TEI comments on proposed cost sharing regulations: November 28, 2005.
On August 22, 2005, the Internal Revenue Service and U.S. Department of Treasury issued proposed regulations under section 482 of the Internal Revenue Code, relating to the methods to be used to determine taxable income in connection with a cost sharing agreement. The proposed regulations were published in the August 29, 2005, issue of the Federal Register (70 Fed. Reg. 51116), and the October 3, 2005, issue of the Internal Revenue Bulletin (200540 I.R.B. 625). A hearing is scheduled for December 16, 2005.
Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,400 members represent 2,800 of the leading corporations in the United States, Canada, Europe, and Asia. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.
Members of TEI are responsible for managing the tax affairs of their companies and must contend daffy with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring a balanced and practical perspective to the issues raised by these proposed regulations.
II. The Value of Cost Sharing Arrangements for Business
Section 482 of the Internal Revenue Code authorizes the Secretary of the Treasury to "distribute, apportion, or allocate gross income, deductions, credits, or allowances" among related parties if it is determined necessary to prevent the "evasion of taxes or clearly to reflect the income" of the entities. In 1986, section 482 was amended to provide that, in the case of any transfer or license of an intangible (such as a copyright, trademark, or patent), the income with respect to such transfer or license must be "commensurate with the income" from that intangible. See Tax Reform Act of 1986, Pub. L. No. 99-514, [section] 1231(e)(1), amending I.R.C. [section] 482.
For a variety of sound business reasons, many taxpayers choose to conduct certain cross-border activities under a cost sharing agreement whereby two or more parties conduct research and development activities and share the risks and rewards associated with that research. As a result, each participant has an ownership interest in the developed intangible and may exploit it without paying a royalty to any other participant or related party. Under the current regulations (which were promulgated in 1995), buy-in payments must be made to any participant that makes preexisting intangible property available to the arrangement.
Broadly stated, businesses generally have three objectives for participating in such an arrangement. First, by pooling and sharing the cost of research and technical know-how among participants, all developed intangible property freely flows among the companies participating in the arrangement. This free flow of technology can occur without any additional contractual arrangements (i.e., legal costs); payments (i.e., administrative costs); or valuations (i.e., consulting costs). Second, by pooling and sharing these costs, participants optimize all available professional expertise and experience, thereby achieving significant economies of scale over what could be achieved by each company acting individually (resulting in significant cost savings). Finally, cost sharing arrangements are a cost effective way to develop and use intangible property among related companies.
In 1986, Congress recognized cost sharing agreements as a valid means of intercompany pricing:
In revising section 482, the conferees do not intend to preclude the use of certain bona fide research and development 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. Rep. No. 99-841, 99th Cong., 2d Sess. II-638 (1986).
Cost sharing is important to many U.S.-based companies because it facilitates their ability to compete in an increasingly global marketplace. Cost sharing allows the centralized management and legal defense of a portfolio of valuable intellectual property rights, while allowing for the shared exploitation of those rights. In addition, the use of cost sharing agreements (CSAs) helps U.S. multinational corporations reduce the amount of foreign withholding taxes on related-party and third-party transactions. Thus, cost sharing enhances a U.S.-based multinational's ability to efficiently exploit its intellectual property on a global basis.
Regrettably, the proposed regulations threaten to undermine congressional intent to permit companies to conduct their affairs in an effective and cost-efficient manner. The new rules proceed from an assumption that taxpayers use cost sharing abusively to disguise the transfer of intangible property outside the United States to an affiliate (often located in a tax haven) at a value substantially less than the fair market value of the intangible property. The regulations are intended to ensure that, where buy-in payments must be made to a participant transferring valuable external contributions to the other participants, such compensation is based on the arm's-length value of what is being transferred. The "investor model" approach prescribed in the proposed regulations, however, goes beyond ensuring that buy-in payments are based on an arm's-length analysis. The investor model requires that two separate transactions be analyzed (i.e., the buy-in payment and the cost sharing contribution) as though they were a single investment decision based on an expectation of a given overall return.
TEI submits that, at best, this linking of the buy-in and cost sharing contribution analyses is unnecessary to address the IRS's concerns. At worst, it deprives a cost sharing participant a fair economic return once that participant has committed to making arm's-length buy-in payments.
Cost sharing is a response to the business reality that many multinational taxpayers conduct their ongoing research and development (R&D) in multiple locations around the world. Scientists and engineers from different countries routinely collaborate in the development of new products and technologies. Much of the best scientific and engineering work now occurs outside the United States. In response to global competition, multinational companies routinely establish multiple R&D centers of excellence around the world, permitting development work to proceed on a 24/7 basis.
As the cost and risks of R&D continue to climb, businesses increasingly cannot "go it alone." To remain globally competitive, U.S. businesses must share the costs, risks, and outcomes of ongoing research and development, without having to evaluate annually the actual vs. projected share of costs per participant and the appropriate vehicle for sharing the results of any successful technologies. Cost sharing permits a sharing of risks and outcomes, but obviates elaborate timesheets, tracking and charge-outs of expenses, and intercompany royalty payments and cross-license agreements. It permits multiple entities to spread risks, jointly fund centers of R&D excellence located in key countries, and benefit from the results.
As more fully described below, the provisions in the proposed regulations to--
* use the so-called investor model;
* require complex valuation methods that may not provide in arm's-length results;
* treat an existing R&D workforce in place as a contribution to a CSA requiring a buy-in;
* require compensation for contributed intangibles over the entire life of the CSA;
* require lump-sum buy-in payments for certain external contributions;
* prohibit the contribution of make-or-sell rights;
* permit the IRS to make one-way adjustments;
* share results on an exclusive geographical basis;
* share all costs of a CSA;
* require inclusion of stock-based compensation in the costs to be shared;
* comply with complex administrative rules; and
* retroactively apply the valuation provisions in certain circumstances
--will discourage companies from entering into new, and continuing to use existing, cost sharing arrangements. CSAs could become the method of last resort, even though they reflect business realities and permit the fair and efficient sharing of the risks, costs, and benefits of intangible development. In the extreme, the proposed regulations may discourage U.S.-based R&D, because they would create an incentive for locating R&D (and the premium profits that accompany R&D under the proposed regulations) outside the United States.
