[Federal Register Volume 76, Number 246 (Thursday, December 22, 2011)]
[Rules and Regulations]
[Pages 80082-80136]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-32458]
[[Page 80081]]
Vol. 76
Thursday,
No. 246
December 22, 2011
Part III
Department of the Treasury
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Internal Revenue Service
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26 CFR Parts 1, 301, and 602
Section 482: Methods To Determine Taxable Income in Connection With a
Cost Sharing Arrangement; Final Rule
Federal Register / Vol. 76 , No. 246 / Thursday, December 22, 2011 /
Rules and Regulations
[[Page 80082]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1, 301, and 602
[TD 9568]
RIN 1545-BI47
Section 482: Methods To Determine Taxable Income in Connection
With a Cost Sharing Arrangement
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations and removal of temporary regulations.
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SUMMARY: This document contains final regulations regarding methods to
determine taxable income in connection with a cost sharing arrangement
under section 482 of the Internal Revenue Code (Code). The final
regulations address issues that have arisen in administering the
current cost sharing regulations. The final regulations affect domestic
and foreign entities that enter into cost sharing arrangements
described in the final regulations.
DATES: Effective Date: These regulations are effective on December 16,
2011.
Applicability Date: For dates of applicability, see Sec. Sec.
1.482-1(j)(6)(i), 1.482-2(f), 1.482-4(h), 1.482-7(l), 1.482-8(c),
1.482-9(n)(3), and 1.301-7701-1(f).
FOR FURTHER INFORMATION CONTACT: Joseph L. Tobin, (202) 435-5265 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations
has been reviewed by the Office of Management and Budget in accordance
with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under
control number 1545-1364. The collections of information in these final
regulations are in Sec. 1.482-7(b)(2) and (k). Responses to the
collections of information are required by the IRS to monitor
compliance of controlled taxpayers with the provisions applicable to
cost sharing arrangements.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by section 6103 of
the Code.
Background
A notice of proposed rulemaking and notice of public hearing
regarding additional guidance to improve compliance with, and
administration of, the rules in connection with a cost sharing
arrangement (CSA) were published in the Federal Register (70 FR 51116)
(REG-144615-02) on August 29, 2005 (2005 proposed regulations). A
correction to the notice of proposed rulemaking and notice of public
hearing was published in the Federal Register (70 FR 56611) on
September 28, 2005. A public hearing was held on December 16, 2005.
The Treasury Department and the IRS received numerous comments on a
wide range of issues addressed in the 2005 proposed regulations. In
response to these comments, temporary and proposed regulations were
published in the Federal Register (74 FR 340-01 and 74 FR 236-01) (REG-
144615-02) on January 5, 2009 (2008 temporary regulations). Corrections
to the 2008 temporary regulations were published in the Federal
Register on February 27, 2009 (74 FR 8863-01), March 5, 2009 (74 FR
9570-01, 74 FR 9570-02, and 74 FR 9577-01), and March 19, 2009 (74 FR
11644-01). A public hearing was held on April 21, 2009.
The Treasury Department and the IRS received comments on a range of
issues addressed in the 2008 temporary regulations. These final
regulations make several changes to the 2008 temporary regulations in
response to these comments. In addition, a number of editorial
clarifications have been made. These regulations adopt the effective
date and transition rules under the 2008 temporary regulations so that
they are generally applicable for all CSAs, with transition rules for
certain preexisting arrangements in existence prior to January 5, 2009.
Explanation of Provisions
A. Overview--Economic Contributions and Their Arm's Length Compensation
in a CSA
These final regulations provide guidance on the determination of
and compensation for all economic contributions by all controlled
participants in connection with a CSA in accordance with the arm's
length standard.
The arm's length analysis under section 482 begins with the factual
and functional analysis of the actual transaction or transactions among
the controlled taxpayers. In a CSA, the controlled participants make
economic contributions of two types, namely, mutual commitments to
prospectively share intangible development costs in proportion to their
reasonably anticipated benefits from exploitation of the cost shared
intangibles (cost contributions) and to provide any existing resources,
capabilities, or rights that are reasonably anticipated to contribute
to developing cost shared intangibles (platform contributions). CSAs
may also involve economic contributions by the controlled participants
of other existing resources, capabilities, or rights related to the
exploitation of cost shared intangibles (operating contributions). The
concepts of platform and operating contributions are intended to
encompass any existing inputs that are reasonably anticipated to
facilitate developing or exploiting cost shared intangibles at any
time, including resources, capabilities, or rights, such as expertise
in decision-making concerning research and product development,
manufacturing or marketing intangibles or services, and management
oversight and direction. Other prospective economic contributions
consist of costs incurred to develop or acquire resources,
capabilities, and rights that facilitate the exploitation of cost
shared intangibles (operating cost contributions). These regulations
provide guidance for determining the arm's length charge for all such
contributions to clearly reflect the incomes of the controlled
participants.
The valuation guidance in the regulations applies to determine the
most reliable measure of arm's length results for these economic
contributions over the duration of the activity of developing and
exploiting cost shared intangibles (CSA Activity). The combined effect
of multiple contributions, potentially including controlled
transactions outside of the CSA (for example, make-or-sell licenses, or
intangible transfers governed by section 367(d)), may need to be
evaluated on an aggregate basis, where that approach provides the most
reliable measure of an arm's length result. So, for example, if a
taxpayer transfers intangibles in a transaction governed by section
367(d) in connection with contributions related to those same
intangibles in connection with a CSA, then the pricing of the
intangibles under section 367(d) may need to be evaluated along with
the pricing of all contributions in connection with the CSA on an
aggregate basis, where that approach provides the most reliable measure
of an arm's length result. Under
[[Page 80083]]
the principles of the investor model, the relative reliability of the
analysis will depend on the degree of consistency of the valuation with
the expectation that each controlled participant's net investment
attributable to cost contributions, platform contributions, operating
contributions, and operating cost contributions, is reasonably
anticipated to earn a rate of return (which might be reflected in a
discount rate used in applying a method) appropriate to the riskiness
of the controlled participant's CSA Activity over the entire period of
the CSA Activity. The duration of the CSA Activity may, or may not,
correspond to the conventional concept of useful life with respect to
any of the underlying economic contributions; it represents the period
over which the controlled participants reasonably anticipate returns
from the CSA Activity.
For purposes of determining the best method of measuring the arm's
length results of a CSA, and any related controlled transactions, these
regulations adopt the guidance included in the 2008 temporary
regulations on assessing the potential applicability of the comparable
uncontrolled transaction (CUT) method. The arm's length standard seeks
to determine the results that would obtain had uncontrolled taxpayers
engaged in the same transaction under the same circumstances. It is
immaterial whether the arrangement among uncontrolled taxpayers is
denominated as a ``cost sharing arrangement,'' so long as the
arrangement involves the same circumstances (or similar circumstances,
assuming that reliable adjustments can be made to account for any
differences). Thus, long-term licenses or research and development
services contracts may provide CUTs, provided and to the extent they
involve the same or similar scope and contractual terms, uncertainty of
outcomes, profit potential, allocation of intangible development and
exploitation risks, including allocation of the risks of existing
contributions and the risks of developing future contributions,
consistent with the actual allocation of risks under the CSA and
through related controlled transactions.
A CSA may benefit from, and contribute to, a controlled group's
unique competitive advantages. Therefore, there may be no uncontrolled
transactions that reliably reflect the same contributions by the
parties, over a similar period of commitment, and with the same risk
profile and profit potential. The arm's length standard requires
application of the method that most reliably reflects the results that
would have been realized had uncontrolled taxpayers engaged in the same
transaction. Where comparable uncontrolled transactions are
unavailable, these regulations, like other regulations under section
482, allow for reference to the results the controlled taxpayers could
have realized by choosing a realistic alternative. These regulations
adopt a specified income method included in the 2008 temporary
regulations that represents an application of the realistic
alternatives principle. These regulations adopt the 2008 temporary
regulations' provision of a licensing alternative to the CSA that
closely aligns with the economics of the CSA, but takes account of the
licensor's commitment to bear the entire risk of the intangible
development that would otherwise have been shared. The realistic
alternatives analysis effectively constructs a comparable uncontrolled
transaction that, depending on the facts and circumstances, may more
reliably reflect the economics of the actual contributions to the CSA
than can be derived from third party transactions. For cases where more
than one controlled participant makes significant contributions to
residual profits (including platform or operating contributions), these
regulations adopt the guidance included in the 2008 temporary
regulations on a specified residual profit split method (RPSM), which
is also an application of the realistic alternatives principle.
These regulations also adopt guidance on the application of two
other specified methods included in the 2008 temporary regulations--the
acquisition price method and the market capitalization method. The
guidance regarding unspecified methods adopted from the 2008 temporary
regulations reemphasizes that any such method should take into account
the general principle that uncontrolled taxpayers evaluate the terms of
a transaction by considering the realistic alternatives to that
transaction, and enter into a particular transaction only if none of
the alternatives is clearly preferable to it.
These regulations resolve issues that have been raised under the
1995 regulations. No inference is intended regarding the appropriate
resolution of those issues under the 1995 regulations. These
regulations do not turn on whether a given transaction in connection
with a CSA involves intangible property within the meaning of section
936(h)(3)(B), or whether such item has been transferred, licensed, or
retained. Rather, if a controlled participant devotes, in whole or
part, any existing resource, capability, or right to intangible
development for the benefit of another controlled participant, whether
by transfer or license to the other controlled participant, or by
leveraging such resource, capability, or right within the context of
the CSA, then the regulations require an arm's length charge for such
platform contribution, in addition to the funding of intangible
development costs.
For example, the regulations require an arm's length charge for one
controlled participant's platform contribution commitment of a
particular research team's experience and expertise to intangible
development under a CSA, in addition to the controlled participants'
sharing of the ongoing intangible development costs of the salaries of
such researchers. To limit the arm's length charge in these
circumstances to sharing the ongoing salary costs would ignore the
value of having the particular research team already in place to
undertake the intangible development with the benefit of its particular
knowhow. See Sec. 1.482-7(c)(5), Example 2. As another example, the
contribution of core entrepreneurial functions such as product
selection, market positioning, research strategy, and risk
determinations and management requires an arm's length charge under
these regulations. To omit charges for these or any other significant
economic contributions one controlled taxpayer makes for another's
benefit would fail to clearly reflect the incomes of such controlled
taxpayers.
A unifying underpinning of the section 482 regulations is that
controlled transactions reflecting similar economics, regardless of the
type of transaction (such as transfer of intangibles or provision of
services), should be valued in accordance with similar principles and
methods. See, for example, Sec. 1.482-1(b)(2)(iii). In conjunction
with finalizing Sec. 1.482-7, parallel rules are also finalized in
Sec. Sec. 1.482-4(g) and 1.482-9(m)(3). Under these provisions, the
principles and methods for valuing platform and operating contributions
under a CSA may also apply for purposes of determining the best method,
which may be an unspecified method, for valuing similar contributions
in connection with controlled transfers of intangibles or provisions of
services.
B. Platform Contributions, Make-or-Sell Rights Excluded--Sec. 1.482-
7(c)(4)
A comment requested clarification of the treatment of an item--
e.g., a program or tool to facilitate research (research tools)--used
under a CSA to further the development of intangibles targeted by the
CSA, as within, or
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outside, the definition of make-or-sell rights. The Treasury Department
and the IRS intend research tools to be treated as platform
contributions, and not as excluded make-or-sell rights. Accordingly,
Sec. 1.482-7(c)(4)(i) has been modified and a new example added to
illustrate this concept.
C. Intangible Development Activity and Costs--Sec. 1.482-7(d)(3)
The Treasury Department and the IRS requested comments in Notice
2005-99, 2005-52 CB 1214, regarding the valuation of stock options and
other stock-based compensation. Several comments were received. The
Treasury Department and the IRS continue to consider the matters
described in Notice 2005-99, and intend to address these issues in a
subsequent regulations project.
D. Reasonably Anticipated Benefit Shares--Sec. 1.482-7(e)(1)(i)
Several comments requested clarification concerning how and when to
update reasonably anticipated benefit (RAB) shares, and whether such
updates may be made retroactively or only prospectively. In response to
these comments, the Treasury Department and the IRS added several
sentences to Sec. 1.482-7(e)(1)(i) to clarify that RAB shares
determined for a particular purpose should not be further updated for
that purpose based on information not available at the time that
determination needed to be made. For example, RAB shares determined in
order to determine intangible development cost shares for a particular
taxable year should not be recomputed based on information not
available during that particular taxable year, and RAB shares
determined for the purpose of using a particular transfer pricing
method to evaluate the arm's length amount charged in a PCT should not
be recomputed based on information not available on the date of that
PCT. An example is added to illustrate this clarification. See Sec.
1.482-7(e)(1)(iii), Example 2. For readability, a portion of the text
of Sec. 1.482-7T(e)(1)(i) was redesignated as Sec. 1.482-7(e)(1)(ii),
and Sec. 1.482-7T(e)(1)(ii) was redesignated as Sec. 1.482-
7(e)(1)(iii). The Treasury Department and the IRS also observe in these
clarifications that nothing in Sec. 1.482-7(e)(1) limits the
Commissioner's use of subsequently available information for purposes
of its allocation determinations in accordance with the provisions of
Sec. 1.482-7(i) (Allocations by the Commissioner in connection with a
CSA).
E. Transfer Pricing Methods--Sec. 1.482-7(g)
1. Supplemental Guidance on Methods Applicable to PCTs--Sec. 1.482-
7(g)(1)
One method for determining the arm's length charge for a
contribution is to calculate the total present value of the stream of
future economic benefits one can expect in connection with such
contribution. In a CSA, the stream of anticipated economic benefits to
be discounted will reflect the economic benefits expected to arise from
cost shared intangibles to be developed under the CSA. Consequently,
the arm's length charge for a PCT can appropriately be determined by
taking into account the economic benefits anticipated to be produced in
the future by cost shared intangibles developed under the CSA.
Accordingly, a sentence has been added to paragraph (g)(1) to clarify
that each method used for evaluating the arm's length amount charged in
a PCT must yield results consistent with measuring the value of a
platform contribution by reference to the future income anticipated to
be generated by the resulting cost shared intangibles.
2. Best Method Analysis Considerations and the Income Method--Sec.
1.482-7(g)(2) and (4)
a. Discounting Operating Income--Sec. 1.482-7(g)(2)(v)
The preamble to the 2008 temporary regulations solicited comments
on whether and how the cost sharing rules could reliably be
administered on the basis of cash flows instead of operating income,
and whether such a basis is consistent with the second sentence of
section 482. No comments were received that addressed this request,
though some comments did object to the use of operating income, rather
than cash flows, in the cost sharing rules.
The Treasury Department and the IRS believe that, while the use of
cash flow projections is permitted under the regulations, detailed
guidance on the specific applications of the methods should be based on
discounting operating income rather than cash flows for a number of
practical and administrative reasons and, accordingly, no changes were
adopted to address this issue.
b. Financial Projections and Discount Rates--Sec. 1.482-7(g)(2)(v) and
(vi)
Under the temporary regulations, the specific applications of the
income method discussed in Sec. 1.482-7(g)(4) require a number of
input parameters, including financial projections and the associated
discount rate under the licensing alternative, and financial
projections and the associated discount rate under the cost sharing
alternative. These regulations modify the 2008 temporary regulations in
several respects to clarify the interaction of these input parameters
in applying the income method.
i. Financial Projections for the Licensing and Cost Sharing
Alternatives Are Interrelated
These regulations provide that, under the specific applications of
the income method, the financial projections associated with the
licensing and cost sharing alternatives are the same except for the
licensing payments to be made under the licensing alternative, and the
cost contributions and PCT Payments to be made under the cost sharing
alternative. Thus, for example, if the PCT Payor anticipates sales
associated with the cost shared intangibles to third parties of $100 in
the cost sharing alternative, then it must anticipate sales associated
with the licensed intangible to third parties of this same $100 under
the licensing alternative. Similarly, if the PCT Payor's anticipated
selling costs associated with those sales are $60 in the cost sharing
alternative, then its anticipated selling costs are the same $60 in the
licensing alternative. The financial projections associated with the
licensing alternative to the CSA are closely associated with the
financial projections associated with the cost sharing alternative,
differing only in the treatment of licensing payments, cost
contributions, and PCT Payments. As a result, the income method, as in
the case of the more traditional discounted cash flow methods, builds
off of the (single) probability-weighted financial projections
associated with the CSA Activity.
ii. Discount Rates for the Licensing and Cost Sharing Alternatives Are
Interrelated
The Treasury Department and the IRS received several comments
requesting further guidance on the relationship between the discount
rate that is appropriate for discounting the operating income
associated with the cost sharing alternative and the discount rate that
is appropriate for discounting the operating income associated with the
licensing alternative. In response to these comments, and as a
corollary to the interrelationship of the financial projections for the
licensing and cost sharing alternatives discussed in the preceding
paragraph, these regulations provide further guidance on the discount
rates appropriate for these two alternatives. Specifically, the
difference,
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if any, in market-correlated risks between the licensing and cost
sharing alternatives is due solely to the different effects on risks of
the PCT Payor making licensing payments under the licensing
alternative, and the PCT Payor making cost contributions and PCT
Payments under the cost sharing alternative. That is, the difference in
risk between the two scenarios solely reflects (1) the incremental
risk, if any, associated with the cost contributions taken on by the
PCT Payor in developing the cost shared intangible under the cost
sharing alternative, and (2) the difference in risk, if any, associated
with the particular payment forms of the licensing payments and the PCT
Payments, in light of the fact that the licensing payments in the
licensing alternative are partially replaced by cost contributions and
partially replaced by PCT Payments in the cost sharing alternative,
each with its own payment form.
c. Valuation Undertaken on a Pre-Tax Basis--Sec. 1.482-7(g)(2)(x)
Several comments requested that the final regulations clarify the
term ``tax rate'' for purposes of determining amounts on a pre-tax
basis. In response, that term has been clarified in Sec. 1.482-7(j)(1)
to mean the reasonably anticipated effective tax rate with respect to
the pre-tax income to which the rate of tax is being applied. For
example, under the income method, this rate would be the reasonably
anticipated effective tax rate of the PCT Payor or PCT Payee under the
cost sharing alternative or licensing alternative, as appropriate. See
Sec. 1.482-7(g)(4)(i)(G).
Several comments also requested clarification on the guidance
concerning the determination of pre-tax PCT Payments under the income
method. While PCT Payments must be determined on a pre-tax basis, in
general, the financial projections and discount rates used to apply the
income method are post-tax measures. Comments suggested that this
discrepancy makes such a determination difficult and raises concerns
about valuation principles to derive a pre-tax PCT Payment based on
post-tax data.
The Treasury Department and the IRS believe that the requirement
that PCT Payments be determined on a pre-tax basis is fundamental to
the determination of an arm's length result, and, while no changes were
made to the regulations in this regard, examples were added to
illustrate this concept. Under the income method, the operative rule in
all cases is to derive the pre-tax PCT Payments that set the post-tax
present value of the cost sharing alternative equal to the post-tax
present value of the licensing alternative. The operative rule can be
satisfied in a number of ways. For example, annual pre-tax PCT Payments
can be directly determined such that, when incorporated into the PCT
Payor's financial projections (which should reflect the deductibility
of the pre-tax PCT Payments), the post-tax net present values of the
licensing and cost sharing alternatives are equated. See Sec. 1.482-
7(g)(4)(viii), Example 4. Alternatively, the present value of post-tax
PCT Payments can be directly determined by subtracting the present
value of the post-tax income associated with the licensing alternative
from the present value of the post-tax income associated with the cost
sharing alternative (exclusive of the PCT Payment). This difference,
which reflects the post-tax present value of the PCT Payment, must be
grossed up to derive the pre-tax PCT Payment. See Sec. 1.482-
7(g)(4)(viii), Example 5. Another alternative, in certain situations
(for example, when financial projections are based on income, rather
than cash flows, and when a controlled participant's tax rate is not
materially affected by whether it enters into the cost sharing or
licensing alternative), is for the present value of pre-tax PCT
Payments to be directly determined by subtracting the present value of
the pre-tax income associated with the licensing alternative from the
present value of the pre-tax income associated with the cost sharing
alternative (exclusive of the PCT Payment), both discounted at post-tax
discount rates. That is, under certain conditions the pre-tax PCT
Payments that equate the pre-tax present values of the two alternatives
will also equate the post-tax present values of the two alternatives
(which satisfies the operative rule). This last method does not reflect
a violation of valuation theory, but merely a method that applies under
certain conditions to derive the pre-tax PCT Payment more directly,
rather than deriving the post-tax PCT Payment under the operative rule
and grossing it up. Discounting pre-tax income with post-tax discount
rates conceptually provides a measure of pre-tax income. Discounting
pre-tax income with pre-tax discount rates, on the other hand,
conceptually provides a measure of post-tax income. See Sec. 1.482-
7(g)(4)(viii), Example 6. The specific applications of the income
method described in paragraphs (g)(4)(ii) through (iv) and the examples
set forth in paragraph (g)(4)(viii) of these final regulations assume
that such circumstances apply, but the regulations do not exclude other
applications.
3. Acquisition Price and Market Capitalization Methods--Sec. 1.482-
7(g)(5) and (6)
The acquisition price method as specified in Sec. 1.482-7(g)(5)
typically may be considered for determining PCT Payments with respect
to platform contributions as a result of asset or stock acquisitions.
Comments were received that, with some acquisitions, there may be
benefits to the controlled group whose scope extends beyond the
development of cost shared intangibles. The Treasury Department and the
IRS agree that these facts and circumstances should be taken into
account in the appropriate application of the acquisition price method
and any other methods for purposes of determining the best method, but
believe that this is adequately addressed by other provisions of the
section 482 regulations. See, for example, Sec. Sec. 1.482-1(c) (Best
method rule) and (d) (Comparability), and 1.482-7(g)(2)(iv)
(Aggregation of transactions).
Several comments requested that the final regulations provide more
guidance on what types of tax adjustments may be needed with respect to
PCT Payments determined under the acquisition price or market
capitalization method. The Treasury Department and the IRS believe that
the determination as to whether to make such adjustments should be
based on facts and circumstances of each case and thus are best
addressed under the general comparability guidance in Treas. Reg. Sec.
1.482-1(d) (Comparability). Therefore, the specific references to tax
adjustments under those methods were removed.
4. Residual Profit Split Method--Sec. 1.482-7(g)(7)
The residual profit split method under Sec. 1.482-7(g)(7)
allocates a PCT Payor's nonroutine residual divisional profit or loss
according to the controlled participants' relative nonroutine
contributions. The calculation of nonroutine residual divisional profit
or loss includes a subtraction of market returns for routine
contributions. See Sec. 1.482-7(g)(7)(iii)(B). These regulations
clarify that market returns for operating cost contributions are
included in, and market returns for cost contributions are excluded
from, that subtraction. Market returns are not assigned to cost
contributions because, under this method, resources, capabilities, and
rights that benefit the development of cost shared intangibles (and
thus make such development more valuable than
[[Page 80086]]
its cost) are compensated as platform contributions.
F. Form of Payment--Sec. 1.482-7(h)
1. Consistency of Form of Payment With Arm's Length Charge
Under the section 482 regulations, controlled taxpayers have
flexibility to choose a form of payment with respect to an arm's length
charge, provided that the form of payment may be reasonably expected to
yield a value consistent with such arm's length charge determined as of
the date of the PCT. Thus, a taxpayer must not only determine an arm's
length charge correctly under Sec. 1.482-7(g) but also designate a
form of payment that is consistent with that arm's length charge
determined as of the date of the PCT. This dual concept of the
flexibility in selecting the form of payment as well as the obligation
to preserve the arm's length charge through determining the form of
payment as of the date of the PCT is clarified by a new sentence added
to Sec. 1.482-7(h)(2)(i).
2. Services Markup Form of Payment
Several comments suggested that the final regulations should
expressly permit the use of methods in Sec. 1.482-9, particularly the
cost of services plus method, for valuing and determining the form of
payment of PCT Payments for services provided as, for example, by a
research team. As noted in the preceding paragraph, these regulations
clarify the flexibility taxpayers enjoy to adopt a form of payment
consistent with the arm's length charge determined for a PCT. In
theory, therefore, the arm's length charge for a platform contribution
of services of a research team might be converted into a cost-of-
services-plus form of payment, provided that, among other conditions,
the method and form of payment treating the platform value of such
research team separately from the arm's length charge for any other
platform contributions provide the most reliable measures of the arm's
length charges. The experience of the IRS, however, is that the arm's
length charges for platform contributions of the services of a research
team along with other platform contributions (e.g., of a base
technology) are most often most reliably determined in the aggregate.
G. Periodic Adjustments--Sec. 1.482-7(i)
1. Determination of Periodic Adjustments--Sec. 1.482-7(i)(6)(v) and
(vi)
a. In General--Sec. 1.482-7(i)(6)(i)
The temporary regulations provided detailed guidance for the
calculation of periodic adjustments in situations where there is a
single adjustment with respect to a single controlled participant. The
Treasury Department and the IRS intended that the principles of that
detailed guidance should also be applied in cases involving multiple
periodic adjustments (whether with respect to one or multiple
controlled participants, or with respect to one or multiple PCT
Payments) and, accordingly, Sec. 1.482-7T(i)(6)(i) provided that the
Commissioner may make periodic adjustments with respect to all PCT
Payments between all PCT Payors and PCT Payees for the Adjustment Year
and all subsequent years for the duration of the CSA Activity. In
response to these comments, a new example in Sec. 1.482-7(i)(6)(vii)
illustrates the application of Sec. 1.482-7(i)(6)(i) when more than
one periodic adjustment is required.
b. Adjusted RPSM--Sec. 1.482-7(i)(6)(v)(B)
One comment suggested that the requirement that an adjusted RPSM be
used for determining periodic adjustments is inconsistent with the
arm's length standard because the arm's length standard requires that
the best method rule be applied in all circumstances, and the adjusted
RPSM will not be the best method in every circumstance. The Treasury
Department and the IRS believe that this is sufficiently addressed by
the 2008 temporary regulations, which provide for periodic adjustments
to be administered consistent with the arm's length standard.
Specifically, Sec. 1.482-7(i)(6)(i) provides that, in determining
whether to make periodic adjustments, the Commissioner may consider
whether the outcome as adjusted more reliably reflects an arm's length
result under all the relevant facts and circumstances.
c. Exceptions to Periodic Adjustments--Sec. 1.482-7(i)(6)(vi)
Several comments suggested that the definition of ``divisional
profits or losses'' is too broad and includes too much value in the
concept of the actually experienced return ratio (AERR), thereby making
the numerator in the Periodic Trigger too large relative to the
denominator, and thus too easily triggered. In response to this
comment, the exception to periodic adjustments in Sec. 1.482-
7T(i)(6)(vi)(A)(3) is expanded to take into account the PCT Payor's
routine platform contributions. The language is further clarified to
provide that, in addition to the exclusion of certain profits or
losses, the PCT Payor's divisional profits or losses are calculated by
taking into account the expenses on account of operating cost
contributions and routine platform contributions.
d. Contractual CWI Provisions--Sec. 1.482-1(d)(3)(ii)(C), Examples 3
Through 7
The IRS has encountered a number of contracts that contain price
terms for transactions that are subject to section 482, including buy-
ins and PCTs, that provide for contingent terms based on subsequent
actual income experience. Some such terms specify a charge for the
transaction and then further provide for adjustments to that charge
based generally on the actual income results. Certain of these terms
are specifically tied to the mechanics of the CWI regulations (for
example, a price adjustment is required if the income is less than 80
percent or greater than 120 percent of the price charged). See
Sec. Sec. 1.482-4(f)(2)(ii)(B)(6) and (C)(4) and 1.482-7T(i)(6)(i) and
(ii).
Controlled participants have flexibility in agreeing to contingent
payment terms and, thus, in allocating upside or downside risk among
the parties. In so doing, the parties can tie their prices to the
income actually earned with respect to the subject of the buy-in or
PCT. Such price terms must be determined on an upfront basis and must
be coordinated and consistent with the arm's length charge. The IRS has
experience, however, with taxpayers failing to provide for arm's length
compensation for the allocation of risk, as well as failing to provide
price terms that are sufficiently clear so as to constitute an upfront
allocation of risk that has economic substance. Accordingly, several
examples have been added to Sec. 1.482-7(h)(2)(iii)(C) to illustrate
the treatment of certain types of contingent price terms under these
regulations, and apply the principles set forth in Sec. Sec. 1.482-
7(h)(2)(iii)(B) and (k)(1)(iv) and 1.482-1(d)(3)(ii)(B)(1) and
(iii)(B).
2. Advance Pricing Agreement
As stated in the Preamble to the 2008 temporary regulations, the
Treasury Department and the IRS are considering issuing a revenue
procedure providing an exception to periodic adjustments, similar to
exceptions provided in Sec. 1.482-7(i)(6)(vi), in the context of an
advance pricing agreement (APA) entered into pursuant to Rev. Proc.
2006-9, 2006-1 CB 278. Accordingly, no periodic adjustments would be
made in any year based on a Trigger PCT that is a covered transaction
under the APA. See Sec. 601.601(d)(2)(ii)(b).
[[Page 80087]]
H. Administrative Requirements--Sec. 1.482-7(k)
1. CSA Statements, mailing to Ogden Campus--Sec. 1.482-7(k)(4)(iii)
A number of comments requested that the regulations provide a
specific address for mailing CSA Statements to the Ogden Campus. In
response to these comments, a specific mailing address for CSA
Statements has been added to the regulations.
2. Advance Pricing Agreements
One comment requested that taxpayers with CSAs covered by APAs be
relieved from the administrative requirements in Sec. 1.482-7(k)(2)
through (4). The Treasury Department and the IRS are considering
guidance addressing this issue, and solicit further comments concerning
the extent to which compliance with the APA procedures should be deemed
to satisfy any of the administrative requirements under Sec. 1.482-
7(k)(2) through (4). These comments should address the impact of any
such change on the ability of the IRS to properly examine CSA-related
transactions.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedure Act (5
U.S.C. chapter 5) does not apply to these regulations. It is hereby
certified that the collections of information in these regulations will
not have a significant economic impact on a substantial number of small
entities. This certification is based on the fact that this rule
applies to U.S. businesses and foreign affiliates that enter into cost
sharing arrangements. Few small entities are expected to enter into
cost sharing agreements, as defined by these regulations. Accordingly,
a Regulatory Flexibility Analysis under the Regulatory Flexibility Act
(5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of
the Code, these regulations were submitted to the Chief Counsel for
Advocacy of the Small Business Administration (CCASBA) for comment on
their impact on small businesses. CCASBA did not have any comments.
Drafting Information
The principal author of these regulations is Joseph L. Tobin of the
Office of Associate Chief Counsel (International). However, other
personnel from the IRS and the Treasury Department participated in
their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 301
Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income
taxes, Penalties, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Amendment to the Regulations
Accordingly, 26 CFR parts 1, 301, and 602 are amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by adding an
entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.482-7 also issued under 26 U.S.C. 482. * * *
0
Par 2. Section 1.367(a)-1 is amended by revising paragraph (d)(3) to
read as follows:
Sec. 1.367(a)-1 Transfers to foreign corporations subject to section
367(a): In general.
* * * * *
(d) * * *
(3) Transfer. For purposes of section 367 and regulations
thereunder, the term ``transfer'' means any transaction that
constitutes a transfer for purposes of section 332, 351, 354, 355, 356,
or 361, as applicable. A person's entering into a cost sharing
arrangement under Sec. 1.482-7 or acquiring rights to intangible
property under such an arrangement shall not be considered a transfer
of property described in section 367(a)(1). See Sec. 1.6038B-1T(b)(4)
for the date on which the transfer is considered to be made.
* * * * *
0
Par. 3. Section 1.367(a)-1T is amended by revising paragraph (d)(3) to
read as follows:
Sec. 1.367(a)-1T Transfers to foreign corporations subject to section
367(a): In general (temporary).
* * * * *
(d) * * *
(3) [Reserved]. For further guidance, see Sec. 1.367(a)-1(d)(3).
* * * * *
Par. 4. Section 1.482-0 is amended as follows:
0
1. The entries for Sec. 1.482-1(b)(2)(i) and (iii) are revised.
0
2. The entries for Sec. 1.482-2(e) and (f) are revised.
0
3. The entries for Sec. 1.482-4(f)(3)(i)(B), (g) and (h) are revised.
0
4. The entry for Sec. 1.482-7 is revised.
0
5. The entries for Sec. 1.482-9(m)(3) and (n) are revised.
The additions and revisions read as follows:
Sec. 1.482-0 Outline of regulations under section 482.
* * * * *
Sec. 1.482-1 Allocation of income and deductions among taxpayers.
* * * * *
(b) * * *
(2) * * *
(i) Methods.
* * * * *
(iii) Coordination of methods applicable to certain intangible
development arrangements.
* * * * *
Sec. 1.482-2 Determination of taxable income in specific situations.
* * * * *
(e) Cost sharing arrangement.
(f) Effective/applicability Date.
(1) In general.
(2) Election to apply paragraph (b) to earlier taxable years.
* * * * *
Sec. 1.482-4 Methods to determine taxable income in connection with a
transfer of intangible property.
* * * * *
(f) * * *
(3) * * *
(i) * * *
(B) Cost sharing arrangements.
* * * * *
(g) Coordination with rules governing cost sharing arrangements.
(h) Effective/applicability date.
(1) In general.
(2) Election to apply regulation to earlier taxable years.
* * * * *
Sec. 1.482-7 Methods to determine taxable income in connection with a
cost sharing arrangement.
(a) In general.
(1) RAB share method for cost sharing transactions (CSTs).
(2) Methods for platform contribution transactions (PCTs).
(3) Methods for other controlled transactions.
(i) Contribution to a CSA by a controlled taxpayer that is not a
controlled participant.
(ii) Transfer of interest in a cost shared intangible.
[[Page 80088]]
(iii) Other controlled transactions in connection with a CSA.
(iv) Controlled transactions in the absence of a CSA.
(4) Coordination with the arm's length standard.
(b) Cost sharing arrangement.
(1) Substantive requirements.
(i) CSTs.
(ii) PCTs.
(iii) Divisional interests.
(iv) Examples.
(2) Administrative requirements.
(3) Date of a PCT.
(4) Divisional interests.
(i) In general.
(ii) Territorial based divisional interests.
(iii) Field of use based divisional interests.
(iv) Other divisional bases.
(v) Examples.
(5) Treatment of certain arrangements as CSAs.
(i) Situation in which Commissioner must treat arrangement as a
CSA.
(ii) Situation in which Commissioner may treat arrangement as a
CSA.
(iii) Examples.
(6) Entity classification of CSAs.
(c) Platform contributions.
(1) In general.
(2) Terms of platform contributions.
(i) Presumed to be exclusive.
(ii) Rebuttal of Exclusivity.
(iii) Proration of PCT Payments to the extent allocable to other
business activities.
(A) In general.
(B) Determining the proration of PCT Payments.
(3) Categorization of the PCT.
(4) Certain make-or-sell rights excluded.
(i) In general.
(ii) Examples.
(5) Examples.
(d) Intangible development costs.
(1) Determining whether costs are IDCs.
(i) Definition and scope of the IDA.
(ii) Reasonably anticipated cost shared intangible.
(iii) Costs included in IDCs.
(iv) Examples.
(2) Allocation of costs.
(3) Stock-based compensation.
(i) In general.
(ii) Identification of stock-based compensation with the IDA.
(iii) Measurement and timing of stock-based compensation IDC.
(A) In general.
(1) Transfers to which section 421 applies.
(2) Deductions of foreign controlled participants.
(3) Modification of stock option.
(4) Expiration or termination of CSA.
(B) Election with respect to options on publicly traded stock.
(1) In general.
(2) Publicly traded stock.
(3) Generally accepted accounting principles.
(4) Time and manner of making the election.
(C) Consistency.
(4) IDC share.
(5) Examples.
(e) Reasonably anticipated benefits share.
(1) Definition.
(i) In general.
(ii) Reliability.
(iii) Examples.
(2) Measure of benefits.
(i) In general.
(ii) Indirect bases for measuring anticipated benefits.
(A) Units used, produced, or sold.
(B) Sales.
(C) Operating profit.
(D) Other bases for measuring anticipated benefits.
(E) Examples.
(iii) Projections used to estimate benefits.
(A) In general.
(B) Examples.
(f) Changes in participation under a CSA.
(1) In general.
(2) Controlled transfer of interests.
(3) Capability variation.
(4) Arm's length consideration for a change in participation.
(5) Examples.
(g) Supplemental guidance on methods applicable to PCTs.
(1) In general.
(2) Best method analysis applicable for evaluation of a PCT
pursuant to a CSA.
(i) In general.
(ii) Consistency with upfront contractual terms and risk
allocation--the investor model.
(A) In general.
(B) Example.
(iii) Consistency of evaluation with realistic alternatives.
(A) In general.
(B) Examples.
(iv) Aggregation of transactions.
(v) Discount rate.
(A) In general.
(B) Considerations in best method analysis of discount rate.
(1) Discount rate variation between realistic alternatives.
(2) [Reserved].
(3) Discount rate variation between forms of payment.
(4) Post-tax rate.
(C) Example.
(vi) Financial projections.
(vii) Accounting principles.
(A) In general.
(B) Examples.
(viii) Valuations of subsequent PCTs.
(A) Date of subsequent PCT.
(B) Best method analysis for subsequent PCT.
(ix) Arm's length range.
(A) In general.
(B) Methods based on two or more input parameters.
(C) Variable input parameters.
(D) Determination of arm's length PCT Payment.
(1) No variable input parameters.
(2) One variable input parameter.
(3) More than one variable input parameter.
(E) Adjustments.
(x) Valuation undertaken on a pre-tax basis.
(3) Comparable uncontrolled transaction method.
(4) Income method.
(i) In general.
(A) Equating cost sharing and licensing alternatives.
(B) Cost sharing alternative.
(C) Licensing alternative.
(D) Only one controlled participant with nonroutine platform
contributions.
(E) Income method payment forms.
(F) Discount rates appropriate to cost sharing and licensing
alternatives.
(G) The effect of taxation on determining the arm's length amount.
(ii) Evaluation of PCT Payor's cost sharing alternative.
(iii) Evaluation of PCT Payor's licensing alternative.
(A) Evaluation based on CUT.
(B) Evaluation based on CPM.
(iv) Lump sum payment form.
(v) [Reserved].
(vi) Best method analysis considerations.
(A) Coordination with Sec. 1.482-1(c).
(B) Assumptions Concerning Tax Rates.
(C) Coordination with Sec. 1.482-4(c)(2).
(D) Coordination with Sec. 1.482-5(c).
(E) Certain Circumstances Concerning PCT Payor.
(F) Discount rates.
(1) Reflection of similar risk profiles of cost sharing alternative
and licensing alternative.
(2) [Reserved].
(vii) Routine platform and operating contributions.
(viii) Examples.
(5) Acquisition Price Method.
(i) In general.
(ii) Determination of arm's length charge.
(iii) Adjusted acquisition price.
(iv) Best method analysis considerations.
(v) Example.
(6) Market capitalization method.
[[Page 80089]]
(i) In general.
(ii) Determination of arm's length charge.
(iii) Average market capitalization.
(iv) Adjusted average market capitalization.
(v) Best method analysis considerations.
(vi) Examples.
(7) Residual profit split method.
(i) In general.
(ii) Appropriate share of profits and losses.
(iii) Profit split.
(A) In general.
(B) Determine nonroutine residual divisional profit or loss.
(C) Allocate nonroutine residual divisional profit or loss.
(1) In general.
(2) Relative value determination.
(3) Determination of PCT Payments.
(4) Routine platform and operating contributions.
(iv) Best method analysis considerations.
(A) In general.
(B) Comparability.
(C) Data and assumptions.
(D) Other factors affecting reliability.
(v) Examples.
(8) Unspecified methods.
(h) Form of payment rules.
(1) CST Payments.
(2) PCT Payments.
(i) In general.
(ii) No PCT Payor stock.
(iii) Specified form of payment.
(A) In general.
(B) Contingent payments.
(C) Examples.
(iv) Conversion from fixed to contingent form of payment.
(3) Coordination of best method rule and form of payment.
(i) Allocations by the Commissioner in connection with a CSA.
(1) In general.
(2) CST allocations.
(i) In general.
(ii) Adjustments to improve the reliability of projections used to
estimate RAB shares.
(A) Unreliable projections.
(B) Foreign-to-foreign adjustments.
(C) Correlative adjustments to PCTs.
(D) Examples.
(iii) Timing of CST allocations.
(3) PCT allocations.
(4) Allocations regarding changes in participation under a CSA.
(5) Allocations when CSTs are consistently and materially
disproportionate to RAB shares.
(6) Periodic adjustments.
(i) In general.
(ii) PRRR.
(iii) AERR.
(A) In general.
(B) PVTP.
(C) PVI.
(iv) ADR.
(A) In general.
