Unwrapping the New Cost Sharing Regulations
On December 16, 2011, the IRS and the Treasury Department issued comprehensive final transfer pricing regulations related to cost sharing arrangements for the development of intangibles ("CSAs"). T.D. 9568. Almost immediately thereafter, on December 19, 2011, accompanying temporary and proposed regulations were issued providing additional guidance related to the application of the income method for valuing contributions to a CSA. T.D. 9569. The final regulations represent the culmination of a decade-long guidance project and parallel administrative initiatives intended to curb perceived abuses of the 1995 cost sharing regulations. In general, the final regulations make modest changes to the temporary regulations. Nevertheless, the final regulations will have an immediate impact on taxpayers with CSAs or contemplating CSAs. More broadly, the final regulations represent the government's latest thinking on issues outside of the CSA context involving transfers of intangible property and the provision of services using or related to intangibles. (The regulations even purport to technically apply the government's thinking to some extent outside of the CSA context).
Cost Sharing Arrangements in General
A CSA is an agreement between related persons to share the costs of developing intangible property in proportion to the participants' respective anticipated benefits from the developed intangible property. As a consequence of the arrangement, each participant is considered an owner of the developed intangible and will be able to exploit it independently without paying a royalty to any other participant or related person. As such, cost sharing is an alternative to the traditional intangible development model, in which one person funds the development of intangible property and then licenses the developed intangible property to others in exchange for royalties.
The participants in a CSA must make a "buy in" or platform contribution payment to any participant that provides existing resources, capabilities, or rights that are reasonably anticipated to contribute to developing cost shared intangibles. Establishing the arm's length pricing for these payments presents a traditional transfer pricing issue within the context of a CSA. The buy-in requirement has generated substantial controversies and litigation in recent years, undermining the perceived simplicity of the CSA alternative to traditional licensing arrangements. See, e.g., VERITAS Software Co. v. Comm'r, 133 T.C. No. 14 (Dec. 10, 2009) (litigation over buy-in payments for CSA under 1995 regulations).
For the most part, the final regulations adopt the temporary and proposed regulations published on January 5, 2009 (the "2008 temporary regulations"), with only modest changes and elaborations.
1. Aggregate-Basis Valuation of Platform and Other Contributions
As with the 2008 temporary regulations, the core of the final regulations is guidance regarding the valuation of platform and other contributions by one or more participants to a CSA. And as with the 2008 temporary regulations, the final regulations reflect the IRS's view that an aggregate valuation of all contributions is likely to lead to a more reliable result than other approaches. In this regard, the preamble to the final regulations contemplates an aggregate valuation for contributions outside the CSA, stating that "[t]he combined effect of multiple contributions, potentially including controlled transactions outside of the CSA . . . may need to be evaluated on an aggregate basis." As an example, the preamble posits transfers of intangibles by one participant to another in a transaction governed by Code section 367(d). The preamble explains that the pricing of those intangibles may need to be evaluated along with the contributions with respect to the CSA on an aggregate basis. This aggregate valuation requirement raises questions regarding the transfer of property, such as foreign goodwill and going concern, that are noncompensable under longstanding law. This issue has been contentious. Consider the recently settled First Data case. First Data Corp. & Subsidiaries v. Comm'r, No. 007042-09 (T.C. Mar. 20, 2009) (regarding the extent to which value transferred to foreign affiliates was attributable to noncompensable foreign goodwill or going concern and not to compensable intangible assets). The final regulations leave open the question of how taxpayers should remove the value of these intangibles from the aggregate valuation.
More fundamentally, the approach of the regulations represents an extreme example of the trend in U.S. transfer pricing policy over the last two decades away from a transactional approach, with the aim of evaluating the price of particular transactions or transaction flows against arm's length pricing, and towards a profits-oriented approach, in which the overall results of a business or entity are evaluated against the results of comparable businesses or against the expected results of the business had it undertaken alternative transactions. Although this approach is noncontroversial in many contexts (for example the ubiquitous use of the comparable profits method in evaluating returns to routine functions), when challenged the IRS has not fared well in litigation under this approach.
2. Irrelevance of Useful Life of Platform Contribution
The useful life of preexisting intangibles or other attributes forming a platform contribution was critical in valuing contributions under the 1995 regulations. While generally adopting the IRS's controversial view that platform contributions may have a perpetual life, the preamble to the 2008 temporary regulations acknowledged that platform contributions may have a finite useful life, stating that "It may be, depending on the facts and circumstances, that the technology is reasonably expected to achieve an incremental improvement in results for only a finite period (after which period, results are reasonably anticipated to return to the levels that would otherwise have been expected absent the investment). The period of enhanced results that justifies the platform investment in such circumstances effectively would correspond to a finite, not a perpetual, life." 74 Fed. Reg. 340, 346 (Jan. 5, 2009).
By contrast, the preamble to the final regulations does not include similar language recognizing the possibility that platform contributions may have a limited life, and instead more fully articulates the IRS's position that such platform contributions should be valued as if they have an infinite life. The preamble states that the platform contribution has value for the entire period of the intangible development activity, the duration of which "may, or may not, correspond to the conventional concept of useful life with respect to any of the underlying economic contributions." This language is similar to the argument that the IRS made, and the Tax Court rejected, under prior law in VERITAS Software Corp. v. Commissioner, 133 T.C. No. 14 (Dec. 10, 2009). In fact, however, the platform contributions will consist mainly of rights to use property with a finite life. To the extent the regulations are applied in a manner that deem transactions that have not occurred to in fact occur, rather than merely using foregone profits as a reference point in pricing actual transactions, Courts may question the results advocated by the IRS.
