefits (Regs. Sec. 1.482-7(A)(2)). * The reasonableness of the cost shares will not be tested by using a cost/income ratio, but by use of the best method rule, which requires use of the most reliable estimate of the sharing of benefits (Regs. Sec. 1.482-7(f)(3)(i)).

Disadvantages

* The unfavorable aspects of the cost-sharing regulations include: * They do not conclusively indicate whether marketing activities may be included in a CSA. * They do not permit depreciation and amortization costs associated with the creation of intangibles to be shared (Regs. Sec. 1..482-7(d))(1)). * They contain more burdensome requirements as to what must be documented in a CSA.

QCSA Diagnostic Checklist

The checklist on pages 34-37 is not exhaustive, but merely illustrates the type of analysis that may be undertaken on behalf of clients with cost-shared, cross-border R&D operations.

QCSA Diagnostic Checklist (Applies to tax years beginning after 1995)

Part I. Ascertain Current Taxpayer Status

1. Is there an existing CSA?

A CSA is an agreement under which the parties agree to share the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement (Regs. Sec. 1.482-7(a)(1)). - If yes, obtain documentation from taxpayer.

2. Was an existing CSA, prior to 1996, a bona fide CSA under Temp. Regs. Sec. 1.482-7T?

- If yes, conform with final regulations by Dec. 31, 1996 (Regs. Sec. 1.482-7(1)).

- If no, taxpayer does not have a QCSA (Regs. Sec. 1.482-7(a)(1)).

Caution: Analyze facts and circumstances to ascertain whether taxpayer is (by default) a member of a partnership to which the rules of subchapter K apply (see Regs. Sec. 301.7701-3(e)).

Caution: A foreign corporation or a nonresident alien individual may be treated as engaged in a trade or business within the US. solely by reason of its participation in such an arrangement (Regs. Sec. 1.864-2(a)).

Part II. QCSA Documentation and

Administrative Requirements

3. A taxpayer may claim that a CSA is a QCSA only if the agreement meets Regs. Sec. 1..482-7(b). Does the CSA include all of the following information?

Two or more participants (Regs. Sec. 1.482-7(b)(1)).

Provide a method to calculate each controlled participant's share of IDCs, based on factors that can reasonably be expected to reflect that participant's share of anticipated benefits (Regs. Sec. 1.482-7(b)(2)).

Provide for adjustment to the controlled participants' shares of IDCs to account for changes in economic conditions, the participants' business operations and practices and the ongoing development of intangibles under the arrangement (Regs. Sec. 1.482-7(b)(3)).

4. Are the terms of the CSA recorded in a document that is contemporaneous with the formation (and any revision) of the CSA and include all of the following information (Regs. Sec 1.482-7(b)(4))?

A list of the arrangement's participants, and any other member of the controlled group that will benefit from the use of intangibles developed under the CSA.

Description of the method used to calculate each controlled participants share of IDCs, based on factors that can be reasonably expected to reflect that participant's share of anticipated benefits.

Description of the method used to adjust the controlled participants' shares of IDCs to account for changes in economic conditions, the participants' business operations and practices and the ongoing development of intangibles under the arrangement.

Description of the scope of R&D to be undertaken, including the intangible or class of intangibles intended to be developed.

Description of each participant's interest in any covered intangibles. A covered intangible is any intangible property developed as a result of the R&D undertaken under the CSA (intangible development area).

Description of the duration of the arrangement.

Description of the conditions under which the arrangement may be modified or terminated and the consequences of such modification or termination, such as the interest that each participant will receive in any covered intangibles.

Note: If any of the foregoing items are not present in an existing CSA, it should be amended by Dec. 31, 1996 to include the omitted items.

5. A controlled participant must maintain sufficient documentation to qualify as a QCSA. The required documentation must be available within 30 days of IRS request. Does the documentation include all of the following (Regs. Sec. 1.482-7(4)(2) and (3))?

The total costs incurred under the CSA.

The costs borne each controlled participant.

A description of the method used to determine each controlled participant's share of IDCs, including the projections used to estimate benefits and an explanation of why that method was selected.

A description of the accounting method used to determine the costs and benefits of the intangible development (including the method used to translate foreign currencies), and, to the extent that the method materially differs from GAAP, an explanation of such material differences.

A description of prior research (if any) undertaken in the tangible development area, any tangible or intangible property made available for use in the arrangement by each controlled participant, and any information used to establish the value of pre-existing and covered intangibles.

Has the controlled participant attached to its Federal income tax return a statement indicating that it is a participant in a QCSA and listing other controlled participants to the arrangement? Controlled participants not required to file a Federal income tax return must ensure that such a statement is attached to Schedule M of any Form 5471, Foreign Corporation Controlled by a US. Person, or Form 5472, Information Return of a Foreign Owned Corporation (under Sec. 6038A), filed with respect to that participant.

Part III. QCSA Participants: Controlled and

Uncontrolled

6. A QCSA includes two or more participants. Participants are taxpayers that are either controlled or uncontrolled (Regs. Sec. 1.482-7(c)(1)). "Controlled taxpayer" means any one of two or more taxpayers owned or controlled directly or indirectly by the same interests, and includes the taxpayer that owns or controls the other taxpayers. "Uncontrolled taxpayer" means any one of two or more taxpayers not owned or controlled directly or indirectly by the same interests (Regs. Sec. 1.482-1(i)(5)).

Is the CSA participant a controlled taxpayer?

Note: Uncontrolled taxpayer participants are not subject to the reasonable anticipation of benefits rule (Regs. Sec. 1.482-7(c)(1)(i)).