(B) Publicly traded companies.
(C) Publicly traded.
(D) PCT Payor WACC.
(E) Generally accepted accounting principles.
(v) Determination of periodic adjustments.
(A) In general.
(B) Adjusted RPSM as of Determination Date.
(vi) Exceptions to periodic adjustments.
(A) Controlled participants establish periodic adjustment not
warranted.
(1) Transactions involving the same platform contribution as in the
Trigger PCT.
(2) Results not reasonably anticipated.
(3) Reduced AERR does not cause Periodic Trigger.
(4) Increased AERR does not cause Periodic Trigger.
(B) Circumstances in which Periodic Trigger deemed not to occur.
(1) 10-year period.
(2) 5-year period.
(vii) Examples.
(j) Definitions and special rules.
(1) Definitions.
(i) In general.
(ii) Examples.
(2) Special rules.
(i) Consolidated group.
(ii) Trade or business.
(iii) Partnership.
(3) Character.
(i) CST Payments.
(ii) PCT Payments.
(iii) Examples.
(k) CSA administrative requirements.
(1) CSA contractual requirements.
(i) In general.
(ii) Contractual provisions.
(iii) Meaning of contemporaneous.
(A) In general.
(B) Example.
(iv) Interpretation of contractual provisions.
(A) In general.
(B) Examples.
(2) CSA documentation requirements.
(i) In general.
(ii) Additional CSA documentation requirements.
(iii) Coordination rules and production of documents.
(A) Coordination with penalty regulations.
(B) Production of documentation.
(3) CSA accounting requirements.
(i) In general.
(ii) Reliance on financial accounting.
(4) CSA reporting requirements.
(i) CSA Statement.
(ii) Content of CSA Statement.
(iii) Time for filing CSA Statement.
(A) 90-day rule.
(B) Annual return requirement.
(1) In general.
(2) Special filing rule for annual return requirement.
(iv) Examples.
(l) Effective/applicability date.
(m) Transition rule.
(1) In general.
(2) Transitional modification of applicable provisions.
(3) Special rule for certain periodic adjustments.
* * * * *
Sec. 1.482-9 Methods to determine taxable income in connection with a
controlled services transaction.
* * * * *
(m) * * *
(3) Coordination with rules governing cost sharing arrangements.
* * * * *
(n) Effective/applicability dates.
Sec. 1.482-0T [Removed]
0
Par. 5. Section 1.482-0T is removed.
0
Par. 6. Section 1.482-1 is amended by:
0
1. Revising paragraph (b)(2)(i) and the last sentence in paragraph
(c)(1).
0
2. Adding a new paragraph (b)(2)(iii).
0
3. Adding a new sentence to the end of paragraph (j)(6)(i).
The additions and revisions read as follows:
Sec. 1.482-1 Allocation of income and deductions among taxpayers.
* * * * *
(b) * * *
(2) Arm's length methods--(i) Methods. Sections 1.482-2 through
1.482-6, 1.482-7, and 1.482-9 provide specific methods to be used to
evaluate whether transactions between or among members of the
controlled group satisfy the arm's length standard, and if they do not,
to determine the arm's length result. Section 1.482-1 and this section
provide general principles applicable in determining arm's length
results of such controlled transactions, but do not provide methods,
for which reference must be made to those other sections in accordance
with paragraphs (b)(2)(ii) and (iii) of this section. Section 1.482-7
provides the specific methods to be used to evaluate whether a cost
sharing arrangement as defined in Sec. 1.482-7 produces results
consistent with an arm's length result.
* * * * *
(iii) Coordination of methods applicable to certain intangible
development arrangements. Section 1.482-7 provides the specific methods
to be used to determine arm's length
[[Page 80090]]
results of controlled transactions in connection with a cost sharing
arrangement as defined in Sec. 1.482-7. Sections 1.482-4 and 1.482-9,
as appropriate, provide the specific methods to be used to determine
arm's length results of arrangements, including partnerships, for
sharing the costs and risks of developing intangibles, other than a
cost sharing arrangement covered by Sec. 1.482-7. See also Sec. Sec.
1.482-4(g) (Coordination with rules governing cost sharing
arrangements) and 1.482-9(m)(3) (Coordination with rules governing cost
sharing arrangements).
* * * * *
(c) * * *
(1) * * * See Sec. 1.482-7 for the applicable methods in the case
of a cost sharing arrangement.
* * * * *
(j) * * *
(6) * * *
(i) * * * The provision of paragraph (b)(2)(iii) of this section is
generally applicable on January 5, 2009.
* * * * *
Sec. 1.482-1T [Removed]
0
Par. 7. Section 1.482-1T is removed.
0
Par. 8. Section 1.482-2 is amended by revising paragraphs (e) and (f)
to read as follows:
Sec. 1.482-2 Determination of taxable income in specific situations.
* * * * *
(e) Cost sharing arrangement. For rules governing allocations under
section 482 to reflect an arm's length consideration for controlled
transactions involving a cost sharing arrangement, see Sec. 1.482-7.
(f) Effective/applicability date--(1) In general. The provision of
paragraph (b) of this section is generally applicable for taxable years
beginning after December 31, 2006. The provision of paragraph (e) of
this section is generally applicable on January 5, 2009.
(2) Election to apply paragraph (b) to earlier taxable years. A
person may elect to apply the provisions of paragraph (b) of this
section to earlier taxable years in accordance with the rules set forth
in Sec. 1.482-9(n)(2).
Sec. 1.482-2T [Removed]
0
Par. 9. Section 1.482-2T is removed.
0
Par. 10. Section 1.482-4 is amended as follows
0
1. Paragraphs (f)(3)(i)(B), (g) and (h) are revised.
0
2. Paragraph (f)(7) is removed.
The revisions read as follows:
Sec. 1.482-4 Methods to determine taxable income in connection with a
transfer of intangible property.
* * * * *
(f) * * *
(3) * * *
(i) * * *
(B) Cost sharing arrangements. The rules in this paragraph (f)(3)
regarding ownership with respect to cost shared intangibles and cost
sharing arrangements will apply only as provided in Sec. 1.482-7.
* * * * *
(g) Coordination with rules governing cost sharing arrangements.
Section 1.482-7 provides the specific methods to be used to determine
arm's length results of controlled transactions in connection with a
cost sharing arrangement. This section provides the specific methods to
be used to determine arm's length results of a transfer of intangible
property, including in an arrangement for sharing the costs and risks
of developing intangibles other than a cost sharing arrangement covered
by Sec. 1.482-7. In the case of such an arrangement, consideration of
the principles, methods, comparability, and reliability considerations
set forth in Sec. 1.482-7 is relevant in determining the best method,
including an unspecified method, under this section, as appropriately
adjusted in light of the differences in the facts and circumstances
between such arrangement and a cost sharing arrangement.
(h) Effective/applicability date--(1) In general. Except as
provided in the succeeding sentence, the provisions of paragraphs
(f)(3) and (4) of this section are generally applicable for taxable
years beginning after December 31, 2006. The provisions of paragraphs
(f)(3)(i)(B) and (g) of this section are generally applicable on
January 5, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraphs (f)(3) and (4) of this
section to earlier taxable years in accordance with the rules set forth
in Sec. 1.482-9(n)(2).
Sec. 1.482-4T [Removed].
0
Par. 11. Section 1.482-4T is removed.
0
Par. 12. Section 1.482-5 is amended by revising the last sentence of
paragraph (c)(2)(iv) to read as follows:
Sec. 1.482-5 Comparable profits method.
* * * * *
(c) * * *
(2) * * *
(iv) * * * As another example, it may be appropriate to adjust the
operating profit of a party to account for material differences in the
utilization of or accounting for stock-based compensation (as defined
by Sec. 1.482-7(d)(3)(i)) among the tested party and comparable
parties.
* * * * *
0
Par. 13. Section 1.482-7 is added to read as follows:
Sec. 1.482-7 Methods to determine taxable income in connection with a
cost sharing arrangement.
(a) In general. The arm's length amount charged in a controlled
transaction reasonably anticipated to contribute to developing
intangibles pursuant to a cost sharing arrangement (CSA), as described
in paragraph (b) of this section, must be determined under a method
described in this section. Each method must be applied in accordance
with the provisions of Sec. 1.482-1, except as those provisions are
modified in this section.
(1) RAB share method for cost sharing transactions (CSTs). See
paragraph (b)(1)(i) of this section regarding the requirement that
controlled participants, as defined in section (j)(1)(i) of this
section, share intangible development costs (IDCs) in proportion to
their shares of reasonably anticipated benefits (RAB shares) by
entering into cost sharing transactions (CSTs).
(2) Methods for platform contribution transactions (PCTs). The
arm's length amount charged in a platform contribution transaction
(PCT) described in paragraph (b)(1)(ii) of this section must be
determined under the method or methods applicable under the other
section or sections of the section 482 regulations, as supplemented by
paragraph (g) of this section. See Sec. 1.482-1(b)(2)(ii) (Selection
of category of method applicable to transaction), Sec. 1.482-
1(b)(2)(iii) (Coordination of methods applicable to certain intangible
development arrangements), and paragraph (g) of this section
(Supplemental guidance on methods applicable to PCTs).
(3) Methods for other controlled transactions--(i) Contribution to
a CSA by a controlled taxpayer that is not a controlled participant. If
a controlled taxpayer that is not a controlled participant contributes
to developing a cost shared intangible, as defined in section (j)(1)(i)
of this section, it must receive consideration from the controlled
participants under the rules of Sec. 1.482-4(f)(4) (Contribution to
the value of an intangible owned by another). Such consideration will
be treated as an intangible development cost for purposes of paragraph
(d) of this section.
[[Page 80091]]
(ii) Transfer of interest in a cost shared intangible. If at any
time (during the term, or upon or after the termination, of a CSA) a
controlled participant transfers an interest in a cost shared
intangible to another controlled taxpayer, the controlled participant
must receive an arm's length amount of consideration from the
transferee under the rules of Sec. Sec. 1.482-4 through 1.482-6 as
supplemented by paragraph (f)(4) of this section regarding arm's length
consideration for a change in participation. For this purpose, a
capability variation described in paragraph (f)(3) of this section is
considered to be a controlled transfer of interests in cost shared
intangibles.
(iii) Other controlled transactions in connection with a CSA.
Controlled transactions between controlled participants that are not
PCTs or CSTs and are not described in paragraph (a)(3)(ii) of this
section (for example, provision of a cross operating contribution, as
defined in paragraph (j)(1)(i) of this section, or make-or-sell rights,
as defined in paragraph (c)(4) of this section) require arm's length
consideration under the rules of Sec. Sec. 1.482-1 through 1.482-6,
and 1.482-9 as supplemented by paragraph (g)(2)(iv) of this section.
(iv) Controlled transactions in the absence of a CSA. If a
controlled transaction is reasonably anticipated to contribute to
developing intangibles pursuant to an arrangement that is not a CSA
described in paragraph (b)(1) or (5) of this section, whether the
results of any such controlled transaction are consistent with an arm's
length result must be determined under the applicable rules of the
other sections of the regulations under section 482. For example, an
arrangement for developing intangibles in which one controlled
taxpayer's costs of developing the intangibles significantly exceeds
its share of reasonably anticipated benefits from exploiting the
developed intangibles would not in substance be a CSA, as described in
paragraphs (b)(1)(i) through (iii) of this section or paragraph
(b)(5)(i) of this section. In such a case, unless the rules of this
section are applicable by reason of paragraph (b)(5) of this section,
the arrangement must be analyzed under other applicable sections of
regulations under section 482 to determine whether it achieves arm's
length results, and if not, to determine any allocations by the
Commissioner that are consistent with such other regulations under
section 482. See Sec. 1.482-1(b)(2)(ii) (Selection of category of
method applicable to transaction) and (iii) (Coordination of methods
applicable to certain intangible development arrangements).
(4) Coordination with the arm's length standard. A CSA produces
results that are consistent with an arm's length result within the
meaning of Sec. 1.482-1(b)(1) if, and only if, each controlled
participant's IDC share (as determined under paragraph (d)(4) of this
section) equals its RAB share, each controlled participant compensates
its RAB share of the value of all platform contributions by other
controlled participants, and all other requirements of this section are
satisfied.
(b) Cost sharing arrangement. A cost sharing arrangement is an
arrangement by which controlled participants share the costs and risks
of developing cost shared intangibles in proportion to their RAB
shares. An arrangement is a CSA if and only if the requirements of
paragraphs (b)(1) through (4) of this section are met.
(1) Substantive requirements-(i) CSTs. All controlled participants
must commit to, and in fact, engage in cost sharing transactions. In
CSTs, the controlled participants make payments to each other (CST
Payments) as appropriate, so that in each taxable year each controlled
participant's IDC share is in proportion to its respective RAB share.
(ii) PCTs. All controlled participants must commit to, and in fact,
engage in platform contributions transactions to the extent that there
are platform contributions pursuant to paragraph (c) of this section.
In a PCT, each other controlled participant (PCT Payor) is obligated
to, and must in fact, make arm's length payments (PCT Payments) to each
controlled participant (PCT Payee) that provides a platform
contribution. For guidance on determining such arm's length obligation,
see paragraph (g) of this section.
(iii) Divisional interests. Each controlled participant must
receive a non-overlapping interest in the cost shared intangibles
without further obligation to compensate another controlled participant
for such interest.
(iv) Examples. The following examples illustrate the principles of
this paragraph (b)(1):
Example 1. Company A and Company B, who are members of the same
controlled group, execute an agreement to jointly develop vaccine X
and own the exclusive rights to commercially exploit vaccine X in
their respective territories, which together comprise the whole
world. The agreement provides that they will share some, but not
all, of the costs for developing Vaccine X in proportion to RAB
share. Such agreement is not a CSA because Company A and Company B
have not agreed to share all of the IDCs in proportion to their
respective RAB shares.
Example 2. Company A and Company B agree to share all the costs
of developing Vaccine X. The agreement also provides for employing
certain resources and capabilities of Company A in this program
including a skilled research team and certain research facilities,
and provides for Company B to make payments to Company A in this
respect. However, the agreement expressly provides that the program
will not employ, and so Company B is expressly relieved of the
payments in regard to, certain software developed by Company A as a
medical research tool to model certain cellular processes expected
to be implicated in the operation of Vaccine X even though such
software would reasonably be anticipated to be relevant to
developing Vaccine X and, thus, would be a platform contribution.
See paragraph (c) of this section. Such agreement is not a CSA
because Company A and Company B have not engaged in a necessary PCT
for purposes of developing Vaccine X.
Example 3. Companies C and D, who are members of the same
controlled group, enter into a CSA. In the first year of the CSA, C
and D conduct the intangible development activity, as described in
paragraph (d)(1) of this section. The total IDCs in regard to such
activity are $3,000,000 of which C and D pay $2,000,000 and
$1,000,000, respectively, directly to third parties. As between C
and D, however, their CSA specifies that they will share all IDCs in
accordance with their RAB shares (as described in paragraph (e)(1)
of this section), which are 60% for C and 40% for D. It follows that
C should bear $1,800,000 of the total IDCs (60% of total IDCs of
$3,000,000) and D should bear $1,200,000 of the total IDCs (40% of
total IDCs of $3,000,000). D makes a CST payment to C of $200,000,
that is, the amount by which D's share of IDCs in accordance with
its RAB share exceeds the amount of IDCs initially borne by D
($1,200,000-$1,000,000), and which also equals the amount by which
the total IDCs initially borne by C exceeds its share of IDCS in
accordance with its RAB share ($2,000,000--$1,800,000). As a result
of D's CST payment to C, the IDC shares of C and D are in proportion
to their respective RAB shares.
(2) Administrative requirements. The CSA must meet the requirements
of paragraph (k) of this section.
(3) Date of a PCT. The controlled participants must enter into a
PCT as of the earliest date on or after the CSA is entered into on
which a platform contribution is reasonably anticipated to contribute
to developing cost shared intangibles.
(4) Divisional interests--(i) In general. Pursuant to paragraph
(b)(1)(iii) of this section, each controlled participant must receive a
non-overlapping interest in the cost shared intangibles without further
obligation to compensate another controlled participant for such
interest. Each controlled participant must be entitled to the perpetual
and exclusive right to the profits from
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transactions of any member of the controlled group that includes the
controlled participant with uncontrolled taxpayers to the extent that
such profits are attributable to such interest in the cost shared
intangibles.
(ii) Territorial based divisional interests. The CSA may divide all
interests in cost shared intangibles on a territorial basis as follows.
The entire world must be divided into two or more non-overlapping
geographic territories. Each controlled participant must receive at
least one such territory, and in the aggregate all the participants
must receive all such territories. Each controlled participant will be
assigned the perpetual and exclusive right to exploit the cost shared
intangibles through the use, consumption, or disposition of property or
services in its territories. Thus, compensation will be required if
other members of the controlled group exploit the cost shared
intangibles in such territory.
(iii) Field of use based divisional interests. The CSA may divide
all interests in cost shared intangibles on the basis of all uses
(whether or not known at the time of the division) to which cost shared
intangibles are to be put as follows. All anticipated uses of cost
shared intangibles must be identified. Each controlled participant must
be assigned at least one such anticipated use, and in the aggregate all
the participants must be assigned all such anticipated uses. Each
controlled participant will be assigned the perpetual and exclusive
right to exploit the cost shared intangibles through the use or uses
assigned to it and one controlled participant must be assigned the
exclusive and perpetual right to exploit cost shared intangibles
through any unanticipated uses.
(iv) Other divisional bases. (A) In the event that the CSA does not
divide interests in the cost shared intangibles on the basis of
exclusive territories or fields of use as described in paragraphs
(b)(4)(ii) and (iii) of this section, the CSA may adopt some other
basis on which to divide all interests in the cost shared intangibles
among the controlled participants, provided that each of the following
criteria is met:
(1) The basis clearly and unambiguously divides all interests in
cost shared intangibles among the controlled participants.
(2) The consistent use of such basis for the division of all
interests in the cost shared intangibles can be dependably verified
from the records maintained by the controlled participants.
(3) The rights of the controlled participants to exploit cost
shared intangibles are non-overlapping, exclusive, and perpetual.
(4) The resulting benefits associated with each controlled
participant's interest in cost shared intangibles are predictable with
reasonable reliability.
(B) See paragraph (f)(3) of this section for rules regarding the
requirement of arm's length consideration for changes in participation
in CSAs involving divisions of interest described in this paragraph
(b)(4)(iv).
(v) Examples. The following examples illustrate the principles of
this paragraph (b)(4):
Example 1. Companies P and S, both members of the same
controlled group, enter into a CSA to develop product Z. Under the
CSA, P receives the interest in product Z in the United States and S
receives the interest in product Z in the rest of the world, as
described in paragraph (b)(4)(ii) of this section. Both P and S have
plants for manufacturing product Z located in their respective
geographic territories. However, for commercial reasons, product Z
is nevertheless manufactured by P in the United States for sale to
customers in certain locations just outside the United States in
close proximity to P's U.S. manufacturing plant. Because S owns the
territorial rights outside the United States, P must compensate S to
ensure that S realizes all the cost shared intangible profits from
P's sales of product Z in S's territory. The pricing of such
compensation must also ensure that P realizes an appropriate return
for its manufacturing efforts. Benefits projected with respect to
such sales will be included for purposes of estimating S's, but not
P's, RAB share.
Example 2. The facts are the same as in Example 1 except that P
and S agree to divide their interest in product Z based on site of
manufacturing. P will have exclusive and perpetual rights in product
Z manufactured in facilities owned by P. S will have exclusive and
perpetual rights to product Z manufactured in facilities owned by S.
P and S agree that neither will license manufacturing rights in
product Z to any related or unrelated party. Both P and S maintain
books and records that allow production at all sites to be verified.
Both own facilities that will manufacture product Z and the relative
capacities of these sites are known. All facilities are currently
operating at near capacity and are expected to continue to operate
at near capacity when product Z enters production so that it will
not be feasible to shift production between P's and S's facilities.
P and S have no plans to build new facilities and the lead time
required to plan and build a manufacturing facility precludes the
possibility that P or S will build a new facility during the period
for which sales of Product Z are expected. Based on these facts,
this basis for the division of interests in Product Z is a division
described in paragraph (b)(4)(iv) of this section. The basis for the
division of interest is unambiguous and clearly defined and its use
can be dependably verified. P and S both have non-overlapping,
exclusive and perpetual rights in Product Z. The division of
interest results in the participant's relative benefits being
predictable with reasonable reliability.
Example 3. The facts are the same as in Example 2 except that
P's and S's manufacturing facilities are not expected to operate at
full capacity when product Z enters production. Production of
Product Z can be shifted at any time between sites owned by P and
sites owned by S, although neither P nor S intends to shift
production as a result of the agreement. The division of interests
in Product Z between P and S based on manufacturing site is not a
division described in paragraph (b)(4)(iv) of this section because
their relative shares of benefits are not predictable with
reasonable reliability. The fact that neither P nor S intends to
shift production is irrelevant.
(5) Treatment of certain arrangements as CSAs--(i) Situation in
which Commissioner must treat arrangement as a CSA. The Commissioner
must apply the rules of this section to an arrangement among controlled
taxpayers if the administrative requirements of paragraph (b)(2) of
this section are met with respect to such arrangement and the
controlled taxpayers reasonably concluded that such arrangement was a
CSA meeting the requirements of paragraphs (b)(1), (3), and (4) of this
section.
(ii) Situation in which Commissioner may treat arrangement as a
CSA. For arrangements among controlled taxpayers not described in
paragraph (b)(5)(i) of this section, the Commissioner may apply the
provisions of this section if the Commissioner concludes that the
administrative requirements of paragraph (b)(2) of this section are
met, and, notwithstanding technical failure to meet the substantive
requirements of paragraph (b)(1), (3), or (4) of this section, the
rules of this section will provide the most reliable measure of an
arm's length result. See Sec. 1.482-1(c)(1) (the best method rule).
For purposes of applying this paragraph (b)(5)(ii), any such
arrangement shall be interpreted by reference to paragraph (k)(1)(iv)
of this section.
(iii) Examples. The following examples illustrate the principles of
this paragraph (b)(5). In the examples, assume that Companies P and S
are both members of the same controlled group.
Example 1. (i) P owns the patent on a formula for a capsulated
pain reliever, P-Cap. P reasonably anticipates, pending further
research and experimentation, that the P-Cap formula could form the
platform for a formula for P-Ves, an effervescent version of P-Cap.
P also owns proprietary software that it reasonably anticipates to
be critical to the research efforts. P and S execute a contract that
purports to be a CSA by which they agree to proportionally share the
costs and risks of developing a formula for P-Ves. The
[[Page 80093]]
agreement reflects the various contractual requirements described in
paragraph (k)(1) of this section and P and S comply with the
documentation, accounting, and reporting requirements of paragraphs
(k)(2) through (4) of this section. Both the patent rights for P-Cap
and the software are reasonably anticipated to contribute to the
development of P-Ves and therefore are platform contributions for
which compensation is due from S as part of PCTs. Though P and S
enter into and implement a PCT for the P-Cap patent rights that
satisfies the arm's length standard, they fail to enter into a PCT
for the software.
(ii) In this case, P and S have substantially complied with the
contractual requirements of paragraph (k)(1) of this section and the
documentation, accounting, and reporting requirements of paragraphs
(k)(2) through (4) of this section and therefore have met the
administrative requirements of paragraph (b)(2) of this section.
However, because they did not enter into a PCT, as required under
paragraphs (b)(1)(ii) and (b)(3) of this section, for the software
that was reasonably anticipated to contribute to the development of
P-Ves (see paragraph (c) of this section), they cannot reasonably
conclude that their arrangement was a CSA. Accordingly, the
Commissioner is not required under paragraph (b)(5)(i) of this
section to apply the rules of this section to their arrangement.
(iii) Nevertheless, the arrangement between P and S closely
resembles a CSA. If the Commissioner concludes that the rules of
this section provide the most reliable measure of an arm's length
result for such arrangement, then pursuant to paragraph (b)(5)(ii)
of this section, the Commissioner may apply the rules of this
section and treat P and S as entering into a PCT for the software in
accordance with the requirements of paragraph (b)(1)(ii) of this
section, and make any appropriate allocations under paragraph (i) of
this section. Alternatively, the Commissioner may conclude that the
rules of this section do not provide the most reliable measure of an
arm's length result. In such case, the arrangement would be analyzed
under the methods under other sections of the 482 regulations to
determine whether the arrangement reaches an arm's length result.
Example 2. The facts are the same as in Example 1 except that P
and S do enter into and implement a PCT for the software as required
under this paragraph (b). The Commissioner determines that the PCT
Payments for the software were not arm's length; nevertheless, under
the facts and circumstances at the time they entered into the CSA
and PCTs, P and S reasonably concluded their arrangement to be a
CSA. Because P and S have met the requirements of paragraph (b)(2)
of this section and reasonably concluded their arrangement is a CSA,
pursuant to paragraph (b)(5)(i) of this section, the Commissioner
must apply the rules of this section to their arrangement.
Accordingly, the Commissioner treats the arrangement as a CSA and
makes adjustments to the PCT Payments as appropriate under this
section to achieve an arm's length result for the PCT for the
software.
Example 3. (i) The facts are the same as in Example 1 except
that P and S do enter into a PCT for the software as required under
this paragraph (b). The agreement entered into by P and S provides
for a fixed consideration of $50 million per year for four years,
payable at the end of each year. This agreement satisfies the arm's
length standard. However, S actually pays P consideration at the end
of each year in the form of four annual royalties equal to two
percent of sales. While such royalties at the time of the PCT were
expected to be $50 million per year, actual sales during the first
year were less than anticipated and the first royalty payment was
only $25 million.
(ii) In this case, P and S failed to implement the terms of
their agreement. Under these circumstances, P and S could not
reasonably conclude that their arrangement was a CSA, as described
in paragraph (b)(1) of this section. Accordingly, the Commissioner
is not required under paragraph (b)(5)(i) of this section to apply
the rules of this section to their arrangement.
(iii) Nevertheless, the arrangement between P and S closely
resembles a CSA. If the Commissioner concludes that the rules of
this section provide the most reliable measure of an arm's length
result for such arrangement, then pursuant to paragraph (b)(5)(ii)
of this section, the Commissioner may apply the rules of this
section and make any appropriate allocations under paragraph (i) of
this section. Alternatively, the Commissioner may conclude that the
rules of this section do not provide the most reliable measure of an
arm's length result. In such case, the arrangement would be analyzed
under the methods under other sections of the 482 regulations to
determine whether the arrangement reaches an arm's length result.
Example 4. (i) The facts are the same as in Example 1 except
that P does not own proprietary software and P and S use a method
for determining the arm's length amount of the PCT Payment for the
P-Cap patent rights different from the method used in Example 1.
(ii) P and S determine that the arm's length amount of the PCT
Payments for the P-Cap patent is $10 million. However, the
Commissioner determines the best method for determining the arm's
length amount of the PCT Payments for the P-Cap patent rights and
under such method the arm's length amount is $100 million. To
determine this $10 million present value, P and S assumed a useful
life of eight years for the platform contribution, because the P-Cap
patent rights will expire after eight years. However, the P-Cap
patent rights are expected to lead to benefits attributable to
exploitation of the cost shared intangibles extending many years
beyond the expiration of the P-Cap patent, because use of the P-Cap
patent rights will let P and S bring P-Ves to market before the
competition, and because P and S expect to apply for additional
patents covering P-Ves, which would bar competitors from selling
that product for many future years. The assumption by P and S of a
useful life for the platform contribution that is less than the
anticipated period of exploitation of the cost shared intangibles is
contrary to paragraph (g)(2)(ii) of this section, and reduces the
reliability of the method used by P and S.
(iii) The method used by P and S employs a declining royalty.
The royalty starts at 8% of sales, based on an application of the
CUT method in which the purported CUTs all involve licenses to
manufacture and sell the current generation of P-Cap, and declines
to 0% over eight years, declining by 1% each year. Such make-or-sell
rights are fundamentally different from use of the P-Cap patent
rights to generate a new product. This difference raises the issue
of whether the make-or-sell rights are sufficiently comparable to
the rights that are the subject of the PCT Payment. See Sec. 1.482-
4(c). While a royalty rate for make-or-sell rights can form the
basis for a reliable determination of an arm's length PCT Payment in
the CUT-based implementation of the income method described in
paragraph (g)(4) of this section, under that method such royalty
rate does not decline to zero. Therefore, the use of a declining
royalty rate based on an initial rate for make-or-sell rights
further reduces the reliability of the method used by P and S.
(iv) Sales of the next-generation product are not anticipated
until after seven years, at which point the royalty rate will have
declined to 1%. The temporal mismatch between the period of the
royalty rate decline and the period of exploitation raises further
concerns about the method's reliability.
(v) For the reasons given in paragraphs (ii) through (iv) of
this Example 4, the method used by P and S is so unreliable and so
contrary to provisions of this section that P and S could not
reasonably conclude that they had contracted to make arm's length
PCT Payments as required by paragraphs (b)(1)(ii) and (b)(3) of this
section, and thus could not reasonably conclude that their
arrangement was a CSA. Accordingly, the Commissioner is not required
under paragraph (b)(5)(i) of this section to apply the rules of this
section to their arrangement.
(vi) Nevertheless, the arrangement between P and S closely
resembles a CSA. If the Commissioner concludes that the rules of
this section provide the most reliable measure of an arm's length
result for such arrangement, then pursuant to paragraph (b)(5)(ii)
of this section, the Commissioner may apply the rules of this
section and make any appropriate allocations under paragraph (i) of
this section. Alternatively, the Commissioner may conclude that the
rules of this section do not provide the most reliable measure of an
arm's length result. In such case, the arrangement would be analyzed
under the methods under other section 482 regulations to determine
whether the arrangement reaches an arm's length result.
(6) Entity classification of CSAs. See Sec. 301.7701-1(c) of this
chapter for the classification of CSAs for purposes of the Internal
Revenue Code.
(c) Platform contributions--(1) In general. A platform contribution
is any resource, capability, or right that a controlled participant has
developed, maintained, or acquired externally to the intangible
development activity (whether prior to or during the course of the CSA)
that is reasonably anticipated to contribute to developing
[[Page 80094]]
cost shared intangibles. The determination whether a resource,
capability, or right is reasonably anticipated to contribute to
developing cost shared intangibles is ongoing and based on the best
available information. Therefore, a resource, capability, or right
reasonably determined not to be a platform contribution as of an
earlier point in time, may be reasonably determined to be a platform
contribution at a later point in time. The PCT obligation regarding a
resource or capability or right once determined to be a platform
contribution does not terminate merely because it may later be
determined that such resource or capability or right has not
contributed, and no longer is reasonably anticipated to contribute, to
developing cost shared intangibles. Notwithstanding the other
provisions of this paragraph (c), platform contributions do not include
rights in land or depreciable tangible property, and do not include
rights in other resources acquired by IDCs. See paragraph (d)(1) of
this section.
(2) Terms of platform contributions--(i) Presumed to be exclusive.
For purposes of a PCT, the PCT Payee's provision of a platform
contribution is presumed to be exclusive. Thus, it is presumed that the
platform resource, capability, or right is not reasonably anticipated
to be committed to any business activities other than the CSA Activity,
as defined in paragraph (j)(1)(i) of this section, whether carried out
by the controlled participants, other controlled taxpayers, or
uncontrolled taxpayers.
(ii) Rebuttal of exclusivity. The controlled participants may rebut
the presumption set forth in paragraph (c)(2)(i) of this section to the
satisfaction of the Commissioner. For example, if the platform resource
is a research tool, then the controlled participants could rebut the
presumption by establishing to the satisfaction of the Commissioner
that, as of the date of the PCT, the tool is reasonably anticipated not
only to contribute to the CSA Activity but also to be licensed to an
uncontrolled taxpayer. In such case, the PCT Payments may need to be
prorated as described in paragraph (c)(2)(iii) of this section.
(iii) Proration of PCT Payments to the extent allocable to other
business activities--(A) In general. Some transfer pricing methods
employed to determine the arm's length amount of the PCT Payments do so
by considering the overall value of the platform contributions as
opposed to, for example, the value of the anticipated use of the
platform contributions in the CSA Activity. Such a transfer pricing
method is consistent with the presumption that the platform
contribution is exclusive (that is, that the resources, capabilities or
rights that are the subject of a platform contribution are reasonably
anticipated to contribute only to the CSA Activity). See paragraph
(c)(2)(i) (Terms of platform contributions--Presumed to be exclusive)
of this section. The PCT Payments determined under such transfer
pricing method may have to be prorated if the controlled participants
can rebut the presumption that the platform contribution is exclusive
to the satisfaction of the Commissioner as provided in paragraph
(c)(2)(ii) of this section. In the case of a platform contribution that
also contributes to lines of business of a PCT Payor that are not
reasonably anticipated to involve exploitation of the cost shared
intangibles, the need for explicit proration may in some cases be
avoided through aggregation of transactions. See paragraph (g)(2)(iv)
of this section (Aggregation of transactions).
(B) Determining the proration of PCT Payments. Proration will be
done on a reasonable basis in proportion to the relative economic
value, as of the date of the PCT, reasonably anticipated to be derived
from the platform contribution by the CSA Activity as compared to the
value reasonably anticipated to be derived from the platform
contribution by other business activities. In the case of an aggregate
valuation done under the principles of paragraph (g)(2)(iv) of this
section that addresses payment for resources, capabilities, or rights
used for business activities other than the CSA Activity (for example,
the right to exploit an existing intangible without further
development), the proration of the aggregate payments may have to
reflect the economic value attributable to such resources,
capabilities, or rights as well. For purposes of the best method rule
under Sec. 1.482-1(c), the reliability of the analysis under a method
that requires proration pursuant to this paragraph is reduced relative
to the reliability of an analysis under a method that does not require
proration.
(3) Categorization of the PCT. For purposes of Sec. 1.482-
1(b)(2)(ii) and paragraph (a)(2) of this section, a PCT must be
identified by the controlled participants as a particular type of
transaction (for example, a license for royalty payments). See
paragraph (k)(2)(ii)(H) of this section. Such designation must be
consistent with the actual conduct of the controlled participants. If
the conduct is consistent with different, economically equivalent types
of transaction, then the controlled participants may designate the PCT
as being any of such types of transaction. If the controlled
participants fail to make such designation in their documentation, the
Commissioner may make a designation consistent with the principles of
paragraph (k)(1)(iv) of this section.
(4) Certain make-or-sell rights excluded--(i) In general. Any right
to exploit an existing resource, capability, or right without further
development of such item, such as the right to make, replicate,
license, or sell existing products, does not constitute a platform
contribution to a CSA (and the arm's length compensation for such
rights (make-or-sell rights) does not satisfy the compensation
obligation under a PCT) unless exploitation without further development
of such item is reasonably anticipated to contribute to developing or
further developing a cost shared intangible.
(ii) Examples. The following examples illustrate the principles of
this paragraph (c)(4):
Example 1. P and S, which are members of the same controlled
group, execute a CSA. Under the CSA, P and S will bear their RAB
shares of IDCs for developing the second generation of ABC, a
computer software program. Prior to that arrangement, P had incurred
substantial costs and risks to develop ABC. Concurrent with entering
into the arrangement, P (as the licensor) executes a license with S
(as the licensee) by which S may make and sell copies of the
existing ABC. Such make-or-sell rights do not constitute a platform
contribution to the CSA. The rules of Sec. Sec. 1.482-1 and 1.482-4
through 1.482-6 must be applied to determine the arm's length
consideration in connection with the make-or-sell licensing
arrangement. In certain circumstances, this determination of the
arm's length consideration may be done on an aggregate basis with
the evaluation of compensation obligations pursuant to the PCTs
entered into by P and S in connection with the CSA. See paragraph
(g)(2)(iv) of this section.
Example 2. (i) P, a software company, has developed and
currently exploits software program ABC. P and S enter into a CSA to
develop future generations of ABC. The ABC source code is the
platform on which future generations of ABC will be built and is
therefore a platform contribution of P for which compensation is due
from S pursuant to a PCT. Concurrent with entering into the CSA, P
licenses to S the make-or-sell rights for the current version of
ABC. P has entered into similar licenses with uncontrolled parties
calling for sales-based royalty payments at a rate of 20%. The
current version of ABC has an expected product life of three years.
P and S enter into a contingent payment agreement to cover both the
PCT Payments due from S for P's platform contribution and payments
due from S for the make-or-sell license. Based on the uncontrolled
make-or-sell licenses, P and S agree on a sales-based royalty rate
of 20% in
[[Page 80095]]
Year 1 that declines on a straight line basis to 0% over the 3 year
product life of ABC.
(ii) The make-or-sell rights for the current version of ABC are
not platform contributions, though paragraph (g)(2)(iv) of this
section provides for the possibility that the most reliable
determination of an arm's length charge for the platform
contribution and the make-or-sell license may be one that values the
two transactions in the aggregate. A contingent payment schedule
based on the uncontrolled make-or-sell licenses may provide an arm's
length charge for the separate make-or-sell license between P and S,
provided the royalty rates in the uncontrolled licenses similarly
decline, but as a measure of the aggregate PCT and licensing
payments it does not account for the arm's length value of P's
platform contributions which include the rights in the source code
and future development rights in ABC.
Example 3. S is a controlled participant that owns Patent Q,
which protects S's use of a research tool that is helpful in
developing and testing new pharmaceutical compounds. The research
tool, which is not itself such a compound, is used in the CSA
Activity to develop such compounds. However, the CSA Activity is not
anticipated to result in the further development of the research
tool or in patents based on Patent Q. Although the right to use
Patent Q is not anticipated to result in the further development of
Patent Q or the technology that it protects, that right constitutes
a platform contribution (as opposed to make-or-sell rights) because
it is anticipated to contribute to the research activity to develop
cost shared intangibles relating to pharmaceutical compounds covered
by the CSA.
(5) Examples. The following examples illustrate the principles of
this paragraph (c). In each example, Companies P and S are members of
the same controlled group, and execute a CSA providing that each will
have the exclusive right to exploit cost shared intangibles in its own
territory. See paragraph (b)(4)(ii) of this section (Territorial based
divisional interests).
Example 1. Company P has developed and currently markets version
1.0 of a new software application XYZ. Company P and Company S
execute a CSA under which they will share the IDCs for developing
future versions of XYZ. Version 1.0 is reasonably anticipated to
contribute to the development of future versions of XYZ and
therefore Company P's rights in version 1.0 constitute a platform
contribution from Company P that must be compensated by Company S
pursuant to a PCT. Pursuant to paragraph (c)(3) of this section, the
controlled participants designate the platform contribution as a
transfer of intangibles that would otherwise be governed by Sec.
1.482-4, if entered into by controlled parties. Accordingly,
pursuant to paragraph (a)(2) of this section, the applicable method
for determining the arm's length value of the compensation
obligation under the PCT between Company P and Company S will be
governed by Sec. 1.482-4 as supplemented by paragraph (g) of this
section. Absent a showing to the contrary by P and S, the platform
contribution in this case is presumed to be the exclusive provision
of the benefit of all rights in version 1.0, other than the rights
described in paragraph (c)(4) of this section (Certain make-or-sell
rights excluded). This includes the right to use version 1.0 for
purposes of research and the exclusive right in S's territory to
exploit any future products that incorporated the technology of
version 1.0, and would cover a term extending as long as the
controlled participants were to exploit future versions of XYZ or
any other product based on the version 1.0 platform. The
compensation obligation of Company S pursuant to the PCT will
reflect the full value of the platform contribution, as limited by
Company S's RAB share.
Example 2. Company P and Company S execute a CSA under which
they will share the IDCs for developing Vaccine Z. Company P will
commit to the project its research team that has successfully
developed a number of other vaccines. 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. Therefore, P's provision of the
capabilities of the research team constitute a platform contribution
for which compensation is due from Company S as part of a PCT.
Pursuant to paragraph (c)(3) of this section, the controlled parties
designate the platform contribution as a provision of services that
would otherwise be governed by Sec. 1.482-9(a) if entered into by
controlled parties. Accordingly, pursuant to paragraph (a)(2) of
this section, the applicable method for determining the arm's length
value of the compensation obligation under the PCT between Company P
and Company S will be governed by Sec. 1.482-9(a) as supplemented
by paragraph (g) of this section. Absent a showing to the contrary
by P and S, the platform contribution in this case is presumed to be
the exclusive provision of the benefits by Company P of its research
team to the development of Vaccine Z. Because the IDCs include the
ongoing compensation of the researchers, the compensation obligation
under the PCT is only for the value of the commitment of the
research team by Company P to the CSA's development efforts net of
such researcher compensation. The value of the compensation
obligation of Company S for the PCT will reflect the full value of
the provision of services, as limited by Company S's RAB share.
(d) Intangible development costs--(1) Determining whether costs are
IDCs. Costs included in IDCs are determined by reference to the scope
of the intangible development activity (IDA).