Although the IRS may have concerns about perceived abuses, the new rules adversely affect legitimate cost sharing arrangements and could well render them obsolete. TEI submits that any abuses that may occur with respect to the offshore transfer of intangibles can be better dealt with through application of the existing rules under Treas. Reg. [section] 1.482-4 (relating to the transfer of intangible property) and do not require an upheaval of the existing cost sharing regulations.
III. The Investor Model
A. In General. Prop. Reg. [section] 1.482-7(a)(1) adopts as a fundamental concept an "investor model" approach, whereby each controlled participant may be viewed as making an aggregate investment, attributable to both cost contributions (ongoing share of intangible development costs) and external contributions (the buy-in), for purposes of achieving an anticipated return appropriate to the risks of the cost sharing arrangement over the term of the development and exploitation of the intangibles resulting from the arrangement.
Thus, under the investor model, the taxpayer must determine (a) what an investor would have paid at the outset for an opportunity to participate in the arrangement, and (b) what a participant with external contributions would require as compensation to allow an investor to join. A valuation will not be considered appropriate if an investor would not undertake to invest in the arrangement because its total anticipated return is less than the total anticipated return that could have been achieved through an alternative investment that is realistically available to it.
In short, the model treats a CSA as essentially a financing transaction, whereby a circumscribed, risk-adjusted return "benefit" is given to the participants on their cash investments, including their contributions to ongoing R&D, while the contributors of external "non-routine" intangibles enjoy all the residual profits of the development efforts covered by the CSA. The model's limitation on the return of the "funding" participant effectively vitiates the notion that there is risk sharing among CSA participants. A third party negotiating at arm's length would not agree to bear the full risk of an unsuccessful intangible development while accepting a severely limited return on its overall investment. Moreover, the model's premise--that a cost sharing arrangement is akin to an investor's managing a diversified portfolio--is facile but ultimately unsound. In a CSA, there is little, if any, opportunity for any party to manage risk through diversification or to divest itself of under-performing assets--characteristics of a true investment.
Finally, the model is inconsistent with the realities of intangible development. By allocating all residual profit to the external contributions, the regulations ignore the value that the ongoing research efforts (funded by all CSA participants) may contribute to the resulting intangibles. The development of many intangibles is a cumulative process with platform technology (the "preliminary or contemporaneous transaction" or PCT) providing value and continuing research (the "cost sharing transaction" or CST) providing additional value. It is presumptuous to assert, as the investor model does, that no excess profit should be attributed to the ongoing research conducted in a CSA.
The proposed rules pay lip-service to the concept that compensation for external contributions is analyzed and valued ex ante, i.e., revenues and costs are forecasted at the outset. The IRS may adjust such compensation after the fact, whereas taxpayers may not. This one-way street for periodic adjustments is contrary to the ex ante approach of the regulations. It may also run afoul of the arm's-length standard and the commensurate-with-income standard required by the statute. In addition, the rationale for the asymmetry (that taxpayers have better access to information) fails to give weight to the IRS's extensive information-gathering authority.
The investor model may increase issues considered by Competent Authority because it substantially departs from the transfer pricing principles set forth in the existing section 482 regulations, as well as the Organisation for Economic Cooperation and Development's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. These rules and guidelines require an allocation of profits among related parties consistent with what parties operating at arm's length would adopt. The need to adhere to the arm's-length standard has been amplified in a recent Tax Court case. In Xilinx, Inc. v. Commissioner, the Tax Court considered a cost sharing agreement that did not include in shared research and development costs any amount related to the issuance or exercise of employee stock options. In concluding that third parties would not include such costs in the cost-shared base, the court specifically rejected the IRS's conceptual arguments about what unrelated parties would have done, preferring instead to rely on real-world transactions. Because unrelated parties would not share stock option costs, the court found the IRS's imposition of such a requirement inconsistent with the overarching principle of Treas. Reg. [section] 1.482-1 (which requires that the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer).
TEI suggests that the court's explanation of the arm's-length principle in Xilinx equally applies to the use of the investor model in these regulations--it attempts to use an economic hypothesis in a manner that would not be done in the actual business world.
There are also administrative concerns about the investor model. The model relies on converting future or past monetary sums into a present value at specified points in time, a crucial variable of which is the discount rate. This emphasis places tremendous pressure on a taxpayer's financial projections and discount rate determinations, potentially increasing audit disputes and litigation. Measuring the discount rate or the cost of capital is not as easy as the regulations imply. The model injects tax rate issues into the debate by emphasizing an after-tax concept, implying that actual tax rates must be used.
Further, reliable long-term projections required by the investor model may be impossible to produce. Generally, the most reliable projections are those used for non-tax business purposes. Projections beyond three-to-five years, however, are rarely used in business, precisely because of their inherent unreliability.
Consider the difficulty the IRS and Treasury have had in issuing guidance in other areas where regulations implementing the investor model were mandated by Congress. Specifically, the congressional reports on the Taxpayer Relief Act of 1997 (Pub. L. No. 105-34) urged the Treasury to "issue prompt guidance, including safe harbors, with respect to [certain Code section 1259] common transactions entered into by taxpayers." After nearly a decade, no such guidance has been issued. One reason for the regulatory delay is technical difficulties in simplistically applying standard financial option-tool valuations (such as Black-Scholes-Merton), as required by the investor model. Not the least of the difficulties is establishing a figure for volatility, for which there are often no historical numbers. Moreover, section 1259 deals with the volatility of securities traded on public stock exchanges. The proposed cost sharing regulations would require something even more difficult--determining the appropriate volatility for transactions negotiated in off-market private transactions. The imperfection of the investor model in respect of publicly traded securities militates against implementing it in the cost sharing environment.
