Section 482: Methods To Determine Taxable Income in Connection With a Cost Sharing Arrangement

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

[REG-144615-02]

RIN 1545-BB26

Section 482: Methods To Determine Taxable Income in Connection With a Cost Sharing Arrangement

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking and notice of public hearing.

SUMMARY:

This document contains proposed regulations that provide guidance regarding methods under section 482 to determine taxable income in connection with a cost sharing arrangement. These proposed regulations potentially affect controlled taxpayers within the meaning of section 482 that enter into cost sharing arrangements as defined herein. This document also provides a notice of public hearing on these proposed regulations.

DATES:

Written or electronic comments must be received November 28, 2005. Requests to speak and outlines of topics to be discussed at the public hearing scheduled for November 16, 2005, at 10:00 a.m. must be received by October 26, 2005.

ADDRESSES:

Send submissions to CC:PA:LPD:PR (REG-144615-02), room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-144615-02), Courier's desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC 20044, or sent electronically, via the IRS Internet site at

www.irs.gov/regs

or via the Federal eRulemaking Portal at

www.regulations.gov

(IRS and REG-144615-02). The public hearing will be held in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations, Jeffrey L. Parry or Christopher J. Bello, (202) 435-5265; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, LaNita Van Dyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

The collections of information contained in this notice of proposed rulemaking have been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)).

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number assigned by the Office of Management and Budget.

The collection of information requirements are in proposed § 1.482-7(b)(1)(iv)-(vii) 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.

Estimated total annual reporting and/or recordkeeping burden:

1250 hours.

Estimated average annual burden hours per respondent and/or recordkeeper:

2.5 hours.

Estimated number of respondents and/or recordkeepers:

500.

Estimated frequency of responses:

Annually.

Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by October 28, 2005.

Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information (see below);

How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information-technology; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

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 26 U.S.C. 6103.

Background

Section 482 of the Internal Revenue Code generally provides that the Secretary may allocate gross income, deductions, credits, and allowances between or among two or more taxpayers that are owned or controlled by the same interests in order to prevent evasion of taxes or clearly to reflect income of a controlled taxpayer. The second sentence of section 482 added by the Tax Reform Act of 1986 enunciates the “commensurate with income” standard that in the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. Public Law 99-5143, 1231(e)(1),

reprinted in

1986-3 C.B. (Vol. 1) 1, 479-80.

Comprehensive regulations under section 482 were published in the

Federal Register

(33 FR 5849) on April 16, 1968, and were revised and updated by transfer pricing regulations in the

Federal Register

(59 FR 34971, 60 FR 65553, 61 FR 21955, and 68 FR 51171) on July 8, 1994, December 20, 1995, May 13, 1996, and August 26, 2003, respectively.

The 1968 regulations contained guidance regarding the sharing of costs and risks. See § 1.482-2A(d)(4). The 1968 regulations were replaced in 1996 by § 1.482-7 regarding the sharing of costs and risks (the 1996 regulations were further modified in 2003 with respect to stock-based compensation).

Experience in the administration of existing § 1.482-7 has demonstrated the need for additional regulatory guidance to improve compliance with, and administration of, the cost sharing rules. In particular, there is a need for additional guidance regarding the external contributions for which arm's length consideration must be provided as a condition to entering into a cost sharing arrangement. The consideration for this type of external contributions is referred to in the existing regulations as the

buy-in.

Furthermore, additional guidance is needed on methods for valuing these external contributions. The proposed regulations also provide the opportunity to address other technical and procedural issues that have arisen in the course of the administration of the cost sharing rules.

Explanation of Provisions

A. Overview

Under a cost sharing arrangement, related parties agree to share the costs and risks of intangible development in proportion to their reasonable expectations of the extent to which they will relatively benefit from their separate exploitation of the developed intangibles. The existing § 1.482-7 regulations and these proposed regulations provide rules governing cost sharing arrangements consistent with the commensurate income standard under the statute and the general arm's length standard under the section 482 regulations.

Comment letters and other information available to the Treasury Department and IRS have provided limited information on third-party arrangements that are asserted to be similar to cost sharing arrangements. Typically, in the context of discussion concerning the current § 1.482-7 regulations, information has been provided on certain arrangements involving cost plus research and development or government contracts, which, while no doubt arm's length transactions, are not viewed by the Treasury Department and IRS as analogous to cost sharing arrangements.

Thus, in accordance with § 1.482-1(b)(1), the task is to provide guidance relative to cost sharing arrangements regarding “the results that

would have been realized

if uncontrolled taxpayers

had engaged

in the same transaction under the same circumstances.” (Emphasis added.) This guidance is necessary because of the fundamental differences in cost sharing arrangements between related parties as compared to any superficially similar arrangements that are entered into between unrelated parties. Such other arrangements typically involve a materially different division of costs, risks, and benefits than in cost sharing arrangements under the regulations. For example, other arrangements may contemplate joint, rather than separate, exploitation of results, or may tie the division of actual results to the magnitude of each party's contributions (for example, by way of preferential returns). Those types of arrangements are not analogous to a cost sharing arrangement in which the controlled participants divide contributions in accordance with reasonably anticipated benefits from separate exploitation of the resulting intangibles.

For purposes of determining the results that would have been realized under an arm's length cost sharing arrangement, the proposed regulations adopt as a fundamental concept an

investor model

for addressing the relationships and contributions of controlled participants in a cost sharing arrangement. Under this model, each controlled participant may be viewed as making an aggregate investment, attributable to both cost contributions (ongoing share of intangible development costs) and external contributions (the preexisting advantages which the parties bring into the arrangement), for purposes of achieving an anticipated return appropriate to the risks of the cost sharing arrangement over the term of the development and exploitation of the intangibles resulting from the arrangement. In particular, the investor model frames the guidance in the proposed regulations for valuing the external contributions that parties at arm's length would not invest, along with their ongoing cost contributions, in the absence of an appropriate reward. In this regard, valuations are not appropriate if an investor would not undertake to invest in the arrangement because its total anticipated return is less than the total anticipated return that could have been achieved through an alternative investment that is realistically available to it.

