On December 31, 2008, the IRS introduced new temporary cost-sharing regulations (T.D. 9441) that replace the old cost-sharing regulations introduced in 1995. The goal of the new regulations is to ensure that cost-sharing arrangements and platform contribution transactions are consistent with Sec. 482’s commensurate with income (CWI) principle. To achieve that goal, the IRS has introduced three new methods—the income method, the acquisition price method, and the market capitalization method—to ensure arm’s-length pricing in all cost-sharing transactions. The comparable uncontrolled transaction (CUT) method and a revised residual profit split (RPS) method are also included as specified methods.
The Nature of the CSA and CSA Transactions
The new regulations apply only to cost-sharing arrangements (CSAs) meeting the standards identified in Temp. Regs. Sec. 1.482-7T and platform contribution transactions (as defined in the new CSA regulations). Other transactions involving intangibles should be analyzed using Regs. Sec. 1.482-4. To ensure consistency with CWI, the new CSA regulations apply the concept of an investor model based on the opportunity cost principle from standard microeconomics. In economic theory, when people make economic decisions they select the option they believe will provide the greatest net gain. The opportunity cost of that option is the next best alternative forgone. In the new CSA regulations, the investor model requires the CSA participants to look at realistic, alternative investment options that would provide the same results as the CSA but with different risk and functional fact patterns.
A CSA is an arrangement in which controlled participants to the CSA share in the cost of developing cost-shared intangibles in proportion to the share of reasonably anticipated benefits (RABs) each participant expects to receive (Temp. Regs. Sec. 1.482-7T(b)). In the CSA, controlled participants must make payments to each other to ensure that their cost contributions to intangible development activities (IDAs) reflect their respective RABs. The scope of the IDAs includes all activities that could reasonably be anticipated to contribute to developing the reasonably anticipated cost-shared intangibles.
The new CSA regulations introduce the concept of a platform contribution transaction (PCT) to replace the overly broad “external contributions” from the 2005 proposed regulations. In a PCT, one CSA participant contributes to a CSA an intangible that will be used to help develop the CSA’s cost-shared intangible. Other members of the arrangement (the PCT payors) must make arm’s-length PCT payments to the participant who contributes the PCT intangible (the PCT payee). The temporary regulations require the PCT payor to compensate the PCT payee only for platform contributions that can reasonably be anticipated to contribute to the CSA activity in the PCT payor’s division. The temporary regulations adopt a presumption that a PCT payee provides any resource, capability, or right to the IDA on an exclusive basis (Temp. Regs. Secs. 1.482-7T(b)(1)(ii) and (c)).
The new CSA regulations require the CSA participants to segment the interests of each CSA member into exclusive divisions. In a division, each controlled participant must receive a nonoverlapping interest in the cost-shared intangibles without further obligation to compensate another participant for such interest. For example, a CSA can segment interests by assigning exclusive territories where each participant is the sole beneficiary of sales in its exclusive region (Temp. Regs. Secs. 1.482-7T(b)(1)(iii) and (b)(4)(ii)).
The new CSA regulations allow the divisions to be created on nonterritorial bases. One method a taxpayer can use is to identify specific fields of use for the intangible and assign each participant exclusive control over a field or set of fields. In the field of use division, each controlled participant must own clearly defined consumer uses for the intangible from which to earn its RAB. An intangible product could have multiple market uses generating multiple income streams. Each unique income stream would need to be identified and assigned to a controlled participant. Income from uses not yet identified would need to be assigned to one participant as well (Temp. Regs. Sec. 1.482-7T(b)(4)(iii)).
Intangible Development Costs
The basis of any CSA is how to divide intangible development costs (IDCs) of performing an IDA. Costs included in IDCs are determined by the scope of IDA activity. The IDA is the activity undertaken by the CSA participants to develop or attempt to develop reasonably anticipated cost-shared intangibles. The scope of the IDA includes all the controlled participants’ activities that could reasonably be anticipated to contribute to developing the reasonably anticipated cost-shared intangibles (Temp. Regs. Sec. 1.482-7T(d) (1)(i)).