As the court in Xilinx noted, taxpayers "are merely required to be compliant, not prescient." TEI strongly recommends that the model be abandoned.
B. Practical Issues Relating to the Discount Rate. Prop. Reg. [section] 1.482-7(g)(2)(vi) provides that the discount rate to be used is one that "most reliably reflects the risk of the activities and the transactions based on all the information potentially available at the time for which the present value calculation is to be performed." The regulation further provides that discount rates are most reliably determined by reference to market information, referring, as an example, to "the weighted average cost of capital (WACC) of the relevant activities and transactions derived using the capital asset pricing model."
Providing that either a company's WACC or a market-based WACC is appropriate for discounting cash flows may undervalue the cost of capital for discrete projects. Both identified rates are system-type rates that may measure the cost of capital across a wide range of different activities or investments based on the investment risks inherent in the company's overall activities. A WACC for an entire company blends together all the projects a company may undertake. The cost of capital for any specific research effort, however, may be considerably higher than a WACC based on the activities of a diversified company as a whole. Instead, a discount rate that takes into account the unique risks and rewards of a CSA must be developed--a highly subjective exercise likely to increase controversy between the taxpayer and the IRS.
The examples in Prop. Reg. [section] 1.482-7(g)(2)(vi) all involve instances where a market-based WACC, a company's overall WACC, or a company's existing hurdle rate is determined to be the appropriate discount rate. TEI proposes that a fourth example be included in which a unique discount rate is developed for the particular project:
The facts are the same as in Example 1 except that no data exist on uncontrolled companies undertaking similar activities and, because of its unique nature, USPharm's internal hurdle rate is not appropriate for Project T. Instead, USPharm develops a risk-adjusted hurdle rate specifically to evaluate Project T. Upon audit, the Commissioner determines that this hurdle rate provides a reliable discount rate in this case.
Further, in determining the discount rate to be used to test if a periodic adjustment is necessary, the regulations have a bias toward using the overall WACC of the company if it is publicly traded. Prop. Reg. [section] 1.482-7(i)(6) provides that the applicable discount rate (ADR) is the WACC of the PCT Payor if it (or its consolidated group parent) is publicly traded in the United States, unless the Commissioner determines (or the participants establish to the Commissioner's satisfaction) that another discount rate better reflects the degree of risk of the CSA activity. This shifts the burden to taxpayers to justify using a discount rate other than its overall WACC. It is more likely, however--especially in the case of publicly traded companies involved in different business activities--that the risk of a given CSA activity is not appropriately measured by the company's WACC as a whole. TEI recommends that this regulation be amended to provide that, at the option of the taxpayer, the WACC of a publicly held company may be used as a safe-harbor ADR. This will provide an objective measure, but also allow the taxpayer to use another method, if appropriate, with no preference given to the WACC. Further, TEI recommends that the term "publicly traded" be expanded to included companies whose stock is regularly traded on a U.S. or foreign securities exchange; the WACC of a foreign publicly traded company is as objective as that of a company traded on a U.S. exchange.
IV. Valuation Methods
Prop. Reg. [section] 1.482-7(g) sets forth several new methods distinct from those provided in Treas. Reg. [section] 1.482-4 for determining the value of the buy-in payment:
* The income method, under which the payment is determined on the basis of the net present value of a participant's best realistic alternative to the cost sharing agreement;
* The market capitalization method, under which the payment is determined by computing a participant's market capitalization and then subtracting the value of the assets unrelated to the CSA;
* The acquisition price method, under which the arm's-length amount is the product of the adjusted price for an acquired business, multiplied by such participant's reasonably anticipated benefit (RAB) share; and
* A revised residual profit split method, which is limited to cases in which more than one participant makes significant contributions of non-routine capabilities and resources.
Regardless of the method used, the proposed regulations require that the valuation of the arm's-length charge take into account the general principle that uncontrolled taxpayers dealing at arm's length would evaluate the terms of a transaction and enter into a particular transaction only if none of the available alternatives is preferable. Thus, buy-in valuations will not meet this condition where, for any controlled participant, the total anticipated value, as of the buy-in date, is less than the total anticipated value that could have been achieved through a realistically available alternative investment. Prop. Reg. [section] 1.482-7(g)(2)(viii) further provides that the buy-in value must result in a reasonably anticipated rate of return for each participant, taking into account the buy-in and on-going cost contributions, that equals each participant's discount rate.
It is unclear, however, how the specified valuation methods interact with the investor model and the realistically available alternative principle. Equally unclear is whether the investor method and the realistically available alternative standards are one and the same, and, even if they are not, why both are necessary. This "belt-and-suspenders" approach introduces greater uncertainty and unnecessary complexity without any correlative benefit. If the government retains the investor model in the final regulations, it should put the realistically available alternative principle aside.
Further, it appears that the benefit of using the five valuation methods prescribed in Prop. Reg. [subsection] 1.482-7(g)(3) through (7) is to provide protection against penalties under section 6662 since Prop. Reg. [section] 1.482-7(i) permits the IRS to make adjustments in connection with a CSA to ensure that the results are consistent with the arm's-length standard. Rather than creating five very complex valuation methods, the better approach would be to use the valuation methods already established under the regulations covering the transfer of intangible property.
V. Preliminary Or Contemporaneous Payments
A. Workforce in Place. Under Treas. Reg. [section] 1.482-7(g)(1), "[a] controlled participant that makes intangible property available to a qualified cost sharing arrangement will be treated as having transferred interests in such property to the other controlled participants, and such other controlled participants must make buy-in payments to it." Prop. Reg. [section] 1.482-7(b)(3) replaces the buy-in transaction with the "preliminary or contemporaneous transaction" (PCT), a seemingly more inclusive concept requiring compensation to be paid whenever a controlled participant makes an "external contribution" of "any resource or capability that is reasonably anticipated to contribute to developing cost shared intangibles." This change not only expands the potential subject matter of transactions coincident to cost sharing agreements, but also arguably alters the character and purpose of such transactions.