(i) Definition and scope of the IDA. For purposes of this section,
the IDA means the activity under the CSA of developing or attempting to
develop reasonably anticipated cost shared intangibles. The scope of
the IDA includes all of the controlled participants' activities that
could reasonably be anticipated to contribute to developing the
reasonably anticipated cost shared intangibles. The IDA cannot be
described merely by a list of particular resources, capabilities, or
rights that will be used in the CSA, because such a list would not
identify reasonably anticipated cost shared intangibles. Also, the
scope of the IDA may change as the nature or identity of the reasonably
anticipated cost shared intangibles changes or the nature of the
activities necessary for their development become clearer. For example,
the relevance of certain ongoing work to developing reasonably
anticipated cost shared intangibles or the need for additional work may
only become clear over time.
(ii) Reasonably anticipated cost shared intangible. For purposes of
this section, reasonably anticipated cost shared intangible means any
intangible, within the meaning of Sec. 1.482-4(b), that, at the
applicable point in time, the controlled participants intend to develop
under the CSA. Reasonably anticipated cost shared intangibles may
change over the course of the CSA. The controlled participants may at
any time change the reasonably anticipated cost shared intangibles but
must document any such change pursuant to paragraph (k)(2)(ii)(A)(1) of
this section. Removal of reasonably anticipated cost shared intangibles
does not affect the controlled participants' interests in cost shared
intangibles already developed under the CSA. In addition, the
reasonably anticipated cost shared intangibles automatically expand to
include the intended result of any further development of a cost shared
intangible already developed under the CSA, or applications of such an
intangible. However, the controlled participants may override this
automatic expansion in a particular case if they separately remove
specified further development of such intangible (or specified
applications of such intangible) from the IDA, and document such
separate removal pursuant to paragraph (k)(2)(ii)(A)(3) of this
section.
(iii) Costs included in IDCs. For purposes of this section, IDCs
mean all costs, in cash or in kind (including stock-based compensation,
as described in paragraph (d)(3) of this section), but excluding
acquisition 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 IDA. Thus, IDCs include costs incurred in
attempting to develop reasonably anticipated cost
[[Page 80096]]
shared intangibles regardless of whether such costs ultimately lead to
development of those intangibles, other intangibles developed
unexpectedly, or no intangibles. IDCs shall also include the arm's
length rental charge for the use of any land or depreciable tangible
property (as determined under Sec. 1.482-2(c) (Use of tangible
property)) directly identified with, or reasonably allocable to, the
IDA. Reference to generally accepted accounting principles or Federal
income tax accounting rules may provide a useful starting point but
will not be conclusive regarding inclusion of costs in IDCs. IDCs do
not include interest expense, foreign income taxes (as defined in Sec.
1.901-2(a)), or domestic income taxes.
(iv) Examples. The following examples illustrate the principles of
this paragraph (d)(1):
Example 1. A contract that purports to be a CSA provides that
the IDA to which the agreement applies consists of all research and
development activity conducted at laboratories A, B, and C but not
at other facilities maintained by the controlled participants. The
contract does not describe the reasonably anticipated cost shared
intangibles with respect to which research and development is to be
undertaken. The contract fails to meet the requirements set forth in
paragraph (k)(1)(ii)(B) of this section because it fails to
adequately describe the scope of the IDA to be undertaken.
Example 2. A contract that purports to be a CSA provides that
the IDA to which the agreement applies consists of all research and
development activity conducted by any of the controlled participants
with the goal of developing a cure for a particular disease. Such a
cure is thus a reasonably anticipated cost shared intangible. The
contract also contains a provision that the IDA will exclude any
activity that builds on the results of the controlled participants'
prior research concerning Enzyme X even though such activity could
reasonably be anticipated to contribute to developing such cure. The
contract fails to meet the requirement set forth in paragraph
(d)(1)(i) of this section that the scope of the IDA include all of
the controlled participants' activities that could reasonably be
anticipated to contribute to developing reasonably anticipated cost
shared intangibles.
(2) Allocation of costs. If a particular cost is directly
identified with, or reasonably allocable to, a function the results of
which will benefit both the IDA and other business activities, the cost
must be allocated on a reasonable basis between the IDA and such other
business activities in proportion to the relative economic value that
the IDA and such other business activities are anticipated to derive
from such results.
(3) Stock-based compensation--(i) In general. As used in this
section, the term stock-based compensation means any compensation
provided by a controlled participant to an employee or independent
contractor in the form of equity instruments, options to acquire stock
(stock options), or rights with respect to (or determined by reference
to) equity instruments or stock options, including but not limited to
property to which section 83 applies and stock options to which section
421 applies, regardless of whether ultimately settled in the form of
cash, stock, or other property.
(ii) Identification of stock-based compensation with the IDA. The
determination of whether stock-based compensation is directly
identified with, or reasonably allocable to, the IDA is made as of the
date that the stock-based compensation is granted. Accordingly, 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 under paragraph (d)(1) of
this section. In the case of a repricing or other modification of a
stock option, the determination of whether the repricing or other
modification constitutes the grant of a new stock option for purposes
of this paragraph (d)(3)(ii) will be made in accordance with the rules
of section 424(h) and related regulations.
(iii) Measurement and timing of stock-based compensation IDC--(A)
In general. Except as otherwise provided in this paragraph (d)(3)(iii),
the cost attributable to stock-based compensation is equal to the
amount allowable to the controlled participant as a deduction for
federal income tax purposes with respect to that stock-based
compensation (for example, under section 83(h)) and is taken into
account as an IDC under this section for the taxable year for which the
deduction is allowable.
(1) Transfers to which section 421 applies. Solely for purposes of
this paragraph (d)(3)(iii)(A), section 421 does not apply to the
transfer of stock pursuant to the exercise of an option that meets the
requirements of section 422(a) or 423(a).
(2) Deductions of foreign controlled participants. Solely for
purposes of this paragraph (d)(3)(iii)(A), an amount is treated as an
allowable deduction of a foreign controlled participant to the extent
that a deduction would be allowable to a United States taxpayer.
(3) Modification of stock option. Solely for purposes of this
paragraph (d)(3)(iii)(A), if the repricing or other modification of a
stock option is determined, under paragraph (d)(3)(ii) of this section,
to constitute the grant of a new stock option not identified with, or
reasonably allocable to, the IDA, the stock option that is repriced or
otherwise modified will be treated as being exercised immediately
before the modification, provided that the stock option is then
exercisable and the fair market value of the underlying stock then
exceeds the price at which the stock option is exercisable.
Accordingly, the amount of the deduction that would be allowable (or
treated as allowable under this paragraph (d)(3)(iii)(A)) to the
controlled participant upon exercise of the stock option immediately
before the modification must be taken into account as an IDC as of the
date of the modification.
(4) Expiration or termination of CSA. Solely for purposes of this
paragraph (d)(3)(iii)(A), if an item of stock-based compensation
identified with, or reasonably allocable to, the IDA is not exercised
during the term of a CSA, that item of stock-based compensation will be
treated as being exercised immediately before the expiration or
termination of the CSA, provided that the stock-based compensation is
then exercisable and the fair market value of the underlying stock then
exceeds the price at which the stock-based compensation is exercisable.
Accordingly, the amount of the deduction that would be allowable (or
treated as allowable under this paragraph (d)(3)(iii)(A)) to the
controlled participant upon exercise of the stock-based compensation
must be taken into account as an IDC as of the date of the expiration
or termination of the CSA.
(B) Election with respect to options on publicly traded stock--(1)
In general. With respect to stock-based compensation in the form of
options on publicly traded stock, the controlled participants in a CSA
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.
(2) Publicly traded stock. As used in this paragraph
(d)(3)(iii)(B), the term publicly traded stock means stock that is
regularly traded on an established United States securities market and
is issued by a company whose financial statements are prepared in
accordance with United States generally accepted accounting principles
for the taxable year.
[[Page 80097]]
(3) Generally accepted accounting principles. For purposes of this
paragraph (d)(3)(iii)(B), a financial statement prepared in accordance
with a comprehensive body of generally accepted accounting principles
other than United States generally accepted accounting principles is
considered to be prepared in accordance with United States generally
accepted accounting principles provided that either--
(i) The fair value of the stock options under consideration is
reflected in the reconciliation between such other accounting
principles and United States generally accepted accounting principles
required to be incorporated into the financial statement by the
securities laws governing companies whose stock is regularly traded on
United States securities markets; or
(ii) In the absence of a reconciliation between such other
accounting principles and United States generally accepted accounting
principles that reflects the fair value of the stock options under
consideration, such other accounting principles require that the fair
value of the stock options under consideration be reflected as a charge
against income in audited financial statements or disclosed in
footnotes to such statements.
(4) Time and manner of making the election. The election described
in this paragraph (d)(3)(iii)(B) is made by an explicit reference to
the election in the written contract required by paragraph (k)(1) of
this section or in a written amendment to the CSA entered into with the
consent of the Commissioner pursuant to paragraph (d)(3)(iii)(C) of
this section. In the case of a CSA in existence on August 26, 2003, the
election by written amendment to the CSA may be made without the
consent of the Commissioner if such amendment is entered into not later
than the latest due date (with regard to extensions) of a federal
income tax return of any controlled participant for the first taxable
year beginning after August 26, 2003.
(C) Consistency. Generally, all controlled participants in a CSA
taking options on publicly traded stock into account under paragraph
(d)(3)(ii), (d)(3)(iii)(A), or (d)(3)(iii)(B) of this section must use
that same method of identification, measurement and timing for all
options on publicly traded stock with respect to that CSA. Controlled
participants may change their method only with the consent of the
Commissioner and only with respect to stock options granted during
taxable years subsequent to the taxable year in which the
Commissioner's consent is obtained. All controlled participants in the
CSA must join in requests for the Commissioner's consent under this
paragraph (d)(3)(iii)(C). Thus, for example, if the controlled
participants make the election described in paragraph (d)(3)(iii)(B) of
this section upon the formation of the CSA, the election may be revoked
only with the consent of the Commissioner, and the consent will apply
only to stock options granted in taxable years subsequent to the
taxable year in which consent is obtained. Similarly, if controlled
participants already have granted stock options that have been or will
be taken into account under the general rule of paragraph
(d)(3)(iii)(A) of this section, then except in cases specified in the
last sentence of paragraph (d)(3)(iii)(B)(4) of this section, the
controlled participants may make the election described in paragraph
(d)(3)(iii)(B) of this section only with the consent of the
Commissioner, and the consent will apply only to stock options granted
in taxable years subsequent to the taxable year in which consent is
obtained.
(4) IDC share. A controlled participant's IDC share for a taxable
year is equal to the controlled participant's cost contribution for the
taxable year, divided by the sum of all IDCs for the taxable year. A
controlled participant's cost contribution for a taxable year means all
of the IDCs initially borne by the controlled participant, plus all of
the CST Payments that the participant makes to other controlled
participants, minus all of the CST Payments that the participant
receives from other controlled participants.
(5) Examples. The following examples illustrate this paragraph (d):
Example 1. Foreign parent (FP) and its U.S. subsidiary (USS)
enter into a CSA to develop a better mousetrap. USS and FP share the
costs of FP's R&D facility that will be exclusively dedicated to
this research, the salaries of the researchers at the facility, and
overhead costs attributable to the project. They also share the cost
of a conference facility that is at the disposal of the senior
executive management of each company. Based on the facts and
circumstances, the cost of the conference facility cannot be
directly identified with, and is not reasonably allocable to, the
IDA. In this case, the cost of the conference facility must be
excluded from the amount of IDCs.
Example 2. U.S. parent (USP) and its foreign subsidiary (FS)
enter into a CSA to develop intangibles for producing a new device.
USP and FS share the costs of an R&D facility, the salaries of the
facility's researchers, and overhead costs attributable to the
project. Although USP also incurs costs related to field testing of
the device, USP does not include those costs in the IDCs that USP
and FS will share under the CSA. The Commissioner may determine,
based on the facts and circumstances, that the costs of field
testing are IDCs that the controlled participants must share.
Example 3. U.S. parent (USP) and its foreign subsidiary (FS)
enter into a CSA to develop a new process patent. USP assigns
certain employees to perform solely R&D to develop a new
mathematical algorithm to perform certain calculations. That
algorithm will be used both to develop the new process patent and to
develop a new design patent the development of which is outside the
scope of the CSA. During years covered by the CSA, USP compensates
such employees with cash salaries, stock-based compensation, or a
combination of both. USP and FS anticipate that the economic value
attributable to the R&D will be derived from the process patent and
the design patent in a relative proportion of 75% and 25%,
respectively. Applying the principles of paragraph (d)(2) of this
section, 75% of the compensation of such employees must be allocated
to the development of the new process patent and, thus, treated as
IDCs. With respect to the cash salary compensation, the IDC is 75%
of the face value of the cash. With respect to the stock-based
compensation, the IDC is 75% of the value of the stock-based
compensation as determined under paragraph (d)(3)(iii) of this
section.
Example 4. Foreign parent (FP) and its U.S. subsidiary (USS)
enter into a CSA to develop a new computer source code. FP has an
executive officer who oversees a research facility and employees
dedicated solely to the IDA. The executive officer also oversees
other research facilities and employees unrelated to the IDA, and
performs certain corporate overhead functions. The full amount of
the costs of the research facility and employees dedicated solely to
the IDA can be directly identified with the IDA and, therefore, are
IDCs. In addition, based on the executive officer's records of time
worked on various matters, the controlled participants reasonably
allocate 20% of the executive officer's compensation to supervision
of the facility and employees dedicated to the IDA, 50% of the
executive officer's compensation to supervision of the facilities
and employees unrelated to the IDA, and 30% of the executive
officer's compensation to corporate overhead functions. The
controlled participants also reasonably determine that the results
of the executive officer's corporate overhead functions yield equal
economic benefit to the IDA and the other business activities of FP.
Applying the principles of paragraph (d)(1) of this section, the
executive officer's compensation allocated to supervising the
facility and employees dedicated to the IDA (amounting to 20% of the
executive officer's total compensation) must be treated as IDCs.
Applying the principles of paragraph (d)(2) of this section, half of
the executive officer's compensation allocated to corporate overhead
functions (that is, half of 30% of the executive officer's total
compensation), must be treated as IDCs. Therefore, a total of 35%
(20% plus 15%) of the executive officer's total compensation must be
treated as IDCs.
(e) Reasonably anticipated benefits share--(1) Definition--(i) In
general. A controlled participant's share of
[[Page 80098]]
reasonably anticipated benefits is equal to its reasonably anticipated
benefits divided by the sum of the reasonably anticipated benefits, as
defined in paragraph (j)(1)(i) of this section, of all the controlled
participants. RAB shares must be updated to account for changes in
economic conditions, the business operations and practices of the
participants, and the ongoing development of intangibles under the CSA.
For purposes of 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, and must
reflect appropriate updates to take into account the most reliable data
regarding past and projected future results available at such time. RAB
shares determined for a particular purpose shall not be further updated
for that purpose based on information not available at the time that
determination needed to be made. For example, RAB shares determined in
order to determine IDC shares for a particular taxable year (as set
forth in paragraphs (b)(1)(i) and (d)(4) of this section) shall not be
recomputed based on information not available at that time. Similarly,
RAB shares determined for the purpose of using a particular method such
as the acquisition price method (as set forth in paragraph (g)(5)(ii)
of this section) to evaluate the arm's length amount charged in a PCT
shall not be recomputed based on information not available at the date
of that PCT. However, nothing in this paragraph (e)(1)(i) shall limit
the Commissioner's use of subsequently available information for
purposes of its allocation determinations in accordance with the
provisions of paragraph (i) (Allocations by the Commissioner in
connection with a CSA) of this section.
(ii) Reliability. A controlled participant's RAB share must be
determined by using the most reliable estimate. In determining which of
two or more available estimates is most reliable, the quality of the
data and assumptions used in the analysis must be taken into account,
consistent with Sec. 1.482-1(c)(2)(ii) (Data and assumptions). Thus,
the reliability of an estimate will depend largely on the completeness
and accuracy of the data, the soundness of the assumptions, and the
relative effects of particular deficiencies in data or assumptions on
different estimates. If two estimates are equally reliable, no
adjustment should be made based on differences between the estimates.
The following factors will be particularly relevant in determining the
reliability of an estimate of RAB shares:
(A) The basis used for measuring benefits, as described in
paragraph (e)(2)(ii) of this section.
(B) The projections used to estimate benefits, as described in
paragraph (e)(2)(iii) of this section.
(iii) Examples. The following examples illustrate the principles of
this paragraph (e)(1):
Example 1. (i) USP and FS plan to conduct research to develop
Product Lines A and B. USP and FS reasonably anticipate respective
benefits from Product Line A of 100X and 200X and respective
benefits from Product Line B, respectively, of 300X and 400X. USP
and FS thus reasonably anticipate combined benefits from Product
Lines A and B of 400X and 600X, respectively.
(ii) USP and FS could enter into a separate CSA to develop
Product Line A with respective RAB shares of 33\1/3\ percent and
66\2/3\ percent (reflecting a ratio of 100X to 200X), and into a
separate CSA to develop Product Line B with respective RAB shares of
42\6/7\ percent and 57\1/7\ percent (reflecting a ratio of 300X to
400X). Alternatively, USP and FS could enter into a single CSA to
develop both Product Lines A and B with respective RAB shares of 40
percent and 60 percent (in the ratio of 400X to 600X). If the
separate CSAs are chosen, then any costs for activities that
contribute to developing both Product Line A and Product Line B will
constitute IDCs of the respective CSAs as required by paragraphs
(d)(1) and (2) of this section.
Example 2. (i) USP, a US company, wholly owns foreign
subsidiary, FS. USP and FS enter into a CSA at the start of Year 1.
The CSA's total IDCs are $100,000 in each year for Years 1 through
4. In Year 1, USP correctly estimates its RAB share as 50%, based on
information available at the time, and therefore correctly computes
$50,000 as its cost contribution for Year 1.
(ii) In Year 4, USP correctly estimates its RAB share to be 70%,
based on information available at the time and, therefore, correctly
computes $70,000 as its cost contribution for Year 4.
(iii) In Year 4, USP also files an amended return for Year 1 in
which USP deducts a cost contribution of $70,000, asserting that,
for this purpose, it should revise its Year 1 estimated RAB share to
70% based on the information that is now available to it in Year 4.
The Commissioner determines that USP is incorrect for two reasons.
First, a RAB share determined for a particular purpose (here, to
determine USP's IDC shares and thus USP's cost contributions in Year
1) should not be revised based on information not available to USP
until Year 4. See paragraph (e)(1)(i) of this section. Second, more
generally, USP is not permitted to file an amended return for this
purpose under Sec. 1.482-1(a)(3). Therefore, for both of these
reasons, Commissioner adjusts USP's amended return for Year 1 by
disallowing $20,000 of the $70,000 deduction.
(2) Measure of benefits--(i) In general. In order to estimate a
controlled participant's RAB share, the amount of each controlled
participant's reasonably anticipated benefits must be measured on a
basis that is consistent for all such participants. See paragraph
(e)(2)(ii)(E) Example 9 of this section. If a controlled participant
transfers a cost shared intangible to another controlled taxpayer,
other than by way of a transfer described in paragraph (f) of this
section, that controlled participant's benefits from the transferred
intangible must be measured by reference to the transferee's benefits,
disregarding any consideration paid by the transferee to the controlled
participant (such as a royalty pursuant to a license agreement).
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. Such indirect bases of measurement
of anticipated benefits are described in paragraph (e)(2)(ii) of this
section. A controlled participant's reasonably anticipated benefits
must be measured on the basis, whether direct or indirect, that most
reliably determines RAB shares. In determining which of two bases of
measurement is most reliable, the factors set forth in Sec. 1.482-
1(c)(2)(ii) (Data and assumptions) must be taken into account. It
normally will be expected that the basis that provided the most
reliable estimate for a particular year will continue to provide the
most reliable estimate in subsequent years, absent a material change in
the factors that affect the reliability of the estimate. Regardless of
whether a direct or indirect basis of measurement is used, adjustments
may be required to account for material differences in the activities
that controlled participants undertake to exploit their interests in
cost shared intangibles. See Examples 4 and 7 of paragraph
(e)(2)(ii)(E) of this section.
(ii) Indirect bases for measuring anticipated benefits. Indirect
bases for measuring anticipated benefits from participation in a CSA
include the following:
(A) Units used, produced, or sold. Units of items used, produced,
or sold by each controlled participant in the business activities in
which cost shared intangibles are exploited may be used as an indirect
basis for measuring its anticipated benefits. This basis of measurement
will more reliably determine RAB shares to the extent that each
controlled participant is expected
[[Page 80099]]
to have a similar increase in net profit or decrease in net loss
attributable to the cost shared intangibles per unit of the item or
items used, produced, or sold. This circumstance is most likely to
arise when the cost shared intangibles are exploited by the controlled
participants in the use, production, or sale of substantially uniform
items under similar economic conditions.
(B) Sales. Sales by each controlled participant in the business
activities in which cost shared intangibles are exploited may be used
as an indirect basis for measuring its anticipated benefits. This basis
of measurement will more reliably determine RAB shares to the extent
that each controlled participant is expected to have a similar increase
in net profit or decrease in net loss attributable to cost shared
intangibles per dollar of sales. This circumstance is most likely to
arise if the costs of exploiting cost shared intangibles are not
substantial relative to the revenues generated, or if the principal
effect of using cost shared intangibles is to increase the controlled
participants' revenues (for example, through a price premium on the
products they sell) without affecting their costs substantially. Sales
by each controlled participant are unlikely to provide a reliable basis
for measuring RAB shares unless each controlled participant operates at
the same market level (for example, manufacturing, distribution, etc.).
(C) Operating profit. Operating profit of each controlled
participant from the activities in which cost shared intangibles are
exploited, as determined before any expense (including amortization) on
account of IDCs, may be used as an indirect basis for measuring
anticipated benefits. This basis of measurement will more reliably
determine RAB shares to the extent that such profit is largely
attributable to the use of cost shared intangibles, or if the share of
profits attributable to the use of cost shared intangibles is expected
to be similar for each controlled participant. This circumstance is
most likely to arise when cost shared intangibles are closely
associated with the activity that generates the profit and the activity
could not be carried on or would generate little profit without use of
those intangibles.
(D) Other bases for measuring anticipated benefits. Other bases for
measuring anticipated benefits may in some circumstances be
appropriate, but only to the extent that there is expected to be a
reasonably identifiable relationship between the basis of measurement
used and additional revenue generated or net costs saved by the use of
cost shared intangibles. For example, a division of costs based on
employee compensation would be considered unreliable unless there were
a relationship between the amount of compensation and the expected
additional revenue generated or net costs saved by the controlled
participants from using the cost shared intangibles.
(E) Examples. The following examples illustrates this paragraph
(e)(2)(ii):
Example 1. Controlled parties A and B enter into a CSA to
develop product and process intangibles for already existing Product
P. Without such intangibles, A and B would each reasonably
anticipate revenue, in present value terms, of $100M from sales of
Product P until it becomes obsolete. With the intangibles, A and B
each reasonably anticipate selling the same number of units each
year, but reasonably anticipate that the price will be higher.
Because the particular product intangible is more highly regarded in
A's market, A reasonably anticipates an increase of $20M in present
value revenue from the product intangible, while B reasonably
anticipates an increase of only $10M in present value from the
product intangible. Further, A and B each reasonably anticipate
spending an additional amount equal to $5M in present value in
production costs to include the feature embodying the product
intangible. Finally, A and B each reasonably anticipate saving an
amount equal to $2M in present value in production costs by using
the process intangible. A and B reasonably anticipate no other
economic effects from exploiting the cost shared intangibles. A's
reasonably anticipated benefits from exploiting the cost shared
intangibles equal its reasonably anticipated increase in revenue
($20M) plus its reasonably anticipated cost savings ($2M) less its
reasonably anticipated increased costs ($5M), which equals $17M.
Similarly, B's reasonably anticipated benefits from exploiting the
cost shared intangibles equal its reasonably anticipated increase in
revenue ($10M) plus its reasonably anticipated cost savings ($2M)
less its reasonably anticipated increased costs ($5M), which equals
$7M. Thus A's reasonably anticipated benefits are $17M and B's
reasonably anticipated benefits are $7M.
Example 2. Foreign Parent (FP) and U.S. Subsidiary (USS) both
produce a feedstock for the manufacture of various high-performance
plastic products. Producing the feedstock requires large amounts of
electricity, which accounts for a significant portion of its
production cost. FP and USS enter into a CSA to develop a new
process that will reduce the amount of electricity required to
produce a unit of the feedstock. FP and USS currently both incur an
electricity cost of $2 per unit of feedstock produced and rates for
each are expected to remain similar in the future. The new process,
if it is successful, will reduce the amount of electricity required
by each company to produce a unit of the feedstock by 50%. Switching
to the new process would not require FP or USS to incur significant
investment or other costs. Therefore, the cost savings each company
is expected to achieve after implementing the new process are $1 per
unit of feedstock produced. Under the CSA, FP and USS divide the
costs of developing the new process based on the units of the
feedstock each is anticipated to produce in the future. In this
case, units produced is the most reliable basis for measuring RAB
shares and dividing the IDCs because each controlled participant is
expected to have a similar $1 (50% of current charge of $2) decrease
in costs per unit of the feedstock produced.
Example 3. The facts are the same as in Example 2, except that
currently USS pays $3 per unit of feedstock produced for electricity
while FP pays $6 per unit of feedstock produced. In this case, units
produced is not the most reliable basis for measuring RAB shares and
dividing the IDCs because the participants do not expect to have a
similar decrease in costs per unit of the feedstock produced. The
Commissioner determines that the most reliable measure of RAB shares
may be based on units of the feedstock produced if FP's units are
weighted relative to USS's units by a factor of 2. This reflects the
fact that FP pays twice as much as USS for electricity and,
therefore, FP's savings of $3 per unit of the feedstock (50%
reduction of current charge of $6) would be twice USS's savings of
$1.50 per unit of feedstock (50% reduction of current charge of $3)
from any new process eventually developed.
Example 4. The facts are the same as in Example 3, except that
to supply the particular needs of the U.S. market USS manufactures
the feedstock with somewhat different properties than FP's
feedstock. This requires USS to employ a somewhat different
production process than does FP. Because of this difference, USS
would incur significant construction costs in order to adopt any new
process that may be developed under the cost sharing agreement. In
this case, units produced is not the most reliable basis for
measuring RAB shares. In order to reliably determine RAB shares, the
Commissioner measures the reasonably anticipated benefits of USS and
FP on a direct basis. USS's reasonably anticipated benefits are its
reasonably anticipated total savings in electricity costs, less its
reasonably anticipated costs of adopting the new process. FS's
reasonably anticipated benefits are its reasonably anticipated total
savings in electricity costs.
Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a CSA to develop new anesthetic drugs. USP obtains the right to
market any resulting drugs in the United States and FS obtains the
right to market any resulting drugs in the rest of the world. USP
and FS determine RAB shares on the basis of their respective total
anticipated operating profit from all drugs under development. USP
anticipates that it will receive a much higher profit than FS per
unit sold because the price of the drugs is not regulated in the
United States, whereas the price of the drugs is regulated in many
non-U.S. jurisdictions. In both controlled participants'
territories, the anticipated operating profits are almost entirely
attributable to the use of the cost
[[Page 80100]]
shared intangibles. In this case, the controlled participants' basis
for measuring RAB shares is the most reliable.
Example 6. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)
manufacture and sell fertilizers. They enter into a CSA to develop a
new pellet form of a common agricultural fertilizer that is
currently available only in powder form. Under the CSA, USS obtains
the rights to produce and sell the new form of fertilizer for the
U.S. market while FP obtains the rights to produce and sell the new
form of fertilizer in the rest of the world. The costs of developing
the new form of fertilizer are divided on the basis of the
anticipated sales of fertilizer in the controlled participants'
respective markets.
(ii) If the research and development is successful, the pellet
form will deliver the fertilizer more efficiently to crops and less
fertilizer will be required to achieve the same effect on crop
growth. The pellet form of fertilizer can be expected to sell at a
price premium over the powder form of fertilizer based on the
savings in the amount of fertilizer that needs to be used. This
price premium will be a similar premium per dollar of sales in each
territory. If the research and development is successful, the costs
of producing pellet fertilizer are expected to be approximately the
same as the costs of producing powder fertilizer and the same for
both FP and USS. Both FP and USS operate at approximately the same
market levels, selling their fertilizers largely to independent
distributors.
(iii) In this case, the controlled participants' basis for
measuring RAB shares is the most reliable.
Example 7. The facts are the same as in Example 6, except that
FP distributes its fertilizers directly while USS sells to
independent distributors. In this case, sales of USS and FP are not
the most reliable basis for measuring RAB shares unless adjustments
are made to account for the difference in market levels at which the
sales occur.
Example 8. Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a CSA to develop materials that will be used to train all new
entry-level employees. FP and USS determine that the new materials
will save approximately ten hours of training time per employee.
Because their entry-level employees are paid on differing wage
scales, FP and USS decide that they should not measure benefits
based on the number of entry-level employees hired by each. Rather,
they measure benefits based on compensation paid to the entry-level
employees hired by each. In this case, the basis used for measuring
RAB shares is the most reliable because there is a direct
relationship between compensation paid to new entry-level employees
and costs saved by FP and USS from the use of the new training
materials.
Example 9. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and
Foreign Subsidiary 2 (FS2) enter into a CSA to develop computer
software that each will market and install on customers' computer
systems. The controlled participants measure benefits on the basis
of projected sales by USP, FS1, and FS2 of the software in their
respective geographic areas. However, FS1 plans not only to sell but
also to license the software to unrelated customers, and FS1's
licensing income (which is a percentage of the licensees' sales) is
not counted in the projected benefits. In this case, the basis used
for measuring the benefits of each controlled participant is not the
most reliable because all of the benefits received by controlled
participants are not taken into account. In order to reliably
determine RAB shares, FS1's projected benefits from licensing must
be included in the measurement on a basis that is the same as that
used to measure its own and the other controlled participants'
projected benefits from sales (for example, all controlled
participants might measure their benefits on the basis of operating
profit).
(iii) Projections used to estimate benefits--(A) In general. The
reliability of an estimate of RAB shares also depends upon the
reliability of projections used in making the estimate. Projections
required for this purpose generally include a determination of the time
period between the inception 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 projection 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 factors that underlie it. For example, a projection of operating
profits may require a projection of sales, cost of sales, operating
expenses, and other factors that affect operating profits. If it is
anticipated that there will be significant variation among controlled
participants in the timing of their receipt of benefits, and
consequently benefit shares are expected to vary significantly over the
years in which benefits will be received, it normally will be necessary
to use the present value of the projected benefits to reliably
determine RAB shares. See paragraph (g)(2)(v) of this section for best
method considerations regarding discount rates used for this purpose.
If it is not anticipated that benefit shares will significantly change
over time, current annual benefit shares may provide a reliable
projection of RAB shares. This circumstance is most likely to occur
when the CSA is a long-term arrangement, the arrangement covers a wide
variety of intangibles, the composition of the cost shared intangibles
is unlikely to change, the cost shared intangibles are unlikely to
generate unusual profits, and each controlled participant's share of
the market is stable.
(B) Examples. The following examples illustrate the principles of
this paragraph (e)(2)(iii):
Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a CSA to develop a new car model. The controlled
participants plan to spend four years developing the new model and
four years producing and selling the new model. USS and FP project
total sales of $4 billion and $2 billion, respectively, over the
planned four years of exploitation of the new model. The controlled
participants determine RAB shares for each year of 66\2/3\% for USS
and 33\1/3\% for FP, based on projected total sales.
(ii) USS typically begins producing and selling new car models a
year after FP begins producing and selling new car models. In order
to reflect USS's one-year lag in introducing new car models, a more
reliable projection of each participant's RAB share would be based
on a projection of all four years of sales for each participant,
discounted to present value.
Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a CSA to develop new and improved household cleaning products.
Both controlled participants have sold household cleaning products
for many years and have stable worldwide market shares. The products
under development are unlikely to produce unusual profits for either
controlled participant. The controlled participants determine RAB
shares on the basis of each controlled participant's current sales
of household cleaning products. In this case, the controlled
participants' RAB shares are reliably projected by current sales of
cleaning products.
Example 3. The facts are the same as in Example 2, except that
FS's market share is rapidly expanding because of the business
failure of a competitor in its geographic area. The controlled
participants' RAB shares are not reliably projected by current sales
of cleaning products. FS's benefit projections should take into
account its growth in market share.
Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a CSA to develop synthetic fertilizers and insecticides. FP and
USS share costs on the basis of each controlled participant's
current sales of fertilizers and insecticides. The market shares of
the controlled participants have been stable for fertilizers, but
FP's market share for insecticides has been expanding. The
controlled participants' projections of RAB shares are reliable with
regard to fertilizers, but not reliable with regard to insecticides;
a more reliable projection of RAB shares would take into account the
expanding market share for insecticides.
(f) Changes in participation under a CSA--(1) In general. A change
in participation under a CSA occurs when there is either a controlled
transfer of interests or a capability variation. A change in
participation requires arm's length consideration under paragraph
(a)(3)(ii) of this section, and as more fully described in this
paragraph (f).
(2) Controlled transfer of interests. A controlled transfer of
interests occurs when a participant in a CSA transfers all or part of
its interests in cost shared intangibles under the CSA in a
[[Page 80101]]
controlled transaction, and the transferee assumes the associated
obligations under the CSA. For example, a change in the territorial
based divisional interests or field of use based divisional interests,
as described in paragraph (b)(4), is a controlled transfer of
interests. After the controlled transfer of interests occurs, the CSA
will still exist if at least two controlled participants still have
interests in the cost shared intangibles. In such a case, the
transferee will be treated as succeeding to the transferor's prior
history under the CSA as pertains to the transferred interests,
including the transferor's cost contributions, benefits derived, and
PCT Payments attributable to such rights or obligations. A transfer
that would otherwise constitute a controlled transfer of interests for
purposes of this paragraph (f)(2) shall not constitute a controlled
transfer of interests if it also constitutes a capability variation for
purposes of paragraph (f)(3) of this section.
(3) Capability variation. A capability variation occurs when, in a
CSA in which interests in cost shared intangibles are divided as
described in paragraph (b)(4)(iv) of this section, the controlled
participants' division of interests or their relative capabilities or
capacities to benefit from the cost shared intangibles are materially
altered. For purposes of paragraph (a)(3)(ii) of this section, a
capability variation is considered to be a controlled transfer of
interests in cost shared intangibles, in which any controlled
participant whose RAB share decreases as a result of the capability
variation is a transferor, and any controlled participant whose RAB
share thus increases is the transferee of the interests in cost shared
intangibles.
(4) Arm's length consideration for a change in participation. In
the event of a change in participation, the arm's length amount of
consideration from the transferee, under the rules of Sec. Sec. 1.482-
1 and 1.482-4 through 1.482-6 and paragraph (a)(3)(ii) of this section,
will be determined consistent with the reasonably anticipated
incremental change in the returns to the transferee and transferor
resulting from such change in participation. Such changes in returns
will themselves depend on the reasonably anticipated incremental
changes in the benefits from exploiting the cost shared intangibles,
IDCs borne, and PCT Payments (if any). However, any arm's length
consideration required under this paragraph (f)(4) with respect to a
capability variation shall be reduced as necessary to prevent
duplication of an adjustment already performed under paragraph
(i)(2)(ii)(A) of this section that resulted from the same capability
variation. If an adjustment has been performed already under this
paragraph (f)(4) with respect to a capability variation, then for
purposes of any adjustment to be performed under paragraph
(i)(2)(ii)(A) of this section, the controlled participants' projected
benefit shares referred to in paragraph (i)(2)(ii)(A) of this section
shall be considered to be the controlled participants' respective RAB
shares after the capability variation occurred.
(5) Examples. The following examples illustrate the principles of
this paragraph (f):
Example 1. X, Y, and Z are the only controlled participants in
a CSA. The CSA divides interests in cost shared intangibles on a
territorial basis as described in paragraph (b)(4)(ii) of this
section. X is assigned the territories of the Americas, Y is
assigned the territory of the UK and Australia, and Z is assigned
the rest of the world. When the CSA is formed, X has a platform
contribution T. Under the PCTs for T, Y and Z are each obligated to
pay X royalties equal to five percent of their respective sales.
Aside from T, there are no platform contributions. Two years after
the formation of the CSA, Y transfers to Z its interest in cost
shared intangibles relating to the UK territory, and the associated
obligations, in a controlled transfer of interests described in
paragraph (f)(2) of this section. At that time the reasonably
anticipated benefits from exploiting cost shared intangibles in the
UK have a present value of $11M, the reasonably anticipated IDCs to
be borne relating to the UK territory have a present value of $3M,
and the reasonably anticipated PCT Payments to be made to X relating
to sales in the UK territory have a present value of $2M. As arm's
length consideration for the change in participation due to the
controlled transfer of interests, Z must pay Y compensation with an
anticipated present value of $11M, less $3M, less $2M, which equals
$6M.
Example 2. As in Example 2 of paragraph (b)(4)(v) of this
section, companies P and S, both members of the same controlled
group, enter into a CSA to develop product Z. P and S agree to
divide their interest in product Z based on site of manufacturing. P
will have exclusive and perpetual rights in product Z manufactured
in facilities owned by P. S will have exclusive and perpetual rights
to product Z manufactured in facilities owned by S. P and S agree
that neither will license manufacturing rights in product Z to any
related or unrelated party. Both P and S maintain books and records
that allow production at all sites to be verified. Both own
facilities that will manufacture product Z and the relative
capacities of these sites are known. All facilities are currently
operating at near capacity and are expected to continue to operate
at near capacity when product Z enters production so that it will
not be feasible to shift production between P's and S's facilities.
P and S have no plans to build new facilities and the lead time
required to plan and build a manufacturing facility precludes the
possibility that P or S will build a new facility during the period
for which sales of Product Z are expected. When the CSA is formed, P
has a platform contribution T. Under the PCT for T, S is obligated
to pay P sales-based royalties according to a certain formula. Aside
from T, there are no other platform contributions. Two years after
the formation of the CSA, owing to a change in plans not reasonably
foreseeable at the time the CSA was entered into, S acquires
additional facilities F for the manufacture of Product Z. Such
acquisition constitutes a capability variation described in
paragraph (f)(3) of this section. Under this capability variation,
S's RAB share increases from 50% to 60%. Accordingly, there is a
compensable change in participation under paragraph (f)(3) of this
section.
(g) Supplemental guidance on methods applicable to PCTs--(1) In
general. This paragraph (g) provides supplemental guidance on applying
the methods listed in this paragraph (g)(1) for purposes of evaluating
the arm's length amount charged in a PCT. Each method will yield a
value for the compensation obligation of each PCT Payor consistent with
the product of the combined pre-tax value to all controlled
participants of the platform contribution that is the subject of the
PCT and the PCT Payor's RAB share. Each method must yield results
consistent with measuring the value of a platform contribution by
reference to the future income anticipated to be generated by the
resulting cost shared intangibles. The methods are--
(i) The comparable uncontrolled transaction method described in
Sec. 1.482-4(c), or the comparable uncontrolled services price method
described in Sec. 1.482-9(c), as further described in paragraph (g)(3)
of this section;
(ii) The income method, described in paragraph (g)(4) of this
section;
(iii) The acquisition price method, described in paragraph (g)(5)
of this section;
(iv) The market capitalization method, described in paragraph
(g)(6) of this section;
(v) The residual profit split method, described in paragraph (g)(7)
of this section; and
(vi) Unspecified methods, described in paragraph (g)(8) of this
section.
(2) Best method analysis applicable for evaluation of a PCT
pursuant to a CSA--(i) In general. Each method must be applied in
accordance with the provisions of Sec. 1.482-1, including the best
method rule of Sec. 1.482-1(c), the comparability analysis of Sec.
1.482-1(d), and the arm's length range of Sec. 1.482-1(e), except as
those provisions are modified in this paragraph (g).
(ii) Consistency with upfront contractual terms and risk
allocation--
[[Page 80102]]
the investor model--(A) In general. Although all of the factors
entering into a best method analysis described in Sec. 1.482-1(c) and
(d) must be considered, specific factors may be particularly relevant
in the context of a CSA. In particular, the relative reliability of an
application of any method depends on the degree of consistency of the
analysis with the applicable contractual terms and allocation of risk
under the CSA and this section among the controlled participants as of
the date of the PCT, unless a change in such terms or allocation has
been made in return for arm's length consideration. In this regard, a
CSA involves an upfront division of the risks as to both reasonably
anticipated obligations and reasonably anticipated benefits over the
reasonably anticipated term of the CSA Activity. Accordingly, the
relative reliability of an application of a method also depends on the
degree of consistency of the analysis with the assumption that, as of
the date of the PCT, each controlled participant's aggregate net
investment in the CSA Activity (including platform contributions,
operating contributions, as such term is defined in paragraph (j)(1)(i)
of this section, operating cost contributions, as such term is defined
in paragraph (j)(1)(i) of this section, and cost contributions) is
reasonably anticipated to earn a rate of return (which might be
reflected in a discount rate used in applying a method) appropriate to
the riskiness of the controlled participant's CSA Activity over the
entire period of such CSA Activity. If the cost shared intangibles
themselves are reasonably anticipated to contribute to developing other
intangibles, then the period described in the preceding sentence
includes the period, reasonably anticipated as of the date of the PCT,
of developing and exploiting such indirectly benefited intangibles.