The investor model is grounded in the legislative history of the Tax Reform Act of 1986 which provided in pertinent part as follows:

In revising section 482, the conferees do not intend to preclude the use of certain bona fide cost-sharing arrangements as an appropriate method of allocating income attributable to intangibles among related parties, if and to the extent such agreements are consistent with the purposes of this provision that the income allocated among the parties reasonably reflect the actual economic activity undertaken by each. Under such a bona fide cost-sharing arrangement, the cost-sharer would be expected to bear its portion of all research and development costs, on successful as well as unsuccessful products within an appropriate product area, and the cost of research and development at all relevant developmental stages would be included. In order for cost-sharing arrangements to produce results consistent with the changes made by the Act to royalty arrangements, it is envisioned that the allocation of R&D cost-sharing arrangements generally should be proportionate to profit as determined before deduction for research and development.

In addition, to the extent, if any, that one party is actually contributing funds toward research and development at a significantly earlier point in time than the other, or is otherwise effectively putting its funds at risk to a greater extent than the other, it would be expected that an appropriate return would be provided to such party to reflect its investment.

H.R. Conf. Rep. No. 99-841 at II-638 (1986)(emphasis supplied).

There are special implications that are derived from determining the arm's length compensation for external contributions in line with the investor model. In evaluating that arm's length compensation, it is appropriate, consistent with the investor model, to determine (1) what an investor would pay at the outset of a cost sharing arrangement for an opportunity to invest in that arrangement, and (2) what a participant with external contributions would require as compensation at the outset of a cost sharing arrangement to allow an investor to join in the investment. The appropriate “price” of undertaking a risky investment is typically determined at the time the investment is undertaken, based on the ex ante expectations of the investors. Given the uncertainty about whether and to what extent intangibles will be successfully developed under a cost sharing arrangement, ex post interpretations of ex ante expectations are inherently unreliable and susceptible to abuse. Accordingly, an important implication of determining the arm's length result under the investor model, reflected in the methods, is that compensation for external contributions is analyzed and valued ex ante. The ex ante perspective is fundamental to achieving arm's length results.

Accordingly, the proposed regulations provide guidance under section 482 that would replace the existing regulations under § 1.482-7 relating to cost sharing arrangements. They revise § 1.482-7 in light of the experience of both the IRS and taxpayers with the existing regulations. The proposed regulations also restructure the format of the existing regulations to be more consistent with that of the 1994 regulations (for example, §§ 1.482-3 and 1.482-4) and to add organizational clarity.

The proposed regulations begin by specifying the transactions relevant to a cost sharing arrangement. Importantly, the proposed regulations acknowledge that in a typical cost sharing arrangement, at least one controlled participant provides resources or capabilities developed, maintained, or acquired externally to the arrangement that are reasonably anticipated to contribute to the development of intangibles under the arrangement, namely what are referred to as external contributions. Thus, the proposed regulations integrate into the definition of a cost sharing arrangement both “cost sharing transactions” regarding the

ongoing sharing of intangible development costs as well as “preliminary or contemporaneous transactions” by which the controlled participants compensate each other for their external contributions to the arrangement (that is, what the existing regulations refer to as the “buy-in”). The proposed regulations provide that § 1.482-7 only governs arrangements that are within (or which the controlled taxpayers reasonably concluded to be within) the definition of a cost sharing arrangement. Arrangements outside that definition must be analyzed under the other sections of the section 482 regulations to determine whether they achieve arm's length results.

The proposed regulations provide supplemental guidance on the valuation of the arm's length amount to be charged in a preliminary or contemporaneous transaction. The proposed regulations clarify that the valuation of the rights associated with the external contribution that is compensated in a preliminary or contemporaneous transaction cannot be artificially limited by purported conditions or restrictions. Rather, the arm's length compensation, and the applicable method used to determine that compensation, must reflect the type of transaction and contractual terms of a “reference transaction” by which the benefit of exclusive and perpetual rights in the relevant resources or capabilities are provided. This compensation will be determined by a method that will yield a value for the obligation of any given controlled participant that is consistent with that participant's share of the combined value of the external contribution to all controlled participants.

The proposed regulations set forth new specified methods and provide rules for application of existing specified methods, for purposes of determining the arm's length compensation due with respect to external contributions in preliminary or contemporaneous transactions. The proposed regulations also enunciate general principles governing all methods, specified and unspecified, for these purposes.

The proposed regulations provide guidance on allocations that the Commissioner may make to more clearly reflect arm's length results for the controlled taxpayers' cost sharing transactions and preliminary or contemporaneous transactions. In particular, building again on the investor model, the proposed regulations provide guidance on the periodic adjustments that the Commissioner may make in situations where the actually experienced results of a controlled participant's investment attributable to cost contributions and external contributions is widely divergent from reasonable expectations at the time of the investment. Exceptions are provided, including one under which the taxpayer may establish that the differential is due to events beyond its control that are extraordinary and not reasonably anticipated (including business growth that was not reasonably anticipated). The proposed regulations provide that periodic adjustments may only be made by the Commissioner.

Finally, the proposed regulations include provisions to facilitate administration of, and compliance with, the cost sharing rules. These include contractual provisions required for cost sharing arrangements, documentation that must be maintained (and produced upon request by the IRS), accounting requirements, and reporting requirements. Transition rules are provided for modified compliance in the case of qualified cost sharing arrangements under existing § 1.482-7, as well as rules for terminating such grandfather status. The proposed regulations also make conforming and other changes to provisions of the current regulations under sections 482 and 6662 that are related to this guidance.