The IDCs that result from the IDAs include all costs, in cash or in kind (including stock-based compensation, as described in Temp. Regs. Sec. 1.482-7T(d) (3)), incurred by the CSA participants. Thus, controlled participants to the CSA must include in the IDCs the costs they incurred in attempting to develop reasonably anticipated cost-shared intangibles, regardless of whether such costs fail to develop those intangibles, unexpectedly develop other intangibles, or produce no intangibles (Temp. Regs. Sec. 1.482- 7T(d)(1)(iii)).
The new CSA regulations are clear about the requirement to include stock options in the IDCs. The cost attributable to stock-based compensation is equal to the amount the controlled participant is allowed to take as a deduction for federal income tax purposes with respect to that stock-based compensation and is taken into account as an IDC for the tax year for which the deduction is allowable. The CSA participants should value the stockbased compensation as of the grant date (Temp. Regs. Sec. 1.482-7T(d)(1)(iii)).
The new CSA regulations are based on the investor model and the analysis of realistic alternatives to the proposed CSA (Temp. Regs. Sec. 1.482-7T(g)(2)(ii)). The PCT payor is investing in the CSA activity with cost-sharing payments and PCT payments to realize a return over time that is consistent with the riskiness of the project. The realistic alternatives to the investor represent the opportunity cost of the project that a third-party investor would have to consider before moving forward with the CSA. The returns are measured using a present value calculation.
The measurement of arm’s-length results requires a complete best method analysis. To ensure that CSA results are consistent with the arm’s-length standard, expected returns to particular functions and risks in the investor model assumed in intangible development should be assessed in light of the facts and circumstances. The facts and circumstances of the transaction will dictate the selection of a best method.
The results of a best method analysis performed in connection with certain methods or forms of payment may depend on the rate or rates of return used to convert projected results of transactions to present value. Discount rate selection plays a central role in the present value analysis. The allocation of costs and establishment of cost contributions rely on forecasts of future anticipated business activities and financial results (Temp. Regs. Sec. 1.482-7T(g)(2)(v)).
The new CSA regulations recognize that different realistic alternatives may carry different risk profiles and require different discount rates. A single method may require the use of multiple rates. When selecting rates for inclusion in the best estimate of a present value calculation, the taxpayer must identify the rate(s) that most reliably assess the market risks of activities and transactions. The new CSA regulations endorse the use of an iterative approach when multiple rates are used to establish an arm’s-length range (Temp. Regs. Sec. 1.482-7T(g)(2)(ix)).
CSA Arm’s-Length Calculation Using the RAB Method
For the arm’s-length allocation for IDCs under a CSA, taxpayers should use the RAB method (Temp. Regs. Sec. 1.482- 7T(a)(1)). When determining RAB shares at any given time, reasonably anticipated benefits must be estimated over the entire period, past and future, of exploitation of the cost-shared intangibles. A controlled participant’s RAB share is equal to its RAB divided by the sum of the RABs of all the controlled participants (Temp. Regs. Sec. 1.482-7T(e)(1)(i)).
Reasonably anticipated benefits are measured either on a direct basis, by reference to estimated benefits to be generated by the use of cost-shared intangibles (generally based on additional revenues plus cost savings less any additional costs incurred), or on an indirect basis, by reference to certain measurements that reasonably can be assumed to relate to benefits to be generated (Temp. Regs. Sec. 1.482-7T(e)(2)). Indirect bases for measuring anticipated benefits from participation in a CSA include units used, produced, or sold; sales; or operating profit. In some circumstances, other bases for measuring anticipated benefits may be appropriate.
The reliability of an estimate of RAB shares also depends upon the reliability of related projections. Projections required for this purpose generally include:
- A determination of the time period between the incep tion of the research and development activities under the CSA and the receipt of benefits;
- A projection of the time over which benefits will be received; and
- A pro jection of the benefits anticipated for each year in which it is anticipated that the cost-shared intangible will generate benefits.