The consequences of these potentially far-reaching changes to the buy-in requirement can be demonstrated by considering the proposed regulations' example of a team of experienced researchers in place as the proper subject of a PCT. By suggesting the inclusion of experienced research teams is a proper subject of an external contribution, the regulations signal that PCTs are no longer to be confined to items of legally protectable intangible property, at least in terms traditionally used in the context of section 482 and other Code provisions. For transfer pricing purposes, Treas. Reg. [section] 1.482-4(b) defines the term "intangible" as including patents, inventions, copyrights, trademarks, licenses, designs, methods, and other specified and unspecified items of property that have substantial value derived from their intellectual content or other intangible properties, but which are "independent of the services of any individual." The proposed regulations assert that the PCT compensation necessary for a trained research team cannot be arm's-length compensation to the team members themselves; rather, such compensation belongs to the sphere of cost sharing contributions.
The preamble explains that the "commitment" of the research team--rather than the research team itself--is the subject of the PCT. 2005-40 I.R.B. at 629. It is exceedingly difficult, however, to fit the concept of such a "commitment" into the statutory and regulatory definition of intangible property items. Unless research team members have transferable employment contracts, a workforce in place is static and makes for poor material to "transfer" between parties. Indeed, if there is a significant risk that a given research team may eventually have different membership, what substance remains from the original "commitment"?
Prop. Reg. [section] 1.482-7(b)(viii), Example (2) concludes--
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 and therefore the RT Rights in the research team constitute an external contribution for which compensation is due from Company S as part of the PCT.... The RT in this case is the perpetual and exclusive provision of the benefits by Company P of its research team to the development of Vaccine Z.
This example is not sensitive to the business reality that companies frequently change their research strategy and personnel. Company P could decide to shut down the R&D center devoted to vaccines in Company P's territory and move the team to a new location in Company S's territory. Or it might redeploy part of the research team to work on Vaccine X instead of Vaccine Z. What if a key scientist on Company P's team leaves the company? What if Company P recruits a key scientist? If a new PCT payment must be computed each time the duties or composition of the research team is modified, the proposed regulations impose an onerous administrative burden on the taxpayer and the IRS auditors.
The experienced research team example also illustrates that the PCT does not require an actual transfer of property to take place. Under the current rules, a buy-in transaction necessarily results in the payors being treated as the owners of the purchased property and the full range of potential risks and rewards inherent in the property. This is entirely consistent with the intent of the current regulations to lodge ownership of the property created under CSAs with those funding the covered activity. Requiring only that a resource be made available broadens the application of the PCT to situations where PCT payors will not own the resources they pay for.
The proposed regulations fail to focus on intangible property as the proper subject of PCTs and limit application of the PCT requirement to situations where actual transfers take place. The inclusion of research teams within the realm of PCTs systemically limits the ability of participants not engaging in intangible development activities themselves to attain the benefits of intangibles ownership through a CSA. Even if a participant were willing to provide significant financial resources to share R&D risks, without its own research team or similar resource contributing to the cost sharing activity itself, that participant will always have the risk that the returns from its own commitments will go to pay for the commitments of others. The proposed regulations will make shared ownership of jointly developed intangibles extremely difficult, if not impossible.
TEI submits that the research team example in the proposed regulations unreasonably eliminates perhaps the single greatest benefit of CSAs since their introduction in the 1968 regulations: their utility to be used as a vehicle for true shared ownership of intangibles through joint investment.
Coupled with the dramatic expansion of the PCT concept, the valuation methods prescribed in Prop. Reg. [section] 1.482-7(g) may result in all of the residual profit from the cost shared intangibles being allocated to the participant that is conducting the intangible development activities. Participants that do not have those R&D capabilities nonetheless share the risk of the CSA's unsuccessful efforts. Limiting the economic upside of their investments is therefore unreasonable.
In sum, TEI submits that the characterization of a workforce in place as an intangible is contrary to the definition of intangible under the statute and regulations and misconstrues the nature of the party providing the intangible development activities. The proper characterization is that the party providing services to the CSA should be compensated in accordance with the services regulations under section 482, and not as contributing intangible property to the CSA that should be compensated as a PCT.
B. Declining Royalties. Prop. Reg. [section] 1.482-7(g)(2)(viii) provides that the valuation of the amount charged in a PCT must be consistent with the assumption that a contributed intangible maintains a constant value throughout the period in which that intangible is used in developing and exploiting the cost-shared intangibles. The proposed regulations provide an example in which two cost sharing parties agree to jointly develop a new generation of genetic tests using a software program previously developed by one party. The example concludes that, under the investor model, the party contributing the software is entitled to a constant return over the life of the genetic tests.
Although the declining royalty method for valuing buy-ins may be inappropriate in some cases, the investor model is flawed because it denies that the economic life of a contributed intangible may decline over the period in which that intangible is developed and exploited. The actual value of pre-existing technology is a question of fact and should not be stipulated, as the regulations require. The proposed regulations do not recognize that the continual development of technology and competition can render the contributed intangible economically obsolete, even while it is used in the jointly developed product.
Consider the following example: Parties A and B enter into a CSA to jointly develop software that will be downloaded through the Internet. Party A contributes certain software code representing a unique feature. The parties launch their joint product two years after entering into the CSA. They continue to improve the joint product, adding new features and improved functionality. Within a few years, competitors have reverse engineered and improved upon the contributed feature to the point that its value has significantly diminished. The parties to the CSA have also continued to develop new software code that improves upon and ultimately replaces the contributed code. As a result of the fast pace of technology development and intense competition, the economic life of the contributed software expires while the parties to the CSA continue to develop the product that initially incorporated that software. Thus, the contributed software becomes economically obsolete in the development process as well as the make-or-sell process.