B. Basic Rules Applicable to CSAs

1. General Rule—Proposed § 1.482-7(a)

Consistent with the rules governing other controlled transactions (for example, transfers of tangibles and intangibles under existing §§ 1.482-3 and 1.482-4), proposed § 1.482-7(a) provides that the arm's length amount charged in a controlled transaction reasonably anticipated to contribute to developing intangibles pursuant to a cost sharing arrangement must be determined under a method described in the proposed regulations.

The controlled participants must share intangible development costs of the intangibles developed or to be developed (the cost shared intangibles) in cost sharing transactions in proportion to their shares of reasonably anticipated benefits (RAB shares) from exploiting cost shared intangibles.

The controlled participants must also compensate other controlled participants for their external contributions in preliminary or contemporaneous transactions. The arm's length amount charged in a preliminary or contemporaneous transaction must be determined pursuant to the method or methods under the other provision or provisions of the section 482 regulations, as supplemented by proposed § 1.482-7(g), applicable to the reference transaction reflected by the preliminary or contemporaneous transaction. Such method will yield a value for the obligation of each obligor in the preliminary or contemporaneous transaction that is consistent with the product of the combined value to all controlled participants of the external contribution that is the subject of the preliminary or contemporaneous transaction multiplied by the obligor's RAB share.

Contributions to developing the cost shared intangibles made by a controlled taxpayer that is not a controlled participant in the cost sharing arrangement must be determined pursuant to § 1.482-4(f)(3)(iii) (Allocations with respect to assistance to the owner). Arm's length consideration for the transfer by a controlled participant of an interest in a cost shared intangible at any time (whether during the term, or upon or after the termination of a cost sharing arrangement) must be determined under the rules of §§ 1.482-1 and 1.482-5 through 1.482-6.

The proposed regulations provide that if an arrangement comes within the definition of a cost sharing arrangement, it is subject to § 1.482-7 (see next section of this Preamble for discussion of the definition of a cost sharing arrangement). Other arrangements that are not cost sharing arrangements (or are not treated as such) must be analyzed under the other provisions of the section 482 regulations to determine whether they achieve arm's length results.

2. Definition of a CSA—Proposed § 1.482-7(b)

a. CSA Transactions in General

Under § 1.482-1(b)(1), a “controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that

would have been realized

if uncontrolled taxpayers

had engaged

in the same transaction under the same circumstances.” (Emphasis added.) Thus, it is important to define with reasonable precision the category of arrangements treated as cost sharing arrangements, their terms, and the functions and risks assumed by the participants in such arrangements. The determination of what “would have been” the arm's length results of such transactions is based on those definitions.

Proposed § 1.482-7(b) identifies two groups of transactions that are integral

to a cost sharing arrangement—cost sharing transactions and preliminary or contemporaneous transactions. A cost sharing transaction or

CST

is a transaction in which the controlled participants share the intangible development costs of one or more cost shared intangibles in proportion to their respective shares of reasonably anticipated benefits from their individual exploitation of their interests in the cost shared intangibles that they obtain under the arrangement. CSTs reflect the results that would have been expected in a cost sharing agreement between uncontrolled taxpayers that did not bring any external contributions to the arrangement. In other words, if uncontrolled taxpayers started in a true “green field,” they would be expected to agree to split ongoing costs of the research in proportion to the relative value of their respective reasonably anticipated benefits from the arrangement.

The proposed regulations are premised in part, however, on the fact that at least one controlled participant typically provides external contributions to a cost sharing arrangement. Thus, the proposed regulations integrate into the definition of a cost sharing arrangement not only the CSTs for the ongoing sharing of intangible development costs, but also the preliminary or contemporaneous transactions or

PCTs

by which the controlled participants compensate one another for their respective external contributions. The necessity of PCTs in connection with cost sharing arrangements was anticipated in the legislative history of the Tax Reform Act of 1986:

In addition, to the extent, if any, that one party is actually contributing funds toward research and development at a significantly earlier point in time than the other, or is otherwise effectively putting its funds at risk to a greater extent than the other, it would be expected that an appropriate return would be provided to such party to reflect its investment.

H.R. Conf. Rep. No. 99-841 at II-638 (1986).

b. Constituent Elements of a CSA—Proposed § 1.482-7(b)(1)

The proposed regulations define a cost sharing arrangement or

CSA

as a contractual agreement to share the costs of one or more intangibles that meet three substantive and four administrative requirements. The term

CSA

, as defined, would replace the term

qualified cost sharing arrangement

employed in the existing regulations. The substantive requirements are that the controlled participants (1) divide all interests in cost shared intangibles on a territorial basis, (2) enter into and effect all CSTs and all PCTs, and (3) as a result, individually own and exploit their respective interests in the cost shared intangibles without any further obligation to compensate one another for such interests. The administrative requirements are that the controlled participants substantially comply with (1) the CSA contractual requirements, (2) the CSA documentation requirements, (3) the CSA accounting requirements, and (4) the CSA reporting requirements.