Part IV. Controlled Participants and the

Business Use Test

7. A controlled taxpayer may be a controlled participant in a QCSA only if it reasonably anticipates that it will derive benefits from the use of covered intangibles Regs. Sec. 1.482-7(c)(ii)).

Does the controlled taxpayer reasonably anticipate that it will derive benefits from the use of covered intangibles?

- If yes, controlled taxpayer is a controlled participant and a proper party to a QCSA.

Part V Treatment of Controlled Taxpayer That

Is Not a Controlled Participant

8. If a controlled taxpayer that is not a controlled participant provides assistance in relation to R&D undertaken in the intangible development area, it must receive consideration from the controlled participants under Regs. Sec. 1.482-74(f)(3)(iii), dealing with allocations with respect to assistance provided to the owner. Such consideration is treated as an operating expense and each controlled participant is treated as incurring a share of such consideration equal to its share of reasonably anticipated benefits (Regs. Sec. 1.482-7(c)(2)(ii).

Do any controlled taxpayers fail to qualify as controlled participants?

- If yes, are such participants rendering services or making tangible or intangible property available to QCSA participants?

- If yes, such participant must receive arm's length consideration from the QCSA controlled participants under Regs. Sec. 1.482-4(f)(3)(iii), dealing with allocations with respect to the owner.

Part VI. IDCs

9. Costs incurred related to the intangible development area consist of operating expenses (as defined in Reg. Sec. 1.482-5(d)(3), other than depreciation or amortization expense). Costs that do not contribute to the intangible development area area are disregarded.

Do any of the costs contribute both to the intangible development area and to other areas or other business activities?

- If yes, costs must be allocated as set forth in Regs. Sec. 1.482-7(d)(1) (Regs. Sec. 1.482-7(d)(2), Example (1)).

Was tangible property made available to the QCSA by a controlled participant?.

- If yes, an appropriate charge must be determined under Regs. Sec. 1.482-2(c), dealing with the use of tangible property.

Caution: IDCs do not include the consideration for the use of any intangible property made available to the QCSA. Such consideration is treated as either buy-in or buy-out payments.

10. A controlled participant's costs of developing intangibles for a tax year include all costs incurred by that participant related to the intangible development area, plus all of the cost-sharing payments it makes to other controlled and uncontrolled participants, minus all of the cost-sharing payments it receives from other controlled and uncontrolled participants (Regs. Sec. 1.482-7(d)(1)).

Were costs properly identified and netted?

Part VII. Buy-in/Buy-out Payments

11. If a controlled participant makes pre-existing intangible property in which it owns an interest available to other controlled participants for purpose, of research in the intangible development area under a QCSA, it is treated as having transferred interests in such property to the other controlled participants and each such other controlled participant must make a buy-in payment to the owner (Regs. Sec. 1.482-1 and -4 payments must reflect an arm's-length charge for the use of the intangible (under Regs. Secs. 1.482-1 and -4 through -6), multiplied by the controlled participant's share of reasonably anticipated benefits. If the other controlled participants fail to make such payments, the district director may such appropriate allocations to reflect arm's-length consideration for the transferred intangible property. Buy-in/buy-out payments may be in the form of lump sums, installment payments and royalties (Regs. Sec. 1.482-7(g)(7)).

Was pre-existing intangible property made available by the taxpayer to other controlled participants under the CSA?

- If yes, verify that appropriate buy-in payments were made.

Did a new controlled participant enter into the QCSA and acquire any interest in the covered intangibles?

- If yes, the new controlled participant must make an appropriate buy-in payment (Regs. Sec. 1.482-7(g)(3)). The new participant must pay an arm's-length consideration (determined under Regs. Secs. 1.481-1 and -4 through -6) for such interest to each controlled participant from whom such interest was acquired (Regs. Sec. 1.482-7(g)(3) and (8), Example (1)).

12. A controlled participant in a QCSA may be deemed to have acquired an interest in one or more covered intangibles if another controlled participant transfers, abandons or otherwise relinquishes an interest under the arrangement to the benefit of the first participant (Regs. Sec. 1.482-7(g)(4)).

Did a controlled participant in a QCSA relinquish, transfer or abandon an interest under the arrangement to the benefit of another controlled participant?

- If yes, a buy-out payment is required

(Regs. Sec. 1.482-7(g)(8), Example (3)).

Did a controlled participant that relinquished its interest in a covered intangible subsequently use that interest (Regs. Sec. 1.482-7(g)(4))?

-If yes, that participant must pay an arm's-length consideration to the controlled participant(s) that acquired the interest.

Note. If any controlled participant bears IDCs over a period of years that are consistently and materially greater or less than its share of reasonably anticipated benefits, the district director may conclude that the economic substance of the arrangement is not in fact a QCSA (see Regs. Sec. 1.482-7(g)(5) and (8), Example (2)).

Part VIII. Tax Treatment of Cost-sharing Payments

13. Payments made under a QCSA are treated as IDCs to the payor and as cost reimbursements to the payee. Payments required of a participant may be netted against payments owed to it under the QCSA from other participants. For purposes of the Sec. 41 research credit, intragroup transaction treatment described in Regs. Sec. 1.41-8(e) applies. Any payment that in substance constitute a cost-sharing payment will be treated as such, regardless of its characterization under foreign law. Foreign currencies are to be translated on a consistent basis (Regs. Sec. 1.482-7(h)(1) and (i)).
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Title Annotation:research and development
Author:Picciano, Kenneth C.
Publication:The Tax Adviser
Date:Jan 1, 1997
Words:7206
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