TEI recommends that the regulations be modified to reflect that the value of pre-existing technology may be neither fixed nor perpetual but rather almost always diminishes over time.
C. Form of Payment for an External Contribution. Prop. Reg. [section] 1.482-7(b)(3)(vi) provides that the form of payment for contributed intangibles that are developed outside the CSA may generally take the form of fixed payments or payments contingent on exploitation of the resulting cost shared intangibles. Payments for contributed Post Formation Acquisition (PFA) intangibles acquired in an uncontrolled transaction after the formation of the CSA, however, must follow the form of payment in the uncontrolled transaction in which the PFA was acquired.
The preamble reasons that (a) the form of payment for PFAs must be consistent with the principle that allocations of cost and risk among controlled participants after a CSA begins should be in proportion to their respective RAB shares and, therefore, (b) the form of payment for a PFA must follow the form of the transaction in which the PFA was acquired. 2005-40 I.R.B. at 630. Clause (b), however, does not necessarily follow from clause (a). Further, many PFAs are acquired in an acquisition of an entire business or stock of a company and often take the form of a lump-sum payment. The proportional value of the acquisition represented by the PFA is often difficult to determine at the time it is contributed to the CSA. Accordingly, it is reasonable that the CSA will provide that the payment be contingent upon the actual value that the PFA produced to the participants. For example, the payment could be structured as a royalty based on sales of product using technology developed from the PFA. Finally, the tax consequences to the PFA contributor that acquired the intangibles in a stock purchase could be severe. If a CSA participant purchases stock of a business for cash and contributes technology associated with that business to a CSA, such participant must receive an upfront payment for the value of technology from the other participants. This could result in significant tax to the purchaser of the stock if the technology has a low-tax basis. In addition, many mergers and acquisitions are structured as tax-free, share-for-share exchanges. As a result, the only "payment" that occurs is made through the dilution of the stock held by the acquiring shareholders. The form-of-payment requirement is contrary to the policy underlying other Code sections that permit tax-free exchanges.
It is really the acquired company that makes any new PCT contribution to a CSA. There is no difference economically between a PCT contribution made by a newly acquired subsidiary and one made earlier by the parent; thus, there is no justification for treating PFAs differently from any other PCT. Even if the intangibles involved in a PFA were acquired directly by the parent, there is still no economic difference between contributing the newly acquired intangibles to a CSA as a PCT and contributing developed intangibles--in either case, the contributor has already taken the risk to obtain the intangibles and their value has to be reflected in valuing the PCT. In this regard, the PFA acquisition price is no better or worse than the market capitalization of the parent as a valuation benchmark. TEI therefore recommends that the restriction on form of payment for PFAs be removed.
D. Make-or-Sell Rights Separate from PCTs. In a departure from the current regulations, Prop. Reg. [section] 1.482-7(c) provides that the rights to exploit the existing technology ("make-or-sell" rights) are not considered external contributions and the amount paid for such rights does not satisfy the compensation obligation for an external contribution. According to the preamble, the exclusion is necessary because--
Taxpayers have asserted that a make-or-sell license of this type satisfies the requirement for a buy-in in the CSA under the current regulations. Such a position misconstrues the existing regulations, which focus the buy-in on the availability of the pre-existing intangibles "for purposes of research in the intangible development area" under the CSA. See [section]1.482-7(g)(2).
Under existing practice, make-or-sell rights are treated as part of the contribution of pre-existing intangibles to a CSA that is subject to a buy-in. This provides for significant tax relief by (a) decreasing the amount that is subject to current tax because the value of the make-or-sell rights contributed by each participant may be netted against other each to minimize the resulting gain, and (b) eliminating withholding tax on future royalties. For example, Participants A, B, and C each contribute platform technology as well as current make-or-sell rights to a CSA. The aggregate value of the platform technology and the make-or-sell rights of each of A, B, and C is $100 and each expects to receive a benefit of $100. The combined value of the platform technology and the make-or-sell rights of A, B, and C is $300.
If the contribution is treated as an external contribution subject to a buy-in, no payments must be made among the participants since each has made a contribution of equal value. If, instead, make-or-sell rights are not treated as an external contribution, each participant must be separately compensated for these rights--outside of the CSA--by either lump-sum payments or licensing arrangements. It may be difficult in practice to separate the value of the make-or-sell rights from the value of the technology as a platform for future research. Where should the line be drawn, particularly in the case of continual incremental changes and improvements to existing technology? Permitting taxpayers to contribute their entire bundle of technology rights to a CSA would simplify valuations, eliminate potential areas of controversy, and ensure that the parties are adequately compensated for the value of the entire bundle of technology rights used in the taxpayer's business, not just the portion carved out as a platform for future research.
Furthermore, if a license subject to a royalty is used, withholding taxes (depending on participants' residency) must be paid on the future royalties. If a lump-sum payment is used, each participant will be subject to tax on the gross proceeds received from the other two participants unreduced by the amount that each must pay the other two participants. This defeats one of the main attractions of cost sharing--to allow for efficient sharing of existing and future intangible property.
The inability to contribute make-or-sell rights is exacerbated by Prop. Reg. [section] 1.482-7(b)(3)(vii), which requires controlled participants to enter into a PCT as of the earliest date on which an external contribution is reasonably anticipated to contribute to developing cost shared intangibles under a CSA. Even if the CSA participants enter into a license with respect to the make-or-sell right, they still must separately contribute and value any platform technology that may be included in such rights. In other words, if pre-existing intangibles could form a platform technology or otherwise contribute to the development of cost shared intangibles, the owner of those intangibles must make them available to other controlled participants. Otherwise, the CSA may not be valid.
Consider Example (1) of Prop. Reg. [section] 1.482-7(b)(5)(iii), in which P and S enter into a CSA to develop an effervescent version (P-Ves) of an existing capsulated pain reliever (P-Cap). P owns a patent on P-Cap that could form the platform for P-Ves, as well as proprietary software that P reasonably anticipates to be critical to the development of P-Ves. P and S enter into a PCT for the P-Cap patent, but not for the software. Because they failed to include the software in the PCT, the example provides that the participants cannot reasonably conclude that their arrangement was a CSA. In the example, the Commissioner is not required to treat P and S as having entered into a PCT for the software.