The Treasury Department and the IRS recognize that a CSA, as defined, represents one possible arrangement by which parties may choose to share the costs, risks, and benefits of intangible development. Other arrangements, however, may involve a materially different division of costs, risks, and benefits in contrast to a CSA. For example, other arrangements may contemplate joint, rather than separate, exploitation of results, or may tie the division of actual results to the magnitude of each party's contributions (for example, by way of preferential returns), rather than divide contributions in accordance with reasonably anticipated benefits from separate exploitation. Given such differences, the guidance under § 1.482-7, as applicable to CSAs, is not appropriate to evaluate what would have been the arm's length results of these other arrangements that do not constitute CSAs when they are undertaken among controlled taxpayers. In such cases the proposed regulations direct taxpayers to guidance under other provisions of the section 482 regulations to determine whether such arrangements achieve arm's length results.

c. External Contributions and PCTs— Proposed § 1.482-7(b)(3)(i) Through (iv)

PCTs are the transactions by which the controlled participants compensate one another for their external contributions to the CSA. External contributions are any resources or capabilities which one or more controlled participants bring to a CSA that were developed, maintained, or acquired externally to the CSA (whether prior to or during the course of the CSA), and that are reasonably anticipated to contribute to developing cost shared intangibles. For example, one controlled participant may have promising in-process technology, or a developed and successful first generation technology, that may reasonably be anticipated to provide a platform for future generation technology to be developed under the CSA. As another example, one controlled participant may have an experienced research team that could reasonably be anticipated to be particularly suited to carrying out the development contemplated under the CSA. The proposed regulations exclude land, depreciable tangible property, and other resources acquired by intangible development costs, since they are compensated by CSTs. See discussion of proposed § 1.482-7(d).

The Treasury Department and the IRS believe that uncontrolled parties entering into a long term commitment to share intangible development costs would require an agreement upfront that all external contributions be made available to the fullest extent for the full period over which they are reasonably anticipated to be needed. Accordingly, the proposed regulations introduce the concept of the reference transaction or

RT

in order to ensure that compensation for external contributions to the CSA reflects the full economic value of resources or capabilities that a participant brings to the CSA. The RT is a transaction providing the benefit of all rights, exclusively and perpetually, in a resource or capability described above, apart from the rights to exploit an existing intangible without further development (see section of Preamble below regarding § 1.482-7(c) (Make-or-sell rights excluded)). The arm's length compensation pursuant to the PCT, and the applicable method used to determine such compensation, must reflect the type of transaction and contractual terms of the RT. The controlled participants must enter into a PCT as of the earliest date (whether on or after the date the CSA is entered into) on which the external contribution is reasonably anticipated to contribute to developing cost shared intangibles (the date of a PCT). The controlled participants are not required to actually enter into the RT and the compensation due from any controlled participant will be limited to its RAB share of the total value of the external contribution, the scope of which is defined by the RT.

The concept of the RT was developed in response to arguments that have been encountered in the examination experience of the IRS under the existing regulations. In numerous situations taxpayers have purported to convey only limited availability of resources or capabilities for purposes of the intangible development activity (IDA) under a CSA. An example is a short-term license of an existing technology. Under the existing regulations, such cases may, of course, be examined to assess whether the purported

limitations conform to economic substance and the parties' conduct. See § 1.482-1(d)(3)(ii)(B) (Identifying contractual terms). In addition, even if the short-term license were respected, the continued availability of the contribution past the initial license term would require new license terms to be negotiated taking into account relevant factors, such as whether the likelihood of success of the IDA had materially changed in the interim. The proposed regulations address the problems in administering such approaches more directly by requiring an upfront valuation of all external contributions which would be much more difficult to calculate if it involved the valuation of a series of short-term licenses with terms contingent on such interim changes. Accordingly, the proposed regulations assume a reference transaction that does not allow for contingencies based on the expiration of short-term licenses that might require further renegotiation of the compensation for the external contribution. No inference is intended concerning the outcome of such limitations under the existing regulations.

Thus, for example, consider a CSA for the development of future generations of an existing technology owned by one controlled participant. The PCT compensation obligation of the other controlled participant or participants would be determined by reference to the RT consisting of the transfer of all rights to the existing technology apart from the rights to exploit the existing technology without further development (see section of Preamble below regarding § 1.482-7(c) (Make-or-sell rights excluded)). The rights transferred in the RT would include the exclusive right to use the technology for purposes of research. They would also include the right to exploit any resulting products that incorporated the technology and any resulting products the development of which is otherwise assisted by the technology. Moreover, the rights transferred in the RT would cover a term extending as long as the exploitation of future generations of the technology continued. The RT provides the basis for selection and application of the method used to value the compensation owed under the PCT by each other controlled participant. The compensation obligation is limited to each such other controlled participant's RAB share of the total value of the rights in the existing technology that would have been transferred in the RT.

Issues have arisen regarding whether an existing research team in place constitutes intangible property for which compensation is due, in addition to sharing the ongoing compensation and other costs of maintaining such team, for purposes of the buy-in provisions under the existing regulations. The Treasury Department and the IRS believe that the proper arm's length treatment is to include the obligation to compensate such external contributions of in-place research capabilities in PCTs. At arm's length, an uncontrolled taxpayer seeking to invest in a research project involving the experienced in-place researchers would require a commitment of the experienced team in place for purposes of the project, rather than assuming the risks presented by an inexperienced team. The Treasury Department and the IRS believe that a contribution of such an experienced team in place would result in the contribution of intangible property within the meaning of § 1.482-4(b) and section 936(h)(3)(B).

The proposed regulations, however, do not restrict the type of transaction that may be the subject of the RT. An RT may consist of the provision of services as well as the transfer of intangible property. For example, in the case of an experienced research team in place, therefore, the RT could be the services agreement to commit the team to the research project under the CSA.

Under the proposed regulations, the controlled participants may designate the type of transaction involved in the RT, if different economically equivalent types of RTs are possible with respect to the relevant resource or capability. If the controlled participants fail to make such a designation, the Commissioner may do so.