(B) Example. The following example illustrates the principles of
this paragraph (g)(2)(ii):
Example. (i) P, a U.S. corporation, has developed a software
program, DEF, which applies certain algorithms to reconstruct
complete DNA sequences from partially-observed DNA sequences. S is a
wholly-owned foreign subsidiary of P. On the first day of Year 1, P
and S enter into a CSA to develop a new generation of genetic tests,
GHI, based in part on the use of DEF. DEF is therefore a platform
contribution of P for which compensation is due from S pursuant to a
PCT. S makes no platform contributions to the CSA. Sales of GHI are
projected to commence two years after the inception of the CSA and
then to continue for eight more years. Based on industry experience,
P and S are confident that GHI will be replaced by a new type of
genetic testing based on technology unrelated to DEF or GHI and
that, at that point, GHI will have no further value. P and S project
that that replacement will occur at the end of Year 10.
(ii) For purposes of valuing the PCT for P's platform
contribution of DEF to the CSA, P and S apply a type of residual
profit split method that is not described in paragraph (g)(7) of
this section and which, accordingly, constitutes an unspecified
method. See paragraph (g)(7)(i) (last sentence) of this section. The
principles of this paragraph (g)(2) apply to any method for valuing
a PCT, including the unspecified method used by P and S.
(iii) Under the method employed by P and S, in each year, a
portion of the income from sales of GHI in S's territory is
allocated to certain routine contributions made by S. The residual
of the profit or loss from GHI sales in S's territory after the
routine allocation step is divided between P and S pro rata to their
capital stocks allocable to S's territory. Each controlled
participant's capital stock is computed by capitalizing, applying a
capital growth factor to, and amortizing its historical expenditures
regarding DEF allocable to S's territory (in the case of P), or its
ongoing cost contributions towards developing GHI (in the case of
S). The amortization of the capital stocks is effected on a
straight-line basis over an assumed four-year life for the relevant
expenditures. The capital stocks are grown using an assumed growth
factor that P and S consider to be appropriate.
(iv) The assumption that all expenditures amortize on a
straight-line basis over four years does not appropriately reflect
the principle that as of the date of the PCT regarding DEF, every
contribution to the development of GHI, including DEF, is reasonably
anticipated to have value throughout the entire period of
exploitation of GHI which is projected to continue through Year 10.
Under this method as applied by P and S, the share of the residual
profit in S's territory that is allocated to P as a PCT Payment from
S will decrease every year. After Year 4, P's capital stock in DEF
will necessarily be $0, so that P will receive none of the residual
profit or loss from GHI sales in S's territory after Year 4 as a PCT
Payment.
(v) As a result of this limitation of the PCT Payments to be
made by S, the anticipated return to S's aggregate investment in the
CSA, over the whole period of S's CSA Activity, is at a rate that is
significantly higher than the appropriate rate of return for S's CSA
Activity (as determined by a reliable method). This discrepancy is
not consistent with the investor model principle that S should
anticipate a rate of return to its aggregate investment in the CSA,
over the whole period of its CSA Activity, appropriate for the
riskiness of its CSA Activity. The inconsistency of the method with
the investor model materially lessens its reliability for purposes
of a best method analysis. See Sec. 1.482-1(c)(2)(ii)(B).
(iii) Consistency of evaluation with realistic alternatives--(A) In
general. The relative reliability of an application of a method also
depends on the degree of consistency of the analysis with the
assumption that uncontrolled taxpayers dealing at arm's length would
have evaluated the terms of the transaction, and only entered into such
transaction, if no alternative is preferable. This condition is not
met, therefore, where for any controlled participant the total
anticipated present value of its income attributable to its entering
into the CSA, as of the date of the PCT, is less than the total
anticipated present value of its income that could be achieved through
an alternative arrangement realistically available to that controlled
participant. In principle, this comparison is made on a post-tax basis
but, in many cases, a comparison made on a pre-tax basis will yield
equivalent results. See also paragraph (g)(2)(v)(B)(1) of this section
(Discount rate variation between realistic alternatives).
(B) Examples. The following examples illustrate the principles of
this paragraph (g)(2)(iii):
Example 1. (i) P, a corporation, and S, a wholly-owned
subsidiary of P, enter into a CSA to develop a personal
transportation device (the product). Under the arrangement, P will
undertake all of the R&D, and manufacture and market the product in
Country X. S will make CST Payments to P for its appropriate share
of P's R&D costs, and manufacture and market the product in the rest
of the world. P owns existing patents and trade secrets that are
reasonably anticipated to contribute to the development of the
product. Therefore the rights in the patents and trade secrets are
platform contributions for which compensation is due from S as part
of a PCT.
(ii) S's manufacturing and distribution activities under the CSA
will be routine in nature, and identical to the activities it would
undertake if it alternatively licensed the product from P.
(iii) Reasonably reliable estimates indicate that P could
develop the product without assistance from S and license the
product outside of Country X for a royalty of 20% of sales. Based on
reliable financial projections that include all future development
costs and licensing revenue that are allocable to the non-Country X
market, and using a discount rate appropriate for the riskiness of
P's role as a licensor (see paragraph (g)(2)(v) of this section),
the post-tax present value of this licensing alternative to P for
the non-Country X market (measured as of the date of the PCT) would
be $500 million. Thus, based on this realistic alternative, the
anticipated post-tax present value under the CSA to P in the non-
Country X market (measured as of the date of the PCT), taking into
account anticipated development costs allocable to the non-Country X
market, and anticipated CST Payments and PCT Payments from S, and
using a discount rate appropriate for the riskiness of P's role as a
participant in the CSA, should not be less than $500 million.
Example 2. (i) The facts are the same as in Example 1, except
that there are no reliable estimates of the value to P from the
licensing
[[Page 80103]]
alternative to the CSA. Further, reasonably reliable estimates
indicate that an arm's length return for S's routine manufacturing
and distribution activities is a 10% mark-up on total costs of goods
sold plus operating expenses related to those activities. Finally,
the Commissioner determines that the respective activities
undertaken by P and S (other than licensing payments, cost
contributions, and PCT Payments) would be identical regardless of
whether the arrangement was undertaken as a CSA (cost sharing
alternative) or as a long-term licensing arrangement (licensing
alternative). In particular, in both alternatives, P would perform
all research activities and S would undertake routine manufacturing
and distribution activities associated with its territory.
(ii) P undertakes an economic analysis that derives S's cost
contributions under the CSA, based on reliable financial
projections. Based on this and further economic analysis, P
determines S's PCT Payment as a certain lump sum amount to be paid
as of the date of the PCT (Date D).
(iii) Based on reliable financial projections that include S's
cost contributions and that incorporate S's PCT Payment, as computed
by P, and using a discount rate appropriate for the riskiness of S's
role as a CSA participant (see paragraphs (g)(2)(v) and (4)(vi)(F)
of this section), the anticipated post-tax net present value to S in
the cost sharing alternative (measured as of Date D) is $800
million. Further, based on these same reliable projections (but
incorporating S's licensing payments instead of S's cost
contributions and PCT Payment), and using a discount rate
appropriate for the riskiness of S's role as a long-term licensee,
the anticipated post-tax net present value to S in the licensing
alternative (measured as of Date D) is $100 million. Thus, S's
anticipated post-tax net present value is $700 million greater in
the cost sharing alternative than in the licensing alternative. This
result suggests that P's anticipated post-tax present value must be
significantly less under the cost sharing alternative than under the
licensing alternative. This means that the reliability of P's
analysis as described in paragraph (ii) of this Example 2 is
reduced, because P would not be expected to enter into a CSA if its
alternative of being a long-term licensor is preferable.
Example 3. (i) The facts are the same as in paragraphs (i) and
(ii) of Example 2. In addition, based on reliable financial
projections that include S's cost contributions and S's PCT Payment,
and using a discount rate appropriate for the riskiness of S's role
as a CSA participant, the anticipated post-tax net present value to
S under the CSA (measured as of the date of the PCT) is $50 million.
Also, instead of entering the CSA, S has the realistic alternative
of manufacturing and distributing product Z unrelated to the
personal transportation device, with the same anticipated 10% mark-
up on total costs that it would anticipate for its routine
activities in Example 2. Under its realistic alternative, at a
discount rate appropriate for the riskiness of S's role with respect
to product Z, S anticipates a present value of $100 million.
(ii) Because the lump sum PCT Payment made by S results in S
having a considerably lower anticipated net present value than S
could achieve through an alternative arrangement realistically
available to it, the reliability of P's calculation of the lump sum
PCT Payment is reduced.
(iv) Aggregation of transactions. The combined effect of multiple
contemporaneous transactions, consisting either of multiple PCTs, or of
one or more PCT and one or more other transactions in connection with a
CSA that are not governed by this section (such as transactions
involving cross operating contributions or make-or-sell rights), may
require evaluation in accordance with the principles of aggregation
described in Sec. 1.482-1(f)(2)(i). In such cases, it may be that the
multiple transactions are reasonably anticipated, as of the date of the
PCT(s), to be so interrelated that the method that provides the most
reliable measure of an arm's length charge is a method under this
section applied on an aggregate basis for the PCT(s) and other
transactions. A section 482 adjustment may be made by comparing the
aggregate arm's length charge so determined to the aggregate payments
actually made for the multiple transactions. In such a case, it
generally will not be necessary to allocate separately the aggregate
arm's length charge as between various PCTs or as between PCTs and such
other transactions. However, such an allocation may be necessary for
other purposes, such as applying paragraph (i)(6) (Periodic
adjustments) of this section. An aggregate determination of the arm's
length charge for multiple transactions will often yield a payment for
a controlled participant that is equal to the aggregate value of the
platform contributions and other resources, capabilities, and rights
covered by the multiple transactions multiplied by that controlled
participant's RAB share. Because RAB shares only include benefits from
cost shared intangibles, the reliability of an aggregate determination
of payments for multiple transactions may be reduced to the extent that
it includes transactions covering resources, capabilities, and rights
for which the controlled participants' expected benefit shares differ
substantially from their RAB shares.
(v) Discount rate--(A) In general. The best method analysis in
connection with certain methods or forms of payment may depend on a
rate or rates of return used to convert projected results of
transactions to present value, or to otherwise convert monetary amounts
at one or more points in time to equivalent amounts at a different
point or points in time. For this purpose, a discount rate or rates
should be used that most reliably reflect the market-correlated risks
of activities or transactions and should be applied to the best
estimates of the relevant projected results, based on all the
information potentially available at the time for which the present
value calculation is to be performed. Depending on the particular facts
and circumstances, the market-correlated risk involved and thus, the
discount rate, may differ among a company's various activities or
transactions. Normally, discount rates are most reliably determined by
reference to market information.
(B) Considerations in best method analysis of discount rate--(1)
Discount rate variation between realistic alternatives. Realistic
alternatives may involve varying risk exposure and, thus, may be more
reliably evaluated using different discount rates. See paragraphs
(g)(4)(i)(F) and (vi)(F) of this section. In some circumstances, a
party may have less risk as a licensee of intangibles needed in its
operations, and so require a lower discount rate, than it would have by
entering into a CSA to develop such intangibles, which may involve the
party's assumption of additional risk in funding its cost contributions
to the IDA. Similarly, self-development of intangibles and licensing
out may be riskier for the licensor, and so require a higher discount
rate, than entering into a CSA to develop such intangibles, which would
relieve the licensor of the obligation to fund a portion of the IDCs of
the IDA.
(2) [Reserved].
(3) Discount rate variation between forms of payment. Certain forms
of payment may involve different risks than others. For example,
ordinarily a royalty computed on a profits base would be more volatile,
and so require a higher discount rate to discount projected payments to
present value, than a royalty computed on a sales base.
(4) Post-tax rate. In general, discount rate estimates that may be
inferred from the operations of the capital markets are post-tax
discount rates. Therefore, an analysis would in principle apply post-
tax discount rates to income net of expense items including taxes
(post-tax income). However, in certain circumstances the result of
applying a post-tax discount rate to post-tax income is equivalent to
the product of the result of applying a post-tax discount rate to
income net of expense items other than taxes (pre-tax income), and the
difference of one minus the tax rate (as defined in paragraph (j)(1)(i)
of this section). Therefore, in such
[[Page 80104]]
circumstances, calculation of pre-tax income, rather than post-tax
income, may be sufficient. See, for example, paragraph (g)(4)(i)(G) of
this section.
(C) Example. The following example illustrates the principles of
this paragraph (g)(2)(v):
Example. (i) P and S form a CSA to develop intangible X, which
will be used in product Y. P will develop X, and S will make CST
Payments as its cost contributions. At the start of the CSA, P has a
platform contribution, for which S commits to make a PCT Payment of
5% of its sales of product Y. As part of the evaluation of whether
that PCT Payment is arm's length, the Commissioner considers whether
P had a more favorable realistic alternative (see paragraph
(g)(2)(iii) of this section). Specifically, the Commissioner
compares P's anticipated post-tax discounted present value of the
financial projections under the CSA (taking into account S's PCT
Payment of 5% of its sales of product Y) with P's anticipated post-
tax discounted present value of the financial projections under a
reasonably available alternative Licensing Arrangement that consists
of developing intangible X on its own and then licensing X to S or
to an uncontrolled party similar to S. In undertaking the analysis,
the Commissioner determines that, because it would be funding the
entire development of the intangible, P undertakes greater risks in
the licensing alternative than in the cost sharing alternative (in
the cost sharing alternative P would be funding only part of the
development of the intangible).
(ii) The Commissioner determines that, as between the two
scenarios, all of the components of P's anticipated financial flows
are identical, except for the CST and PCT Payments under the CSA,
compared to the licensing payments under the Licensing Alternative.
Accordingly, the Commissioner concludes that the differences in
market-correlated risks between the two scenarios, and therefore the
differences in discount rates between the two scenarios, relate to
the differences in these components of the financial projections.
(vi) Financial projections. The reliability of an estimate of the
value of a platform or operating contribution in connection with a PCT
will often depend upon the reliability of projections used in making
the estimate. Such projections should reflect the best estimates of the
items projected (normally reflecting a probability weighted average of
possible outcomes and thus also reflecting non-market-correlated risk).
Projections necessary for this purpose may include a projection of
sales, IDCs, costs of developing operating contributions, routine
operating expenses, and costs of sales. Some method applications
directly estimate projections of items attributable to separate
development and exploitation by the controlled participants within
their respective divisions. Other method applications indirectly
estimate projections of items from the perspective of the controlled
group as a whole, rather than from the perspective of a particular
participant, and then apportion the items so estimated on some assumed
basis. For example, in some applications, sales might be directly
projected by division, but worldwide projections of other items such as
operating expenses might be apportioned among divisions in the same
ratio as the divisions' respective sales. Which approach is more
reliable depends on which provides the most reliable measure of an
arm's length result, considering the competing perspectives under the
facts and circumstances in light of the completeness and accuracy of
the underlying data, the reliability of the assumptions, and the
sensitivity of the results to possible deficiencies in the data and
assumptions. For these purposes, projections that have been prepared
for non-tax purposes are generally more reliable than projections that
have been prepared solely for purposes of meeting the requirements in
this paragraph (g).
(vii) Accounting principles--(A) In general. Allocations or other
valuations done for accounting purposes may provide a useful starting
point but will not be conclusive for purposes of the best method
analysis in evaluating the arm's length charge in a PCT, particularly
where the accounting treatment of an asset is inconsistent with its
economic value.
(B) Examples. The following examples illustrate the principles of
this paragraph (g)(2)(vii):
Example 1. (i) USP, a U.S. corporation and FSub, a wholly-owned
foreign subsidiary of USP, enter into a CSA in Year 1 to develop
software programs with application in the medical field. Company X
is an uncontrolled software company located in the United States
that is engaged in developing software programs that could
significantly enhance the programs being developed by USP and FSub.
Company X is still in a startup phase, so it has no currently
exploitable products or marketing intangibles and its workforce
consists of a team of software developers. Company X has negligible
liabilities and tangible property. In Year 2, USP purchases Company
X as part of an uncontrolled transaction in order to acquire its in-
process technology and workforce for purposes of the development
activities of the CSA. USP files a consolidated return that includes
Company X. For accounting purposes, $50 million of the $100 million
acquisition price is allocated to the in-process technology and
workforce, and the residual $50 million is allocated to goodwill.
(ii) The in-process technology and workforce of Company X
acquired by USP are reasonably anticipated to contribute to
developing cost shared intangibles and therefore the rights in the
in-process technology and workforce of Company X are platform
contributions for which FSub must compensate USP as part of a PCT.
In determining whether to apply the acquisition price or another
method for purposes of evaluating the arm's length charge in the
PCT, relevant best method analysis considerations must be weighed in
light of the general principles of paragraph (g)(2) of this section.
The allocation for accounting purposes raises an issue as to the
reliability of using the acquisition price method in this case
because it suggests that a significant portion of the value of
Company X's nonroutine contributions to USP's business activities is
allocable to goodwill, which is often difficult to value reliably
and which, depending on the facts and circumstances, might not be
attributable to platform contributions that are to be compensated by
PCTs. See paragraph (g)(5)(iv)(A) of this section.
(iii) Paragraph (g)(2)(vii)(A) of this section provides that
accounting treatment may be a starting point, but is not
determinative for purposes of assessing or applying methods to
evaluate the arm's length charge in a PCT. The facts here reveal
that Company X has nothing of economic value aside from its in-
process technology and assembled workforce. The $50 million of the
acquisition price allocated to goodwill for accounting purposes,
therefore, is economically attributable to either of, or both, the
in-process technology and the workforce. That moots the potential
issue under the acquisition price method of the reliability of
valuation of assets not to be compensated by PCTs, since there are
no such assets. Assuming the acquisition price method is otherwise
the most reliable method, the aggregate value of Company X's in-
process technology and workforce is the full acquisition price of
$100 million. Accordingly, the aggregate value of the arm's length
PCT Payments due from FSub to USP for the platform contributions
consisting of the rights in Company X's in-process technology and
workforce will equal $100 million multiplied by FSub's RAB share.
Example 2. (i) The facts are the same as in Example 1, except
that Company X is a mature software business in the United States
with a successful current generation of software that it markets
under a recognized trademark, in addition to having the research
team and new generation software in process that could significantly
enhance the programs being developed under USP's and FSub's CSA. USP
continues Company X's existing business and integrates the research
team and the in-process technology into the efforts under its CSA
with FSub. For accounting purposes, the $100 million price for
acquiring Company X is allocated $50 million to existing software
and trademark, $25 million to in-process technology and research
workforce, and the residual $25 million to goodwill and going
concern value.
(ii) In this case an analysis of the facts indicates a
likelihood that, consistent with the allocation under the accounting
treatment (although not necessarily in the same amount), a
significant amount of the
[[Page 80105]]
nonroutine contributions to the USP's business activities consist of
goodwill and going concern value economically attributable to the
existing U.S. software business rather than to the platform
contributions consisting of the rights in the in-process technology
and research workforce. In addition, an analysis of the facts
indicates that a significant amount of the nonroutine contributions
to USP's business activities consist of the make-or-sell rights
under the existing software and trademark, which are not platform
contributions and might be difficult to value. Accordingly, further
consideration must be given to the extent to which these
circumstances reduce the relative reliability of the acquisition
price method in comparison to other potentially applicable methods
for evaluating the PCT Payment.
Example 3. (i) USP, a U.S. corporation, and FSub, a wholly-
owned foreign subsidiary of USP, enter into a CSA in Year 1 to
develop Product A. Company Y is an uncontrolled corporation that
owns Technology X, which is critical to the development of Product
A. Company Y currently markets Product B, which is dependent on
Technology X. USP is solely interested in acquiring Technology X,
but is only able to do so through the acquisition of Company Y in
its entirety for $200 million in an uncontrolled transaction in Year
2. For accounting purposes, the acquisition price is allocated as
follows: $120 million to Product B and the underlying Technology X,
$30 million to trademark and other marketing intangibles, and the
residual $50 million to goodwill and going concern value. After the
acquisition of Company Y, Technology X is used to develop Product A.
No other part of Company Y is used in any manner. Immediately after
the acquisition, product B is discontinued, and, therefore, the
accompanying marketing intangibles become worthless. None of the
previous employees of Company Y is retained.
(ii) The Technology X of Company Y acquired by USP is reasonably
anticipated to contribute to developing cost shared intangibles and
is therefore a platform contribution for which FSub must compensate
USP as part of a PCT. Although for accounting purposes a significant
portion of the acquisition price of Company Y was allocated to items
other than Technology X, the facts demonstrate that USP had no
intention of using and therefore placed no economic value on any
part of Company Y other than Technology X. If USP was willing to pay
$200 million for Company Y solely for purposes of acquiring
Technology X, then assuming the acquisition price method is
otherwise the most reliable method, the value of Technology X is the
full $200 million acquisition price. Accordingly, the value of the
arm's length PCT Payment due from FSub to USP for the platform
contribution consisting of the rights in Technology X will equal the
product of $200 million and FSub's RAB share.
(viii) Valuations of subsequent PCTs--(A) Date of subsequent PCT.
The date of a PCT may occur subsequent to the inception of the CSA. For
example, an intangible initially developed outside the IDA may only
subsequently become a platform contribution because that later time is
the earliest date on which it is reasonably anticipated to contribute
to developing cost shared intangibles within the IDA. In such case, the
date of the PCT, and the analysis of the arm's length amount charged in
the subsequent PCT, is as of such later time.
(B) Best method analysis for subsequent PCT. In cases where PCTs
occur on different dates, the determination of the arm's length amount
charged, respectively, in the prior and subsequent PCTs must be
coordinated in a manner that provides the most reliable measure of an
arm's length result. In some circumstances, a subsequent PCT may be
reliably evaluated independently of other PCTs, as may be possible for
example, under the acquisition price method. In other circumstances,
the results of prior and subsequent PCTs may be interrelated and so a
subsequent PCT may be most reliably evaluated under the residual profit
split method of paragraph (g)(7) of this section. In those cases, for
purposes of allocating the present value of nonroutine residual
divisional profit or loss, and so determining the present value of the
subsequent PCT Payments, in accordance with paragraph (g)(7)(iii)(C) of
this section, the PCT Payor's interest in cost shared intangibles, both
already developed and in process, are treated as additional PCT Payor
operating contributions as of the date of the subsequent PCT.
(ix) Arm's length range-(A) In general. The guidance in Sec.
1.482-1(e) regarding determination of an arm's length range, as
modified by this section, applies in evaluating the arm's length amount
charged in a PCT under a transfer pricing method provided in this
section (applicable method). Section 1.482-1(e)(2)(i) provides that the
arm's length range is ordinarily determined by applying a single
pricing method selected under the best method rule to two or more
uncontrolled transactions of similar comparability and reliability
although use of more than one method may be appropriate for the
purposes described in Sec. 1.482-1(c)(2)(iii). The rules provided in
Sec. 1.482-1(e) and this section for determining an arm's length range
shall not override the rules provided in paragraph (i)(6) of this
section for periodic adjustments by the Commissioner. The provisions in
paragraphs (g)(2)(ix)(C) and (D) of this section apply only to
applicable methods that are based on two or more input parameters as
described in paragraph (g)(2)(ix)(B) of this section. For an example of
how the rules of this section for determining an arm's length range of
PCT Payments are applied, see paragraph (g)(4)(viii) of this section.
(B) Methods based on two or more input parameters. An applicable
method may determine PCT Payments based on calculations involving two
or more parameters whose values depend on the facts and circumstances
of the case (input parameters). For some input parameters (market-based
input parameters), the value is most reliably determined by reference
to data that derives from uncontrolled transactions (market data). For
example, the value of the return to a controlled participant's routine
contributions, as such term is defined in paragraph (j)(1)(i) of this
section, to the CSA Activity (which value is used as an input parameter
in the income method described in paragraph (g)(4) of this section) may
in some cases be most reliably determined by reference to the profit
level of a company with rights, resources, and capabilities comparable
to those routine contributions. See Sec. 1.482-5. As another example,
the value for the discount rate that reflects the riskiness of a
controlled participant's role in the CSA (which value is used as an
input parameter in the income method described in paragraph (g)(4) of
this section) may in some cases be most reliably determined by
reference to the stock beta of a company whose overall risk is
comparable to the riskiness of the controlled participant's role in the
CSA.
(C) Variable input parameters. For some market-based input
parameters (variable input parameters), the parameter's value is most
reliably determined by considering two or more observations of market
data that have, or with adjustment can be brought to, a similar
reliability and comparability, as described in Sec. 1.482-1(e)(2)(ii)
(for example, profit levels or stock betas of two or more companies).
See paragraph (g)(2)(ix)(B) of this section.
(D) Determination of arm's length PCT Payment. For purposes of
applying this paragraph (g)(2)(ix), each input parameter is assigned a
single most reliable value, unless it is a variable input parameter as
described in paragraph (g)(2)(ix)(C) of this section. The determination
of the arm's length payment depends on the number of variable input
parameters.
(1) No variable input parameters. If there are no variable input
parameters, the arm's length PCT Payment is a single value determined
by using the single most reliable value determined for each input
parameter.
(2) One variable input parameter. If there is exactly one variable
input parameter, then under the applicable
[[Page 80106]]
method, the arm's length range of PCT Payments is the interquartile
range, as described in Sec. 1.482-1(e)(2)(iii)(C), of the set of PCT
Payment values calculated by selecting--
(i) Iteratively, the value of the variable input parameter that is
based on each observation as described in paragraph (g)(2)(ix)(C) of
this section; and
(ii) The single most reliable values for each other input
parameter.
(3) More than one variable input parameter. If there are two or
more variable input parameters, then under the applicable method, the
arm's length range of PCT Payments is the interquartile range, as
described in Sec. 1.482-1(e)(2)(iii)(C), of the set of PCT Payment
values calculated iteratively using every possible combination of
permitted choices of values for the input parameters. For input
parameters other than a variable input parameter, the only such
permitted choice is the single most reliable value. For variable input
parameters, such permitted choices include any value that is--
(i) Based on one of the observations described in paragraph
(g)(2)(ix)(C) of this section; and
(ii) Within the interquartile range (as described in Sec. 1.482-
1(e)(2)(iii)(C)) of the set of all values so based.
(E) Adjustments. Section 1.482-1(e)(3), applied as modified by this
paragraph (g)(2)(ix), determines when the Commissioner may make an
adjustment to a PCT Payment due to the taxpayer's results being outside
the arm's length range. Adjustment will be to the median, as defined in
Sec. 1.482-1(e)(3). Thus, the Commissioner is not required to
establish an arm's length range prior to making an allocation under
section 482.
(x) Valuation undertaken on a pre-tax basis. PCT Payments in
general may increase the PCT Payee's tax liability and decrease the PCT
Payor's tax liability. The arm's length amount of a PCT Payment
determined under the methods in this paragraph (g) is the value of the
PCT Payment itself, without regard to such tax effects. Therefore, the
methods under this section must be applied, with suitable adjustments
if needed, to determine the PCT Payments on a pre-tax basis. See
paragraphs (g)(2)(v)(B) and (4)(i)(G) of this section.
(3) Comparable uncontrolled transaction method. The comparable
uncontrolled transaction (CUT) method described in Sec. 1.482-4(c),
and the comparable uncontrolled services price (CUSP) method described
in Sec. 1.482-9(c), may be applied to evaluate whether the amount
charged in a PCT is arm's length by reference to the amount charged in
a comparable uncontrolled transaction. Although all of the factors
entering into a best method analysis described in Sec. 1.482-1(c) and
(d) must be considered, comparability and reliability under this method
are particularly dependent on similarity of contractual terms, degree
to which allocation of risks is proportional to reasonably anticipated
benefits from exploiting the results of intangible development, similar
period of commitment as to the sharing of intangible development risks,
and similar scope, uncertainty, and profit potential of the subject
intangible development, including a similar allocation of the risks of
any existing resources, capabilities, or rights, as well as of the
risks of developing other resources, capabilities, or rights that would
be reasonably anticipated to contribute to exploitation within the
parties' divisions, that is consistent with the actual allocation of
risks between the controlled participants as provided in the CSA in
accordance with this section. When applied in the manner described in
Sec. 1.482-4(c) or 1.482-9(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. The reliability of a CUT or CUSP that
yields a value for the platform contribution only in the PCT Payor's
division will be reduced to the extent that value is not consistent
with the total worldwide value of the platform contribution multiplied
by the PCT Payor's RAB share.
(4) Income method--(i) In general--(A) Equating cost sharing and
licensing alternatives. The income method evaluates whether the amount
charged in a PCT is arm's length by reference to a controlled
participant's best realistic alternative to entering into a CSA. Under
this method, the arm's length charge for a PCT Payment will be an
amount such that a controlled participant's present value, as of the
date of the PCT, of its cost sharing alternative of entering into a CSA
equals the present value of its best realistic alternative. In general,
the best realistic alternative of the PCT Payor 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 best realistic alternative of the PCT Payee to
entering into the CSA would be to undertake the commitment 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. Paragraphs (g)(4)(i)(B) through (vi) of this
section describe specific applications of the income method, but do not
exclude other possible applications of this method.
(B) Cost sharing alternative. The PCT Payor's cost sharing
alternative corresponds to the actual CSA in accordance with this
section, with the PCT Payor's obligation to make the PCT Payments to be
determined and its commitment for the duration of the IDA to bear cost
contributions.
(C) Licensing alternative. 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. Accordingly, 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,
capabilities, or rights 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. Apart from any difference in the allocation of the risks of the
IDA, the licensing alternative should assume contractual provisions
with regard to non-overlapping divisional intangible interests, and
with regard to allocations of other risks, that are consistent with the
actual CSA in accordance with this section. For example, the analysis
under the licensing alternative should assume a similar allocation of
the risks of any existing resources, capabilities, or rights, as well
as of the risks of developing other resources, capabilities, or rights
that would be reasonably anticipated to contribute to exploitation
within the parties' divisions, that is consistent with the actual
allocation of risks between the controlled participants as provided in
the CSA in accordance with this section. Accordingly, the financial
projections associated with the licensing and cost sharing alternatives
are necessarily the same except for the licensing payments to be made
under the licensing alternative and the cost contributions and PCT
Payments to be made under the CSA.
(D) Only one controlled participant with nonroutine platform
contributions. This method involves only one of the
[[Page 80107]]
controlled participants providing nonroutine platform contributions as
the PCT Payee. For a method under which more than one controlled
participant may be a PCT Payee, see the application of the residual
profit method pursuant to paragraph (g)(7) of this section.
(E) Income method payment forms. The income method may be applied
to determine PCT Payments in any form of payment (for example, lump
sum, royalty on sales, or royalty on divisional profit). For converting
to another form of payment, see generally paragraph (h) (Form of
payment rules) of this section.
(F) Discount rates appropriate to cost sharing and licensing
alternatives. The present value of the cost sharing and licensing
alternatives, respectively, should be determined using the appropriate
discount rates in accordance with paragraphs (g)(2)(v) and
(g)(4)(vi)(F) of this section. See, for example, Sec. 1.482-
7(g)(2)(v)(B)(1) (Discount rate variation between realistic
alternatives). In circumstances where the market-correlated risks as
between the cost sharing and licensing alternatives are not materially
different, a reliable analysis may be possible by using the same
discount rate with respect to both alternatives.
(G) The effect of taxation on determining the arm's length amount.
(1) In principle, the present values of the cost sharing and licensing
alternatives should be determined by applying post-tax discount rates
to post-tax income (including the post-tax value to the controlled
participant of the PCT Payments). If such approach is adopted, then the
post-tax value of the PCT Payments must be appropriately adjusted in
order to determine the arm's length amount of the PCT Payments on a
pre-tax basis. See paragraph (g)(2)(x) of this section.
(2) In certain circumstances, post-tax income may be derived as the
product of the result of applying a post-tax discount rate to pre-tax
income, and a factor equal to one minus the tax rate (as defined in
(j)(1)(i)). See paragraph (g)(2)(v)(B) of this section.
(3) To the extent that a controlled participant's tax rate is not
materially affected by whether it enters into the cost sharing or
licensing alternative (or reliable adjustments may be made for varying
tax rates), the factor (that is, one minus the tax rate) may be
cancelled from both sides of the equation of the cost sharing and
licensing alternative present values. Accordingly, in such circumstance
it is sufficient to apply post-tax discount rates to projections of
pre-tax income for the purpose of equating the cost sharing and
licensing alternatives. The specific applications of the income method
described in paragraphs (g)(4)(ii) through (iv) of this section and the
examples set forth in paragraph (g)(4)(viii) of this section assume
that a controlled participant's tax rate is not materially affected by
whether it enters into the cost sharing or licensing alternative.
(ii) Evaluation of PCT Payor's cost sharing alternative. 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 cost contributions, minus PCT
Payments.
(iii) Evaluation of PCT Payor's licensing alternative--(A)
Evaluation based on CUT. The present value of the PCT Payor's licensing
alternative may be determined using the comparable uncontrolled
transaction method, as described in Sec. 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 cost sharing 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 comparable
uncontrolled transaction method.
(B) Evaluation based on CPM. The present value of the PCT Payor's
licensing alternative may be determined using the comparable profits
method, as described in Sec. 1.482-5. In this case, the present value
of the licensing alternative is determined as in paragraph
(g)(4)(iii)(A) of this section, except that the PCT Payor's licensing
payments, as defined in paragraph (j)(1)(i) of this section, are
determined in each period to equal 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 market returns for
routine contributions, as defined in paragraph (j)(1)(i) of this
section. However, treatment of net operating contributions as operating
cost contributions shall be coordinated with the treatment of other
routine contributions pursuant to this paragraph so as to avoid
duplicative market returns to such contributions.
(iv) Lump sum payment form. Where the form of PCT Payment is a lump
sum as of the date of the PCT, then, based on paragraphs (g)(4)(i)
through (iii) of this section, the PCT Payment equals the difference
between--
(A) The present value, using the discount rate appropriate for the
cost sharing alternative, of the stream of the reasonably anticipated
residuals over the duration of the CSA Activity of divisional profits
or losses, minus cost contributions and operating cost contributions;
and
(B) The present value of the licensing alternative.
(v) [Reserved].
(vi) Best method analysis considerations. (A) Coordination with
Sec. 1.482-1(c). Whether results derived from this method are the most
reliable measure of an arm's length result is determined using the
factors described under the best method rule in Sec. 1.482-1(c). Thus,
comparability and the quality of data, the reliability of the
assumptions, and the sensitivity of the results to possible
deficiencies in the data and assumptions, must be considered in
determining whether this method provides the most reliable measure of
an arm's length result.
(B) Assumptions Concerning Tax Rates. This method will be more
reliable to the extent that the controlled participants' respective tax
rates are not materially affected by whether they enter into the cost
sharing or licensing alternative. Even if this assumption of invariant
tax rates across alternatives does not hold, this method may still be
reliable to the extent that reliable adjustments can be made to reflect
the variation in tax rates.
(C) Coordination with Sec. 1.482-4(c)(2). If the licensing
alternative is evaluated using the comparable uncontrolled transactions
method, as described in paragraph (g)(4)(iii)(A) of this section, any
additional comparability and reliability considerations stated in Sec.
1.482-4(c)(2) may apply.
(D) Coordination with Sec. 1.482-5(c). If the licensing
alternative is evaluated using the comparable profits method, as
described in paragraph (g)(4)(iii)(B) of this section, any additional
comparability and reliability considerations stated in Sec. 1.482-5(c)
may apply.
(E) Certain Circumstances Concerning PCT Payor. This method may be
used even if the PCT Payor furnishes significant operating
contributions, or commits to assume the risk of significant operating
cost contributions, to the PCT Payor's division. However, in such a
case, any comparable uncontrolled transactions described in paragraph
(g)(4)(iii)(A) of this section, and any comparable transactions used
[[Page 80108]]
under Sec. 1.482-5(c) as described in paragraphs (g)(4)(iii)(B) of
this section, should be consistent with such contributions (or reliable
adjustments must be made for material differences).
(F) Discount rates.
(1) Reflection of similar risk profiles of cost sharing alternative
and licensing alternative. Because the financial projections associated
with the licensing and cost sharing alternatives are the same, except
for the licensing payments to be made under the licensing alternative
and the cost contributions and PCT Payments to be made under the cost
sharing alternative, the analysis of the risk profile and financial
projections for a realistic alternative to the cost sharing alternative
must be closely associated with the risk profile and financial
projections associated with the cost sharing alternative, differing
only in the treatment of licensing payments, cost contributions, and
PCT Payments. When using discount rates in applying the income method,
this means that even if different discount rates are warranted for the
two alternatives, the risk profiles for the two discount rates are
closely related to each other because the discount rate for the
licensing alternative and the discount rate for the cost sharing
alternative are both derived from the single probability-weighted
financial projections associated with the CSA Activity. The difference,
if any, in market-correlated risks between the licensing and cost
sharing alternatives is due solely to the different effects on risks of
the PCT Payor making licensing payments under the licensing
alternative, on the one hand, and the PCT Payor making cost
contributions and PCT Payments under the cost sharing alternative, on
the other hand. That is, the difference in the risk profile between the
two scenarios solely reflects the incremental risk, if any, associated
with the cost contributions taken on by the PCT Payor in developing the
cost shared intangible under the cost sharing alternative, and the
difference, if any, in risk associated with the particular payment
forms of the licensing payments and the PCT Payments, in light of the
fact that the licensing payments in the licensing alternative are
partially replaced by cost contributions and partially replaced by PCT
Payments in the cost sharing alternative, each with its own payment
form. An analysis under the income method that uses a different
discount rate for the cost sharing alternative than for the licensing
alternative will be more reliable the greater the extent to which the
difference, if any, between the two discount rates reflects solely
these differences in the risk profiles of these two alternatives. See,
for example, paragraph (g)(2)(iii), Example 2 of this section.
(2) [Reserved].
(vii) Routine platform and operating contributions. For purposes of
this paragraph (g)(4), any routine contributions that are platform or
operating contributions, the valuation and PCT Payments for which are
determined and made independently of the income method, are treated
similarly to cost contributions and operating cost contributions,
respectively. Accordingly, wherever used in this paragraph (g)(4), the
term ``routine contributions'' shall not include routine platform or
operating contributions, and wherever the terms ``cost contributions''
and ``operating cost contributions'' appear in this paragraph, they
shall include net routine platform contributions and net routine
operating contributions, respectively. Net routine platform
contributions are the value of a controlled participant's total
reasonably anticipated routine platform contributions, plus its
reasonably anticipated PCT Payments to other controlled participants in
respect of their routine platform contributions, minus the reasonably
anticipated PCT Payments it is to receive from other controlled
participants in respect of its routine platform contributions. Net
routine operating contributions are the value of a controlled
participant's total reasonably anticipated routine operating
contributions, plus its reasonably anticipated arm's length
compensation to other controlled participants in respect of their
routine operating contributions, minus the reasonably anticipated arm's
length compensation it is to receive from other controlled participants
in respect of its routine operating contributions.
(viii) Examples. The following examples illustrate the principles
of this paragraph (g)(4):
Example 1. (i) For simplicity of calculation in this Example 1,
all financial flows are assumed to occur at the beginning of each
period. USP, a software company, has developed version 1.0 of a new
software application that it is currently marketing. In Year 1 USP
enters into a CSA with its wholly-owned foreign subsidiary, FS, to
develop future versions of the software application. Under the CSA,
USP will have the rights to exploit the future versions in the
United States, and FS will have the rights to exploit them in the
rest of the world. The future rights in version 1.0, and USP's
development team, are reasonably anticipated to contribute to the
development of future versions and therefore the rights in version
1.0 and the research and development team are platform contributions
for which compensation is due from FS as part of a PCT. USP does not
transfer the current exploitation rights in version 1.0 to FS. FS
will not perform any research or development activities and does not
furnish any platform contributions nor does it control any operating
intangibles at the inception of the CSA that would be relevant to
the exploitation of version 1.0 or future versions of the software.
(ii) FS undertakes financial projections in its territory of the
CSA:
----------------------------------------------------------------------------------------------------------------
(5) Operating
income under
(1) Year (2) Sales (3) Operating (4) Cost cost sharing
costs contributions alternative
(excluding PCT)
----------------------------------------------------------------------------------------------------------------
1............................................ 0 0 50 -50
2............................................ 0 0 50 -50
3............................................ 200 100 50 50
4............................................ 400 200 50 150
5............................................ 600 300 60 240
6............................................ 650 325 65 260
7............................................ 700 350 70 280
8............................................ 750 375 75 300
9............................................ 750 375 75 300
10........................................... 675 338 68 269
11........................................... 608 304 61 243
12........................................... 547 273 55 219
[[Page 80109]]
13........................................... 410 205 41 164
14........................................... 308 154 31 123
15........................................... 231 115 23 93
----------------------------------------------------------------------------------------------------------------
FS anticipates that activity on this application will cease after
Year 15. The application was derived from software developed by
Company Q, an uncontrolled party. FS has a license under Company Q's
copyright, but that license expires after Year 15 and will not be
renewed.