The CSA participants may not, however, be aware that a given technology may contribute to the CSA intangible development. It is difficult to identify in advance those technologies that may turn out to be critical or the platform for future development. Uncertainty is inherent in the nature of R&D, and crucial developments can sometimes only be identified with the benefit of hindsight. Many extremely valuable products (such as penicillin) were the result of serendipity, having been discovered by scientists driving toward different objectives. A failure to identify and separately compensate these fortuitous technologies could cause an arrangement to fail to qualify as a CSA, even though it may meet all the other requirements.
In practice, it is frequently difficult to distinguish between the value of existing intangibles as a platform or basis for future development and their value with respect to make-or-sell rights for existing products. Product development often does not come neatly labeled in the form of a separate, discrete project. Instead, in some cases it may take the form of small incremental improvements--for example, tweaking a manufacturing process to save a fraction of a cent per unit or making a slight modification in a package design to make it easier to open. Over time, the cumulative effect of many small changes may be a product that is truly next generation, but it is impossible to draw a line between the existing product and the next-generation product. Prop. Reg. [section] 1.482-7(g)(2)(v) provides that in certain cases "the method that provides the most reliable measure of an arm's length charge for the multiple PCTs and other transactions not governed by this section, if any, is a method that determines the arm's length charge for the multiple transactions on an aggregate basis under this section." This section does not address how the aggregate value should be split between the transactions covered by the CSA and those not covered--such as make-or-sell rights.
TEI submits that the separation of make-or-sell rights from platform rights is inconsistent with how third parties arrange their transactions and thus is inconsistent with the arm's-length principle. Indeed, a party to a joint development arrangement would not be willing to invest in ongoing improvements of another party's existing products without first obtaining commercial rights with respect to those existing products or being compensated by an appropriate royalty that reflects the development risks. Thus, the separation of rights required by the proposed regulations is at best a theoretical construct based on abstract economic principles, not a component of real-life arm's-length dealing.
The proposed regulations' approach to preventing any abuse of the current buy-in requirements is impractical in the truest sense of the word: it is not adopted in practice between unrelated parties. Thus, rather than being forced to segregate technology into distinct "existing" and "in-development" categories, TEI submits that the taxpayer should be allowed to contribute a broad and comprehensive portfolio of technology rights in a given field or business to the CSA, covering both existing make-or-sell rights as well as platform rights for future development. If the current regulations do not sufficiently guide taxpayers in making this contribution, they should be supplemented rather than replaced.
E. Periodic Adjustments. Prop. Reg. [section] 1.482-7(i)(1) provides that the Commissioner may make allocations to adjust the results of a controlled transaction in connection with a CSA to ensure consistency with the arm's-length standard. Subparagraph (6)(i) limits the right to make periodic adjustments with respect to PCT payments to the Commissioner, if he determines that the ratio of a controlled participant's actual profits in relation to the present value of its total investments (i.e., its PCT and ongoing cost sharing contributions) is outside a specified range (generally between 200 percent and 50 percent of the anticipated return) and none of the exceptions (for extraordinary events beyond the taxpayer's control) apply. The rules for making such adjustments are detailed and mechanical. The rationale for such an approach is that taxpayers can always structure their affairs in a certain manner and there is "an asymmetry of information" available to the IRS.
TEI submits that this one-way street approach is inherently unfair, contrary to the statute, and inconsistent with the arm's-length standard. Section 482's mandate that the income with respect to a transfer or license of an intangible shall be "commensurate with income" is neutral and unequivocal. What the statute does not provide is that the transfer must be commensurate with income only when the U.S. fisc is benefitted. To maintain that taxpayers can protect themselves from the IRS's one-sided approach by adopting a different arrangement ignores the right of taxpayers to structure their affairs in the most efficient manner. Moreover, the regulations overestimate the amount of information available to the taxpayer at the time the CSA is created. In fact, the IRS's information-gathering tools in respect of comparables may well exceed those available to taxpayers in many cases.
Treas. Reg. [section] 1.482-1(a)(3) provides that, if necessary to reflect an arm's-length result, "a controlled taxpayer may report on a timely filed U.S. income tax return (including extensions) the results of its controlled transactions based upon prices different from those actually charged." In addition, the set-off provisions of Treas. Reg. [section] 1.482-1(g)(4) explicitly permit taxpayers to advance affirmative section 482 adjustments. A different standard does not apply in respect of cost sharing arrangements. See Xilinx, Inc. v. Commissioner (confirming that the commensurate-with-income standard complements, but does not replace, the arm's-length standard).
V. Requirements for Cost Sharing Agreements
A. Geographic Exclusivity for Cost Shared Intangibles. Prop. Reg. [section] 1.482-7(b)(4)(i) requires the participants in a CSA to divide the world into two or more non-overlapping, geographic territories. Each controlled participant must then be assigned the exclusive right to exploit developed intangibles in at least one of the pre-determined territories.
According to the preamble, this territorial requirement facilitates the ability of controlled participants (a) to individually exploit their interests in the cost shared intangibles and (b) to estimate the reasonably anticipated benefits from the individual exploitation of those intangibles. Comments are requested on whether alternatives should be provided to the territorial division of interests in cost shared intangibles, stating that alternatives should "further the goal of dividing the universe of interests into exclusive, non-overlapping segments to promote the measurability of anticipated benefits and administrability by both taxpayers and the IRS." 2005-40 I.R.B. at 630.