Exacting compensation for an external contribution pursuant to a PCT is distinguishable from charging for another's business opportunity. Any taxpayer, controlled or uncontrolled, is free to undertake the business opportunity of trying to develop an intangible on its own. In that case, the taxpayer is bearing all costs and risks, and has no obligation to compensate anyone for taking free advantage of the opportunity. Where, however, the benefit of existing resources or capabilities belonging to another are desired that are reasonably anticipated to contribute to the development effort, then, at arm's length, the supplier of such resources or capabilities would not contribute them absent appropriate compensation.

d. Form of PCT Payment and Post Formation Acquisitions—Proposed § 1.482-7(b)(3)(v) and (vi)

Under the proposed regulations, the general rule is that the consideration owing pursuant to a PCT for an external contribution, referred to as the

PCT Payments

, may take the form of fixed payments, payments contingent on the exploitation of the cost shared intangibles, or a combination of both. The selected payment form must be specified no later than the date of the PCT. The payor of PCT Payments is referred to as the

PCT Payor

, and the payee is referred to as the

PCT Payee

.

In the case of resources or capabilities developed, maintained, or acquired prior to the time they are reasonably concluded to contribute to developing cost shared intangibles (for example, resources or capabilities that predate the CSA), the controlled participants have the flexibility to structure PCT Payments in any of the available forms, subject to conforming to contractual terms, economic substance, and the parties' conduct. See § 1.482-1(d)(3)(ii)(B) (Identifying contractual terms). A CSA generally contemplates that the participants undertake costs and risks in parallel and in proportion to their RAB shares, but this result cannot be achieved in the case of external contributions that are the product of previously incurred costs and risks. So, for such resources or capabilities, the proposed regulations allow the controlled participants to provide for the applicable payment form by the date of the PCT.

A post formation acquisition (PFA) is an external contribution representing resources or capabilities acquired by a controlled participant in an uncontrolled transaction that takes place after formation of the CSA and that, as of the date of the acquisition, are reasonably anticipated to contribute to developing cost shared intangibles. Resources or capabilities may be acquired in a PFA either directly or indirectly through the acquisition of an interest in an entity or tier of entities.

The Treasury Department and the IRS believe that the form of PCT Payments for PFAs must be consistent with the principle that allocations of cost and risk among controlled participants after a CSA has commenced should be in proportion to their respective RAB shares. Accordingly, the proposed regulations provide that the consideration under a PCT for a PFA must follow the form of payment in the uncontrolled transaction in which the PFA was acquired. For example, if subsequent to the formation of a CSA one controlled participant makes a stock acquisition of a target the assets of which consist of resources and capabilities reasonably anticipated as of the date of the acquisition to contribute to developing cost shared intangibles,

the PCT Payment by each other controlled participant must be in a lump sum. To avoid the possibility that any payments are inappropriately characterized by the participants, neither PCT Payments, nor cost sharing payments, may be paid in shares of stock in the payor.

e. Territorial Division of Interests—Proposed § 1.482-7(b)(4)

Controlled participants in a CSA own interests in the cost shared intangibles and are able to exploit those intangibles without any obligation to compensate other participants (other than pursuant to CSTs or PCTs). Controlled participants must share intangible development costs in proportion to their reasonably anticipated benefits from their individual exploitation of such interests. Taxpayers have entered into cost sharing arrangements in which the controlled participants receive nonexclusive, indivisible worldwide interests in cost shared intangibles. Taxpayers have taken the position under the existing regulations that such interests are susceptible to being individually exploited, and that the participants' respective shares of benefits from such exploitation are susceptible to being reasonably estimated.

The proposed regulations require that controlled participants receive non-overlapping territorial interests in the cost shared intangibles that in the aggregate utilize all the available territories worldwide. The proposed regulations also require that a controlled participant be entitled to the perpetual and exclusive right to cost shared intangible profits of any other controlled taxpayer in the same controlled group as the participant from transactions with uncontrolled taxpayers regarding property or services for use, consumption, or disposition within the participant's territory or territories. For example, where one controlled participant sells part of its output into a territory belonging to another controlled participant, the former must pay the latter participant arm's length compensation to ensure that the intangible profit on the sale is realized by the latter participant. These territoriality requirements facilitate the ability to individually exploit, and estimate the reasonably anticipated benefits from individual exploitation of, interests in cost shared intangibles. No inference is intended as to the permissibility of nonexclusive interests under the existing regulations.

Comments are requested concerning whether alternatives should be provided to territorial division of interests in cost shared intangibles. Proposed alternatives should further the goal of dividing the universe of interests into exclusive, non-overlapping segments to promote measurability of anticipated benefits and administrability both by taxpayers and the IRS. Comments are also requested about how to facilitate attribution of sales to territories, or other non-overlapping divisions of interests, such as in the case of sales via electronic commerce. Comments are also requested on the division, territorially or otherwise, of interests in exploiting cost shared intangibles in space.

f. CSAs in Substance or Form—Proposed § 1.482-7(b)(5)

Pursuant to proposed § 1.482-7(b)(5)(i), as under the existing regulations, the Commissioner may, consistently with § 1.482-1(d)(3)(ii)(B) (Identifying contractual terms), apply the § 1.482-7 rules to any arrangement that in substance constitutes a CSA in accordance with the three substantive requirements enumerated in proposed § 1.482-7(b)(1)(i) through (iii), notwithstanding a failure otherwise to meet the § 1.482-7 requirements.

Provided a taxpayer has followed the formal requirements enumerated in proposed § 1.482-7(b)(1)(iv) through (vii), the Commissioner must treat the arrangement as a CSA if the taxpayer reasonably concluded the arrangement to be a CSA. The Commissioner may also treat any other arrangement as a CSA, if the taxpayer has followed such formal requirements.