(iii) In evaluating the cost sharing alternative, FS concludes
that the cost sharing alternative represents a riskier alternative
for FS than the licensing alternative because, in cost sharing, FS
will take on the additional risks associated with cost
contributions. Taking this difference into account, FS concludes
that the appropriate discount rate to apply in assessing the
licensing alternative, based on discount rates of comparable
uncontrolled companies undertaking comparable licensing
transactions, would be 13% per year, whereas the appropriate
discount rate to apply in assessing the cost sharing alternative
would be 15% per year. FS determines that the arm's length rate USP
would have charged an uncontrolled licensee for a license of future
versions of the software (if USP had further developed version 1.0
on its own) is 35% of the sales price, as determined under the CUT
method in Sec. 1.482-4(c). FS also determines that the tax rate
applicable to it will be the same in the licensing alternative as in
the CSA. Accordingly, the financial projections associated with the
licensing alternative are:
----------------------------------------------------------------------------------------------------------------
(11) Operating
income under
(10) Operating cost sharing
(8) Operating (9) Licensing income under alternative
(6) Year (7) Sales costs payments licensing minus operating
alternative income under
licensing
alternative
----------------------------------------------------------------------------------------------------------------
1............................ 0 0 0 0 -50
2............................ 0 0 0 0 -50
3............................ 200 100 70 30 20
4............................ 400 200 140 60 90
5............................ 600 300 210 90 150
6............................ 650 325 228 97 163
7............................ 700 350 245 105 175
8............................ 750 375 263 112 188
9............................ 750 375 263 112 188
10........................... 675 338 236 101 168
11........................... 608 304 213 91 152
12........................... 547 273 191 83 136
13........................... 410 205 144 61 103
14........................... 308 154 108 46 77
15........................... 231 115 81 35 58
----------------------------------------------------------------------------------------------------------------
(iv) Based on these projections and applying the appropriate
discount rate, FS determines that under the cost sharing
alternative, the present value of the stream of residuals of its
anticipated divisional profits, reduced by the anticipated operating
cost contributions and cost contributions, but not reduced by any
PCT Payments (that is, the stream of anticipated operating income as
shown in column 5) would be $889 million. Under the licensing
alternative, the present value of the stream of residuals of its
anticipated divisional profits and losses minus the operating cost
contributions (that is, the stream of anticipated operating income
before licensing payments, which is the present value of column 7
reduced by column 8) would be $1.419 billion, and the present value
of the licensing payments would be $994 million. Therefore, the
total value of the licensing alternative would be $425 million. In
order for the present value of the cost sharing alternative to equal
the present value of the licensing alternative, the present value of
the PCT Payments must equal $464 million. Therefore, the taxpayer
makes and reports PCT Payments with a present value of $464 million.
Example 2. Arm's length range. (i) The facts are the same as in
Example 1. The Commissioner accepts the financial projections
undertaken by FS. Further, the Commissioner determines that the
licensing discount rate and the CUT licensing rate are most reliably
determined by reference to comparable uncontrolled discount rates
and license rates, respectively. The observations that are in the
interquartile range of the respective input parameters (see
paragraph (g)(2)(ix) of this section) are as follows:
------------------------------------------------------------------------
Comparable
Observations that are within interquartile range uncontrolled
discount rate
------------------------------------------------------------------------
1..................................................... 11%
2..................................................... 12
3 (Median)............................................ 13
4..................................................... 15
5..................................................... 17
------------------------------------------------------------------------
------------------------------------------------------------------------
Comparable
Observations that are within interquartile range uncontrolled
licensing rate
------------------------------------------------------------------------
1..................................................... 30%
2..................................................... 32
3 (Median)............................................ 35
4..................................................... 37
5..................................................... 40
------------------------------------------------------------------------
(ii) Following the principles of paragraph (g)(2)(ix) of this
section, the Commissioner undertakes 25 different applications of
the
[[Page 80110]]
income method, using each combination of the discount rate and
licensing rate parameters. In undertaking this analysis, the
Commissioner assumes that the ratio of the median discount rate for
the cost sharing alternative to the median discount rate for the
licensing alternative (that is, 15% to 13%) is maintained. The
results of the 25 applications of the income method, sorted in
ascending order of calculated present value of the PCT Payment, are
as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Comparable Comparable
uncontrolled uncontrolled Comparable Calculated lump Interquartile range of PCT
Income method application number: licensing CSA discount uncontrolled sum PCT payment payments
discount rate rate licensing rate
--------------------------------------------------------------------------------------------------------------------------------------------------------
1........................................... 17% 19.6% 30% 217
2........................................... 17 19.6 32 263
3........................................... 15 17.3 30 264
4........................................... 15 17.3 32 315
5........................................... 13 15 30 321
6........................................... 17 19.6 35 331
7........................................... 12 13.8 30 354 LQ = 354
8........................................... 17 19.6 37 376
9........................................... 13 15 32 378
10.......................................... 11 12.7 30 391 ..................................
11.......................................... 15 17.3 35 391
12.......................................... 12 13.8 32 415
13.......................................... 15 17.3 37 442 Median = 442
14.......................................... 17 19.6 40 444
15.......................................... 11 12.7 32 455
16.......................................... 13 15 35 464
17.......................................... 12 13.8 35 505
18.......................................... 15 17.3 40 517
19.......................................... 13 15 37 520 UQ = 520
20.......................................... 11 12.7 35 551
21.......................................... 12 13.8 37 566
22.......................................... 13 15 40 605
23.......................................... 11 12.7 37 615
24.......................................... 12 13.8 40 655
25.......................................... 11 12.7 40 710
--------------------------------------------------------------------------------------------------------------------------------------------------------
(iii) Accordingly, the Commissioner determines that a taxpayer
will not be subject to adjustment if its initial (ex ante)
determination of the present value of PCT Payments is between $354
million and $520 million (the lower and upper quartile results as
shown in the last column). Because FS's determination of the present
value of the PCT Payments, $464 million, is within the interquartile
range, no adjustments are warranted.
Example 3. (i) For simplicity of calculation in this Example 3,
all financial flows are assumed to occur at the beginning of each
period. USP, a U.S. software company, has developed version 1.0 of a
new software application, employed to store and retrieve complex
data sets in certain types of storage media. Version 1.0 is
currently being marketed. In Year 1, USP enters into a CSA with its
wholly-owned foreign subsidiary, FS, to develop future versions of
the software application. Under the CSA, USP will have the exclusive
rights to exploit the future versions in the U.S., and FS will have
the exclusive rights to exploit them in the rest of the world. USP's
rights in version 1.0, and its development team, are reasonably
anticipated to contribute to the development of future versions of
the software application and, therefore, the rights in version 1.0
are platform contributions for which compensation is due from FS as
part of a PCT. USP also transfers the current exploitation rights in
version 1.0 to FS and the arm's length amount of the compensation
for such transfer is determined in the aggregate with the arm's
length PCT Payments in this Example 3. FS does not furnish any
platform contributions to the CSA nor does it control any operating
intangibles at the inception of the CSA that would be relevant to
the exploitation of version 1.0 or future versions of the software.
It is reasonably anticipated that FS will have gross sales of $1000X
in its territory for 5 years attributable to its exploitation of
version 1.0 and the cost shared intangibles, after which time the
software application will be rendered obsolete and unmarketable by
the obsolescence of the storage medium technology to which it
relates. FS's costs reasonably attributable to the CSA, other than
cost contributions and operating cost contributions, are anticipated
to be $250X per year. Certain operating cost contributions that will
be borne by FS are reasonably anticipated to equal $200X per annum
for 5 years. In addition, FS is reasonably anticipated to pay cost
contributions of $200X per year as a controlled participant in the
CSA.
(ii) FS concludes that its realistic alternative would be to
license software from an uncontrolled licensor that would undertake
the commitment to bear the entire risk of software development.
Applying CPM using the profit levels experienced by uncontrolled
licensees with contractual provisions and allocations of risk that
are comparable to those of FS's licensing alternative, FS determines
that it could, as a licensee, reasonably expect a (pre-tax) routine
return equal to 14% of gross sales or $140X per year for 5 years.
The remaining net revenue would be paid to the uncontrolled licensor
as a license fee of $410X per year. FS determines that the discount
rate that would be applied to determine the present value of income
and costs attributable to its participation in the licensing
alternative would be 12.5% as compared to the 15% discount rate that
would be applicable in determining the present valuable of the net
income attributable to its participation in the CSA (reflecting the
increased risk borne by FS in bearing a share of the R&D costs in
the cost sharing alternative). FS also determines that the tax rate
applicable to it will be the same in the licensing alternative as in
the CSA.
(iii) On these facts, the present value to FS of entering into
the cost sharing alternative equals the present value of the annual
divisional profits ($1,000X minus $250X) minus operating cost
contributions ($200X) minus cost contributions ($200X) minus PCT
Payments, determined over 5 years by discounting at a discount rate
of 15%. Thus, the present value of the residuals, prior to
subtracting the present value of the PCT Payments, is $1349X.
(iv) On these facts, the present value to FS of entering into
the licensing alternative would be $561X determined by discounting,
over 5 years, annual divisional profits ($1,000X minus $250X) minus
operating cost contributions ($200X) and licensing payments ($410X)
at a discount rate of 12.5% per annum. The present value of the cost
sharing alternative must also equal $561X but
[[Page 80111]]
equals $1349X prior to subtracting the present value of the PCT
Payments. Consequently, the PCT Payments must have a present value
of $788X.
Example 4. Pre-tax PCT Payment derived from post-tax
information. (i) For simplicity of calculation in this Example 4, it
is assumed that all payments are made at the end of each year.
Domestic controlled participant USP has developed a technology, Z,
that it would like to exploit for three years in a CSA. USP enters
into a CSA with its wholly-owned foreign subsidiary, FS, that
provides for PCT Payments from FS to USP with respect to USP's
platform contribution to the CSA of Z in the form of three annual
installment payments due from FS to USP on the last day of each of
the first three years of the CSA. FS makes no platform contributions
to the CSA. Prior to entering into the CSA, FS considers that it has
the realistic alternative available to it of licensing Z from USP
rather than entering into a CSA with USP to further develop Z for
three years.
(ii) FS undertakes financial projections for both the licensing
and cost sharing alternatives for exploitation of Z in its territory
of the CSA. These projections are set forth in the following tables.
The example assumes that there is a reasonably anticipated effective
tax rate of 25% in each of years 1 through 3 under both the
licensing and cost sharing alternatives. FS determines that the
appropriate post-tax discount rate under the licensing alternative
is 12.5%, and that the appropriate post-tax discount rate under the
cost sharing alternative is 15%.
----------------------------------------------------------------------------------------------------------------
Present value
Licensing alternative (12.5% DR) Year 1 Year 2 Year 3
----------------------------------------------------------------------------------------------------------------
(1) Sales............................... ................ $1000 $1100 $1210
(2) License Fee......................... ................ 400 440 484
(3) Operating costs..................... ................ 500 550 605
(4) Operating Income.................... $261 100 110 121
(5) Tax (25%)........................... ................ 25 28 30
(6) Post-tax income..................... $196 $75 $82 $91
----------------------------------------------------------------------------------------------------------------
Present value
Cost sharing alternative (15% DR) Year 1 Year 2 Year 3
----------------------------------------------------------------------------------------------------------------
(7) Sales............................... ................ $1000 $1100 $1210
(8) Cost Contributions.................. ................ 200 220 242
(9) PCT Payments........................ D A B C
(10) Operating costs.................... ................ 500 550 605
(11) Operating income excluding PCT..... $749 300 330 363
(12) Operating income................... H E F G
(13) Tax................................ ................ ................ ................ ................
(14) Post-tax income excluding PCT...... $562 $225 $248 $272
(15) Post-tax income.................... L I J K
----------------------------------------------------------------------------------------------------------------
(iii) Under paragraph (g)(4) of this section, the arm's length
charge for a PCT Payment will be an amount such that a controlled
participant's present value, as of the date of the PCT of its cost
sharing alternative of entering into a CSA equals the present value
of its best realistic alternative. This requires that L, the present
value of the post-tax income under the CSA, equals the present value
of the post-tax income under the licensing alternative, or $196.
(iv) FS determines that PCT Payments for Z should be $196 in
Year 1 (A), $215 in Year 2 (B), and $236 in Year 3 (C). By using
these amounts for A, B, and C in the table above, FS is able to
derive the values of E, F, G, I, J, and K in the table above. Based
on these PCT Payments for Z, the post-tax income will be $78 in Year
1 (I), $86 in Year 2 (J), and $95 in Year 3 (K). When this post-tax
income stream is discounted at the appropriate rate for the cost
sharing alternative (15%), the net present value is $196 (L). The
present value of the PCT Payments, when discounted at the
appropriate post-tax rate, is $488 (D).
(v) The Commissioner undertakes an audit of the PCT Payments
made by FS to USP for Z in Years 1 through 3. The Commissioner
concludes that the PCT Payments for Z are arm's length in accordance
with this paragraph (g)(4).
Example 5. Pre-tax PCT Payment derived from post-tax
information. (i) The facts are the same as in paragraphs (i) and
(ii) of Example 4. In addition, under this paragraph (g)(4), the
arm's length charge for a PCT Payment will be an amount such that a
controlled participant's present value, as of the date of the PCT of
its cost sharing alternative equals the present value of its best
realistic alternative. This requires that L, the present value of
the post-tax income under the CSA, equals the present value of the
post-tax income under the licensing alternative, or $196.
(ii) FS determines that the post-tax present value of the cost
sharing alternative (excluding PCT Payments) is $562. The post-tax
present value of the licensing alternative is $196. Accordingly,
payments with a post-tax present value of $366 are required.
(iii) The Commissioner undertakes an audit of the PCT Payments
made by FS to USP for Z in Years 1 through 3. In correspondence to
the Commissioner, USP maintains that the arm's length PCT Payment
for Z should have a present value of $366 (D).
(iv) The Commissioner considers that if FS makes PCT Payments
for Z with a present value of $366, then the post-tax present value
under the CSA (considering the deductibility of the PCT Payments)
will be $287, substantially higher than the post-tax present value
of the licensing arrangement, $196. The Commissioner determines
that, under the specific facts and assumptions of this example, the
present value of the post-tax payments may be grossed up by a factor
of (one minus the tax rate), resulting in a present value of pre-tax
payments of $488. Accordingly, FS must make yearly PCT Payments (A,
B, and C) such that the present value of the Payments is $488 (D).
(When FS's post-tax income after these PCT Payments for Z is
discounted at the appropriate rate for the cost sharing alternative
(15%), the net present value is $196 (L), which is equal to the
present value of post-tax income under the licensing alternative.)
The Commissioner concludes that the calculations that it has made
for the PCT Payments for Z are arm's length in accordance with this
paragraph (g)(4) and, accordingly, makes the appropriate adjustments
to USP's income tax return to account for the gross-up required by
paragraph (g)(2)(x) of this section.
Example 6. Pre-tax PCT Payment derived from pre-tax information.
(i) The facts are the same as in paragraphs (i) and (ii) of Example
4. In addition, under paragraph (g)(4) of this section, the arm's
length charge for a PCT Payment will be an amount such that a
controlled participant's present value, as of the date of the PCT of
its cost sharing alternative of entering into a CSA equals the
present value of its best realistic alternative. This requires that
``L,'' the present value of the post-tax income under the CSA,
equals the present value of the post-tax income under the licensing
alternative, or $196.
(ii) Under the specific facts and assumptions of this Example 6
(see paragraph (g)(4)(i)(G) of this section), and using the same
(post-tax) discount rates as in Example 4, the present value of pre-
tax income under the licensing alternative (that is, the operating
income) is $261, and the present value of pre-tax income under the
cost sharing alternative (excluding PCT Payments) is $749.
Accordingly, FS determines that its PCT Payments for Z should have a
present value equal to the difference between the two, or $488 (D).
Such
[[Page 80112]]
PCT Payments for Z result in a present value of post-tax income
under the cost sharing alternative of $196 (L), which is equal to
the present value of post-tax income under the licensing
alternative.
(iii) The Commissioner undertakes an audit of the PCT Payments
for Z made by FS to USP in Years 1 through 3. The Commissioner
concludes that the PCT Payments for Z are arm's length in accordance
with this paragraph (g)(4).
Example 7. Application of income method with a terminal value
calculation. (i) For simplicity of calculation in this Example 7,
all financial flows are assumed to occur at the beginning of each
period. USP's research and development team, Q, has developed a
technology, Z, for which it has several applications on the market
now and several planned for release at future dates. In Year 1, USP,
enters into a CSA with its wholly-owned subsidiary, FS, to develop
future applications of Z. Under the CSA, USP will have the rights to
further develop and exploit the future applications of Z in the
United States, and FS will have the rights to further develop and
exploit the future applications of Z in the rest of the world. Both
Q and the rights to further develop and exploit future applications
of Z are reasonably anticipated to contribute to the development of
future applications of Z. Therefore, both Q and the rights to
further develop and exploit the future applications of Z are
platform contributions for which compensation is due from FS to USP
as part of a PCT. USP does not transfer the current exploitation
rights for current applications of Z to FS. FS will not perform any
research or development activities on Z and does not furnish any
platform contributions to the CSA, nor does it control any operating
intangibles at the inception of the CSA that would be relevant to
the exploitation of either current or future applications of Z.
(ii) At the outset of the CSA, FS undertakes an analysis of the
PCTs involving Q and the rights with respect to Z in order to
determine the arm's length PCT Payments owing from FS to USP under
the CSA. In that evaluation, FS concludes that the cost sharing
alternative represents a riskier alternative for FS than the
licensing alternative. FS further concludes that the appropriate
discount rate to apply in assessing the licensing alternative, based
on discount rates of comparable uncontrolled companies undertaking
comparable licensing transactions, would be 13% per annum, whereas
the appropriate discount rate to apply in assessing the cost sharing
alternative would be 14% per annum. FS undertakes financial
projections and anticipates making $100 million in sales during the
first two years of the CSA in its territory with sales in Years 3
through 8 increasing to $200 million, $400 million, $600 million,
$650 million, $700 million, and $750 million, respectively. After
Year 8, FS expects its sales of all products based upon exploitation
of Z in the rest of the world to grow at 3% per annum for the
future. FS and USP do not anticipate cessation of the CSA Activity
with respect to Z at any determinable date. FS anticipates that its
manufacturing and distribution costs for exploiting Z (including its
operating cost contributions), will equal 60% of gross sales of Z
from Year 1 onwards, and anticipates its cost contributions will
equal $25 million per annum for Years 1 and 2, $50 million per annum
for Years 3 and 4, and 10% of gross sales per annum thereafter.
(iii) Based on this analysis, FS determines that the arm's
length royalty rate that USP would have charged an uncontrolled
licensee for a license of future applications of Z if USP had
further developed future applications of Z on its own is 30% of the
sales price of the Z-based product, as determined under the
comparable uncontrolled transaction method in Sec. 1.482-4(c). In
light of the expected sales growth and anticipation that the CSA
Activity will not cease as of any determinable date, FS's
determination includes a terminal value calculation. FS further
determines that under the cost sharing alternative, the present
value of FS's divisional profits, reduced by the present values of
the anticipated operating cost contributions and cost contributions,
would be $1,361 million. Under the licensing alternative, the
present value of the operating divisional profits and losses,
reduced by the operating cost contributions, would be $2,113
million, and the present value of the licensing payments would be
$1,585 million. Therefore, the total value of the licensing
alternative would be $528 million. In order for the present value of
the cost sharing alternative to equal the present value of the
licensing alternative, the present value of the PCT Payments must
equal $833 million. Accordingly, FS pays USP a lump sum PCT Payment
of $833 million in Year 1 for USP's platform contributions of Z and
Q.
(iv) The Commissioner undertakes an audit of the PCTs and
concludes, based on his own analysis, that this lump sum PCT Payment
is within the interquartile range of arm's length results for these
platform contributions. The calculations made by FS in determining
the PCT Payment in this Example 7 are set forth in the following
tables:
Cost Sharing Alternative
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year, TV = Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 TV
Terminal Value).
Discount Period............... 0 1 2 3 4 5 6 7 7
Items of Income/Expense at
Beginning of Year:
1 Sales................... 100 100 200 400 600 650 700 750 (3% annual
growth in each
year from
previous year).
2 Routine Cost and 60 60 120 240 360 390 420 450 (60% of annual
Operating Cost sales in row 1
Contributions (60% of for each year).
sales amount in row 1 of
relevant year).
3 Cost Contributions (10% 25 25 50 50 60 65 70 75 (10% of annual
of sales amount in row 1 sales in row 1
for relevant year after for each year).
Year 5).
4 Profit = amount in row 1 15 15 30 110 180 195 210 225 (row 1 minus
reduced by amounts in rows 2 and 3
rows 2 and 3. for each year).
5 PV (using 14% discount 15 13.2 23.1 74.2 107 101 95.7 89.9 842.
rate).
----------------------------------------------------------------------------------------------------------------
6 TOTAL PV of Cost Sharing Alternative = Sum of all PV amounts in Row 5 for all Time Periods = $1,361
million..
----------------------------------------------------------------------------------------------------------------
Licensing Alternative
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year, TV = Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 TV
Terminal Value).
Discount Period............... 0 1 2 3 4 5 6 7 7
Items of Income/Expense at
Beginning of Year:
[[Page 80113]]
7 Sales................... 100 100 200 400 600 650 700 750 (3% annual
growth in each
year from
previous year).
8 Routine Cost and 60 60 120 240 360 390 420 450 (60% of annual
Operating Cost sales in row 7
Contributions (60% of for each year).
sales amount in row 7 of
relevant year).
9 Operating Profit = 40 40 80 160 240 260 280 300 (Row 7 minus row
amount in Row 7 reduced 8 for each
by amount in Row 8. year).
10 PV of row 9 (using 13% 40 35.4 62.7 111 147 141 135 128 1313.
discount rate).
----------------------------------------------------------------------------------------------------------------
11 TOTAL PV FOR ALL AMOUNTS IN ROW 10 = $2,112.7 million....................................................
----------------------------------------------------------------------------------------------------------------
12 Licensing Payments (30% 30 30 60 120 180 195 210 225 (30% of amount
of sales amount in row 7). in row 7 for
each year).
13 PV of amount in row 12 30 26.5 47 83.2 110 106 101 95.6 985.
(using 13% discount rate).
----------------------------------------------------------------------------------------------------------------
14 TOTAL PV FOR ALL AMOUNTS IN ROW 13 = $1,584.5 million.
15 TOTAL PV of Licensing Alternative = Row 11 minus Row 14 = $528 million.
----------------------------------------------------------------------------------------------------------------
Calculation of PCT Payment
------------------------------------------------------------------------
------------------------------------------------------------------------
16..................... TOTAL PV OF COST $1,361 million.
SHARING ALTERNATIVE
(FROM ROW 6 ABOVE) =.
17..................... TOTAL PV OF LICENSING $528 million.
ALTERNATIVE (FROM ROW
15 ABOVE) =.
18..................... LUMP SUM PCT PAYMENT = $833 million.
ROW 16 - ROW 17 =.
------------------------------------------------------------------------
(5) Acquisition price method--(i) In general. The acquisition price
method applies the comparable uncontrolled transaction method of Sec.
1.482-4(c), or the comparable uncontrolled services price method
described in Sec. 1.482-9(c), to evaluate whether the amount charged
in a PCT, or group of PCTs, is 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, as such term
is defined in paragraph (j)(1)(i) of this section, made to the PCT
Payee's business activities are covered by a PCT or group of PCTs.
(ii) Determination of arm's length charge. Under this method, the
arm's length charge for a PCT or group of PCTs covering resources,
capabilities, and rights of the target is equal to the adjusted
acquisition price, as divided among the controlled participants
according to their respective RAB shares.
(iii) Adjusted acquisition price. The adjusted acquisition price is
the acquisition price of the target increased by the value of the
target's liabilities on the date of the acquisition, other than
liabilities not assumed in the case of an asset purchase, and decreased
by the value of the target's tangible property on that date and by the
value on that date of any other resources, capabilities, and rights not
covered by a PCT or group of PCTs.
(iv) Best method analysis considerations. The comparability and
reliability considerations stated in Sec. 1.482-4(c)(2) apply.
Consistent with those considerations, the reliability of applying the
acquisition price method as a measure of the arm's length charge for
the PCT Payment normally is reduced if--
(A) A substantial portion of the target's nonroutine contributions
to the PCT Payee's business activities is not required to be covered by
a PCT or group of PCTs, and that portion of the nonroutine
contributions cannot reliably be valued;
(B) A substantial portion of the target's assets consists of
tangible property that cannot reliably be valued; or
(C) The date on which the target is acquired and the date of the
PCT are not contemporaneous.
(v) Example. The following example illustrates the principles of
this paragraph (g)(5):
Example. USP, a U.S. corporation, and its newly incorporated,
wholly-owned foreign subsidiary (FS) enter into a CSA at the start
of Year 1 to develop Group Z products. Under the CSA, USP and FS
will have the exclusive rights to exploit the Group Z products in
the U.S. and the rest of the world, respectively. At the start of
Year 2, USP acquires Company X for cash consideration worth $110
million. At this time USP's RAB share is 60%, and FS's RAB share is
40% and is not reasonably anticipated to change as a result of this
acquisition. Company X joins in the filing of a U.S. consolidated
income tax return with USP. Under paragraph (j)(2)(i) of this
section, Company X and USP are treated as one taxpayer for purposes
of this section. Accordingly, the rights in any of Company X's
resources and capabilities that are reasonably anticipated to
contribute to the development activities of the CSA will be
considered platform contributions furnished by USP. Company X's
resources and capabilities consist of its workforce, certain
technology intangibles, $15 million of tangible property and other
assets and $5 million in liabilities. The technology intangibles, as
well as Company X's workforce, are reasonably anticipated to
contribute to the development of the Group Z products under the CSA
and, therefore, the rights in the technology intangibles and the
workforce are platform contributions for which FS must make a PCT
Payment to USP. None of Company X's existing intangible assets or
any of its workforce are anticipated to contribute to activities
outside the CSA. For purposes of this example, it is assumed that no
additional adjustment on account of tax liabilities is needed.
Applying the acquisition price method, the value of USP's platform
contributions is the adjusted acquisition price of $100 million
($110 million acquisition price plus $5 million liabilities less $15
million tangible property and other assets). FS must make a PCT
Payment to USP for these platform contributions with a reasonably
anticipated present value of $40 million, which is the product of
$100 million (the value of the platform contributions) and 40% (FS's
RAB share).
(6) Market capitalization method--(i) In general. The market
capitalization
[[Page 80114]]
method applies the comparable uncontrolled transaction method of Sec.
1.482-4(c), or the comparable uncontrolled services price method
described in Sec. 1.482-9(c), to evaluate whether the amount charged
in a PCT, or group of PCTs, is 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
of the PCT Payee's nonroutine contributions to the PCT Payee's business
are covered by a PCT or group of PCTs.
(ii) Determination of arm's length charge. Under the market
capitalization method, the arm's length charge for a PCT or group of
PCTs 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.
(iii) Average market capitalization. The average market
capitalization is the average of the daily market capitalizations of
the PCT Payee over a period of time beginning 60 days before the date
of the PCT and ending on the date of the PCT. The daily market
capitalization of the PCT Payee is calculated on each day its stock is
actively traded as the total number of shares outstanding multiplied by
the adjusted closing price of the stock on that day. The adjusted
closing price is the daily closing price of the stock, after
adjustments for stock-based transactions (dividends and stock splits)
and other pending corporate (combination and spin-off) restructuring
transactions for which reliable arm's length adjustments can be made.
(iv) Adjusted average market capitalization. The adjusted average
market capitalization is the average market capitalization of the PCT
Payee increased by the value of the PCT Payee's liabilities on the date
of the PCT and decreased by the value on such date of the PCT Payee's
tangible property and of any other resources, capabilities, or rights
of the PCT Payee not covered by a PCT or group of PCTs.
(v) Best method analysis considerations. The comparability and
reliability considerations stated in Sec. 1.482-4(c)(2) apply.
Consistent with those considerations, the reliability of applying the
comparable uncontrolled transaction method using the adjusted market
capitalization of a company as a measure of the arm's length charge for
the PCT Payment normally is reduced if--
(A) A substantial portion of the PCT Payee's nonroutine
contributions to its business activities is not required to be covered
by a PCT or group of PCTs, and that portion of the nonroutine
contributions cannot reliably be valued;
(B) A substantial portion of the PCT Payee's assets consists of
tangible property that cannot reliably be valued; or
(C) Facts and circumstances demonstrate the likelihood of a
material divergence between the average market capitalization of the
PCT Payee and the value of its resources, capabilities, and rights for
which reliable adjustments cannot be made.
(vi) Examples. The following examples illustrate the principles of
this paragraph (g)(6):
Example 1. (i) USP, a publicly traded U.S. company, and its
newly incorporated wholly-owned foreign subsidiary (FS) enter into a
CSA on Date 1 to develop software. At that time USP has in-process
software but has no software ready for the market. Under the CSA,
USP and FS will have the exclusive rights to exploit the software
developed under the CSA in the United States and the rest of the
world, respectively. On Date 1, USP's RAB share is 70% and FS's RAB
share is 30%. USP's assembled team of researchers and its in-process
software are reasonably anticipated to contribute to the development
of the software under the CSA. Therefore, the rights in the research
team and in-process software are platform contributions for which
compensation is due from FS. Further, these rights are not
reasonably anticipated to contribute to any business activity other
than the CSA Activity.
(ii) On Date 1, USP had an average market capitalization of $205
million, tangible property and other assets that can be reliably
valued worth $5 million, and no liabilities. Aside from those
assets, USP had no assets other than its research team and in-
process software. Applying the market capitalization method, the
value of USP's platform contributions is $200 million ($205 million
average market capitalization of USP less $5 million of tangible
property and other assets). The arm's length value of the PCT
Payments FS must make to USP for the platform contributions, before
any adjustment on account of tax liability as described in paragraph
(g)(2)(ii) of this section, is $60 million, which is the product of
$200 million (the value of the platform contributions) and 30% (FS's
RAB share on Date 1).
Example 2. Aggregation with make-or-sell rights. (i) The facts
are the same as in Example 1, except that on Date 1 USP also has
existing software ready for the market. USP separately enters into a
license agreement with FS for make-or-sell rights for all existing
software outside the United States. No marketing has occurred, and
USP has no marketing intangibles. This license of current make-or-
sell rights is a transaction governed by Sec. 1.482-4. However,
after analysis, it is determined that the arm's length PCT Payments
and the arm's length payments for the make-or-sell license may be
most reliably determined in the aggregate using the market
capitalization method, under principles described in paragraph
(g)(2)(iv) of this section, and it is further determined that those
principles are most reliably implemented by computing the aggregate
arm's length charge as the product of the aggregate value of the
existing and in-process software and FS's RAB share on Date 1.
(ii) Applying the market capitalization method, the aggregate
value of USP's platform contributions and the make-or-sell rights in
its existing software is $250 million ($255 million average market
capitalization of USP less $5 million of tangible property and other
assets). The total arm's length value of the PCT Payments and
licensing payments FS must make to USP for the platform
contributions and current make-or-sell rights, before any adjustment
on account of tax liability, if any, is $75 million, which is the
product of $250 million (the value of the platform contributions and
the make-or-sell rights) and 30% (FS's RAB share on Date 1).
Example 3. Reduced reliability. The facts are the same as in
Example 1 except that USP also has significant nonroutine assets
that will be used solely in a nascent business division that is
unrelated to the subject of the CSA and that cannot themselves be
reliably valued. Those nonroutine contributions are not platform
contributions and accordingly are not required to be covered by a
PCT. The reliability of using the market capitalization method to
determine the value of USP's platform contributions to the CSA is
significantly reduced in this case because that method would require
adjusting USP's average market capitalization to account for the
significant nonroutine contributions that are not required to be
covered by a PCT.
(7) Residual profit split method--(i) In general. The residual
profit split method evaluates whether the allocation of combined
operating profit or loss attributable to one or more platform
contributions subject to a PCT is 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 include 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
provisions of Sec. 1.482-6 shall apply to CSAs only to the extent
provided and as modified in this paragraph (g)(7). Any other
application to a CSA of a residual profit method not described in
paragraphs (g)(7)(ii) and (iii) of this section will constitute an
unspecified method for purposes of sections 482 and 6662(e)
[[Page 80115]]
and the regulations under those sections.
(ii) Appropriate share of profits and losses. 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, consistent with the best
method analysis described in Sec. 1.482-1(c) and (d). 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. The profit
allocated to any particular controlled participant is not necessarily
limited to the total operating profit of the group from the relevant
business activity. For example, in a given year, one controlled
participant may earn a profit while another controlled participant
incurs a loss. In addition, it may not be assumed that the combined
operating profit or loss from the relevant business activity should be
shared equally, or in any other arbitrary proportion.
(iii) Profit split--(A) In general. Under the residual profit split
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 between
the controlled participants that each furnish significant nonroutine
contributions (including platform or operating contributions) to the
relevant business activity in that division.
(B) Determine nonroutine residual divisional profit or loss. The
present value of each controlled participant's nonroutine residual
divisional profit or loss must be determined to reflect the most
reliable measure of an arm's length result. 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
in accordance with paragraph (g)(2)(v) of this section. As used in this
paragraph (g)(7), the phrase ``market returns for routine
contributions'' includes market returns for operating cost
contributions and excludes market returns for cost contributions.
(C) Allocate nonroutine residual divisional profit or loss--(1) In
general. The present value of nonroutine residual divisional profit or
loss in each controlled participant's division must be allocated among
all of the controlled participants based upon the relative values,
determined as of the date of the PCTs, of the PCT Payor's as compared
to the PCT Payee's nonroutine contributions to the PCT Payor's
division. For this purpose, the PCT Payor's nonroutine contribution
consists of the sum of the PCT Payor's nonroutine operating
contributions and the PCT Payor's RAB share of the PCT Payor's
nonroutine platform contributions. For this purpose, the PCT Payee's
nonroutine contribution consists of the PCT Payor's RAB share of the
PCT Payee's nonroutine platform contributions.
(2) Relative value determination. The relative values of the
controlled participants' nonroutine contributions must be determined so
as to reflect the most reliable measure of an arm's length result.
Relative values may be measured by external market benchmarks that
reflect the fair market value of such nonroutine contributions.
Alternatively, the relative value of nonroutine contributions may be
estimated by the capitalized cost of developing the nonroutine
contributions and updates, as appropriately grown or discounted so that
all contributions may be valued on a comparable dollar basis as of the
same date. If the nonroutine contributions by a controlled participant
are also used in other business activities (such as the exploitation of
make-or-sell rights described in paragraph (c)(4) of this section), an
allocation of the value of the nonroutine contributions must be made on
a reasonable basis among all the business activities in which they are
used in proportion to the relative economic value that the relevant
business activity and such other business activities are anticipated to
derive over time as the result of such nonroutine contributions.
(3) Determination of PCT Payments. Any amount of the present value
of a controlled participant's nonroutine residual divisional profit or
loss that is allocated to another controlled participant represents the
present value of the PCT Payments due to that other controlled
participant for its platform contributions to the relevant business
activity in the relevant division. For purposes of paragraph (j)(3)(ii)
of this section, the present value of a PCT Payor's PCT Payments under
this paragraph shall be deemed reduced to the extent of the present
value of any PCT Payments owed to it from other controlled participants
under this paragraph (g)(7). The resulting remainder may be converted
to a fixed or contingent form of payment in accordance with paragraph
(h) (Form of payment rules) of this section.
(4) Routine platform and operating contributions. For purposes of
this paragraph (g)(7), any routine platform or operating contributions,
the valuation and PCT Payments for which are determined and made
independently of the residual profit split method, are treated
similarly to cost contributions and operating cost contributions,
respectively. Accordingly, wherever used in this paragraph (g)(7), the
term ``routine contributions'' shall not include routine platform or
operating contributions, and wherever the terms ``cost contributions''
and ``operating cost contributions'' appear in this paragraph (g)(7),
they shall include net routine platform contributions and net routine
operating contributions, respectively, as defined in paragraph
(g)(4)(vii) of this section. However, treatment of net operating
contributions as operating cost contributions shall be coordinated with
the treatment of other routine contributions pursuant to paragraphs
(g)(4)(iii)(B) and (7)(iii)(B) of this section so as to avoid
duplicative market returns to such contributions.
(iv) Best method analysis considerations--(A) In general. Whether
results derived from this method are the most reliable measure of the
arm's length result is determined using the factors described under the
best method rule in Sec. 1.482-1(c). Thus, comparability and quality
of data, reliability of assumptions, and sensitivity of results to
possible deficiencies in the data and assumptions, must be considered
in determining whether this method provides the most reliable measure
of an arm's length result. The application of these factors to the
residual profit split in the context of the relevant business activity
of developing and exploiting cost shared intangibles is discussed in
paragraphs (g)(7)(iv)(B) through (D) of this section.
(B) Comparability. The derivation of the present value of
nonroutine residual divisional profit or loss includes a carveout on
account of market returns for routine contributions. Thus, the
comparability considerations that are relevant for that purpose include
those that are relevant for the methods that are used to determine
market returns for the routine contributions.
(C) Data and assumptions. The reliability of the results derived
from the residual profit split is affected by the quality of the data
and assumptions used to apply this method. In particular, the following
factors must be considered:
[[Page 80116]]
(1) The reliability of the allocation of costs, income, and assets
between the relevant business activity and the controlled participants'
other activities that will affect the reliability of the determination
of the divisional profit or loss and its allocation among the
controlled participants. See Sec. 1.482-6(c)(2)(ii)(C)(1).
(2) The degree of consistency between the controlled participants
and uncontrolled taxpayers in accounting practices that materially
affect the items that determine the amount and allocation of operating
profit or loss affects the reliability of the result. See Sec. 1.482-
6(c)(2)(ii)(C)(2).
(3) The reliability of the data used and the assumptions made in
estimating the relative value of the nonroutine contributions by the
controlled participants. In particular, if capitalized costs of
development are used to estimate the relative value of nonroutine
contributions, the reliability of the results is reduced relative to
the reliability of other methods that do not require such an estimate.
This is because, in any given case, the costs of developing a
nonroutine contribution may not be related to its market value and
because the calculation of the capitalized costs of development may
require the allocation of indirect costs between the relevant business
activity and the controlled participant's other activities, which may
affect the reliability of the analysis.
(D) Other factors affecting reliability. Like the methods described
in Sec. Sec. 1.482-3 through 1.482-5 and Sec. 1.482-9(c), the
carveout on account of market returns for routine contributions relies
exclusively on external market benchmarks. As indicated in Sec. 1.482-
1(c)(2)(i), as the degree of comparability between the controlled
participants and uncontrolled transactions increases, the relative
weight accorded the analysis under this method will increase. In
addition, to the extent the allocation of nonroutine residual
divisional profit or loss is not based on external market benchmarks,
the reliability of the analysis will be decreased in relation to an
analysis under a method that relies on market benchmarks. Finally, the
reliability of the analysis under this method may be enhanced by the
fact that all the controlled participants are evaluated under the
residual profit split. However, the reliability of the results of an
analysis based on information from all the controlled participants is
affected by the reliability of the data and the assumptions pertaining
to each controlled participant. Thus, if the data and assumptions are
significantly more reliable with respect to one of the controlled
participants than with respect to the others, a different method,
focusing solely on the results of that party, may yield more reliable
results.
(v) Examples. The following examples illustrate the principles of
this paragraph (g)(7):
Example 1. (i) For simplicity of calculation in this Example 1,
all financial flows are assumed to occur at the beginning of each
period. USP, a U.S. electronic data storage company, has partially
developed technology for a type of extremely small compact storage
devices (nanodisks) which are expected to provide a significant
increase in data storage capacity in various types of portable
devices such as cell phones, MP3 players, laptop computers and
digital cameras. At the same time, USP's wholly-owned subsidiary,
FS, has developed significant marketing intangibles outside the
United States in the form of customer lists, ongoing relations with
various OEMs, and trademarks that are well recognized by consumers
due to a long history of marketing successful data storage devices
and other hardware used in various types of consumer electronics. At
the beginning of Year 1, USP enters into a CSA with FS to develop
nanodisk technologies for eventual commercial exploitation. Under
the CSA, USP will have the right to exploit nanodisks in the United
States, while FS will have the right to exploit nanodisks in the
rest of the world. The partially developed nanodisk technologies
owned by USP are reasonably anticipated to contribute to the
development of commercially exploitable nanodisks and therefore the
rights in the nanodisk technologies constitute platform
contributions of USP for which compensation is due under PCTs. FS
does not have any platform contributions for the CSA. Due to the
fact that nanodisk technologies have yet to be incorporated into any
commercially available product, neither USP nor FS transfers rights
to make or sell current products in conjunction with the CSA.