A projection of the relevant basis for measuring anticipated benefits may require a projection of the underlying factors. For example, a projection of operating profits may require a projection of sales, cost of sales, and operating expenses (Temp. Regs. Sec. 1.482-7T(e)(2)(iii)).
Income Method
Under the new income method (Temp. Regs. Sec. 1.482-7T(g)(4)), a proposed CSA advances a cost-sharing scenario between a PCT payor and PCT payee, where the PCT payor makes payments for its share of the platform intangible contributed by the PCT payee, and the parties to the CSA agree to share in the costs of the IDAs. The present value of the PCT payor’s cost-sharing alternative is the present value of the stream of the reasonably anticipated residuals, over the duration of the CSA activity, of divisional profits or losses, minus operating cost contributions, minus intangible cost contributions, minus PCT payments (Temp. Regs. Sec. 1.482-7T(g)(4)(ii)).
The income method uses realistic alternatives to measure the opportunity cost of the proposed CSA. The method employs the CUT method and the comparable profits method (CPM) to build up specified types of comparable sets for the realistic alternatives. The income method evaluates whether the amount charged in a PCT is determined at arm’s length by reference to a controlled participant’s best realistic alternative to entering into a CSA. Under this method, the arm’slength charge for a PCT payment will be an amount where the present value of the controlled participant’s cost-sharing alternative, at the date of the PCT, equals the present value of the next best realistic alternative.
In general, the PCT payor’s best realistic alternative to entering into the CSA would be to license intangibles to be developed by an uncontrolled licensor that undertakes the commitment to bear the entire risk of intangible development that would otherwise have been shared under the CSA. Similarly, the PCT payee’s best realistic alternative to entering into the CSA would be to commit to bear the entire risk of intangible development that would otherwise have been shared under the CSA and license the resulting intangibles to an uncontrolled licensee (Temp. Regs. Sec. 1.482-7T(g)(4)(i)(A)).
The new CSA regulations discuss two applications of the income method licensing scenario, one using a CUT method and one using a CPM. The licensing alternative is derived on the basis of a functional and risk analysis of the cost-sharing alternative, but with a shift of the risk of cost contributions to the licensor. The PCT payor’s licensing alternative consists of entering into a license with an uncontrolled party, for a term extending for what would be the duration of the CSA activity, to license the make-or-sell rights in to-be-developed resources of the licensor. Under such license, the licensor would undertake the commitment to bear the entire risk of intangible development that would otherwise have been shared under the CSA.
The present value of the PCT payor’s licensing alternative may be determined using the CUT method, as described in Regs. Secs. 1.482-4(c)(1) and (2). In this case, the present value of the PCT payor’s licensing alternative is the present value of the stream, over what would be the duration of the CSA activity under the costsharing alternative, of the reasonably anticipated residuals of the divisional profits or losses that would be achieved under the cost-sharing alternative, minus operating cost contributions that would be made under the cost-sharing alternative, minus the licensing payments as determined under the CUT method (Temp. Regs. Sec. 1.482-7T(g)(4)(iii)(A)).
The present value of the PCT payor’s licensing alternative may be determined using the CPM, as described in Regs. Sec. 1.482-5. In this case, the present value of the licensing alternative is the same as in the CUT scenario, except that the PCT payor’s licensing payments are determined to be a lump sum, as of the date of the PCT, equal to the present value of the stream, over what would be the duration of the CSA activity under the cost-sharing alternative, of the reasonably anticipated residuals of the divisional profits or losses that would be achieved under the costsharing alternative, minus operating cost contributions that would be made under the cost-sharing alternative, minus market returns for routine contributions (Temp. Regs. Sec. 1.482-7T(g)(4)(iii)(B)).
