Time to Evaluate Cost-Sharing Arrangements

By Bert Hawkins, CPA, MST

Co-Editors: Michael Metz, CPA; Nick Gruidl, CPA, MBT

Treasury proposed new regulations on cost-sharing arrangements (CSAs) in REG-144615-02 (8/29/05). CSAs can help businesses operate in the global marketplace in a tax-efficient manner; however, the proposed regulations need to be carefully reviewed.


CSAs, formally prescribed by regulations effective on Jan. 1, 1996 (TD 8632, 12/20/95), have become an increasingly popular vehicle for global businesses to manage development and global use of intellectual property in a tax-efficient way. Conceptually, a CSA permits two or more companies to share (1) jointly in the cost of developing intellectual property and (2) proportionally in the revenue and profits resulting from exploiting it. As a practical matter, multinational corporations use CSAs to shift some of the revenue and profits resulting from the successful exploitation of intellectual property from the U.S. to foreign tax (often, low-tax) jurisdictions. The result is lower effective tax rates and higher earnings-per-share.

CSAs may be used in connection with various kinds of intellectual property, including manufacturing technology, processes and know-how (whether patented or not) and marketing properties (such as trademarks and tradenames). CSAs are formally recognized by many foreign tax authorities under international guidelines published by the Organisation for Economic Co-operation and Development. A CSA will be respected in the U.S. only if it meets certain requirements. Among these, it must be pursuant to a written agreement and disclosed in a U.S. income tax return.

Treasury’s Concerns

Treasury is concerned that the aggressive use of CSAs by some taxpayers has resulted in a loss of U.S. tax revenue, particularly the undervaluation of “buy-in payments.” In connection with entering into a CSA, one party (the contributor) typically contributes pre-existing intellectual property to the CSA. The other party (the payer) must pay the contributor for the value of such property, via a buy-in payment. Under Regs. Sec. 1.482-7(g), the buy-in payment is determined based on the value of the pre-existing intellectual property at the CSA’s inception. If the pre-existing intellectual property is still “on the laboratory bench,” or at least not yet proven commercially, a relatively low value is often ascribed to the payment. If the intellectual property proves to be commercially successful, the profits shifted from the U.S. to the foreign tax jurisdiction may be quite large relative to the combined buy-in payment and cost-sharing payments.

Prop. Regs.

Treasury has introduced the “investor model,” a framework for addressing the quantitative elements of a CSA, including buy-in payments. Generally, its underlying premise is that the payer should earn no greater than a market rate of return from exploitation of the intellectual property, and that any above-market returns should be realized by the contributor. The investor model effectively limits the income that can be shifted outside the U.S. tax net by U.S. developers of technology and other intellectual property.

As an adjunct to the investor model, buy-in payments must account for the exclusive, perpetual and territorial right to enhance and develop the contributed intangible property. This limits taxpayers’ ability to place an unreasonably low value on pre-existing contributed property, based on the premise that the rights to it are severely limited. The proposed regulations introduce a variety of new methods for valuing property contributed to a CSA.

Prop. Regs. Sec. 1.482-7 grants the IRS unilateral authority to make allocations to adjust the results of a CSA if they are inconsistent with arm’s-length results. Taxpayers may avoid such adjustments if the CSA results fall within a safe-harbor range of returns, generally defined as 50%–200% of a market return, and if certain administrative requirements are met. Taxpayers have limited rights to refute proposed adjustments based on facts and circumstances.

Additionally, Prop. Regs. Sec. 1.482-7(c) formalizes the Service’s position that make-sell rights must be addressed separately outside the CSA. Thus, if a taxpayer wishes to cost-share technology currently used to manufacture products and that serves as a springboard for the development of derivative technologies, it must charge a royalty for the make-sell rights outside the CSA and a separate buy-in payment for the right to develop derivative technologies within the CSA. Finally, Prop. Regs. Sec. 1.482-7(d) incorporates the IRS’s position that intangible development costs must include all costs in cash or kind, including stock-based compensation.

Effective Date

The regulations are proposed to be effective for CSAs commencing on or after the date final regulations are published in the Federal Register, which is anticipated to be in 2007. CSAs in existence as of Dec. 31, 2006 remain generally subject to the 1996 regulations; however, such grandfathered CSAs may become subject to the new regulations if any of certain changes to a CSA occur, or if the taxpayer fails to comply with the transition rules.


The proposed regulations contain provisions that give the Service broad and unilateral authority to make allocations to adjust taxpayers’ results of CSAs after the fact. Although some of the more controversial provisions will likely be revised in final regulations, CSAs may become less attractive than they are currently. Until regulations are finalized, taxpayers should consider alternative and interim strategies, including developing new intellectual property offshore under the developer-assister rules and structuring acquisitions to leave acquired intellectual property rights offshore.

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