3. Exclusion of Make-or-Sell Rights—Proposed § 1.482-7(c)

Disputes have arisen under the existing regulations regarding the buy-in related to a CSA to develop future generations of an intangible that is being exploited in its then current version by the PCT Payee. For example, there may be licenses of the current generation intangible to uncontrolled taxpayers, perhaps with certain rights to make adaptations for their customers. Taxpayers have asserted that a make-and-sell license of this type satisfies the requirement for a buy-in in the CSA under the current regulations. Such a position misconstrues the existing regulations, which focus the buy-in on the availability of the pre-existing intangibles “for purposes of research in the intangible development area” under the CSA. See § 1.482-7(g)(2).

The proposed regulations expressly exclude from the scope of a CSA any provision to the extent it relates to exploiting an existing intangible without further development, such as the right to make or sell existing products. The proposed regulations do, however, allow the aggregate valuation of controlled transactions relating to make-or-sell rights with PCT Payments, where such aggregate evaluation provides a more reliable measure of an arm's length result than a separate valuation of the transactions. See proposed § 1.482-7(g)(2)(v).

4. Intangible Development Costs—Proposed § 1.482-7(d)

The proposed regulations restate the provisions defining intangible development costs or

IDCs

that are shared pursuant to CSTs under a CSA to coordinate with the conceptual framework of the proposed regulations and with the stock-based compensation provisions added in 2003.

As discussed, CSTs and PCTs are the two major groupings of transactions entered into pursuant to a CSA. In CSTs, the controlled participants share

all

ongoing costs of developing intangibles. In contrast, in PCTs they compensate one another for resources or capabilities developed, maintained, or acquired externally to the CSA (whether prior to or during the course of the CSA). It is necessary to define IDCs shared in CSTs in a comprehensive manner that does not overlap with the definition of external contributions compensated in PCTs.

The proposed regulations, accordingly, define IDCs as all costs, in cash or in kind (including stock-based compensation), but excluding costs for land and 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. The IDA replaces the concept of the

intangible development area

under the existing regulations. The self-contained IDC definition eliminates the need for the cross-reference to operating expenses as defined in § 1.482-5(d)(3) of the existing regulations and thus eliminates potential disputes over the interaction of these sections.

The proposed regulations also avoid overlapping definitions of IDCs and external contributions. IDCs are limited to costs in the ordinary course of business incurred after the formation of a CSA and that are directly identified with, or reasonably allocable to, the IDA. Thus, for example, the expected value over and above ongoing compensation and other costs of an experienced research team would be compensated by PCTs, but the ongoing compensation and other costs of the team attributable to the IDA would be

IDCs shared in CSTs. Moreover, costs for depreciable property, which under section 197(f)(7) would include amortization of any amortizable section 197 intangible, are carved out from IDCs. Instead, to the extent such intangibles are reasonably anticipated to contribute to developing cost shared intangibles, they would be compensated in PCTs.

Land and depreciable tangible property (for example, use of a laboratory facility) would represent an external contribution. The proposed regulations, however, continue the practical approach of the existing regulations of treating the arm's length rental charge under § 1.482-2(c) (Use of tangible property) for such land and depreciable tangible property as IDCs, since typically these items can be readily valued.

In line with the direction in the 1986 legislative history to reflect “the actual economic activity” undertaken pursuant to a CSA, the proposed regulations expressly provide that 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. As under the existing regulations, IDCs exclude interest expense, foreign income taxes, and domestic income taxes.

The balance of the proposed regulations restate the existing regulations with conforming changes in light of the new terminology and framework. Technical amendments were made to the special transition rule on time and manner of making the election with respect to certain stock-based compensation and the consistency rules for measurement and timing with respect to such stock-based compensation.

Except for such technical amendments, these proposed regulations incorporate the existing provisions relating to the elective method of measurement and timing permitted with respect to certain options on publicly traded stock. However, the Treasury Department and the IRS are considering extending availability of the elective method to other forms of publicly traded stock-based compensation. The Treasury Department and the IRS request comments on which forms of publicly traded stock-based compensation should be eligible for the elective method.

5. Reasonably Anticipated Benefits Share (RAB Share)—Proposed § 1.482-7(e)

Proposed § 1.482-7(e) restates existing § 1.482-7(f)(3)(i) through (iv)(A) with some technical clarifications and changes to conform to the new terminology and framework. The proposed regulations provide, as is implicit in existing § 1.482-7(b)(3), (e)(2), and (f)(3), that 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 current reliable data regarding past and projected future results as is available at such time.

6. Changes in Participation Under a CSA—Proposed § 1.482-7(f)

Proposed § 1.482-7(f) replaces existing § 1.482-7(g)(3) and (4), as well as the third and fourth sentences of existing § 1.482-7(g)(1). This provision clarifies the application of the rules of § 1.482-7 in the event of a change in participation under a CSA. A change in participation includes the transfer between controlled participants of all or part of a participant's territorial rights coupled with the assumption by the transferee of the associated obligations under the CSA, the entry into a CSA of a new controlled participant that acquires any territorial rights and associated obligations under the CSA, and the withdrawal of a controlled participant or other relinquishment or abandonment of territorial rights and associated obligations under the CSA. In the event of a change in participation, the transferee of the territorial rights and associated obligations under the CSA succeeds to the transferor's prior history under the CSA, including IDCs borne, benefits derived, and compensation expenditures pursuant to any PCTs. The transferor must receive an arm's length amount of consideration from the transferee under the rules of §§ 1.482-1 and 1.482-4 through 1.482-6.

Proposed § 1.482-7(e)(2)(i) provides that in the case of transfers of cost shared intangibles between controlled participants, other than by way of a change in participation described in proposed § 1.482-7(f), the transferor's benefits for purposes of RAB share determination are measured on a look-through basis with reference to the transferee's benefits, disregarding any consideration paid by the transferee (such as a royalty pursuant to a license agreement).