(ii) Because only in FS's territory do both controlled
participants make significant nonroutine contributions, USP and FS
determine that they need to determine the relative value of their
respective contributions to residual divisional profit or loss
attributable to the CSA Activity only in FS's territory. FS
anticipates making no nanodisk sales during the first year of the
CSA in its territory with revenues in Year 2 reaching $200 million.
Revenues through Year 5 are reasonably anticipated to increase by
50% per year. The annual growth rate for revenues is then expected
to decline to 30% per annum in Years 6 and 7, 20% per annum in Years
8 and 9 and 10% per annum in Year 10. Revenues are then expected to
decline 10% in Year 11 and 5% per annum, thereafter. The routine
costs (defined here as costs other than cost contributions, routine
platform and operating contributions, and nonroutine contributions)
that are allocable to this revenue in calculating FS's divisional
profit or loss, are anticipated to equal $40 million for the first
year of the CSA and $130 for the second year and $200 and $250
million in Years 3 and 4. Total operating expenses attributable to
product exploitation (including operating cost contributions) equal
52% of sales per year. FS undertakes routine distribution activities
in its markets that constitute routine contributions to the relevant
business activity of exploiting nanodisk technologies. USP and FS
estimate that the total market return on these routine contributions
will amount to 6% of the routine costs. FS expects its cost
contributions to be $60 million in Year 1, rise to $100 million in
Years 2 and 3, and then decline again to $60 million in Year 4.
Thereafter, FS's cost contributions are expected to equal 10% of
revenues.
(iii) USP and FS determine the present value of the stream of
the reasonably anticipated residuals in FS's territory over the
duration of the CSA Activity of the divisional profit or loss
(revenues minus routine costs), minus the market returns for routine
contributions, the operating cost contributions, and the cost
contributions. USP and FS determine, based on the considerations
discussed in paragraph (g)(2)(v) of this section, that the
appropriate discount rate is 17.5% per annum. Therefore, the present
value of the nonroutine residual divisional profit is $1,395
million.
(iv) After analysis, USP and FS determine that the relative
value of the nanodisk technologies contributed by USP to CSA (giving
effect only to its value in FS's territory) is roughly 150% of the
value of FS's marketing intangibles (which only have value in FS's
territory). Consequently, 60% of the nonroutine residual divisional
profit is attributable to USP's platform contribution. Therefore,
FS's PCT Payments should have an expected present value equal to
$837 million (.6 x $1,395 million).
(v) The calculations for this Example 1 are displayed in the
following table:
--------------------------------------------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV = Terminal Value)....... Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 Y11 TV
Discount Period.................................... 0 1 2 3 4 5 6 7 8 9 10 10
[1] Sales.......................................... 0 200 300 450 675 878 1141 1369 1643 1807 1626
[2] Growth Rate.................................... ...... ...... 50% 50% 50% 30% 30% 20% 20% 10% -10%
[3] Exploitation Costs and Operating Cost 40 130 200 250 351 456 593 712 854 940 846
Contributions (52% of Sales [1])..................
[4] Return on [3] (6% of [3])...................... 2.4 8 12 15 21 27 36 43 51 56 51
[5] Cost Contributions (10% of Sales [1] after Year 60 100 100 60 68 88 114 137 164 181 163
5)................................................
[6] Residual Profit = [1] minus {[3] + [4] + -102 -38 -12 125 235 306 398 477 573 630 567 2395
[5]{time} ........................................
[[Page 80117]]
[7] Residual Profit [6] Discounted at 17.5% -102 -32 -9 77 124 137 151 154 158 148 113 477
discount rate.....................................
--------------------------------------------------------------------------------------------------------------------------------------------------------
[8] Sum of all amounts in [7] for all time periods = $1,395 million
--------------------------------------------------------------------------------------------------------------------------------------------------------
[9] Relative value in FS's division of USP's nanotechnology to FS's marketing intangibles = 150%
--------------------------------------------------------------------------------------------------------------------------------------------------------
[10] Profit Split (USP)............................ 60% = 1.5 x [11]
----------------------------------------------------------------------------------------------------
[11] Profit Split (FS)............................. 40%
----------------------------------------------------------------------------------------------------
[12] FS's PCT Payments............................. [8] x [10] = $1,395 million x 60% = $837 million
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 2. (i) For simplicity of calculation in this Example 2,
all financial flows are assumed to occur at the beginning of each
period. USP is a U.S. automobile manufacturing company that has
completed significant research on the development of diesel-electric
hybrid engines that, if they could be successfully manufactured,
would result in providing a significant increased fuel economy for a
wide variety of motor vehicles. Successful commercialization of the
diesel-electric hybrid engine will require the development of a new
class of advanced battery that will be light, relatively cheap to
manufacture and yet capable of holding a substantial electric
charge. FS, a foreign subsidiary of USP, has completed significant
research on developing lithium-ion batteries that appear likely to
have the requisite characteristics. At the beginning of Year 1, USP
enters into a CSA with FS to further develop diesel-electric hybrid
engines and lithium-ion battery technologies for eventual commercial
exploitation. Under the CSA, USP will have the right to exploit the
diesel-electric hybrid engine and lithium-ion battery technologies
in the United States, while FS will have the right to exploit such
technologies in the rest of the world. The partially developed
diesel-electric hybrid engine and lithium-ion battery technologies
owned by USP and FS, respectively, are reasonably anticipated to
contribute to the development of commercially exploitable automobile
engines and therefore the rights in both these technologies
constitute platform contributions of USP and of FS for which
compensation is due under PCTs. At the time of inception of the CSA,
USP owns operating intangibles in the form of self-developed
marketing intangibles which have significant value in the United
States, but not in the rest of the world, and that are relevant to
exploiting the cost shared intangibles. Similarly, FS owns self-
developed marketing intangibles which have significant value in the
rest of the world, but not in the United States, and that are
relevant to exploiting the cost shared intangibles. Although the new
class of diesel-electric hybrid engine using lithium-ion batteries
is not yet ready for commercial exploitation, components based on
this technology are beginning to be incorporated in current-
generation gasoline-electric hybrid engines and the rights to make
and sell such products are transferred from USP to FS and vice-versa
in conjunction with the inception of the CSA, following the same
territorial division as in the CSA.
(ii) USP's estimated RAB share is 66.7%. During Year 1, it is
anticipated that sales in USP's territory will be $1000X in Year 1.
Sales in FS's territory are anticipated to be $500X. Thereafter, as
revenue from the use of components in gasoline-electric hybrids is
supplemented by revenues from the production of complete diesel-
electric hybrid engines using lithium-ion battery technology,
anticipated sales in both territories will increase rapidly at a
rate of 50% per annum through Year 4. Anticipated sales are then
anticipated to increase at a rate of 40% per annum for another 4
years. Sales are then anticipated to increase at a rate of 30% per
annum through Year 10. Thereafter, sales are anticipated to decrease
at a rate of 5% per annum for the foreseeable future as new
automotive drivetrain technologies displace diesel-electric hybrid
engines and lithium-ion batteries. Total operating expenses
attributable to product exploitation (including operating cost
contributions) equal 40% of sales per year for both USP and FS. USP
and FS estimate that the total market return on these routine
contributions to the CSA will amount to 6% of these operating
expenses. USP is expected to bear \2/3\ of the total cost
contributions for the foreseeable future. Cost contributions are
expected to total $375X in Year 1 (of which $250X are borne by USP)
and increase at a rate of 25% per annum through Year 6. In Years 7
through 10, cost contributions are expected to increase 10% a year.
Thereafter, cost contributions are expected to decrease by 5% a year
for the foreseeable future.
(iii) USP and FS determine the present value of the stream of
FS's reasonably anticipated residual divisional profit, which is the
stream of FS's reasonably anticipated divisional profit or loss,
minus the market returns for routine contributions, minus operating
cost contributions, minus cost contributions. USP and FS determine,
based on the considerations discussed in paragraph (g)(2)(v) of this
section, that the appropriate discount rate is 12% per year.
Therefore, the present value of the nonroutine residual divisional
profit in USP's territory is $41,727X and in CFC's territory is
$20,864X.
(iv) After analysis, USP and FS determine that, in the United
States the relative value of the technologies contributed by USP and
FS to the CSA and of the operating intangibles used by USP in the
exploitation of the cost shared intangibles (reported as equaling
100 in total), equals: USP's platform contribution (59.5); FS's
platform contribution (25.5); and USP's operating intangibles (15).
Consequently, the present value of the arm's length amount of the
PCT Payments that USP should pay to FS for FS's platform
contribution is $10,640X (.255 x $41,727X). Similarly, USP and FS
determine that, in the rest of the world, the relative value of the
technologies contributed by USP and FS to the CSA and of the
operating intangibles used by FS in the exploitation of the cost
shared intangibles can be divided as follows: USP's platform
contribution (63); FS's platform contribution (27); and FS's
operating intangibles (10). Consequently, the present value of the
arm's length amount of the PCT Payments that FS should pay to USP
for USP's platform contribution is $13,144X (.63 x $20,864X).
Therefore, FS is required to make a net payment to USP with a
present value of $2,504X ($13,144X - 10,640X).
(v) The calculations for this Example 2 are displayed in the
following tables:
Calculation of USP's PCT Payment to FS
--------------------------------------------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV = Terminal Value).................... Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 TV
Discount Period................................................. 0 1 2 3 4 5 6 7 8 9 9
[1] Sales....................................................... 1000 1500 2250 3375 4725 6615 9261 12965 16855 21912
[2] Growth Rate................................................. ...... 50% 50% 50% 40% 40% 40% 40% 30% 30%
[3] Exploitation Costs and Operating Cost Contributions (40% of 400 600 900 1350 1890 2646 3704 5186 6742 8765
Sales [1]).....................................................
[4] Return on [3] = 6% of [3]................................... 24 36 54 81 113 159 222 311 405 526
[5] Cost Contributions.......................................... 250 313 391 488 610 763 839 923 1015 1117
[6] Residual Profit = [1] minus {[3] + [4] + [5]{time} ......... 326 552 905 1456 2111 3047 4495 6545 8693 11504 64287
[7] Residual Profit [6] Discounted at 12% discount rate......... 326 492 722 1036 1342 1729 2277 2961 3511 4148 23183
--------------------------------------------------------------------------------------------------------------------------------------------------------
[8] Sum of all amounts in [7] for all time periods = $41,727X
--------------------------------------------------------------------------------------------------------------------------------------------------------
Profit Split for Calculation of USP's PCT Payment to FS: [Total of US contributions = 74.5%]
[9] USP's Platform Contribution = 59.5%
[[Page 80118]]
[10] FS's Platform Contribution = 25.5%
[11] USP's Operating Intangibles = 15%
--------------------------------------------------------------------------------------------------------------------------------------------------------
[12] USP's PCT Payment to FS = [8] x [10] = $41,727X multiplied by 25.5% = $10,640X
--------------------------------------------------------------------------------------------------------------------------------------------------------
Calculation of FS's Net PCT Payment to USF
--------------------------------------------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV = Terminal Value).................... Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 TV
Discount Period................................................. 0 1 2 3 4 5 6 7 8 9 9
[13] Sales...................................................... 500 750 1125 1688 2363 3308 4631 6483 8428 10956
[14] Growth Rate................................................ ...... 50% 50% 50% 40% 40% 40% 40% 30% 30%
[15] Exploitation Costs and Operating Cost Contributions (40% of 200 300 450 675 945 1323 1852 2593 3371 4382
Sales [13])....................................................
[16] Return on [15] = 6% of [15]................................ 12 18 27 41 57 79 111 156 202 263
[17] Cost Contributions......................................... 125 156 195 244 305 381 420 462 508 559
[18] Residual Profit = [13] minus {[15] + [16] + [17]{time} .... 163 276 453 728 1056 1524 2248 3272 4347 5752 32144
[19] Residual Profit [18] Discounted at 12% discount rate....... 163 246 361 518 671 865 1139 1480 1755 2074 11591
--------------------------------------------------------------------------------------------------------------------------------------------------------
[20] Sum of all amounts in [19] for all time periods = $20,864X
--------------------------------------------------------------------------------------------------------------------------------------------------------
Profit Split for Calculation of FS's PCT Payment to USP: [Total of FS's contributions = 37%]
[21] USP's Platform Contribution = 63%
[22] FS's Platform Contribution = 27%
[23] FS's Operating Intangibles = 10%
--------------------------------------------------------------------------------------------------------------------------------------------------------
[24] FS's PCT Payment to USP = [20] x [21] = $20,864X multiplied by 63% = $13,144X
--------------------------------------------------------------------------------------------------------------------------------------------------------
[25] FS's Net PCT Payment to USP = [24] minus [12] = $13,144X minus $10,640X = $2,504X..................................................................
--------------------------------------------------------------------------------------------------------------------------------------------------------
(8) Unspecified methods. Methods not specified in paragraphs (g)(3)
through (7) of this section may be used to evaluate whether the amount
charged for a PCT is arm's length. Any method used under this paragraph
(g)(8) must be applied in accordance with the provisions of Sec.
1.482-1 and of paragraph (g)(2) of this section. Consistent with the
specified methods, an unspecified method should take into account the
general principle that uncontrolled taxpayers evaluate the terms of a
transaction by considering the realistic alternatives to that
transaction, and only enter into a particular transaction if none of
the alternatives is preferable to it. Therefore, in establishing
whether a PCT achieved an arm's length result, an unspecified method
should provide information on the prices or profits that the controlled
participant could have realized by choosing a realistic alternative to
the CSA. See paragraph (k)(2)(ii)(J) of this section. As with any
method, an unspecified method will not be applied unless it provides
the most reliable measure of an arm's length result under the
principles of the best method rule. See Sec. 1.482-1(c) (Best method
rule). In accordance with Sec. 1.482-1(d) (Comparability), to the
extent that an unspecified method relies on internal data rather than
uncontrolled comparables, its reliability will be reduced. Similarly,
the reliability of a method will be affected by the reliability of the
data and assumptions used to apply the method, including any
projections used.
(h) Form of payment rules--(1) CST Payments. CST Payments may not
be paid in shares of stock in the payor (or stock in any member of the
controlled group that includes the controlled participants).
(2) PCT Payments--(i) In general. The consideration under a PCT for
a platform contribution may take one or a combination of both of the
following forms:
(A) Payments of a fixed amount (fixed payments), either paid in a
lump sum payment or in installment payments spread over a specified
period, with interest calculated in accordance with Sec. 1.482-2(a)
(Loans or advances).
(B) Payments contingent on the exploitation of cost shared
intangibles by the PCT Payor (contingent payments). Accordingly,
controlled participants have flexibility to adopt a form and period of
payment, provided that such form and period of payment are consistent
with an arm's length charge as of the date of the PCT. See also
paragraphs (h)(2)(iv) and (3) of this section.
(ii) No PCT Payor Stock. PCT Payments may not be paid in shares of
stock in the PCT Payor (or stock in any member of the controlled group
that includes the controlled participants).
(iii) Specified form of payment--(A) In general. The form of
payment selected (subject to the rules of this paragraph (h)) for any
PCT, including, in the case of contingent payments, the contingent base
and structure of the payments as set forth in paragraph (h)(2)(iii)(B)
of this section, must be specified no later than the due date of the
applicable tax return (including extensions) for the later of the
taxable year of the PCT Payor or PCT Payee that includes the date of
that PCT.
(B) Contingent payments. In accordance with paragraph (k)(1)(iv)(A)
of this section, a provision of a written contract described in
paragraph (k)(1) of this section, or of the additional documentation
described in paragraph (k)(2) of this section, that provides for
payments for a PCT (or group of PCTs) to be contingent on the
exploitation of cost shared intangibles will be respected as consistent
with economic substance only if the allocation between the controlled
participants of the risks attendant on such form of payment is
determinable before the outcomes of such allocation that would have
materially affected the PCT pricing are known or reasonably knowable. A
contingent payment provision must clearly and unambiguously specify the
basis on which the contingent payment obligations are to be determined.
In particular, the contingent payment provision must clearly and
unambiguously specify the events that give rise to an obligation to
make PCT Payments, the royalty base (such as sales or revenues), and
the computation used to determine the PCT Payments. The royalty base
specified must be one that permits verification of its proper use by
reference to books and records maintained by the controlled
participants in the normal course of business (for example, books and
records maintained for financial
[[Page 80119]]
accounting or business management purposes).
(C) Examples. The following examples illustrate the principles of
this paragraph (h)(2).
Example 1. A CSA provides that PCT Payments with respect to a
particular platform contribution shall be contingent payments equal
to 15% of the revenues from sales of products that incorporate cost
shared intangibles. The terms further permit (but do not require)
the controlled participants to adjust such contingent payments in
accordance with a formula set forth in the arrangement so that the
15% rate is subject to adjustment by the controlled participants at
their discretion on an after-the-fact, uncompensated basis. The
Commissioner may impute payment terms that are consistent with
economic substance with respect to the platform contribution because
the contingent payment provision does not specify the computation
used to determine the PCT Payments.
Example 2. Taxpayer, an automobile manufacturer, is a controlled
participant in a CSA that involves research and development to
perfect certain manufacturing techniques necessary to the actual
manufacture of a state-of-the-art, hybrid fuel injection system
known as DRL337. The arrangement involves the platform contribution
of a design patent covering DRL337. Pursuant to paragraph
(h)(2)(iii)(B) of this section, the CSA provides for PCT Payments
with respect to the platform contribution of the patent in the form
of royalties contingent on sales of automobiles that contain the
DRL337 system. However, Taxpayer's system of book- and record-
keeping does not enable Taxpayer to track which automobile sales
involve automobiles that contain the DRL337 system. Because Taxpayer
has not complied with paragraph (h)(2)(iii)(B) of this section, the
Commissioner may impute payment terms that are consistent with
economic substance and susceptible to verification by the
Commissioner.
Example 3. (i) Controlled participants A and B enter into a CSA
that provides for PCT Payments from A to B with respect to B's
platform contribution, Z, in the form of three annual installment
payments due from A to B on the last day of each of the first three
years of the CSA.
(ii) On audit, based on all the facts and circumstances, the
Commissioner determines that the installment PCT Payments are
consistent with an arm's length charge as of the date of the PCT.
Accordingly, the Commissioner does not make an adjustment with
respect to the PCT Payments in any year.
Example 4. (i) The facts are the same as in Example 3 except
that the CSA contains an additional term with respect to the PCT
Payments. Under this provision, A and B further agreed that, if the
present value (as of the CSA Start Date) of A's actual divisional
operating profit or loss during the three-year period is less than
the present value (as of the CSA Start Date) of the divisional
operating profit or loss that the parties projected for A upon
formation of the CSA for that period, then the third installment
payment shall be subject to a compensating adjustment in the amount
necessary to reduce the present value (as of the CSA Start Date) of
the aggregate PCT Payments for those three years to the amount that
would have been calculated if the actual results had been used for
the calculation instead of the projected results.
(ii) This provision further specifies that A will pay B an
additional amount, $Q, in the first year of the CSA to compensate B
for taking on additional downside risk through the contingent
payment term described in paragraph (i) of this Example 4.
(iii) During the first two years, A pays B installment payments
as agreed, as well as the additional amount, $Q. In the third year,
A and B determine that the present value (as of the CSA Start Date)
of A's actual divisional operating profit or loss during the three-
year period is less than the present value (as of the CSA Start
Date) of the divisional operating profit or loss that the parties
projected for A upon formation of the CSA for that period. A reduces
the PCT Payment to B in the third year in the amount necessary to
reduce the present value (as of the CSA Start Date) of the aggregate
PCT Payments for those three years to the amount that would have
been calculated if the actual results had been used for the
calculation instead of the projected results.
(iv) On audit, based on all the facts and circumstances, the
Commissioner determines that the installment PCT Payments agreed to
be paid by A to B were consistent with an arm's length charge as of
the date of the PCT. The Commissioner further determines that the
contingency was sufficiently specified such that its occurrence or
nonoccurrence was unambiguous and determinable; that the projections
were reliable; and that the contingency did, in fact, occur.
Finally, the Commissioner determines, based on all the facts and
circumstances, that $Q was within the arm's length range for the
additional allocation of risk to B. Accordingly, no adjustment is
made with respect to the installment PCT Payments, or the additional
PCT Payment for the contingent payment term, in any year.
Example 5. (i) The facts are the same as in Example 4 except
that the CSA states the amount that A will pay B for the contingent
payment term is $X, an amount that is less than $Q, and A pays B $X
in the first year of the CSA.
(ii) On audit, based on all the facts and circumstances, the
Commissioner determines that the installment PCT Payments agreed to
be paid by A to B were consistent with an arm's length charge as of
the date of the PCT. The Commissioner further determines that the
contingency was sufficiently specified such that its occurrence or
nonoccurrence was unambiguous and determinable; that the projections
were reliable; and that the contingency did, in fact, occur.
However, the Commissioner also determines, based on all the facts
and circumstances, that the additional PCT Payment of $X from A to B
for the contingent payment term was not an arm's length charge for
the additional allocation of risk as of the CSA Start Date in
connection with the contingent payment term. Accordingly, the
Commissioner makes an adjustment to B's results equal to the
difference between $X and the median of the arm's length range of
charges for the contingent payment term.
Example 6. (i) The facts are the same as in Example 3 except
that A and B further agreed that, if the present value (as of the
CSA Start Date) of A's actual divisional operating profit or loss
during the three-year period is either less or greater than the
present value (as of the CSA Start Date) of the divisional operating
profit or loss that the parties projected for A upon formation of
the CSA for that period, then A may make a compensating adjustment
to the third installment payment in the amount necessary to reduce
(if actual divisional operating profit or loss is less than the
projections) or increase (if actual divisional operating profit or
loss exceeds the projections) the present value (as of the CSA Start
Date) of the aggregate PCT Payments for those three years to the
amount that would have been calculated if the actual results had
been used for the calculation instead of the projected results.
(ii) On audit, the Commissioner determines that the contingent
payment term lacks economic substance under Sec. Sec. 1.482-
1(d)(3)(iii)(B) and 1.482-7(h)(2)(iii)(B). It lacks economic
substance because the allocation of the risks between A and B was
indeterminate as of the CSA Start Date due to the elective nature of
the potential compensating adjustments. Specifically, the parties
agreed upfront only that A might make compensating adjustments to
the installment payments. By the terms of the agreement, A could
decide whether to make such adjustments after the outcome of the
risks was known or reasonably knowable. Even though the contingency
and potential compensating adjustments were clearly defined in the
CSA, no compensating adjustments were required by the CSA regardless
of the occurrence or nonoccurrence of the contingency. As a result,
the contingent payment terms did not clearly and unambiguously
specify the events that give rise to an obligation to make PCT
Payments, and, accordingly, the obligation to make compensating
adjustments pursuant to the contingency was indeterminate. The
contingent payment term allows the taxpayer to make adjustments that
are favorable to its overall tax position in those years where the
agreement allows it to make such adjustments, but decline to
exercise its right to make any adjustment in those years in which
such an adjustment would be unfavorable to its overall tax position.
Such terms do not reflect a substantive upfront allocation of risk.
In addition, the vagueness of the agreement makes it impossible to
determine whether such contingent payment term warrants an
additional arm's length charge and, if so, how much.
(iii) Accordingly, the Commissioner may disregard the contingent
payment term under Sec. Sec. 1.482-1(d)(3)(ii)(B)(1) and 1.482-
7(k)(1)(iv) and may impute other contractual terms in its place
consistent with the economic substance of the CSA.
Example 7. (i) The facts are the same as in Example 6 except
that the contingent payment term provides that, if the present
[[Page 80120]]
value (as of the CSA Start Date) of A's actual divisional operating
profit or loss during the three-year period is either less or
greater than the present value (as of the CSA Start Date) of the
divisional operating profit or loss that the parties projected for A
upon formation of the CSA for that period, then A will make a
compensating adjustment to the third installment payment. The CSA
does not specify the amount of (or a formula for) any such
compensating adjustments.
(ii) On audit, the Commissioner determines that the contingent
payment term lacks economic substance under Sec. Sec. 1.482-
1(d)(3)(iii)(B) and 1.482-7(h)(2)(iii)(B). It lacks economic
substance because the allocation of the risks between A and B was
indeterminate as of the CSA Start Date due to the failure to specify
the amount of (or a formula for) the compensating adjustments that
must be made if a contingency occurs. The basis on which the
compensating adjustments were to be determined was neither clear nor
unambiguous. Even though the contingency was clearly defined in the
CSA and the requirement of a compensating adjustment in the event of
a contingency was clearly specified in the CSA, the parties had no
agreement regarding the amount of such compensating adjustments. As
a result, the computation used to determine the PCT Payments was
indeterminate. The parties could choose to make a small positive
compensating adjustment if the actual results turned out to be much
greater than the projections, and could choose to make a significant
negative compensating adjustment if the actual results turned out to
be less than the projections. Such terms do not reflect a
substantive upfront allocation of risk. In addition, the vagueness
of the agreement makes it impossible to determine whether such
contingent payment term warrants an additional arm's length charge
and, if so, how much.
(iii) Accordingly, the Commissioner may disregard the contingent
price term under Sec. Sec. 1.482-1(d)(3)(ii)(B)(1) and 1.482-
7(k)(1)(iv) and may impute other contractual terms in its place
consistent with economic substance of the CSA.
(iv) Conversion from fixed to contingent form of payment. With
regard to a conversion of a fixed present value to a contingent form of
payment, see paragraphs (g)(2)(v) (Discount rate) and (vi) (Financial
projections) of this section.
(3) Coordination of best method rule and form of payment. A method
described in paragraph (g)(1) of this section evaluates the arm's
length amount charged in a PCT in terms of a form of payment (method
payment form). For example, the method payment form for the acquisition
price method described in paragraph (g)(5) of this section, and for the
market capitalization method described in paragraph (g)(6) of this
section, is fixed payment. Applications of the income method provide
different method payment forms. See paragraphs (g)(4)(i)(E) and (iv) of
this section. The method payment form may not necessarily correspond to
the form of payment specified pursuant to paragraphs (h)(2)(iii) and
(k)(2)(ii)(l) of this section (specified payment form). The
determination under Sec. 1.482-1(c) of the method that provides the
most reliable measure of an arm's length result is to be made without
regard to whether the respective method payment forms under the
competing methods correspond to the specified payment form. If the
method payment form of the method determined under Sec. 1.482-1(c) to
provide the most reliable measure of an arm's length result differs
from the specified payment form, then the conversion from such method
payment form to such specified payment form will be made to the
satisfaction of the Commissioner.
(i) Allocations by the Commissioner in connection with a CSA--(1)
In general. The Commissioner may make allocations to adjust the results
of a controlled transaction in connection with a CSA so that the
results are consistent with an arm's length result, in accordance with
the provisions of this paragraph (i).
(2) CST allocations--(i) In general. The Commissioner may make
allocations to adjust the results of a CST so that the results are
consistent with an arm's length result, including any allocations to
make each controlled participant's IDC share, as determined under
paragraph (d)(4) of this section, equal to that participant's RAB
share, as determined under paragraph (e)(1) of this section. Such
allocations may result from, for purposes of CST determinations,
adjustments to--
(A) Redetermine IDCs by adding any costs (or cost categories) that
are directly identified with, or are reasonably allocable to, the IDA,
or by removing any costs (or cost categories) that are not IDCs;
(B) Reallocate costs between the IDA and other business activities;
(C) Improve the reliability of the selection or application of the
basis used for measuring benefits for purposes of estimating a
controlled participant's RAB share;
(D) Improve the reliability of the projections used to estimate RAB
shares, including adjustments described in paragraph (i)(2)(ii) of this
section; and
(E) Allocate among the controlled participants any unallocated
interests in cost shared intangibles.
(ii) Adjustments to improve the reliability of projections used to
estimate RAB shares--(A) Unreliable projections. A significant
divergence between projected benefit shares and benefit shares adjusted
to take into account any available actual benefits to date (adjusted
benefit shares) may indicate that the projections were not reliable for
purposes of estimating RAB shares. In such a case, the Commissioner may
use adjusted benefit shares as the most reliable measure of RAB shares
and adjust IDC shares accordingly. The projected benefit shares will
not be considered unreliable, as applied in a given taxable year, based
on a divergence from adjusted benefit shares for every controlled
participant that is less than or equal to 20% of the participant's
projected benefits share. Further, the Commissioner will not make an
allocation based on such divergence if the difference is due to an
extraordinary event, beyond the control of the controlled participants,
which could not reasonably have been anticipated at the time that costs
were shared. The Commissioner generally may adjust projections of
benefits used to calculate benefit shares in accordance with the
provisions of Sec. 1.482-1. In particular, if benefits are projected
over a period of years, and the projections for initial years of the
period prove to be unreliable, this may indicate that the projections
for the remaining years of the period are also unreliable and thus
should be adjusted. For purposes of this paragraph (i)(2)(ii)(A), all
controlled participants that are not U.S. persons are treated as a
single controlled participant. Therefore, an adjustment based on an
unreliable projection of RAB shares will be made to the IDC shares of
foreign controlled participants only if there is a matching adjustment
to the IDC shares of controlled participants that are U.S. persons.
Nothing in this paragraph (i)(2)(ii)(A) prevents the Commissioner from
making an allocation if a taxpayer did not use the most reliable basis
for measuring anticipated benefits. For example, if the taxpayer
measures its anticipated benefits based on units sold, and the
Commissioner determines that another basis is more reliable for
measuring anticipated benefits, then the fact that actual units sold
were within 20% of the projected unit sales will not preclude an
allocation under this section.
(B) Foreign-to-foreign adjustments. Adjustments to IDC shares based
on an unreliable projection also may be made among foreign controlled
participants if the variation between actual and projected benefits has
the effect of substantially reducing U.S. tax.
(C) Correlative adjustments to PCTs. Correlative adjustments will
be made to any PCT Payments of a fixed amount that were determined
based on RAB
[[Page 80121]]
shares that are subsequently adjusted on a finding that they were based
on unreliable projections. No correlative adjustments will be made to
contingent PCT Payments regardless of whether RAB shares were used as a
parameter in the valuation of those payments.
(D) Examples. The following examples illustrate the principles of
this paragraph (i)(2)(ii):
Example 1. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a CSA to develop new food products, dividing costs on the basis
of projected sales two years in the future. In Year 1, USP and FS
project that their sales in Year 3 will be equal, and they divide
costs accordingly. In Year 3, the Commissioner examines the
controlled participants' method for dividing costs. USP and FS
actually accounted for 42% and 58% of total sales, respectively. The
Commissioner agrees that sales two years in the future provide a
reliable basis for estimating benefit shares. Because the
differences between USP's and FS's adjusted and projected benefit
shares are less than 20% of their projected benefit shares, the
projection of future benefits for Year 3 is reliable.
Example 2. The facts are the same as in Example 1, except that
in Year 3 USP and FS actually accounted for 35% and 65% of total
sales, respectively. The divergence between USP's projected and
adjusted benefit shares is greater than 20% of USP's projected
benefit share and is not due to an extraordinary event beyond the
control of the controlled participants. The Commissioner concludes
that the projected benefit shares were unreliable, and uses adjusted
benefit shares as the basis for an adjustment to the cost shares
borne by USP and FS.
Example 3. U.S. Parent (USP), a U.S. corporation, and its
foreign subsidiary (FS) enter into a CSA in Year 1. They project
that they will begin to receive benefits from cost shared
intangibles in Years 4 through 6, and that USP will receive 60% of
total benefits and FS 40% of total benefits. In Years 4 through 6,
USP and FS actually receive 50% each of the total benefits. In
evaluating the reliability of the controlled participants'
projections, the Commissioner compares the adjusted benefit shares
to the projected benefit shares. Although USP's adjusted benefit
share (50%) is within 20% of its projected benefit share (60%), FS's
adjusted benefit share (50%) is not within 20% of its projected
benefit share (40%). Based on this discrepancy, the Commissioner may
conclude that the controlled participants' projections were
unreliable and may use adjusted benefit shares as the basis for an
adjustment to the cost shares borne by USP and FS.
Example 4. Three controlled taxpayers, USP, FS1, and FS2 enter
into a CSA. FS1 and FS2 are foreign. USP is a domestic corporation
that controls all the stock of FS1 and FS2. The controlled
participants project that they will share the total benefits of the
cost shared intangibles in the following percentages: USP 50%; FS1
30%; and FS2 20%. Adjusted benefit shares are as follows: USP 45%;
FS1 25%; and FS2 30%. In evaluating the reliability of the
controlled participants' projections, the Commissioner compares
these adjusted benefit shares to the projected benefit shares. For
this purpose, FS1 and FS2 are treated as a single controlled
participant. The adjusted benefit share received by USP (45%) is
within 20% of its projected benefit share (50%). In addition, the
non-US controlled participant's adjusted benefit share (55%) is also
within 20% of their projected benefit share (50%). Therefore, the
Commissioner concludes that the controlled participant's projections
of future benefits were reliable, despite the fact that FS2's
adjusted benefit share (30%) is not within 20% of its projected
benefit share (20%).
Example 5. The facts are the same as in Example 4. In addition,
the Commissioner determines that FS2 has significant operating
losses and has no earnings and profits, and that FS1 is profitable
and has earnings and profits. Based on all the evidence, the
Commissioner concludes that the controlled participants arranged
that FS1 would bear a larger cost share than appropriate in order to
reduce FS1's earnings and profits and thereby reduce inclusions USP
otherwise would be deemed to have on account of FS1 under subpart F.
Pursuant to paragraph (i)(2)(ii)(B) of this section, the
Commissioner may make an adjustment solely to the cost shares borne
by FS1 and FS2 because FS2's projection of future benefits was
unreliable and the variation between adjusted and projected benefits
had the effect of substantially reducing USP's U.S. income tax
liability (on account of FS1 subpart F income).
Example 6. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a CSA in 1996 to develop a new treatment for baldness.
USS's interest in any treatment developed is the right to produce
and sell the treatment in the U.S. market while FP retains rights to
produce and sell the treatment in the rest of the world. USS and FP
measure their anticipated benefits from the CSA based on their
respective projected future sales of the baldness treatment. The
following sales projections are used:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1............................................. 5 10
2............................................. 20 20
3............................................. 30 30
4............................................. 40 40
5............................................. 40 40
6............................................. 40 40
7............................................. 40 40
8............................................. 20 20
9............................................. 10 10
10............................................ 5 5
------------------------------------------------------------------------
(B) In Year 1, the first year of sales, USS is projected to have
lower sales than FP due to lags in U.S. regulatory approval for the
baldness treatment. In each subsequent year, USS and FP are
projected to have equal sales. Sales are projected to build over the
first three years of the period, level off for several years, and
then decline over the final years of the period as new and improved
baldness treatments reach the market.
(ii) To account for USS's lag in sales in the Year 1, the
present discounted value of sales over the period is used as the
basis for measuring benefits. Based on the risk associated with this
venture, a discount rate of 10 percent is selected. The present
discounted value of projected sales is determined to be
approximately $154.4 million for USS and $158.9 million for FP. On
this basis USS and FP are projected to obtain approximately 49.3%
and 50.7% of the benefit, respectively, and the costs of developing
the baldness treatment are shared accordingly.
(iii)(A) In Year 6, the Commissioner examines the CSA. USS and
FP have obtained the following sales results through Year 5:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1............................................. 0 17
2............................................. 17 35
3............................................. 25 35
4............................................. 38 41
5............................................. 39 41
------------------------------------------------------------------------
(B) USS's sales initially grew more slowly than projected while
FP's sales grew more quickly. In each of the first three years of
the period, the share of total sales of at least one of the parties
diverged by over 20% from its projected share of sales. However, by
Year 5 both parties' sales had leveled off at approximately their
projected values. Taking into account this leveling off of sales and
all the facts and circumstances, the Commissioner determines that it
is appropriate to use the original projections for the remaining
years of sales. Combining the actual results through Year 5 with the
projections for subsequent years, and using a discount rate of 10%,
the present discounted value of sales is approximately $141.6
million for USS and $187.3 million for FP. This result implies that
USS and FP obtain approximately 43.1% and 56.9%, respectively, of
the anticipated benefits from the baldness treatment. Because these
adjusted benefit shares are within 20% of the benefit shares
calculated based on the original sales projections, the Commissioner
determines that, based on the difference between adjusted and
projected benefit shares, the original projections were not
unreliable. No adjustment is made based on the difference between
adjusted and projected benefit shares.
Example 7. (i) The facts are the same as in Example 6, except
that the actual sales results through Year 5 are as follows:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1............................................. 0 17
2............................................. 17 35
3............................................. 25 44
[[Page 80122]]
4............................................. 34 54
5............................................. 36 55
------------------------------------------------------------------------
(ii) Based on the discrepancy between the projections and the
actual results and on consideration of all the facts, the
Commissioner determines that for the remaining years the following
sales projections are more reliable than the original projections:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
6............................................. 36 55
7............................................. 36 55
8............................................. 18 28
9............................................. 9 14
10............................................ 4.5 7
------------------------------------------------------------------------
(iii) Combining the actual results through Year 5 with the
projections for subsequent years, and using a discount rate of 10%,
the present discounted value of sales is approximately $131.2
million for USS and $229.4 million for FP. This result implies that
USS and FP obtain approximately 35.4% and 63.6%, respectively, of
the anticipated benefits from the baldness treatment. These adjusted
benefit shares diverge by greater than 20% from the benefit shares
calculated based on the original sales projections, and the
Commissioner determines that, based on the difference between
adjusted and projected benefit shares, the original projections were
unreliable. The Commissioner adjusts cost shares for each of the
taxable years under examination to conform them to the recalculated
shares of anticipated benefits.
(iii) Timing of CST allocations. If the Commissioner makes an
allocation to adjust the results of a CST, the allocation must be
reflected for tax purposes in the year in which the IDCs were incurred.
When a CST payment is owed by one controlled participant to another
controlled participant, the Commissioner may make appropriate
allocations to reflect an arm's length rate of interest for the time
value of money, consistent with the provisions of Sec. 1.482-2(a)
(Loans or advances).
(3) PCT allocations. The Commissioner may make allocations to
adjust the results of a PCT so that the results are consistent with an
arm's length result in accordance with the provisions of the applicable
sections of the regulations under section 482, as determined pursuant
to paragraph (a)(2) of this section.
(4) Allocations regarding changes in participation under a CSA. The
Commissioner may make allocations to adjust the results of any
controlled transaction described in paragraph (f) of this section if
the controlled participants do not reflect arm's length results in
relation to any such transaction.
(5) Allocations when CSTs are consistently and materially
disproportionate to RAB shares. If a controlled participant bears IDC
shares that are consistently and materially greater or lesser than its
RAB share, then the Commissioner may conclude that the economic
substance of the arrangement between the controlled participants is
inconsistent with the terms of the CSA. In such a case, the
Commissioner may disregard such terms and impute an agreement that is
consistent with the controlled participants' course of conduct, under
which a controlled participant that bore a disproportionately greater
IDC share received additional interests in the cost shared intangibles.
See Sec. Sec. 1.482-1(d)(3)(ii)(B) (Identifying contractual terms) and
1.482-4(f)(3)(ii) (Identification of owner). Such additional interests
will consist of partial undivided interests in the other controlled
participant's interest in the cost shared intangible. Accordingly, that
controlled participant must receive arm's length consideration from any
controlled participant whose IDC share is less than its RAB share over
time, under the provisions of Sec. Sec. 1.482-1 and 1.482-4 through
1.482-6 to provide compensation for the latter controlled participants'
use of such partial undivided interest.
(6) Periodic adjustments--(i) In general. Subject to the exceptions
in paragraph (i)(6)(vi) of this section, the Commissioner may make
periodic adjustments for an open taxable year (the Adjustment Year) and
for all subsequent taxable years for the duration of the CSA Activity
with respect to all PCT Payments, if the Commissioner determines that,
for a particular PCT (the Trigger PCT), a particular controlled
participant that owes or owed a PCT Payment relating to that PCT (such
controlled participant being referred to as the PCT Payor for purposes
of this paragraph (i)(6)) has realized an Actually Experienced Return
Ratio (AERR) that is outside the Periodic Return Ratio Range (PRRR).
The satisfaction of the condition stated in the preceding sentence is
referred to as a Periodic Trigger. See paragraphs (i)(6)(ii) through
(vi) of this section regarding the PRRR, the AERR, and periodic
adjustments. In determining whether to make such adjustments, the
Commissioner may consider whether the outcome as adjusted more reliably
reflects an arm's length result under all the relevant facts and
circumstances, including any information known as of the Determination
Date. The Determination Date is the date of the relevant determination
by the Commissioner. The failure of the Commissioner to determine for
an earlier taxable year that a PCT Payment was not arm's length will
not preclude the Commissioner from making a periodic adjustment for a
subsequent year. A periodic adjustment under this paragraph (i)(6) may
be made without regard to whether the taxable year of the Trigger PCT
or any other PCT remains open for statute of limitations purposes or
whether a periodic adjustment has previously been made with respect to
any PCT Payment.