Acquisition Price Method
The acquisition price method (Temp. Regs. Sec. 1.482-7T(g)(5)) applies the CUT method of Regs. Sec. 1.482-4(c) or the comparable uncontrolled services price (CUSP) method described in Temp. Regs. Sec. 1.482-9T(c) to evaluate whether the amount charged in a PCT is determined at arm’s length by reference to the amount charged (the acquisition price) for the stock or asset purchase of an entire organization or portion thereof (the target) in an uncontrolled transaction. The acquisition price method is ordinarily used where substantially all the target’s nonroutine contributions made to the PCT payee’s business activities are covered by a PCT. Under this method, the arm’s-length charge for a PCT is equal to the adjusted acquisition price, as divided among the controlled participants according to their respective RAB shares.
Market Capitalization Method
The market capitalization method (Temp. Regs. Sec. 1.482-7T(g)(6)) applies the CUT method of Regs. Sec. 1.482- 4(c) or the CUSP method described in Temp. Regs. Sec. 1.482-9T(c) to evaluate whether the amount charged in a PCT is determined at arm’s length by reference to the average market capitalization of a controlled participant (PCT payee) whose stock is regularly traded on an established securities market. The market capitalization method is ordinarily used where substantially all the PCT payee’s nonroutine contributions to the PCT payee’s business are covered by a PCT.
Under the market capitalization method, the arm’s-length charge for a PCT covering resources, capabilities, and rights of the PCT payee is equal to the adjusted average market capitalization, as divided among the controlled participants according to their respective RAB shares. The average market capitalization is the average of the daily market capitalizations of the PCT payee over a period beginning 60 days before the date of the PCT and ending on the date of the PCT.
Residual Profit Split Method
The RPS method (Temp. Regs. Sec. 1.482-7T(g)(7)) evaluates whether the allocation of combined operating profit or loss attributable to one or more platform contributions subject to a PCT is determined at arm’s length by reference to the relative value of each controlled participant’s contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity (relevant business activity) of the controlled participants for which data are available that includes the CSA activity. The residual profit split method may not be used where only one controlled participant makes significant nonroutine contributions (including platform or operating contributions) to the CSA activity.
The relative value of each controlled participant’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity. Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled participants engaged in the relevant business activity.
Under the RPS method, the present value of each controlled participant’s residual divisional profit or loss attributable to nonroutine contributions (nonroutine residual divisional profit or loss) is allocated among the controlled participants that furnish significant nonroutine contributions (including platform or operating contributions) to the relevant business activity in that division (Temp. Regs. Sec. 1.482-7T(g)(7)(iii)(A)).
The present value of nonroutine residual divisional profit or loss equals the present value of the stream of the reasonably anticipated residuals, over the duration of the CSA activity, of divisional profit or loss, minus market returns for routine contributions, minus operating cost contributions, minus cost contributions, using a discount rate appropriate to such residuals. The present value of nonroutine residual divisional profit or loss in each controlled participant’s division must be allocated among all the controlled participants based upon the relative values (determined as of the date of the PCTs) of the PCT payor’s PCT payments as compared with the PCT payee’s nonroutine contributions to the PCT payor’s division (Temp. Regs. Sec. 1.482- 7T(g)(7)(iii)(B)).
Comparable Uncontrolled Transaction Method
The CUT method described in Regs. Sec. 1.482-4(c) and the CUSP method described in Temp. Regs. Sec. 1.482- 9T(c) may be applied to evaluate whether the amount charged in a PCT is determined at arm’s length by reference to the amount charged in a CUT (Temp. Regs. Sec. 1.482-7T(g)(3)). When applied in the manner described in Regs. Sec. 1.482- 4(c) or Temp. Regs. Sec. 1.482-9T(c), the CUT or CUSP method will typically yield an arm’s-length total value for the platform contribution that is the subject of the PCT. That value must then be multiplied by each PCT payor’s respective RAB share in order to determine the arm’s-length PCT payment due from each PCT payor.
EditorNotes
Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or mindy.cozewith@rsmi.com.