C. Supplemental Guidance on Methods Applicable to PCTs

The Treasury Department and the IRS recognize that taxpayers and the IRS need additional guidance on the appropriate methods for valuation of external contributions to a CSA. A typical challenge to valuing nonroutine intangibles is the uncertainty as to the profitability of their exploitation. In the case of a CSA, however, there is also the uncertainty whether and to what extent any intangible will be successfully developed under the CSA. Accordingly, proposed § 1.482-7(g) provides supplemental guidance on evaluating external contributions compensated by PCTs, including general principles for specified and unspecified methods, guidance on the application of existing specified methods, and new specified methods.

The investor model informs the guidance on valuation. The guidance generally aims at valuation of the amount charged in a PCT such that a controlled participant's aggregate net investment in a CSA attributable to cost contributions and external contributions may be expected to earn a return appropriate to the riskiness of the CSA.

1. General Rule—Proposed § 1.482-7(g)(1)

As discussed, PCTs are one of two major categories of transactions (the other being CSTs) entered into pursuant to a CSA. In PCTs, the controlled participants compensate one another for their respective external contributions that they bring into a CSA, that is, the resources or capabilities they have developed, maintained, or acquired externally to (whether prior to or during the course of) the CSA that are reasonably anticipated to contribute to developing cost shared intangibles.

Pursuant to § 1.482-1(b)(2), different sections of the section 482 regulations apply to different types of transactions, such as transfers of tangible and intangible property, services, loans or advances, and rentals. The method or methods most appropriate to the calculation of arm's length results for controlled transactions in each category must be selected. When interrelated controlled transactions are of different types, the participants, depending on what produces the most reliable means of measuring arm's length results, may either (1) apply different methods to the different transactions or (2) aggregate the transactions for valuation purposes. See also § 1.482-1(f)(2)(i) and proposed § 1.482-7(g)(2)(v) regarding aggregation of transactions.

A key concept in valuing PCTs is the RT. The RT is a transaction providing the benefit of all rights, exclusively and perpetually, in a resource or capability that is the subject of the external contribution, apart from the rights to exploit an existing intangible without further development. If in fact, the resource or capability is reasonably anticipated to contribute both to developing or exploiting cost shared intangibles and to other business activities of a PCT Payee, the proposed regulations provide that the otherwise applicable value of the relevant PCT Payments may need to be prorated between the CSA and any other business activities on a reasonable basis that reflects the relative economic values of the different business activities.

For purposes of the selection of the category of method applicable to a controlled transaction pursuant to § 1.482-1(b)(2)(ii), proposed § 1.482-7(b)(3)(iii) provides that the applicable method used to determine the compensation for a PCT shall reflect the type of transaction of the RT. For example, in the case of an external contribution consisting of an in-process intangible, the RT could be a transfer of intangibles generally to be evaluated pursuant to §§ 1.482-1 and 1.482-4 through 1.482-6. As a further example, in the case of an external contribution consisting of an experienced research team in place, the RT could be the provision of services generally to be evaluated pursuant to § 1.482-2(b). If different economically equivalent types of RTs are possible with respect to the relevant resource or capability, the controlled participants may designate the type of transaction involved in the RT.

Proposed § 1.482-7(a)(2) provides that the arm's length amount charged in a PCT must be determined pursuant to the method or methods applicable to the RT under the relevant provision or provisions of the section 482 regulations (as those methods are supplemented by proposed § 1.482-7(g)). Such method will yield a value for the obligation of each obligor in the PCT (PCT Payor) consistent with the product of the combined value to all controlled participants of the external contribution that is the subject of the PCT multiplied by the PCT Payor's RAB share. Although some specified and unspecified methods may involve measuring PCT Payments with reference to the value of exploiting cost shared intangibles in one or more controlled participants' territories, the application of such methods must still yield a value that is consistent with the foregoing RAB share of the total value of the external contribution to all controlled participants.

Proposed § 1.482-7(g) sets forth new specified methods for purposes of determining the arm's length compensation due under a PCT, namely, the income method, the acquisition price method, and the market capitalization method. The proposed regulations also provide rules for application of existing specified methods, such as the comparable uncontrolled transaction method and the residual profit method. The proposed regulations also enunciate general principles governing all methods, specified and unspecified, for these purposes. Proposed § 1.482-7(g)(1) provides that each method must be applied in accordance with the provisions of § 1.482-1, including the best method rule of § 1.482-1(c), the comparability analysis of § 1.482-1(d), and the arm's length range of § 1.482-1(e), except as those provisions are modified in § 1.482-7(g).

2. General Principles—Proposed § 1.482-7(g)(2)

a. In General—Proposed § 1.482-7(g)(2)(i)

The proposed regulations provide general principles for valuing PCT Payments, applicable for both specified and unspecified methods.

b. Valuation Consistent With Upfront Contractual Terms and Risk Allocations—Proposed § 1.482-7(g)(2)(ii)

Existing § 1.482-1(d)(3)(ii) and (iii) generally provide that contractual terms and risk allocations are significant factors in evaluating the most reliable measure of arm's length results. The proposed regulations provide for particular contractual terms and allocations of risk with regard to PCTs determined no later than the date of the PCT. See, for example, proposed § 1.482-7(b)(1)(ii), (b)(3), and (k)(1). Proposed § 1.482-7(g)(ii) accordingly reiterates the requirement that any method applied at any time for purposes of valuing PCT Payments must be consistent with the applicable contractual terms and allocation of risk under the CSA and proposed § 1.482-7 as of the date of a PCT, unless there has been a change in such terms or allocation made in return for arm's length consideration.