(ii) PRRR. Except as provided in the next sentence, the PRRR will
consist of return ratios that are not less than .667 nor more than 1.5.
Alternatively, if the controlled participants have not substantially
complied with the documentation requirements referenced in paragraph
(k) of this section, as modified, if applicable, by paragraphs (m)(2)
and (3) of this section, the PRRR will consist of return ratios that
are not less than .8 nor more than 1.25.
(iii) AERR--(A) In general. The AERR is the present value of total
profits (PVTP) divided by the present value of investment (PVI). In
computing PVTP and PVI, present values are computed using the
applicable discount rate (ADR), and all information available as of the
Determination Date is taken into account.
(B) PVTP. The PVTP is the present value, as of the CSA Start Date,
as defined in section (j)(1)(i) of this section, of the PCT Payor's
actually experienced divisional profits or losses from the CSA Start
Date through the end of the Adjustment Year.
(C) PVI. The PVI is the present value, as of the CSA Start Date, of
the PCT Payor's investment associated with the CSA Activity, defined as
the sum of its cost contributions and its PCT Payments, from the CSA
Start Date through the end of the Adjustment Year. For purposes of
computing the PVI, PCT Payments means all PCT Payments due from a PCT
Payor before netting against PCT Payments due from other controlled
participants pursuant to paragraph (j)(3)(ii) of this section.
(iv) ADR--(A) In general. Except as provided in paragraph
(i)(6)(iv)(B) of this section, the ADR is the discount rate pursuant to
paragraph (g)(2)(v) of this section, subject to such adjustments as the
Commissioner determines appropriate.
[[Page 80123]]
(B) Publicly traded companies. If the PCT Payor meets the
conditions of paragraph (i)(6)(iv)(C) of this section, the ADR is the
PCT Payor WACC as of the date of the Trigger PCT. However, if the
Commissioner determines, or the controlled participants establish to
the satisfaction of the Commissioner, that a discount rate other than
the PCT Payor WACC better reflects the degree of risk of the CSA
Activity as of such date, the ADR is such other discount rate.
(C) Publicly traded. A PCT Payor meets the conditions of this
paragraph (i)(6)(iv)(C) if--
(1) Stock of the PCT Payor is publicly traded; or
(2) Stock of the PCT Payor is not publicly traded, provided the PCT
Payor is included in a group of companies for which consolidated
financial statements are prepared; and a publicly traded company in
such group owns, directly or indirectly, stock in PCT Payor. Stock of a
company is publicly traded within the meaning of this paragraph
(i)(6)(iv)(C) if such stock is regularly traded on an established
United States securities market and the company issues financial
statements prepared in accordance with United States generally accepted
accounting principles for the taxable year.
(D) PCT Payor WACC. The PCT Payor WACC is the WACC, as defined in
paragraph (j)(1)(i) of this section, of the PCT Payor or the publicly
traded company described in paragraph (i)(6)(iv)(C)(2)(ii) of this
section, as the case may be.
(E) Generally accepted accounting principles. For purposes of
paragraph (i)(6)(iv)(C) of this section, a financial statement prepared
in accordance with a comprehensive body of generally accepted
accounting principles other than United States generally accepted
accounting principles is considered to be prepared in accordance with
United States generally accepted accounting principles provided that
the amounts of debt, equity, and interest expense are reflected in any
reconciliation between such other accounting principles and United
States generally accepted accounting principles required to be
incorporated into the financial statement by the securities laws
governing companies whose stock is regularly traded on United States
securities markets.
(v) Determination of periodic adjustments. In the event of a
Periodic Trigger, subject to paragraph (i)(6)(vi) of this section, the
Commissioner may make periodic adjustments with respect to all PCT
Payments between all PCT Payors and PCT Payees for the Adjustment Year
and all subsequent years for the duration of the CSA Activity pursuant
to the residual profit split method as provided in paragraph (g)(7) of
this section, subject to the further modifications in this paragraph
(i)(6)(v). A periodic adjustment may be made for a particular taxable
year without regard to whether the taxable years of the Trigger PCT or
other PCTs remain open for statute of limitation purposes.
(A) In general. Periodic adjustments are determined by the
following steps:
(1) First, determine the present value, as of the date of the
Trigger PCT, of the PCT Payments under paragraph (g)(7)(iii)(C)(3) of
this section pursuant to the Adjusted RPSM as defined in paragraph
(i)(6)(v)(B) of this section (first step result).
(2) Second, convert the first step result into a stream of
contingent payments on a base of reasonably anticipated divisional
profits or losses over the entire duration of the CSA Activity, using a
level royalty rate (second step rate). See paragraph (h)(2)(iv) of this
section (Conversion from fixed to contingent form of payment). This
conversion is made based on all information known as of the
Determination Date.
(3) Third, apply the second step rate to the actual divisional
profit or loss for taxable years preceding and including the Adjustment
Year to yield a stream of contingent payments for such years, and
convert such stream to a present value as of the CSA Start Date under
the principles of paragraph (g)(2)(v) of this section (third step
result). For this purpose, the second step rate applied to a loss for a
particular year will yield a negative contingent payment for that year.
(4) Fourth, convert any actual PCT Payments up through the
Adjustment Year to a present value as of the CSA Start Date under the
principles of paragraph (g)(2)(v) of this section. Then subtract such
amount from the third step result. Determine the nominal amount in the
Adjustment Year that would have a present value as of the CSA Start
Date equal to the present value determined in the previous sentence to
determine the periodic adjustment in the Adjustment Year.
(5) Fifth, apply the second step rate to the actual divisional
profit or loss for each taxable year after the Adjustment Year up to
and including the taxable year that includes the Determination Date to
yield a stream of contingent payments for such years. For this purpose,
the second step rate applied to a loss will yield a negative contingent
payment for that year. Then subtract from each such payment any actual
PCT Payment made for the same year to determine the periodic adjustment
for such taxable year.
(6) For each taxable year subsequent to the year that includes the
Determination Date, the periodic adjustment for such taxable year
(which is in lieu of any PCT Payment that would otherwise be payable
for that year under the taxpayer's position) equals the second step
rate applied to the actual divisional profit or loss for that year. For
this purpose, the second step rate applied to a loss for a particular
year will yield a negative contingent payment for that year.
(7) If the periodic adjustment for any taxable year is a positive
amount, then it is an additional PCT Payment owed from the PCT Payor to
the PCT Payee for such year. If the periodic adjustment for any taxable
year is a negative amount, then it is an additional PCT Payment owed by
the PCT Payee to the PCT Payor for such year.
(B) Adjusted RPSM as of Determination Date. The Adjusted RPSM is
the residual profit split method pursuant to paragraph (g)(7) of this
section applied to determine the present value, as of the date of the
Trigger PCT, of the PCT Payments under paragraph (g)(7)(iii)(C)(3) of
this section, with the following modifications.
(1) Actual results up through the Determination Date shall be
substituted for what otherwise were the projected results over such
period, as reasonably anticipated as of the date of the Trigger PCT.
(2) Projected results for the balance of the CSA Activity after the
Determination Date, as reasonably anticipated as of the Determination
Date, shall be substituted for what otherwise were the projected
results over such period, as reasonably anticipated as of the date of
the Trigger PCT.
(3) The requirement in paragraph (g)(7)(i) of this section, that at
least two controlled participants make significant nonroutine
contributions, does not apply.
(vi) Exceptions to periodic adjustments--(A) Controlled
participants establish periodic adjustment not warranted. No periodic
adjustment will be made under paragraphs (i)(6)(i) and (v) of this
section if the controlled participants establish to the satisfaction of
the Commissioner that all the conditions described in one of paragraphs
(i)(6)(vi)(A)(1) through (4) of this section apply with respect to the
Trigger PCT.
(1) Transactions involving the same platform contribution as in the
Trigger PCT.
[[Page 80124]]
(i) The same platform contribution is furnished to an uncontrolled
taxpayer under substantially the same circumstances as those of the
relevant Trigger PCT and with a similar form of payment as the Trigger
PCT;
(ii) This transaction serves as the basis for the application of
the comparable uncontrolled transaction method described in paragraph
(g)(3) of this section, in the first year and all subsequent years in
which substantial PCT Payments relating to the Trigger PCT were
required to be paid; and
(iii) The amount of those PCT Payments in that first year was arm's
length.
(2) Results not reasonably anticipated. The differential between
the AERR and the nearest bound of the PRRR is due to extraordinary
events beyond the control of the controlled participants that could not
reasonably have been anticipated as of the date of the Trigger PCT.
(3) Reduced AERR does not cause Periodic Trigger. The Periodic
Trigger would not have occurred had the PCT Payor's divisional profits
or losses used to calculate its PVTP both taken into account expenses
on account of operating cost contributions and routine platform
contributions, and excluded those profits or losses attributable to the
PCT Payor's routine contributions to its exploitation of cost shared
intangibles, nonroutine contributions to the CSA Activity, operating
cost contributions, and routine platform contributions.
(4) Increased AERR does not cause Periodic Trigger--(i) The
Periodic Trigger would not have occurred had the divisional profits or
losses of the PCT Payor used to calculate its PVTP included its
reasonably anticipated divisional profits or losses after the
Adjustment Year from the CSA Activity, including from its routine
contributions, its operating cost contributions, and its nonroutine
contributions to that activity, and had the cost contributions and PCT
Payments of the PCT Payor used to calculate its PVI included its
reasonably anticipated cost contributions and PCT Payments after the
Adjustment Year. The reasonably anticipated amounts in the previous
sentence are determined based on all information available as of the
Determination Date.
(ii) For purposes of this paragraph (i)(6)(vi)(A)(4), the
controlled participants may, if they wish, assume that the average
yearly divisional profits or losses for all taxable years prior to and
including the Adjustment Year, in which there has been substantial
exploitation of cost shared intangibles resulting from the CSA
(exploitation years), will continue to be earned in each year over a
period of years equal to 15 minus the number of exploitation years
prior to and including the Determination Date.
(B) Circumstances in which Periodic Trigger deemed not to occur. No
Periodic Trigger will be deemed to have occurred at the times and in
the circumstances described in paragraph (i)(6)(vi)(B)(1) or (2) of
this section.
(1) 10-year period. In any year subsequent to the 10-year period
beginning with the first taxable year in which there is substantial
exploitation of cost shared intangibles resulting from the CSA, if the
AERR determined is within the PRRR for each year of such 10-year
period.
(2) 5-year period. In any year of the 5-year period beginning with
the first taxable year in which there is substantial exploitation of
cost shared intangibles resulting from the CSA, if the AERR falls below
the lower bound of the PRRR.
(vii) Examples. The following examples illustrate the rules of this
paragraph (i)(6):
Example 1. (i) For simplicity of calculation in this Example 1,
all financial flows are assumed to occur at the beginning of the
year. At the beginning of Year 1, USP, a publicly traded U.S.
company, and FS, its wholly-owned foreign subsidiary, enter into a
CSA to develop new technology for cell phones. USP has a platform
contribution, the rights for an in-process technology that when
developed will improve the clarity of calls, for which compensation
is due from FS. FS has no platform contributions to the CSA, no
operating contributions, and no operating cost contributions. USP
and FS agree to fixed PCT payments of $40 million in Year 1 and $10
million per year for Years 2 through 10. At the beginning of Year 1,
the weighted average cost of capital of the controlled group that
includes USP and FS is 15%. In Year 9, the Commissioner audits Years
5 through 7 of the CSA and considers whether any periodic
adjustments should be made. USP and FS have substantially complied
with the documentation requirements of paragraph (k) of this
section.
(ii) FS experiences the results reported in the following table
from its participation in the CSA through Year 7. In the table, all
present values (PV) are reported as of the CSA Start Date, which is
the same as the date of the PCT (and reflect a 15% discount rate as
discussed in paragraph (iii) of this Example 1). Thus, in any year
the present value of the cumulative investment is PVI and of the
cumulative divisional profit or loss is PVTP. All amounts in this
table and the tables that follow are reported in millions of dollars
and cost contributions are referred to as ``CCs'' (for simplicity of
calculation in this Example 1, all financial flows are assumed to
occur at the beginning of the year).
--------------------------------------------------------------------------------------------------------------------------------------------------------
a b c d e f g h
--------------------------------------------------------------------------------------------------------------------------------------------------------
Divisional
Year Sales Non CC costs CCs PCT payments Investment profit or loss AERR (PVTP/
(d+e) (b-c) PVI) (g/f)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1....................................... 0 0 15 40 55 0 ..............
2....................................... 0 0 17 10 27 0 ..............
3....................................... 0 0 18 10 28 0 ..............
4....................................... 705 662 20 10 30 46 ..............
5....................................... 886 718 22 10 32 168 ..............
6....................................... 1,113 680 24 10 34 433 ..............
7....................................... 1,179 747 27 10 37 432 ..............
PV through Year 5....................... 970 846 69 69 138 124 0.90
PV through Year 6....................... 1,523 1,184 81 74 155 340 2.20
PV through Year 7....................... 2,033 1,507 93 78 171 526 3.09
--------------------------------------------------------------------------------------------------------------------------------------------------------
(iii) Because USP is publicly traded in the United States and
is a member of the controlled group to which FS (the PCT Payor)
belongs, for purposes of calculating the AERR for FS, the present
values of its PVTP and PVI are determined using an ADR of 15%, the
weighted average cost of capital of the controlled group. (It is
assumed that no other rate was determined or established, under
paragraph (i)(6)(iv)(B) of this section, to better reflect the
relevant degree of risk.) At a 15% discount rate, the PVTP,
calculated as of Year 1, and based on actual profits realized by FS
through Year 7 from exploiting the new cell phone technology
developed by the CSA, is $526 million. The PVI, based on FS's cost
contributions and its PCT Payments, is $171 million. The AERR for FS
is equal to
[[Page 80125]]
its PVTP divided by its PVI, $526 million/$171 million, or 3.09.
There is a Periodic Trigger because FS's AERR of 3.09 falls outside
the PRRR of .67 to 1.5, the applicable PRRR for controlled
participants complying with the documentation requirements of this
section.
(iv) At the time of the Determination Date, it is determined
that the first Adjustment Year in which a Periodic Trigger occurred
was Year 6, when the AERR of FS was determined to be 2.20. It is
also determined that for Year 6 none of the exceptions to periodic
adjustments described in paragraph (i)(6)(vi) of this section
applies. The Commissioner exercises its discretion under paragraph
(i)(6)(i) of this section to make periodic adjustments using Year 6
as the Adjustment Year. Therefore, the arm's length PCT Payments
from FS to USP shall be determined for each taxable year using the
adjusted residual profit split method described in paragraphs (g)(7)
and (i)(6)(v)(B) of this section. Periodic adjustments will be made
for each year to the extent the PCT Payments actually made by FS
differ from the PCT Payment calculation under the adjusted residual
profit split method.
(v) It is determined, as of the Determination Date, that the
cost shared intangibles will be exploited through Year 10. FS's
return for routine contributions (determined by the Commissioner,
based on the return for comparable functions undertaken by
comparable uncontrolled companies, to be 8% of non-CC costs), and
its actual and projected results, are described in the following
table.
--------------------------------------------------------------------------------------------------------------------------------------------------------
a b c d e f g
--------------------------------------------------------------------------------------------------------------------------------------------------------
Divisional Residual
Year Sales Non-CC costs profit or loss CCs Routing return proift (d-e-
(b-c) f)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1....................................................... 0 0 0 15 0 -15
2....................................................... 0 0 0 17 0 -17
3....................................................... 0 0 0 18 0 -18
4....................................................... 705 662 43 20 53 -30
5....................................................... 886 718 168 22 57 89
6....................................................... 1,113 680 433 24 54 355
7....................................................... 1,179 747 432 27 60 345
8....................................................... 1,238 822 416 29 66 321
9....................................................... 1,300 894 406 32 72 302
10...................................................... 1,365 974 391 35 78 278
Cumulative PV through Year 10 as of CSA Start Date...... 3,312 2,385 927 124 191 612
--------------------------------------------------------------------------------------------------------------------------------------------------------
(vi) The periodic adjustments are calculated in a series of
steps set out in paragraph (i)(6)(v)(A) of this section. First, a
lump sum for the PCT Payment is determined using the adjusted
residual profit split method. Under the method, based on the
considerations discussed in paragraph (g)(2)(v) of this section, the
appropriate discount rate is 15% per year. The nonroutine residual
divisional profit or loss described in paragraph (g)(7)(iii)(B) of
this section is $612 million. Further, under paragraph
(g)(7)(iii)(C) of this section, the entire nonroutine residual
divisional profit constitutes the PCT Payment because only USP has
nonroutine contributions.
(vii) In step two, the first step result ($612 million) is
converted into a level royalty rate based on the reasonably
anticipated divisional profit or losses of the CSA Activity, the PV
of which is reported in the table above (net PV of divisional profit
or loss for Years 1 through 10 is $927 million). Consequently, the
step two result is a level royalty rate of 66.0% ($612/$927) of the
divisional profit in Years 1 through 10.
(viii) In step three, the Commissioner calculates the PCT
Payments due through Year 6 by applying the step two royalty rate to
the actual divisional profits for each year and then determines the
aggregate PV of these PCT Payments as of the CSA Start Date ($224
million as reported in the following table). In step four, the PCT
Payments actually made through Year 6 are similarly converted to PV
as of the CSA Start Date ($74 million) and subtracted from the
amount determined in step three ($224 million--$74 million = $150
million). That difference of $150 million, representing a net PV as
of the CSA Start Date, is then converted to a nominal amount, as of
the Adjustment Year, of equivalent present value (again using a
discount rate of 15%). That nominal amount is $302 million (not
shown in the table), and is the periodic adjustment in Year 6.
----------------------------------------------------------------------------------------------------------------
a b c d e
----------------------------------------------------------------------------------------------------------------
Nominal royalty
Year Divisional profit Royalty rate due under adjusted Nominal payments
RPSM (b*c) made
----------------------------------------------------------------------------------------------------------------
Year 1.......................... 0 66.0 $0 $40
Year 2.......................... 0 66.0 0 10
Year 3.......................... 0 66.0 0 10
Year 4.......................... 43 66.0 28 10
Year 5.......................... 168 66.0 111 10
Year 6.......................... 433 66.0 286 10
Cumulative PV as of Year 1...... .................. .................. 224 74
----------------------------------------------------------------------------------------------------------------
(ix) Under step five, the royalties due from FS to USP for Year
7 (the year after the Adjustment Year) through Year 9 (the year
including the Determination Date) are determined. (These
determinations are made for Years 8 and 9 after the divisional
profit for those years becomes available.) For each year, the
periodic adjustment is a PCT Payment due in addition to the $10
million PCT Payment that must otherwise be paid under the CSA as
described in paragraph (i) of this Example 1. That periodic
adjustment is calculated as the product of the step two royalty rate
and the divisional profit, minus the $10 million that was otherwise
paid for that year. The calculations are shown in the following
table:
[[Page 80126]]
--------------------------------------------------------------------------------------------------------------------------------------------------------
a b c d e f
--------------------------------------------------------------------------------------------------------------------------------------------------------
Divisional Royalty due PCT Payments Periodic
Year profit Royalty rate (b*c) otherwise paid adjustment d-e)
--------------------------------------------------------------------------------------------------------------------------------------------------------
7............................................................. 432 66.0% $285 $10 $275
8............................................................. 416 66.0 275 10 265
9............................................................. 406 66.0 268 10 258
--------------------------------------------------------------------------------------------------------------------------------------------------------
(x) Under step six, the periodic adjustment for Year 10 (the
only exploitation year after the year containing the Determination
Date) will be determined by applying the step two royalty rate to
the divisional profit. This periodic adjustment is a PCT Payment
payable from FS to USP, and is in lieu of the $10 payment otherwise
due. The calculations are shown in the following table, based on a
divisional profit of $391 million. USP and FS experienced the
following results in Year 10.
--------------------------------------------------------------------------------------------------------------------------------------------------------
PCT payment
called for under
Year Divisional Royalty rate Royalty due original Periodic
profit agreement but adjustment
not made
--------------------------------------------------------------------------------------------------------------------------------------------------------
10............................................................ 391 66.0% $258 $10 (not paid) $258
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 2. The facts are the same as in paragraphs (i) through
(iii) of Example 1. At the time of the Determination Date, it is
determined that the first Adjustment Year in which a Periodic
Trigger occurred was Year 6, when the AERR of FS was determined to
be 2.73. Upon further investigation as to what may have caused the
high return in FS's market, the Commissioner learns that, in Years 4
through 6, USP's leading competitors experienced severe, unforeseen
disruptions in their supply chains resulting in a significant
increase in USP's and FS's market share for cell phones. Further
analysis determines that without this unforeseen occurrence the
Periodic Trigger would not have occurred. Based on paragraph
(i)(6)(vi)(A)(2) of this section, the Commissioner determines to his
satisfaction that no adjustments are warranted.
Example 3. (i) USP, a U.S. corporation, and its wholly-owned
foreign subsidiaries FS1, FS2, and FS3 enter into a CSA at the start
of Year 1 to develop version 2.0 of a computer program. USP makes a
platform contribution, version 1.0 of the program (upon which
version 2.0 will be based), for which compensation is due from FS1,
FS2, and FS3. None of the foreign subsidiaries makes any platform
contributions.
(ii) In Year 6, the Commissioner audits Years 3 through 5 of the
CSA and considers whether any periodic adjustments should be made.
At the time of the Determination Date, the Commissioner determines
that the first Adjustment Year in which a Periodic Trigger occurred
was Year 3, and further determines that none of the exceptions to
periodic adjustments described in paragraph (i)(6)(vi) of this
section applies. The Commissioner exercises his discretion under
paragraph (i)(6)(i) of this section to make periodic adjustments
using Year 3 as the Adjustment Year. Therefore, the arm's length PCT
Payments from FS1, FS2, and FS3 to USP shall be determined using the
adjusted residual profit split method described in paragraphs
(g)(7)(v)(B) and (i)(6)(v)(B) of this section. Periodic adjustments
will be made for each year to the extent the PCT Payments actually
made by FS1, FS2, and FS3 differ from the PCT Payment calculation
under the adjusted residual profit split method.
(iii) The periodic adjustments are calculated in a series of
steps set out in paragraph (i)(6)(v)(A) of this section. First, a
lump sum for the PCT Payments is determined using the adjusted
residual profit split method. The following results are calculated
(based on actual results for years for which actual results are
available and projected results for all years thereafter) in order
to apply the adjusted residual profit split method (it is determined
that the cost shared intangibles will be exploited through Year 7,
so the results reported in the following table are cumulative values
through Year 7):
----------------------------------------------------------------------------------------------------------------
Divisional profits Residual profits
(cumulative PV through (cumulative PV through
Participant year 7 as of the CSA year 7 as of the CSA
start date) start date)
----------------------------------------------------------------------------------------------------------------
FS1........................................................... $667 $314
FS2........................................................... 271 159
FS3........................................................... 592 295
----------------------------------------------------------------------------------------------------------------
Because only USP had nonroutine contributions, under paragraph
(g)(7)(iii)(C) of this section, the entire nonroutine residual
divisional profit constitutes the PCT Payment owed to USP.
Therefore, the present values (as of the CSA Start Date) of the PCT
Payments owed are as follows:
PCT Payment owed from FS1 to USP: $314 million
PCT Payment owed from FS2 to USP: $159 million
PCT Payment owed from FS3 to USP: $295 million
Pursuant to paragraph (i)(6)(v)(A) of this section, the steps in
paragraphs (i)(6)(v)(A)(2) through (7) of this section are performed
separately for the PCT Payments that are owed to USP by each of FS1,
FS2, and FS3.
(iv) First, the steps are performed with respect to FS1. In step
two, the first step result ($314 million) is converted into a level
royalty rate based on FS1's reasonably anticipated divisional
profits or losses through Year 7 (the PV of which is $667 million).
Consequently, the step two result is a level royalty rate of 47.1%
($314/$667) of the divisional profits in Years 1 through 7. In step
three, the Commissioner calculates the PCT Payments due through Year
3 (the Adjustment Year) by applying the step two royalty rate
(47.1%) to FS1's actual divisional profits for each year up to and
including Year 3 and then determining the aggregate PV of these PCT
Payments as of Year 3. In step four, the PCT Payments actually made
by FS1 to USP through Year 3 are similarly converted to a PV as of
Year 3 and subtracted from the amount determined in step three. That
difference is the periodic adjustment in Year 3 with respect to the
PCT Payments made for Years 1 through 3 from FS1 to USP. Under step
five, the royalties due from FS1 to USP for Year 4 (the year after
the Adjustment Year) through Year 6 (the year including the
Determination Date) are determined. The periodic adjustment for each
of these years is calculated as the product of the step two royalty
rate and the
[[Page 80127]]
divisional profit for that year, minus any actual PCT Payment made
by FS1 to USP in that year. The periodic adjustment for each such
year is a PCT Payment due in addition to the PCT Payment from FS1 to
USP that was already made under the CSA. Under step six, the
periodic adjustment for Year 7 (the only exploitation year after the
year containing the Determination Date) will be determined by
applying the step two royalty rate to FS1's divisional profit for
that year. This periodic adjustment for Year 7 is a PCT Payment
payable from FS1 to USP and is in lieu of any PCT Payment from FS1
to USP otherwise due.
(v) Next, the steps in paragraphs (i)(6)(v)(A)(2) through (7) of
this section are performed with respect to FS2. In step two, the
first step result ($159 million) is converted into a level royalty
rate based on FS2's reasonably anticipated divisional profits or
losses through Year 7 (the PV of which is $271 million).
Consequently, the step two result is a level royalty rate of 58.7%
($159/$271) of the divisional profits in Years 1 through 7. In step
three, the Commissioner calculates the PCT Payments due through Year
3 (the Adjustment Year) by applying the step two royalty rate
(58.7%) to FS2's actual divisional profits for each year up to and
including Year 3 and then determining the aggregate PV of these PCT
Payments as of Year 3. In step four, the PCT Payments actually made
by FS2 to USP through Year 3 are similarly converted to a PV as of
Year 3 and subtracted from the amount determined in step three. That
difference is the periodic adjustment in Year 3 with respect to the
PCT Payments made for Years 1 through 3 from FS2 to USP. Under step
five, the royalties due from FS2 to USP for Year 4 (the year after
the Adjustment Year) through Year 6 (the year including the
Determination Date) are determined. The periodic adjustment for each
of these years is calculated as the product of the step two royalty
rate and the divisional profit for that year, minus any actual PCT
Payment made by FS2 to USP in that year. The periodic adjustment for
each such year is a PCT Payment due in addition to the PCT Payment
from FS2 to USP that was already made under the CSA. Under step six,
the periodic adjustment for Year 7 (the only exploitation year after
the year containing the Determination Date) will be determined by
applying the step two royalty rate to FS2's divisional profit for
that year. This periodic adjustment for Year 7 is a PCT Payment
payable from FS2 to USP and is in lieu of any PCT Payment from FS2
to USP otherwise due.
(vi) Finally, the steps in paragraphs (i)(6)(v)(A)(2) through
(7) of this section are performed with respect to FS3. In step two,
the first step result ($295 million) is converted into a level
royalty rate based on FS3's reasonably anticipated divisional
profits or losses through Year 7 (the PV of which is $592 million).
Consequently, the step two result is a level royalty rate of 49.8%
($295/$592) of the divisional profits in Years 1 through 7. In step
three, the Commissioner calculates the PCT Payments due through Year
3 (the Adjustment Year) by applying the step two royalty rate
(49.8%) to FS3's actual divisional profits for each year up to and
including Year 3 and then determining the aggregate PV of these PCT
Payments as of Year 3. In step four, the PCT Payments actually made
by FS3 to USP through Year 3 are similarly converted to a PV as of
Year 3 and subtracted from the amount determined in step three. That
difference is the periodic adjustment in Year 3 with respect to the
PCT Payments made for Years 1 through 3 from FS3 to USP. Under step
five, the royalties due from FS3 to USP for Year 4 (the year after
the Adjustment Year) through Year 6 (the year including the
Determination Date) are determined. The periodic adjustment for each
of these years is calculated as the product of the step two royalty
rate and the divisional profit for that year, minus any actual PCT
Payment made by FS3 to USP in that year. The periodic adjustment for
each such year is a PCT Payment due in addition to the PCT Payment
from FS3 to USP that was already made under the CSA. Under step six,
the periodic adjustment for Year 7 (the only exploitation year after
the year containing the Determination Date) will be determined by
applying the step two royalty rate to FS3's divisional profit for
that year. This periodic adjustment for Year 7 is a PCT Payment
payable from FS3 to USP and is in lieu of any PCT Payment from FS3
to USP otherwise due.
(j) Definitions and special rules--(1) Definitions--(i) In general.
For purposes of this section--
------------------------------------------------------------------------
Main cross
Term Definition references
------------------------------------------------------------------------
Acquisition price........... .................... Sec. 1.482-
7(g)(5)(i).
Adjusted acquisition price.. .................... Sec. 1.482-
7(g)(5)(iii).
Adjusted average market .................... Sec. 1.482-
capitalization. 7(g)(6)(iv).
Adjusted benefit shares..... .................... Sec. 1.482-
7(i)(2)(ii)(A).
Adjusted RPSM............... .................... Sec. 1.482-
7(i)(6)(v)(B).
Adjustment Year............. .................... Sec. 1.482-
7(i)(6)(i).
ADR......................... .................... Sec. 1.482-
7(i)(6)(iv).
AERR........................ .................... Sec. 1.482-
7(i)(6)(iii).
Applicable Method........... .................... Sec. 1.482-
7(g)(2)(ix)(A).
Average market .................... Sec. 1.482-
capitalization. 7(g)(6)(iii).
Benefits.................... Benefits mean the Sec. 1.482-
sum of additional 7(e)(1)(i).
revenue generated,
plus cost savings,
minus any cost
increases from
exploiting cost
shared intangibles.
Capability variation........ .................... Sec. 1.482-
7(f)(3).
Change in participation .................... Sec. 1.482-7(f).
under a CSA.
Consolidated group.......... .................... Sec. 1.482-
7(j)(2)(i).
Contingent payments......... .................... Sec. 1.482-
7(h)(2)(i)(B).
Controlled participant...... Controlled Sec. 1.482-
participant means a 7(a)(1).
controlled
taxpayer, as
defined under Sec.
1.482-1(i)(5),
that is a party to
the contractual
agreement that
underlies the CSA,
and that reasonably
anticipates that it
will derive
benefits, as
defined in
paragraph (e)(1)(i)
of this section,
from exploiting one
or more cost shared
intangibles.
Controlled transfer of .................... Sec. 1.482-
interests. 7(f)(2).
Cost contribution........... .................... Sec. 1.482-
7(d)(4).
[[Page 80128]]
Cost shared intangible...... Cost shared Sec. 1.482-7(b).
intangible means
any intangible,
within the meaning
of Sec. 1.482-
4(b), that is
developed by the
IDA, including any
portion of such
intangible that
reflects a platform
contribution.
Therefore, an
intangible
developed by the
IDA is a cost
shared intangible
even though the
intangible was not
always or was never
a reasonably
anticipated cost
shared intangible.
Cost sharing alternative.... .................... Sec. 1.482-
7(g)(4)(i)(B).
Cost sharing arrangement or .................... Sec. 1.482-7(a),
CSA. (b).
Cost sharing transactions or .................... Sec. 1.482-
CSTs. 7(a)(1), (b)(1)(i).
Cross operating A cross operating Sec. 1.482-
contributions. contribution is any 7(a)(3)(iii),
resource or (g)(2)(iv).
capability or
right, other than a
platform
contribution, that
a controlled
participant has
developed,
maintained, or
acquired prior to
the CSA Start Date,
or subsequent to
the CSA start date
by means other than
operating cost
contributions or
cost contributions,
that is reasonably
anticipated to
contribute to the
CSA Activity within
another controlled
participant's
division.
CSA Activity................ CSA Activity is the Sec. 1.482-
activity of 7(c)(2)(i).
developing and
exploiting cost
shared intangibles.
CSA Start Date.............. The CSA Start Date Sec. 1.482-
is the earlier of 7(i)(6)(iii)(B) and
the date of the CSA (k)(1)(ii) and
contract or the (iii).
first occurrence of
any IDC to which
the CSA applies, in
accordance with
Sec. 1.482-
7(k)(1)(iii).
CST Payments................ .................... Sec. 1.482-
7(b)(1).
Date of PCT................. .................... Sec. 1.482-
7(b)(3).
Determination Date.......... .................... Sec. 1.482-
7(i)(6)(i).
Differential income stream.. .................... Sec. 1.482-
7(g)(4)(vi)(F)(2).
Division.................... Division means the See definitions of
territory or other divisional profit
division that or loss, operating
serves as the basis contribution, and
of the division of operating cost
interests under the contribution.
CSA in the cost
shared intangibles
pursuant to Sec.
1.482-7(b)(4).
Divisional interest......... .................... Sec. 1.482-
7(b)(1)(iii),
(b)(4).
Divisional profit or loss... Divisional profit or Sec. 1.482-
loss means the 7(g)(4)(iii).
operating profit or
loss as separately
earned by each
controlled
participant in its
division from the
CSA Activity,
determined before
any expense
(including
amortization) on
account of cost
contributions,
operating cost
contributions,
routine platform
and operating
contributions,
nonroutine
contributions
(including platform
and operating
contributions), and
tax.
Fixed payments.............. .................... Sec. 1.482-
7(h)(2)(i)(A).
Implied discount rate....... .................... Sec. 1.482-
7(g)(2)(v)(B)(2).
IDC share................... .................... Sec. 1.482-
7(d)(4).
Input parameters............ .................... Sec. 1.482-
7(g)(2)(ix)(B).
Intangible development .................... Sec. 1.482-
activity or IDA. 7(d)(1).
Intangible development costs .................... Sec. 1.482-
or IDCs. 7(a)(1), (d)(1).
Licensing alternative....... .................... Sec. 1.482-
7(g)(4)(i)(C).
Licensing payments.......... Licensing payments Sec. 1.482-
means payments 7(g)(4)(iii).
pursuant to the
licensing
obligations under
the licensing
alternative.
Make-or-sell rights......... .................... Sec. 1.482-
7(c)(4),
(g)(2)(iv).
Market-based input parameter .................... Sec. 1.482-
7(g)(2)(ix)(B).
Market returns for routine Market returns for Sec. 1.482-
contributions routine 7(g)(4), (g)(7).
contributions means
returns determined
by reference to the
returns achieved by
uncontrolled
taxpayers engaged
in activities
similar to the
relevant business
activity in the
controlled
participant's
division,
consistent with the
methods described
in Sec. Sec.
1.482-3, 1.482-4,
1.482-5, or Sec.
1.482-9(c).
Method payment form......... .................... Sec. 1.482-
7(h)(3).
[[Page 80129]]
Nonroutine contributions.... Nonroutine Sec. 1.482-7(g).
contributions means
a controlled
participant's
contributions to
the relevant
business activities
that are not
routine
contributions.
Nonroutine
contributions
ordinarily include
both nonroutine
platform
contributions and
nonroutine
operating
contributions used
by controlled
participants in the
commercial
exploitation of
their interests in
the cost shared
intangibles (for
example, marketing
intangibles used by
a controlled
participant in its
division to sell
products that are
based on the cost
shared intangible).
Nonroutine residual .................... Sec. 1.482-
divisional profit or loss. 7(g)(7)(iii).
Operating contributions..... An operating Sec. 1.482-
contribution is any 7(g)(2)(ii),
resource or (g)(4)(vi)(E),
capability or (g)(7)(iii)(A) and
right, other than a (C).
platform
contribution, that
a controlled
participant has
developed,
maintained, or
acquired prior to
the CSA Start Date,
or subsequent to
the CSA Start Date
by means other than
operating cost
contributions or
cost contributions,
that is reasonably
anticipated to
contribute to the
CSA Activity within
the controlled
participant's
division.
Operating cost contributions Operating cost Sec. 1.482-
contributions means 7(g)(2)(ii),
all costs in the (g)(4)(iii),
ordinary course of (g)(7)(iii)(B).
business on or
after the CSA Start
Date that, based on
analysis of the
facts and
circumstances, are
directly identified
with, or are
reasonably
allocable to,
developing
resources,
capabilities, or
rights (other than
reasonably
anticipated cost
shared intangibles)
that are reasonably
anticipated to
contribute to the
CSA Activity within
the controlled
participant's
division.
PCT Payee................... .................... Sec. 1.482-
7(b)(1)(ii).
PCT Payment................. .................... Sec. 1.482-
7(b)(1)(ii).
PCT Payor................... .................... Sec. 1.482-
7(b)(1)(ii),
(i)(6)(i).
PCT Payor WACC.............. .................... Sec. 1.482-
7(i)(6)(iv)(D).
Periodic adjustments........ .................... Sec. 1.482-
7(i)(6)(i).
Periodic Trigger............ .................... Sec. 1.482-
7(i)(6)(i).
Platform contribution .................... Sec. 1.482-
transaction or PCT. 7(a)(2),
(b)(1)(ii).
Platform contributions...... .................... Sec. 1.482-
7(c)(1).
Post-tax income............. .................... Sec. 1.482-
7(g)(2)(v)(B)(4),
(g)(4)(i)(G).
Pre-tax income.............. .................... Sec. 1.482-
7(g)(2)(v)(B)(4),
(g)(4)(i)(G).
Projected benefit shares.... .................... Sec. 1.482-
7(i)(2)(ii)(A).
PRRR........................ .................... Sec. 1.482-
7(i)(6)(ii).
PVI......................... .................... Sec. 1.482-
7(i)(6)(iii)(C).
PVTP........................ .................... Sec. 1.482-
7(i)(6)(iii)(B).
Reasonably anticipated A controlled Sec. 1.482-
benefits. participant's 7(e)(1).
reasonably
anticipated
benefits mean the
benefits that
reasonably may be
anticipated to be
derived from
exploiting cost
shared intangibles.
For purposes of
this definition,
benefits mean the
sum of additional
revenue generated,
plus cost savings,
minus any cost
increases from
exploiting cost
shared intangibles.
Reasonably anticipated .................... Sec. 1.482-
benefits or RAB shares. 7(a)(1), (e)(1).
Reasonably anticipated cost .................... Sec. 1.482-
shared intangible. 7(d)(1)(ii).
Relevant business activity.. .................... Sec. 1.482-
7(g)(7)(i).
[[Page 80130]]
Routine contributions....... Routine Sec. 1.482-
contributions means 7(g)(4), (g)(7).
a controlled
participant's
contributions to
the relevant
business activities
that are of the
same or similar
kind to those made
by uncontrolled
taxpayers involved
in similar business
activities for
which it is
possible to
identify market
returns. Routine
contributions
ordinarily include
contributions of
tangible property,
services and
intangibles that
are generally owned
by uncontrolled
taxpayers engaged
in similar
activities. A
functional analysis
is required to
identify these
contributions
according to the
functions
performed, risks
assumed, and
resources employed
by each of the
controlled
participants.
Routine platform and .................... Sec. 1.482-
operating contributions, 7(g)(4)(vii), 1.482-
and net routine platform 7(g)(7)(iii)(C)(4).
and operating contributions.
Specified payment form...... .................... Sec. 1.482-
7(h)(3).
Stock-based compensation.... .................... Sec. 1.482-
7(d)(3).
Stock options............... .................... Sec. 1.482-
7(d)(3)(i).
Subsequent PCT.............. .................... Sec. 1.482-
7(g)(2)(viii).
Target...................... .................... Sec. 1.482-
7(g)(5)(i).
Tax rate.................... Reasonably Sec. 1.482-
anticipated 7(g)(2)(v)(B)(4)(ii
effective tax rate ), (g)(4)(i)(G).
with respect to the
pre-tax income to
which the tax rate
is being applied.
For example, under
the income method,
this rate would be
the reasonably
anticipated
effective tax rate
of the PCT Payor or
PCT Payee under the
cost sharing
alternative or the
licensing
alternative, as
appropriate.
Trigger PCT................. .................... Sec. 1.482-
7(i)(6)(i).
Variable input parameter.... .................... Sec. 1.482-
7(g)(2)(ix)(C).
WACC........................ WACC means weighted Sec. 1.482-
average cost of 7(i)(6)(iv)(D).
capital.
------------------------------------------------------------------------
(ii) Examples. The following examples illustrate certain
definitions in paragraph (j)(1)(i) of this section:
Example 1. Controlled participant. Foreign Parent (FP) is a
foreign corporation engaged in the extraction of a natural resource.