As a practical matter, Taxpayers have achieved results comparable to using finite useful lives through the use of discount rates under the income method and its variants. The final regulations and the new temporary regulations provide additional guidance regarding the appropriate interrelationship of the discount rates and financial projections used in applying the income method. This guidance merits careful analysis by taxpayers making platform contributions into CSAs outside of the acquisition context. The guidance is intended to prevent taxpayers from taking "unreasonable positions" in applying the income method by using relatively low licensing discount rates and relatively high cost sharing discount rates that do not appropriately reflect those interrelationships. The new temporary regulations provide that the discount rates used in applying the income method may be tested by evaluating the reasonableness of the implied discount rate derived from the "differential income stream" between the licensing alternative and cost sharing alternative.
3. Tax Adjustments
The 2008 temporary regulations required certain tax adjustments when using each specified method for valuing platform contributions to the extent necessary to convert post-tax valuations into pre-tax platform contribution payments. The final regulations remove these references in the context of the acquisition price and market capitalization methods. Instead, the determination of whether any tax adjustments are warranted will be based on the specific facts and circumstances under the general comparability guidance found in Treas. Reg. § 1.482-7(g)(7). The conceptual basis for tax adjustments under these methods is uncertain, and therefore the more flexible approach of the final regulations is welcome.
4. Taxpayer Use of CWI
The preamble to the final regulations recognizes that some CSA contracts include contingent terms relating to buy-ins and platform contribution transactions that are based on subsequent, actual income experience. These contingent terms are sometimes tied to the commensurate with income ("CWI") regulations and may allow for adjustments based on subsequent experience. While the final regulations generally confirm the ability of taxpayers to do this and thereby circumvent the otherwise "one-way street" of CWI, they provide that such contingent terms must have economic substance and must be factored into the pricing of the overall transaction. The final regulations add several examples to illustrate this point. In one such example, Example 7 of Treas. Reg. § 1.482-7(h)(2)(iii)(C), contingent price terms are disregarded based on a lack of economic substance because they did not apply automatically and therefore the arrangement did not allocate the risks between the parties as of the CSA date.
5. Retroactive Readjustment of RAB Shares
In discussing reasonably anticipated benefit shares ("RAB Shares"), the preamble to the final regulations explains that once a taxpayer determines a RAB Share for a particular purpose, the taxpayer should not update the RAB Share based on information not then available. In other words, taxpayers should not use future information to recompute a previously-determined RAB Share. Interestingly, the preamble to the final regulations explains that nothing in the regulations limits the Commissioner's ability to use subsequent information for purposes of determining allocations under a CSA. The final regulations incorporate this language from the preamble in Treas. Reg. § 1.482-7(e)(1)(i). This new language seems to create an inequitable result to taxpayers by prohibiting taxpayer-initiated adjustments to RAB Shares based on subsequent, actual data while at the same time allowing the IRS to use that information for reallocation purposes. It is not clear under what circumstances the IRS would choose to assert this authority given that the RAB Share determination clearly is an ex ante determination. The preamble leaves open the possibility that taxpayers may mitigate this inequity by crafting agreements that effectively take into account subsequent events, as they have done in the context of the commensurate with income standard.
Implications Beyond Cost Sharing
The final regulations confirm and further articulate principles in the 2008 temporary regulations whereby the guidance for valuing platform contributions in the CSA context may be used for valuing "similar contributions in connection with controlled transfers of intangibles or provisions of services" outside the CSA context. See Treas. Reg. § 1.482-4(g) and -9(m)(3) (containing language identical to that in the 2008 temporary regulations). The scope of this guidance is not clear given the comprehensive guidance already available with respect to intangible transfers and services. The language leaves open the possibility that other non-CSA arrangements, for example a contract research arrangement, could be subject to the CSA valuation principles and methods outlined in the final regulations. Interestingly, in the case of R&D services in a CSA, the IRS refused to apply principles of the services regulations, rejecting suggestions by commentators to permit taxpayers to charge an arm's length price for such services (e.g., under a cost-plus methodology) rather than treat the commitment to provide at-cost R&D services as a platform contribution of the "research team" and deal with the incidental valuation issues. While this is consistent with the IRS's recent approach to "high value" services, it goes beyond that approach by rejecting out of hand a traditional cost-plus methodology.
The language of the preamble to the final regulations further suggests that the IRS does not view cost sharing as a safe harbor, but rather as an articulation of the arm's length standard in a particular case. This view is noteworthy given the proscriptive nature of some aspects of the final regulations as compared to the more subjective transfer pricing regulations in other contexts, and opens up opportunities for both taxpayers and the IRS to analogize between each set of rules.
The final regulations make modest changes to the 2008 Temporary Regulations and generally reconfirm and further elaborate the views of the IRS and Treasury in this area. Further, they appear to extend those views to outside of the CSA context to other intangible transfers and even to the provision of services. The regulations therefore merit careful attention by all taxpayers.
For more information, please contact:
Rocco Femia, email@example.com, 202-626-5823
Kevin Kenworthy, firstname.lastname@example.org, 202-626-5848
Kathryn Morrison Sneade*
*Former Miller & Chevalier attorney
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