TEI submits that the territorial requirement does not promote either of the government's stated objectives. Exclusive geographic rights make little sense in a market with suppliers and customers acquiring goods and services on a global basis. In today's economy, taxpayers frequently enter into third-party agreements that provide for nonexclusive, overlapping rights. For example, rights to exploit digital products may be licensed nonexclusively through multiple licensees that, in turn, distribute to overlapping territories, using various media for distribution. Or a digital content provider may license its content to multiple distributors of hardware, each capable of displaying the digital content. It is in the interest of the licensor to have the product distributed widely. Moreover, in the pharmaceutical industry, it is common for a drug to have multiple licensees in the same territory for different indications.
Requiring participants in a CSA to divide the world into exclusive territories to exploit their interests in cost-shared intangibles is unnecessary to ensure that each participant pays its fair share of the associated development costs. If the relative benefits derived by the participants from selling those products do not correspond to each participant's share of the costs incurred to develop those products, then the current cost sharing regulations provide an effective and efficient way for the participants to true up the costs with the benefits.
Contrary to the preamble, the territorial requirement does not facilitate the process by which participants estimate the benefits they reasonably expect to derive from the exploitation of cost shared intangibles. Participants estimate anticipated benefits today by reviewing their own business results. If geographic differences in those business results need to be considered, the participants may take those differences into account.
Requiring exclusive, geographic territories unnecessarily burdens participants in two ways. Participants that adhere to the exclusive, geographic division of the world mandated by the proposed regulations lose the sort of operational flexibility needed to meet unpredictable changes in supply and demand forces, thereby rendering them less competitive in the global marketplace. Alternatively, participants that have no choice but to make cross-territorial sales have imposed on them a cumbersome and unwieldy burden by having to pay each other royalties, which in some cases will be subject to non-creditable withholding taxes. In both situations, the government's interests are not protected any better than they are today under the existing cost sharing regulations. For that reason, there is no need to include the territorial requirement in the final regulations.
At a minimum, if the exclusivity requirement is retained, the regulations should recognize that taxpayers today structure and manage business operations in a wide variety of ways that may not be consistent with geographical exclusivity. For example, some multinational companies are structured globally along product lines. Business may be managed according to URLs rather than destination sales. Distribution of digital products may be through various moveable channels--including wireless handheld devices--that use any or all available platforms. TEI submits that the regulations must allow taxpayers to structure their cost sharing arrangements consistent with their operational structures.
B. Participants" Sharing in All Costs. Prop. Reg. [section] 1.482-7(b)(1) provides the basic requirements that an arrangement must meet in order to be treated as a CSA. One substantive requirement is that the controlled participants must enter into and effect cost sharing transactions (CSTs) covering all intangible development costs (IDCs) and preliminary or contemporaneous transactions (PCTs) covering all external contributions, for purposes of developing the cost shared intangibles under the CSA.
On its face, this seems to require that all costs of developing the cost shared intangibles must be included in the costs to be shared under the CSA. It could also be read, however, to require that all participants share in each and every cost and not permit a CSA under which the cost of developing intangibles that only benefit a few participants is shared only by those participants. For example, a CSA may cover research with respect to development of new technologies for the manufacture of automobiles. The CSA includes a specific project, Project X, aimed at developing a more environmentally friendly automobile that would meet the regulatory standards applicable to Western Europe that are not consistent with the standards for Asia. The CSA contains participants that manufacture and sell cars to customers in Western Europe as well as participants that do not. Under the CSA's terms, only the participants that manufacture and sell cars to Western European customers will share in the costs associated with Project X. TEI believes that such a result is consistent with the requirement in both the current and proposed regulations that participants in a CSA share IDCs in proportion to their shares of reasonably anticipated benefits (RAB). To require sharing of all IDCs by all participants--without regard to their applicability to all participants of the ensuing cost shared intangible--is contrary to the RAB principle.
TEI recommends that Prop. Reg. [section] 1.482-7(b)(1)(ii) be clarified to provide that a CSA must cover all costs but that not all participants must share in each and every cost of the CSA.
VI. Stock-based Compensation and the Effect of Xilinx
For taxable years beginning after August 26, 2003, Treas. Reg. [section] 1.482-7(d)(2) requires that stock-based compensation incurred by any controlled participant to an employee or independent contractor involved in the development of intangible property be taken into account in the cost-sharing pool and borne by all of the controlled participants in proportion to each participant's reasonably anticipated benefits.
Prop. Reg. [section] 1.482-7(d) generally restates the provisions of the 2003 regulations by defining intangible development costs (IDCs) to mean "ali costs, in cash or in kind (including stock-based compensation ...) but excluding 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 activity under the CSA of developing or attempting to develop intangibles (IDA)." (Emphasis added.) 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. Both the 2003 regulations and the proposed regulations provide that generally accepted accounting principles (GAAP) or federal income tax accounting rules may provide a useful starting point "but will not be conclusive regarding inclusion of costs in IDCs." Technical amendments have been made to the special transition rule on the time and manner of making the election and the consistency rules for measurement and timing with respect to stock-based compensation.
Except for such technical amendments, the proposed regulations incorporate the existing provisions relating to the elective method of measurement and timing permitted with respect to certain options on publicly traded stock. Thus, the regulations provide that with respect to stock-based compensation in the form of options on publicly traded stock, CSA participants 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." Because Treasury and the IRS are considering extending the availability of the elective method, comments have been requested on which forms of publicly traded stock-based compensation should be eligible for the elective method. 2005-40 I.R.B. at 631.
TEI believes that stock-based compensation should not be included in cost sharing arrangements, based on either the grant date or the exercise date, because such inclusion is inconsistent with the arm's-length standard of section 482. See Xilinx, Inc. v. Commissioner, 125 T.C. No. 4 (2005). There is no evidence that parties dealing at arm's length would allocate the spread or the grant date value relating to employee stock options.
If the final regulations retain the stock-based compensation inclusion, however, TEI believes it is appropriate to expand the GAAP election to taxpayers issuing other forms of equity-based compensation. Expanding the GAAP election will significantly reduce compliance burdens for taxpayers and improve the ability of the IRS to audit compliance. Finally, there is no reason why different forms of equity compensation should be subject to section 83's valuation rule (rather than GAAP) for purposes of determining the appropriate amount to include in the cost sharing pool.