FP has a U.S. subsidiary (USS) to which FP sells supplies of this
resource for sale in the United States. FP enters into a CSA with
USS to develop a new machine to extract the natural resource. The
machine uses a new extraction process that will be patented in the
United States and in other countries. The CSA provides that USS will
receive the rights to exploit the machine in the extraction of the
natural resource in the United States, and FP will receive the
rights in the rest of the world. This resource does not, however,
exist in the United States. Despite the fact that USS has received
the right to exploit this process in the United States, USS is not a
controlled participant because it will not derive a benefit from
exploiting the intangible developed under the CSA.
Example 2. Controlled participants. (i) U.S. Parent (USP), one
foreign subsidiary (FS), and a second foreign subsidiary
constituting the group's research arm (R+D) enter into a CSA to
develop manufacturing intangibles for a new product line A. USP and
FS are assigned the exclusive rights to exploit the intangibles
respectively in the United States and the rest of the world, where
each presently manufactures and sells various existing product
lines. R+D is not assigned any rights to exploit the intangibles.
R+D's activity consists solely in carrying out research for the
group. It is reliably projected that the RAB shares of USP and FS
will be 66\2/3\% and 33\1/3\%, respectively, and the parties'
agreement provides that USP and FS will reimburse 66\2/3\% and 33\1/
3\%, respectively, of the IDCs incurred by R+D with respect to the
new intangible.
(ii) R+D does not qualify as a controlled participant within the
meaning of paragraph (j)(1)(i) of this section, because it will not
derive any benefits from exploiting cost shared intangibles.
Therefore, R+D is treated as a service provider for purposes of this
section and must receive arm's length consideration for the
assistance it is deemed to provide to USP and FS, under the rules of
paragraph (a)(3) of this section and Sec. Sec. 1.482-4(f)(3)(iii)
and (4), and 1.482-9, as appropriate. Such consideration must be
treated as IDCs incurred by USP and FS in proportion to their RAB
shares (that is, 66\2/3\% and 33\1/3\%, respectively). R+D will not
be considered to bear any share of the IDCs under the arrangement.
Example 3. Cost shared intangible, reasonably anticipated cost
shared intangible. U.S. Parent (USP) has developed and currently
exploits an antihistamine, XY, which is manufactured in tablet form.
USP enters into a CSA with its wholly-owned foreign subsidiary (FS)
to develop XYZ, a new improved version of XY that will be
manufactured as a nasal spray. Work under the CSA is fully devoted
to developing XYZ, and XYZ is developed. During the development
period, XYZ is a reasonably anticipated cost shared intangible under
the CSA. Once developed, XYZ is a cost shared intangible under the
CSA.
Example 4. Cost shared intangible. The facts are the same as in
Example 3, except that in the course of developing XYZ, the
controlled participants by accident discover ABC, a cure for disease
D. ABC is a cost shared intangible under the CSA.
Example 5. Reasonably anticipated benefits. Controlled parties A
and B enter into a cost sharing arrangement to develop product and
process intangibles for an already existing Product P. Without such
intangibles, A and B would each reasonably anticipate revenue, in
present value terms, of $100M from sales of Product P until it
became obsolete. With the intangibles, A and B each reasonably
anticipate selling the same number of units each year, but
reasonably anticipate that the price will be higher. Because the
particular product intangible is more highly regarded in A's market,
A reasonably anticipates an increase of $20M in present value
revenue from the product intangible, while B reasonably anticipates
only an increase of $10M. Further, A and B each reasonably
anticipate spending an extra $5M present value in production costs
to include the feature embodying the product intangible. Finally, A
and B each reasonably anticipate saving $2M present value in
[[Page 80131]]
production costs by using the process intangible. A and B reasonably
anticipate no other economic effects from exploiting the cost shared
intangibles. A's reasonably anticipated benefits from exploiting the
cost shared intangibles equal its reasonably anticipated increase in
revenue ($20M) plus its reasonably anticipated cost savings ($2M)
minus its reasonably anticipated increased costs ($5M), which equals
$17M. Similarly, B's reasonably anticipated benefits from exploiting
the cost shared intangibles equal its reasonably anticipated
increase in revenue ($10M) plus its reasonably anticipated cost
savings ($2M) minus its reasonably anticipated increased costs
($5M), which equals $7M. Thus A's reasonably anticipated benefits
are $17M and B's reasonably anticipated benefits are $7M.
(2) Special rules--(i) Consolidated group. For purposes of this
section, all members of the same consolidated group shall be treated as
one taxpayer. For these purposes, the term consolidated group means all
members of a group of controlled entities created or organized within a
single country and subjected to an income tax by such country on the
basis of their combined income.
(ii) Trade or business. A participant that is a foreign corporation
or nonresident alien individual will not be treated as engaged in a
trade or business within the United States solely by reason of its
participation in a CSA. See generally Sec. 1.864-2(a).
(iii) Partnership. A CSA, or an arrangement to which the
Commissioner applies the rules of this section, will not be treated as
a partnership to which the rules of subchapter K of the Internal
Revenue Code apply. See Sec. 301.7701-1(c) of this chapter.
(3) Character--(i) CST Payments. CST Payments generally will be
considered the payor's costs of developing intangibles at the location
where such development is conducted. For these purposes, IDCs borne
directly by a controlled participant that are deductible are deemed to
be reduced to the extent of any CST Payments owed to it by other
controlled participants pursuant to the CSA. Each cost sharing payment
received by a payee will be treated as coming pro rata from payments
made by all payors and will be applied pro rata against the deductions
for the taxable year that the payee is allowed in connection with the
IDCs. Payments received in excess of such deductions will be treated as
in consideration for use of the land and tangible property furnished
for purposes of the CSA by the payee. For purposes of the research
credit determined under section 41, CST Payments among controlled
participants will be treated as provided for intra-group transactions
in Sec. 1.41-6(i). Any payment made or received by a taxpayer pursuant
to an arrangement that the Commissioner determines not to be a CSA will
be subject to the provisions of Sec. Sec. 1.482-1 through 1.482-6 and
1.482-9. Any payment that in substance constitutes a cost sharing
payment will be treated as such for purposes of this section,
regardless of its characterization under foreign law.
(ii) PCT Payments. A PCT Payor's payment required under paragraph
(b)(1)(ii) of this section is deemed to be reduced to the extent of any
payments owed to it under such paragraph from other controlled
participants. Each PCT Payment received by a PCT Payee will be treated
as coming pro rata out of payments made by all PCT Payors. PCT Payments
will be characterized consistently with the designation of the type of
transaction pursuant to paragraphs (c)(3) and (k)(2)(ii)(H) of this
section. Depending on such designation, such payments will be treated
as either consideration for a transfer of an interest in intangible
property or for services.
(iii) Examples. The following examples illustrate this paragraph
(j)(3):
Example 1. U.S. Parent (USP) and its wholly owned Foreign
Subsidiary (FS) form a CSA to develop a miniature widget, the Small
R. Based on RAB shares, USP agrees to bear 40% and FS to bear 60% of
the costs incurred during the term of the agreement. The principal
IDCs are operating costs incurred by FS in Country Z of 100X
annually, and costs incurred by USP in the United States also of
100X annually. Of the total costs of 200X, USP's share is 80X and
FS's share is 120X so that FS must make a payment to USP of 20X. The
payment will be treated as a reimbursement of 20X of USP's costs in
the United States. Accordingly, USP's Form 1120 will reflect an 80X
deduction on account of activities performed in the United States
for purposes of allocation and apportionment of the deduction to
source. The Form 5471 ``Information Return of U.S. Persons With
Respect to Certain Foreign Corporations'' for FS will reflect a 100X
deduction on account of activities performed in Country Z and a 20X
deduction on account of activities performed in the United States.
Example 2. The facts are the same as in Example 1, except that
the 100X of costs borne by USP consist of 5X of costs incurred by
USP in the United States and 95X of arm's length rental charge, as
described in paragraph (d)(1)(iii) of this section, for the use of a
facility in the United States. The depreciation deduction
attributable to the U.S. facility is 7X. The 20X net payment by FS
to USP will first be applied in reduction pro rata of the 5X
deduction for costs and the 7X depreciation deduction attributable
to the U.S. facility. The 8X remainder will be treated as rent for
the U.S. facility.
Example 3. (i) Four members (A, B, C, and D) of a controlled
group form a CSA to develop the next generation technology for their
business. Based on RAB shares, the participants agree to bear shares
of the costs incurred during the term of the agreement in the
following percentages: A 40%; B 15%; C 25%; and D 20%. The arm's
length values of the platform contributions they respectively own
are in the following amounts for the taxable year: A 80X; B 40X; C
30X; and D 30X. The provisional (before offsets) and final PCT
Payments among A, B, C, and D are shown in the table as follows:
(All amounts stated in X's)
------------------------------------------------------------------------
A B C D
------------------------------------------------------------------------
Payments............................ <40> <21> <37.5> <30>
Receipts............................ 48 34 22.5 24
Final............................... 8 13 <15> <6>
------------------------------------------------------------------------
(ii) The first row/first column shows A's provisional PCT
Payment equal to the product of 100X (sum of 40X, 30X, and 30X) and
A's RAB share of 40%. The second row/first column shows A's
provisional PCT receipts equal to the sum of the products of 80X and
B's, C's, and D's RAB shares (15%, 25%, and 20%, respectively). The
other entries in the first two rows of the table are similarly
computed. The last row shows the final PCT receipts/payments after
offsets. Thus, for the taxable year, A and B are treated as
receiving the 8X and 13X, respectively, pro rata out of payments by
C and D of 15X and 6X, respectively.
(k) CSA administrative requirements. A controlled participant meets
the requirements of this paragraph if it substantially complies,
respectively, with the CSA contractual, documentation, accounting, and
reporting requirements of paragraphs (k)(1) through (4) of this
section.
(1) CSA contractual requirements--(i) In general. A CSA must be
recorded in writing in a contract that is contemporaneous with the
formation (and any revision) of the CSA and that includes the
contractual provisions described in this paragraph (k)(1).
(ii) Contractual provisions. The written contract described in this
paragraph (k)(1) must include provisions that--
[[Page 80132]]
(A) List the controlled participants and any other members of the
controlled group that are reasonably anticipated to benefit from the
use of the cost shared intangibles, including the address of each
domestic entity and the country of organization of each foreign entity;
(B) Describe the scope of the IDA to be undertaken and each
reasonably anticipated cost shared intangible or class of reasonably
anticipated cost shared intangibles;
(C) Specify the functions and risks that each controlled
participant will undertake in connection with the CSA;
(D) Divide among the controlled participants all divisional
interests in cost shared intangibles and specify each controlled
participant's divisional interest in the cost shared intangibles, as
described in paragraphs (b)(1)(iii) and (4) of this section, that it
will own and exploit without any further obligation to compensate any
other controlled participant for such interest;
(E) Provide a method to calculate the controlled participants' RAB
shares, based on factors that can reasonably be expected to reflect the
participants' shares of anticipated benefits, and require that such RAB
shares must be updated, as described in paragraph (e)(1) of this
section (see also paragraph (k)(2)(ii)(F) of this section);
(F) Enumerate all categories of IDCs to be shared under the CSA;
(G) Specify that the controlled participant must use a consistent
method of accounting to determine IDCs and RAB shares, as described in
paragraphs (d) and (e) of this section, respectively, and must
translate foreign currencies on a consistent basis;
(H) Require the controlled participant to enter into CSTs covering
all IDCs, as described in paragraph (b)(1)(i) of this section, in
connection with the CSA;
(I) Require the controlled participants to enter into PCTs covering
all platform contributions, as described in paragraph (b)(1)(ii) of
this section, in connection with the CSA;
(J) Specify the form of payment due under each PCT (or group of
PCTs) in existence at the formation (and any revision) of the CSA,
including information and explanation that reasonably supports an
analysis of applicable provisions of paragraph (h) of this section; and
(K) Specify the date on which the CSA is entered into (CSA Start
Date) and the duration of the CSA, the conditions under which the CSA
may be modified or terminated, and the consequences of a modification
or termination (including consequences described under the rules of
paragraph (f) of this section).
(iii) Meaning of contemporaneous--(A) In general. For purposes of
this paragraph (k)(1), a written contractual agreement is
contemporaneous with the formation (or revision) of a CSA if, and only
if, the controlled participants record the CSA, in its entirety, in a
document that they sign and date no later than 60 days after the first
occurrence of any IDC described in paragraph (d) of this section to
which such agreement (or revision) is to apply.
(B) Example. The following example illustrates the principles of
this paragraph (k)(1)(iii):
Example. Companies A and B, both of which are members of the
same controlled group, commence an IDA on March 1, Year 1. Company A
pays the first IDCs in relation to the IDA, as cash salaries to A's
research staff, for the staff's work during the first week of March,
Year 1. A and B, however, do not sign and date any written
contractual agreement until August 1, Year 1, whereupon they execute
a ``Cost Sharing Agreement'' that purports to be ``effective as of''
March 1 of Year 1. The arrangement fails the requirement that the
participants record their arrangement in a written contractual
agreement that is contemporaneous with the formation of a CSA. The
arrangement has failed to meet the requirements set forth in
paragraph (b)(2) of this section and, pursuant to paragraph (b) of
this section, cannot be a CSA.
(iv) Interpretation of contractual provisions--(A) In general. The
provisions of a written contract described in this paragraph (k)(1) and
of the additional documentation described in paragraph (k)(2) of this
section must be clear and unambiguous. The provisions will be
interpreted by reference to the economic substance of the transaction
and the actual conduct of the controlled participants. See Sec. 1.482-
1(d)(3)(ii)(B) (Identifying contractual terms). Accordingly, the
Commissioner may impute contractual terms in a CSA consistent with the
economic substance of the CSA and may disregard contractual terms that
lack economic substance. An allocation of risk between controlled
participants after the outcome of such risk is known or reasonably
knowable lacks economic substance. See Sec. 1.482-1(d)(3)(iii)(B)
(Identification of taxpayer that bears risk). A contractual term that
is disregarded due to a lack of economic substance does not satisfy a
contractual requirement set forth in this paragraph (k)(1) or
documentation requirement set forth in paragraph (k)(2) of this
section. See paragraph (b)(5) of this section for the treatment of an
arrangement among controlled taxpayers that fails to comply with the
requirements of this section.
(B) Examples. The following examples illustrate the principles of
this paragraph (k)(1)(iv). In each example, it is assumed that the
Commissioner will exercise the discretion granted pursuant to paragraph
(b)(5)(ii) of this section to apply the provisions of this section to
the arrangement that purports to be a CSA.
Example 1. The contractual provisions recorded upon formation of
an arrangement that purports to be a CSA provide that PCT Payments
with respect to a particular platform contribution will consist of
payments contingent on sales. Contrary to the contractual
provisions, the PCT Payments actually made are contingent on
profits. Because the controlled participants' actual conduct is
different from the contractual terms, the Commissioner may
determine, based on the facts and circumstances, that--
(i) The actual payments have economic substance and, therefore,
impute payment terms in the CSA consistent with the actual payments;
or
(ii) The contract terms reflect the economic substance of the
arrangement and, therefore, the actual payments must be adjusted to
conform to the terms.
Example 2. An arrangement that purports to be a CSA provides
that PCT Payments with respect to a particular platform contribution
shall be contingent payments equal to 10% of sales of products that
incorporate cost shared intangibles. The contract terms further
provide that the controlled participants must adjust such contingent
payments in accordance with a formula set forth in the terms. During
the first three years of the arrangement, the controlled
participants fail to make the adjustments required by the terms with
respect to the PCT Payments. The Commissioner may determine, based
on the facts and circumstances, that--
(i) The contingent payment terms with respect to the platform
contribution do not have economic substance because the controlled
participants did not act in accordance with their upfront risk
allocation; or
(ii) The contract terms reflect the economic substance of the
arrangement and, therefore, the actual payments must be adjusted to
conform to the terms.
(2) CSA documentation requirements--(i) In general. The controlled
participants must timely update and maintain sufficient documentation
to establish that the participants have met the CSA contractual
requirements of paragraph (k)(1) of this section and the additional CSA
documentation requirements of this paragraph (k)(2).
(ii) Additional CSA documentation requirements. The controlled
participants to a CSA must timely update and maintain documentation
sufficient to--
(A) Describe the current scope of the IDA and identify--
(1) Any additions or subtractions from the list of reasonably
anticipated cost shared intangibles reported pursuant to paragraph
(k)(1)(ii)(B) of this section;
[[Page 80133]]
(2) Any cost shared intangible, together with each controlled
participant's interest therein; and
(3) Any further development of intangibles already developed under
the CSA or of specified applications of such intangibles which has been
removed from the IDA (see paragraphs (d)(1)(ii) and (j)(1)(i) of this
section for the definitions of reasonably anticipated cost shared
intangible and cost shared intangible) and the steps (including any
accounting classifications and allocations) taken to implement such
removal.
(B) Establish that each controlled participant reasonably
anticipates that it will derive benefits from exploiting cost shared
intangibles;
(C) Describe the functions and risks that each controlled
participant has undertaken during the term of the CSA;
(D) Provide an overview of each controlled participant's business
segments, including an analysis of the economic and legal factors that
affect CST and PCT pricing;
(E) Establish the amount of each controlled participant's IDCs for
each taxable year under the CSA, including all IDCs attributable to
stock-based compensation, as described in paragraph (d)(3) of this
section (including the method of measurement and timing used in
determining such IDCs, and the data, as of the date of grant, used to
identify stock-based compensation with the IDA);
(F) Describe the method used to estimate each controlled
participant's RAB share for each year during the course of the CSA,
including--
(1) All projections used to estimate benefits;
(2) All updates of the RAB shares in accordance with paragraph
(e)(1) of this section; and
(3) An explanation of why that method was selected and why the
method provides the most reliable measure for estimating RAB shares;
(G) Describe all platform contributions;
(H) Designate the type of transaction involved for each PCT or
group of PCTs;
(I) Specify, within the time period provided in paragraph
(h)(2)(iii) of this section, the form of payment due under each PCT or
group of PCTs, including information and explanation that reasonably
supports an analysis of applicable provisions of paragraph (h) of this
section;
(J) Describe and explain the method selected to determine the arm's
length payment due under each PCT, including--
(1) An explanation of why the method selected constitutes the best
method, as described in Sec. 1.482-1(c)(2), for measuring an arm's
length result;
(2) The economic analyses, data, and projections relied upon in
developing and selecting the best method, including the source of the
data and projections used;
(3) Each alternative method that was considered, and the reason or
reasons that the alternative method was not selected;
(4) Any data that the controlled participant obtains, after the CSA
takes effect, that would help determine if the controlled participant's
method selected has been applied in a reasonable manner;
(5) The discount rate or rates, where applicable, used for purposes
of evaluating PCT Payments, including information and explanation that
reasonably supports an analysis of applicable provisions of paragraph
(g)(2)(v) of this section;
(6) The estimated arm's length values of any platform contributions
as of the dates of the relevant PCTs, in accordance with paragraph
(g)(2)(ii) of this section;
(7) A discussion, where applicable, of why transactions were or
were not aggregated under the principles of paragraph (g)(2)(iv) of
this section;
(8) The method payment form and any conversion made from the method
payment form to the specified payment form, as described in paragraph
(h)(3) of this section; and
(9) If applicable under paragraph (i)(6)(iv) of this section, the
WACC of the parent of the controlled group that includes the controlled
participants.
(iii) Coordination rules and production of documents--(A)
Coordination with penalty regulations. See Sec. 1.6662-6(d)(2)(iii)(D)
regarding coordination of the rules of this paragraph (k) with the
documentation requirements for purposes of the accuracy-related penalty
under section 6662(e) and (h).
(B) Production of documentation. Each controlled participant must
provide to the Commissioner, within 30 days of a request, the items
described in this paragraph (k)(2) and paragraph (k)(3) of this
section. The time for compliance described in this paragraph
(k)(2)(iii)(B) may be extended at the discretion of the Commissioner.
(3) CSA accounting requirements--(i) In general. The controlled
participants must maintain books and records (and related or underlying
data and information) that are sufficient to--
(A) Establish that the controlled participants have used (and are
using) a consistent method of accounting to measure costs and benefits;
(B) Permit verification that the amount of any contingent PCT
Payments due have been (and are being) properly determined;
(C) Translate foreign currencies on a consistent basis; and
(D) To the extent that the method of accounting used materially
differs from U.S. generally accepted accounting principles, explain any
such material differences.
(ii) Reliance on financial accounting. For purposes of this
section, the controlled participants may not rely solely upon financial
accounting to establish satisfaction of the accounting requirements of
this paragraph (k)(3). Rather, the method of accounting must clearly
reflect income. Thor Power Tools Co. v. Commissioner, 439 U.S. 522
(1979).
(4) CSA reporting requirements--(i) CSA Statement. Each controlled
participant must file with the Internal Revenue Service, in the manner
described in this paragraph (k)(4), a ``Statement of Controlled
Participant to Sec. 1.482-7 Cost Sharing Arrangement'' (CSA Statement)
that complies with the requirements of this paragraph (k)(4).
(ii) Content of CSA Statement. The CSA Statement of each controlled
participant must--
(A) State that the participant is a controlled participant in a
CSA;
(B) Provide the controlled participant's taxpayer identification
number;
(C) List the other controlled participants in the CSA, the country
of organization of each such participant, and the taxpayer
identification number of each such participant;
(D) Specify the earliest date that any IDC described in paragraph
(d)(1) of this section occurred; and
(E) Indicate the date on which the controlled participants formed
(or revised) the CSA and, if different from such date, the date on
which the controlled participants recorded the CSA (or any revision)
contemporaneously in accordance with paragraphs (k)(1)(i) and (iii) of
this section.
(iii) Time for filing CSA Statement--(A) 90-day rule. Each
controlled participant must file its original CSA Statement with the
Internal Revenue Service Ogden Campus (addressed as follows: ``Attn:
CSA Statements, Mail Stop 4912, Internal Revenue Service, 1973 North
Rulon White Blvd., Ogden, Utah 84404-0040''), no later than 90 days
after the first occurrence of an IDC to which the newly-formed CSA
applies, as described in paragraph (k)(1)(iii)(A) of this section, or,
in the case of a taxpayer that became a
[[Page 80134]]
controlled participant after the formation of the CSA, no later than 90
days after such taxpayer became a controlled participant. A CSA
Statement filed in accordance with this paragraph (k)(4)(iii)(A) must
be dated and signed, under penalties of perjury, by an officer of the
controlled participant who is duly authorized (under local law) to sign
the statement on behalf of the controlled participant.
(B) Annual return requirement--(1) In general. Each controlled
participant must attach to its U.S. income tax return, for each taxable
year for the duration of the CSA, a copy of the original CSA Statement
that the controlled participant filed in accordance with the 90-day
rule of paragraph (k)(4)(iii)(A) of this section. In addition, the
controlled participant must update the information reflected on the
original CSA Statement annually by attaching a schedule that documents
changes in such information over time.
(2) Special filing rule for annual return requirement. If a
controlled participant is not required to file a U.S. income tax
return, the participant must ensure that the copy or copies of the CSA
Statement and any updates are attached to Schedule M of any Form 5471,
any Form 5472 ``Information Return of a Foreign Owned Corporation,'' or
any Form 8865 ``Return of U.S. Persons With Respect to Certain Foreign
Partnerships,'' filed with respect to that participant.
(iv) Examples. The following examples illustrate this paragraph
(k)(4). In each example, Companies A and B are members of the same
controlled group.
Example 1. A and B, both of which file U.S. tax returns, agree
to share the costs of developing a new chemical formula in
accordance with the provisions of this section. On March 30, Year 1,
A and B record their agreement in a written contract styled, ``Cost
Sharing Agreement.'' The contract applies by its terms to IDCs
occurring after March 1, Year 1. The first IDCs to which the CSA
applies occurred on March 15, Year 1. To comply with paragraph
(k)(4)(iii)(A) of this section, A and B individually must file
separate CSA Statements no later than 90 days after March 15, Year 1
(June 13, Year 1). Further, to comply with paragraph (k)(4)(iii)(B)
of this section, A and B must attach copies of their respective CSA
Statements to their respective Year 1 U.S. income tax returns.
Example 2. The facts are the same as in Example 1, except that a
year has passed and C, which files a U.S. tax return, joined the CSA
on May 9, Year 2. To comply with the annual filing requirement
described in paragraph (k)(4)(iii)(B) of this section, A and B must
each attach copies of their respective CSA Statements (as filed for
Year 1) to their respective Year 2 income tax returns, along with a
schedule updated appropriately to reflect the changes in information
described in paragraph (k)(4)(ii) of this section resulting from the
addition of C to the CSA. To comply with both the 90-day rule
described in paragraph (k)(4)(iii)(A) of this section and the annual
filing requirement described in paragraph (k)(4)(iii)(B) of this
section, C must file a CSA Statement no later than 90 days after May
9, Year 2 (August 7, Year 2), and must attach a copy of such CSA
Statement to its Year 2 income tax return.
(l) Effective/applicability date. This section applies on December
16, 2011.
(m) Transition rule--(1) In general. An arrangement in existence on
January 5, 2009, will be considered a CSA, as described under paragraph
(b) of this section, if, prior to such date, it was a qualified cost
sharing arrangement under the provisions of Sec. 1.482-7 (as contained
in the 26 CFR part 1 edition revised as of January 1, 1996, hereafter
referred to as ``former Sec. 1.482-7''), but only if the written
contract, as described in paragraph (k)(1) of this section, is amended,
if necessary, to conform with, and only if the activities of the
controlled participants substantially comply with, the provisions of
this section, as modified by paragraphs (m)(2) and (m)(3) of this
section, by July 6, 2009.
(2) Transitional modification of applicable provisions. For
purposes of this paragraph (m), conformity and substantial compliance
with the provisions of this section shall be determined with the
following modifications:
(i) CSTs and PCTs occurring prior to January 5, 2009, shall be
subject to the provisions of former Sec. 1.482-7 rather than this
section.
(ii) Except to the extent provided in paragraph (m)(3) of this
section, PCTs that occur under a CSA that was a qualified cost sharing
arrangement under the provisions of former Sec. 1.482-7 and remained
in effect on January 5, 2009, shall be subject to the periodic
adjustment rules of Sec. 1.482-4(f)(2) rather than the rules of
paragraph (i)(6) of this section.
(iii) Paragraphs (b)(1)(iii) and (b)(4) of this section shall not
apply.
(iv) Paragraph (k)(1)(ii)(D) of this section shall not apply.
(v) Paragraphs (k)(1)(ii)(H) and (I) of this section shall be
construed as applying only to transactions entered into on or after
January 5, 2009.
(vi) The deadline for recordation of the revised written
contractual agreement pursuant to paragraph (k)(1)(iii) of this section
shall be no later than July 6, 2009.
(vii) Paragraphs (k)(2)(ii)(G) through (J) of this section shall be
construed as applying only with reference to PCTs entered into on or
after January 5, 2009.
(viii) Paragraph (k)(4)(iii)(A) of this section shall be construed
as requiring a CSA Statement with respect to the revised written
contractual agreement described in paragraph (m)(2)(vi) of this section
no later than September 2, 2009.
(ix) Paragraph (k)(4)(iii)(B) of this section shall be construed as
only applying for taxable years ending after the filing of the CSA
Statement described in paragraph (m)(2)(viii) of this section.
(3) Special rule for certain periodic adjustments. The periodic
adjustment rules in paragraph (i)(6) of this section (rather than the
rules of Sec. 1.482-4(f)(2)) shall apply to PCTs that occur on or
after the date of a material change in the scope of the CSA from its
scope as of January 5, 2009. A material change in scope would include a
material expansion of the activities undertaken beyond the scope of the
intangible development area, as described in former Sec. 1.482-
7(b)(4)(iv). For this purpose, a contraction of the scope of a CSA,
absent a material expansion into one or more lines of research and
development beyond the scope of the intangible development area, does
not constitute a material change in scope of the CSA. Whether a
material change in scope has occurred is determined on a cumulative
basis. Therefore, a series of expansions, any one of which is not a
material expansion by itself, may collectively constitute a material
expansion.
Sec. 1.482-7T [Removed]
0
Par. 14. Section 1.482-7T is removed.
0
Par. 15. Section 1.482-8 is amended by:
0
1. Revising Examples 13 through 18 at the end of paragraph (b).
0
2. Revising paragraph (c)(1).
The additions and revision reads as follows:
Sec. 1.482-8 Examples of the best method rule.
* * * * *
(b) * * *
Example 13. Preference for acquisition price method. (i) USP
develops, manufacturers, and distributes pharmaceutical products.
USP and FS, USP's wholly-owned subsidiary, enter into a CSA to
develop a new oncological drug, Oncol. Immediately prior to entering
into the CSA, USP acquires Company X, an unrelated U.S.
pharmaceutical company. Company X is solely engaged in oncological
pharmaceutical research, and its only significant resources and
capabilities are its workforce and its sole patent, which is
associated with Compound X, a promising molecular compound derived
from a rare plant, which USP reasonably
[[Page 80135]]
anticipates will contribute to developing Oncol. All of Company X
researchers will be engaged solely in research that is reasonably
anticipated to contribute to developing Oncol as well. The rights in
the Compound X and the commitment of Company X's researchers to the
development of Oncol are platform contributions for which
compensation is due from FS as part of a PCT.
(ii) In this case, the acquisition price method, based on the
lump sum price paid by USP for Company X, is likely to provide a
more reliable measure of an arm's length PCT Payment due to USP than
the application of any other method. See Sec. Sec. 1.482-4(c)(2)
and 1.482-7(g)(5)(iv)(A).
Example 14. Preference for market capitalization method. (i)
Company X is a publicly traded U.S. company solely engaged in
oncological pharmaceutical research and its only significant
resources and capabilities are its workforce and its sole patent,
which is associated with Compound Y, a promising molecular compound
derived from a rare plant. Company X has no marketable products.
Company X enters into a CSA with FS, a newly-formed foreign
subsidiary, to develop a new oncological drug, Oncol, derived from
Compound Y. Compound Y is reasonably anticipated to contribute to
developing Oncol. All of Company X researchers will be engaged
solely in research that is reasonably anticipated to contribute to
developing Oncol under the CSA. The rights in Compound Y and the
commitment of Company X's researchers are platform contributions for
which compensation is due from FS as part of a PCT.
(ii) In this case, given that Company X's platform contributions
covered by PCTs relate to its entire economic value, the application
of the market capitalization method, based on the market
capitalization of Company X, provides a reliable measure of an arm's
length result for Company X's PCTs to the CSA. See Sec. Sec. 1.482-
4(c)(2) and 1.482-7(g)(6)(v)(A).
Example 15. Preference for market capitalization method. (i)
MicroDent, Inc. (MDI) is a publicly traded company that developed a
new dental surgical microscope ScopeX-1, which drastically shortens
many surgical procedures. On January 1 of Year 1, MDI entered into a
CSA with a wholly-owned foreign subsidiary (FS) to develop ScopeX-2,
the next generation of ScopeX-1. In the CSA, divisional interests
are divided on a territorial basis. The rights associated with
ScopeX-1, as well as MDI's research capabilities are reasonably
anticipated to contribute to the development of ScopeX-2 and are
therefore platform contributions for which compensation is due from
FS as part of a PCT. At the time of the PCT, MDI's only product was
the ScopeX-I microscope, although MDI was in the process of
developing ScopeX-2. Concurrent with the CSA, MDI separately
transfers exclusive and perpetual exploitation rights associated
with ScopeX-1 to FS in the same territory as assigned to FS in the
CSA.
(ii) Although the transactions between MDI and FS under the CSA
are distinct from the transactions between MDI and FS relating to
the exploitation rights for ScopeX-1, it is likely to be more
reliable to evaluate the combined effect of the transactions than to
evaluate them in isolation. This is because the combined
transactions between MDI and FS relate to all of the economic value
of MDI (that is, the exploitation rights and research rights
associated with ScopeX-1, as well as the research capabilities of
MDI). In this case, application of the market capitalization method,
based on the enterprise value of MDI on January 1 of Year 1, is
likely to provide a reliable measure of an arm's length payment for
the aggregated transactions. See Sec. Sec. 1.482-4(c)(2) and 1.482-
7(g)(6)(v)(A).
(iii) Notwithstanding that the market capitalization method
provides the most reliable measure of the aggregated transactions
between MDI and FS, see Sec. 1.482-7(g)(2)(iv) for further
considerations of when further analysis may be required to
distinguish between the remuneration to MDI associated with PCTs
under the CSA (for research rights and capabilities associated with
ScopeX-1) and the remuneration to MDI for the exploitation rights
associated with ScopeX-1.
Example 16. Income method (applied using CPM) preferred to
acquisition price method. The facts are the same as in Example 13,
except that the acquisition occurred significantly in advance of
formation of the CSA, and reliable adjustments cannot be made for
this time difference. In addition, Company X has other valuable
molecular patents and associated research capabilities, apart from
Compound X, that are not reasonably anticipated to contribute to the
development of Oncol and that cannot be reliably valued. The CSA
divides divisional interests on a territorial basis. Under the terms
of the CSA, USP will undertake all R&D (consisting of laboratory
research and clinical testing) and manufacturing associated with
Oncol, as well as the distribution activities for its territory (the
United States). FS will distribute Oncol in its territory (the rest
of the world). FS's distribution activities are routine in nature,
and the profitability from its activities may be reliably determined
from third-party comparables. FS does not furnish any platform
contributions. At the time of the PCT, reliable (ex ante) financial
projections associated with the development of Oncol and its
separate exploitation in each of USP's and FSub's assigned
geographical territories are undertaken. In this case, application
of the income method using CPM is likely to provide a more reliable
measure of an arm's length result than application of the
acquisition price method based on the price paid by USP for Company
X. See Sec. 1.482-7(g)(4)(vi) and (5)(iv)(C).
Example 17. Evaluation of alternative methods. (i) The facts are
the same as in Example 13, except that the acquisition occurred
sometime prior to the CSA, and Company X has some areas of promising
research that are not reasonably anticipated to contribute to
developing Oncol. For purposes of this example, the CSA is assumed
to divide divisional interests on a territorial basis. In general,
the Commissioner determines that the acquisition price data is
useful in informing the arm's length price, but not necessarily
determinative. Under the terms of the CSA, USP will undertake all
R&D (consisting of laboratory research and clinical testing) and
manufacturing associated with Oncol, as well as the distribution
activities for its territory (the United States). FS will distribute
Oncol in its territory (the rest of the world). FS's distribution
activities are routine in nature, and the profitability from its
activities may be reliably determined from third-party comparables.
At the time of the PCT, financial projections associated with the
development of Oncol and its separate exploitation in each of USP's
and FSub's assigned geographical territories are undertaken.
(ii) Under the facts, it is possible that the acquisition price
method or the income method using CPM might reasonably be applied.
Whether the acquisition price method or the income method provides
the most reliable evidence of the arm's length price of USP's
contributions depends on a number of factors, including the
reliability of the financial projections, the reliability of the
discount rate chosen, and the extent to which the acquisition price
of Company X can be reliably adjusted to account for changes in
value over the time period between the acquisition and the formation
of the CSA and to account for the value of the in-process research
done by Company X that does not constitute platform contributions to
the CSA. See Sec. 1.482-7(g)(4)(vi) and (5)(iv)(A) and (C).
Example 18. Evaluation of alternative methods. (i) The facts are
the same as in Example 17, except that FS has a patent on Compound
Y, which the parties reasonably anticipate will be useful in
mitigating potential side effects associated with Compound X and
thereby contribute to the development of Oncol. The rights in
Compound Y constitute a platform contribution for which compensation
is due from USP as part of a PCT. The value of FS's platform
contribution cannot be reliably measured by market benchmarks.
(ii) Under the facts, it is possible that either the acquisition
price method and the income method together or the residual profit
split method might reasonably be applied to determine the arm's
length PCT Payments due between USP and FS. Under the first option
the PCT Payment for the platform contributions related to Company
X's workforce and Compound X would be determined using the
acquisition price method referring to the lump sum price paid by USP
for Company X. Because the value of these platform contributions can
be determined by reference to a market benchmark, they are
considered routine platform contributions. Accordingly, under this
option, the platform contribution related to Compound Y would be the
only nonroutine platform contribution and the relevant PCT Payment
is determined using the income method. Under the second option,
rather than looking to the acquisition price for Company X, all the
platform contributions are considered nonroutine and the RPSM is
applied to determine the PCT Payments for each platform
contribution. Under either option, the PCT Payments will be netted
against each other.
(iii) Whether the acquisition price method together with the
income method or the
[[Page 80136]]
residual profit split method provides the most reliable evidence of
the arm's length price of the platform contributions of USP and FS
depends on a number of factors, including the reliability of the
determination of the relative values of the platform contributions
for purposes of the RPSM, and the extent to which the acquisition
price of Company X can be reliably adjusted to account for changes
in value over the time period between the acquisition and the
formation of the CSA and to account for the value of the rights in
the in-process research done by Company X that does not constitute
platform contributions to the CSA. In these circumstances, it is
also relevant to consider whether the results of each method are
consistent with each other, or whether one or both methods are
consistent with other potential methods that could be applied. See
Sec. 1.482-7(g)(4)(vi), (5)(iv), and (7)(iv).
(c) Effective/applicability date--(1) In general. Paragraphs (a)
and (b) Examples 10 through 12 of this section are generally applicable
for taxable years beginning after December 31, 2006. Paragraph (b)
Examples 13 through 18 of this section are generally applicable on
January 5, 2009.
* * * * *
Sec. 1.482-8T [Removed].
0
Par. 16. Section 1.482-8T is removed.
0
Par. 17. Section 1.482-9 is amended by revising paragraph (m)(3) to
read as follows:
Sec. 1.482-9 Methods to determine taxable income in connection with a
controlled services transaction.
* * * * *
(m) * * *
(3) Coordination with rules governing cost sharing arrangements.
Section 1.482-7 provides the specific methods to be used to determine
arm's length results of controlled transactions in connection with a
cost sharing arrangement. This section provides the specific methods to
be used to determine arm's length results of a controlled service
transaction, including in an arrangement for sharing the costs and
risks of developing intangibles other than a cost sharing arrangement
covered by Sec. 1.482-7. In the case of such an arrangement,
consideration of the principles, methods, comparability, and
reliability considerations set forth in Sec. 1.482-7 is relevant in
determining the best method, including an unspecified method, under
this section, as appropriately adjusted in light of the differences in
the facts and circumstances between such arrangement and a cost sharing
arrangement.
* * * * *
Sec. 1.482-9T [Removed].
0
Par. 18. Section 1.482-9T is removed.
0
Par. 19. Section 1.861-17 is amended by revising paragraph (c)(3)(iv)
to read as follows:
Sec. 1.861-17 Allocation and apportionment of research and
experimental expenditures.
* * * * *
(c) * * *
(3) * * *
(iv) Effect of cost sharing arrangements. If the corporation
controlled by the taxpayer has entered into a cost sharing arrangement,
in accordance with the provisions of Sec. 1.482-7, with the taxpayer
for the purpose of developing intangible property, then that
corporation shall not reasonably be expected to benefit from the
taxpayer's share of the research expense.
* * * * *
0
Par. 20. Section 1.6662-6 is amended by revising paragraph
(d)(2)(iii)(D) to read as follows:
Sec. 1.6662-6 Transaction between persons described in section 482
and net section 482 transfer price adjustments.
* * * * *
(d) * * *
(2) * * *
(iii) * * *
(D) Satisfaction of the documentation requirements described in
Sec. 1.482-7(k)(2) for the purpose of complying with the rules for
CSAs under Sec. 1.482-7 also satisfies all of the documentation
requirements listed in paragraph (d)(2)(iii)(B) of this section, except
the requirements listed in paragraphs (d)(2)(iii)(B)(2) and (10) of
this section, with respect to CSTs and PCTs described in Sec. 1.482-
7(b)(1)(i) and (ii), provided that the documentation also satisfies the
requirements of paragraph (d)(2)(iii)(A) of this section.
* * * * *
PART 301--PROCEDURE AND ADMINISTRATION
0
Par. 21. The authority citation for part 301 continues to read in part
as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 22. Section 301.7701-1 is amended by revising paragraph (c) to
read as follows:
Sec. 301.7701-1 Classification of organizations for Federal tax
purposes.
* * * * *
(c) Cost sharing arrangements. A cost sharing arrangement that is
described in Sec. 1.482-7 of this chapter, including any arrangement
that the Commissioner treats as a CSA under Sec. 1.482-7(b)(5) of this
chapter, is not recognized as a separate entity for purposes of the
Internal Revenue Code. See Sec. 1.482-7 of this chapter for the rules
regarding CSAs.
* * * * *
PART 602--OMB CONTROL NUMBER UNDER THE PAPERWORK REDUCTION ACT
0
Par. 23. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
0
Par. 24. In Sec. 602.101, paragraph (b) is amended as follows:
1. The following entry to the table is removed:
Sec. 602.101 OMB Control numbers.
* * * * *
(b) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.482-7T................................................... 1545-1364
* * * * *
------------------------------------------------------------------------
Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
Approved: December 8, 2011.
Emily S. McMahon,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2011-32458 Filed 12-16-11; 2 pm]
BILLING CODE 4830-01-P