VII. Administrative Requirements
Prop. Reg. [section] 1.482-7(k) contains the contractual, documentation, accounting, and reporting requirements that a CSA must meet initially and on an annual basis. These requirements are more extensive than those under the current regulations. In particular, the reporting rules applicable to each participant may prove to be a trap for the unsophisticated. Under Prop. Reg. [section] 1.482-7(k)(4), each participant must file a "CSA Statement" with the IRS setting forth the participants and the date of formation of the CSA within 90 days after the first occurrence of an IDC or, if the participant joined the CSA after its formation, within 90 days of joining. In addition, each participant must annually file the CSA Statement with its U.S. tax return (or if no return is required to be filed, as an attachment to a Form 5471, 5472, or 8865 filed with respect to a participant).
By increasing administrative and compliance burdens, these new requirements will significantly affect both taxpayer and government resources. In addition, because of the increased complexity of the technical rules, the likelihood of controversy occurring between taxpayers, the IRS, and foreign governments will increase. Finally, the proposed requirements will further strain the Competent Authority process.
It is not clear what the consequences are for failing to meet the reporting requirements. A CSA may comply in every other way with the rules in the regulations but one controlled participant out of many hundreds may fail to file its annual CSA Statement. Given that a CSA usually includes participants not subject to U.S. tax, it would not be unusual for an annual CSA Statement to unintentionally omit one foreign controlled participant. TEI recommends that the final regulations provide that a CSA will be deemed to have complied with the reporting requirement if its participants make a good faith effort to comply.
VIII. Transition Rules
Prop. Reg. [section] 1.482-7(m) provides that CSAs qualified under the existing regulations will be considered a CSA under the proposed regulations if they are timely amended to comply with these new regulations. Further, such grandfathered CSAs will not be subject to the territorial exclusivity requirements of the proposed regulations and will be subject to the requirement that all participants share in all costs of the CSA only for costs incurred after the effective date. Most significantly, costs (CSTs and PCTs) incurred prior to the effective date will be subject to the current regulations, not the proposed ones. Grandfather status will be terminated, if among other things, there is a "Periodic Trigger"--an adjustment made by the IRS under the rules of Prop. Reg. [section] 1.482-7(i))--that is caused by a post-effective date PCT.
First, it is unclear how the PCT that causes a Periodic Trigger is identified. Second, the effect of this rule is to make the valuation provisions of the proposed regulations retroactive to all cost sharing arrangements. TEI believes that it is not appropriate or fair to extend the valuation provisions of the proposed regulations to pre-existing CSAs, given the radical changes they effect for valuing intangible property. Therefore, the rule eliminating grand-fathering due to a Periodic Trigger should be removed. If not removed, the regulations should clarify how the PCT causing the Periodic Trigger will be identified.
Other transitional issues should also be addressed, perhaps through the use of examples. What is the effect to a grandfathered CSA upon the acquisition of another company that itself has grandfathered CSAs? Does this trigger an adjustment? How is the grandfathered status of the various CSAs affected?
Tax Executives Institute appreciates this opportunity to present its views on the proposed regulations under section 482, relating to the methods to be used to determine taxable income in connection with a cost sharing agreement. If you have any questions, please do not hesitate to call John J. Herson, chair of TEI's International Tax Committee, at 678.518.3216, or Mary L. Fahey of the Institute's professional staff at 202.638.5601.
(1) See I.R.C. [section] 274, which recognizes the validity of R&D deductions after the product is in the marketplace.
(2) 125 T.C. No. 4 (2005).
(3) For example, a company may use a three-to-five year projection and then apply a growth rate to the last year of the projection, which is not the same as requiring projections over the term of the CSA.
(4) H.R. Rep. No. 105-220, 105th Cong., 1st Sess. 514 (July 30, 1997); S. Rep. No. 105-33, 105th Cong., 1st Sess. 127 (June 20, 1997).
(5) The comparable uncontrolled transaction method is the fifth valuation method in the proposed regulations.
(6) Prop. Reg. [section] 1.482-7(g)(2)(iv).
(7) The realistically available alternative standard introduces a hypothetical that an alternative to cost sharing exists--without specifying which party--the taxpayer or the Commissioner--should select the appropriate alternative.
(8) See Explanation of Provisions, Section C, 2005-40 I.R.B. at 632; Prop. Reg. [section] 1.482-7(b)(3)(viii), Ex. 2.
(9) See also I.R.C. [subsection] 936(h)(3)(B) (defining intangible property as any "(i) patent, invention, formula, process, design, pattern, or know-how; (ii) copyright, literary, musical, or artistic composition; (iii) trademark, trade name, or brand name; (iv) franchise, license, or contract; (v) method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or (vi) any similar item, which has substantial value independent of the services of any individual."), and 367(d)(1) (cross referencing the definition in section 936(h)(3)(B)).
(10) A new company could engage the entire team and pay the salaries that are subject of the CSA. What is the incremental value of being "in place"?
(11) 2005-40 I.R.B. at 631. This is a strained interpretation of the current regulations and contrary to current practice. Although the existing regulation includes the phrase "for purposes of research in the intangible development area," it does not require that such an intangible be contributed solely for such use.
(12) 2005-40 I.R.B. at 639.
(13) See OECD Transfer Pricing Guidelines for Multinational Enterprises [paragraph] 1.36 (1995) ("Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured.").
(14) The October 18, 1988 discussion draft, A Study of Intercompany Pricing (commonly known as Treasury's Section 482 White Paper), proposed a territorial exclusivity requirement that was rightly rejected by the drafters of the 1995 regulations.
(15) Of course, the latter point assumes a tax treaty exists, which may or may not be the case depending on the particular facts and circumstances. If one does not, the issue is even more significant.
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|Title Annotation:||Tax Executives Institute|
|Date:||Nov 1, 2005|
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