It may be particularly important to maintain consistency with upfront contractual terms and allocation of risk for CSAs, since PCT Payments may extend over a period of years. Thus, for example, PCT Payments may become due in subsequent years when actual economic results may have departed from those reasonably anticipated as of the date of the PCT. Subject to the Commissioner's ability to make periodic adjustments (see proposed § 1.482-7(i)(6)), the method for determining the PCT Payments due in the subsequent year must remain consistent with the contractual terms and allocation of risks as of the date of the PCT. Cost sharing participants, like unrelated investors, are held to the terms of their deal at the outset of the investment. For example, under the proposed income method, this upfront contractual-risk consistency principle is illustrated by the use of the applicable rate on sales or profits determined as of the date of the PCT. Thus, while actual sales or profits may depart from projections, the upfront risk allocation continues to be respected by use of the applicable rate determined as of the date of the PCT. Note, while a taxpayer may defend the amount of its PCT Payment in a subsequent year as arm's length based on a different method than that applied in earlier years, it may only do so to the extent the other method also satisfies the upfront contractual-risk consistency principle.

Proposed § 1.482-7(b)(3)(vi) provides that the form of payment for a PCT must be specified no later than the date of the PCT. The form of payment of a PCT, that is, fixed and/or contingent payments, involves an allocation of risk among the controlled participants. In the case of PCT Payments regarding a PFA, the form of payment in the uncontrolled acquisition must be followed. However, in the case of other PCT Payments, the taxpayer has flexibility in the choice of form, subject to economic substance and the parties' conduct.

As the result of the upfront contractual-risk consistency principle, it will be possible for the taxpayer to compute a present value, as of the date of the PCT, of the total arm's length amount of all PCT Payments. Under the CSA documentation requirements in proposed § 1.482-7(k)(2)(ii)(J)(

6

) and (k)(2)(iii)(B), the taxpayer is required to maintain documentation of such upfront valuation and produce it to the IRS within 30 days of a request.

c. Projections—Proposed § 1.482-7(g)(2)(iii)

Since PCT Payments often extend over a period of years and may be contingent on items (for example, sales, costs, and operating profit) in such future periods, the valuation method, specified or unspecified, may rely on projections of such items. The reliability of the valuation method will in such

cases depend on the reliability of such projections. The proposed regulations provide that, 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 PCT Payment valuations.

d. Realistic Alternatives—Proposed § 1.482-7(g)(2)(iv)

Regardless of the method or methods used, evaluation of the arm's length charge for a PCT should take into account the general principle that uncontrolled taxpayers dealing at arm's length would evaluate the terms of a transaction, and would enter into a particular transaction only if none of the alternatives is preferable. See § 1.482-1(d)(3)(iv)(H) (The alternatives realistically available to the buyer and seller). Based on that principle, PCT valuations would not meet the foregoing condition where, for any controlled participant, the total anticipated value, as of the date of the PCT, is less than the total anticipated value that could have been achieved through a realistically available alternative investment (whether it is an alternative arrangement for the development of the cost shared intangibles or an alternative with a similar risk profile to the CSA). In other words, a controlled participant, like any rational investor, would not enter into an investment when a better alternative investment is available. Examples are provided illustrating the application of the realistic alternatives principle in the CSA context.

e. Aggregation of Transactions—Proposed § 1.482-7(g)(2)(v)

The proposed regulations provide that multiple PCTs, or one or more PCTs and one or more transactions not governed by proposed § 1.482-7 (such as a make-or-sell license excluded from CSA coverage by proposed § 1.482-7(c)), may be aggregated for purposes of valuation, subject to consideration of whether such aggregate valuation yields a more reliable measure of an arm's length result than would separate valuations. See also § 1.482-1(f)(2)(i) (Aggregation of transactions). For example, assume the CSA involves a PCT for an external contribution of an existing intangible for purposes of developing future generations of the intangible. Also assume that there is a license to the other controlled participants of make-and-sell rights with respect to the current generation of the intangible. The reliability of an aggregate analysis of the PCT and the license will be affected by the degree to which the relative current exploitation benefits from the existing intangible of the controlled participants may be expected to match up with the RAB shares regarding exploitation of the future generations of the intangible. Though it will not generally be necessary to allocate a reliable aggregate arm's length charge as between the various transactions, in certain cases such an allocation may be necessary, for example, in applying the periodic adjustment rules in proposed § 1.482-7(i)(6).

f. Discount Rate—Proposed § 1.482-7(g)(2)(vi)

Specified and unspecified methods for valuing PCT Payments may involve converting future or past monetary sums into a present value as of the date of a PCT. The proposed regulations recognize that there may be different risks and, hence, different discount rates associated with different activities undertaken by a taxpayer. Consistent with the investor model, for items relating to a CSA, the discount rate employed should be that which most appropriately reflects, as of the date of the PCT, the risks of development and exploitation of the intangibles anticipated to result from the CSA. In other words, this follows the approach that unrelated investors would take to making an ex ante evaluation of a prospective investment. Namely, the expected value of the investment would equal the projected future cash flows discounted using a discount rate that appropriately reflects the anticipated level of risk being undertaken.

The proposed regulations enumerate several possibilities for choosing an appropriate discount rate. Where there are publicly traded entities that would be comparables dedicated to similar development and exploitation activities, their weighted average cost of capital (WACC) may provide a reliable basis for derivation of an appropriate discount rate. Or, if the taxpayer's group's activities are dedicated to development and exploitation of the contemplated cost shared intangibles, then the taxpayer's own WACC may provide a reliable basis for derivation of an appropriate discount rate. In other cases, depending upon the facts and circumstances, a taxpayer's internal hurdle rate for investments having a comparable risk profile may provide a reliable basis for derivation of an appropriate discount rate.

g. Accounting Principles—Proposed § 1.482-7(g)(2)(vii)

The proposed regulations provide that, while allocations and valuations for accounting purposes may provide a useful starting point, they will not be determinative of PCT Payments to the extent that the accounting treatment is not consistent with economic value. For example, with respect to an acquisition of a target business consisting of wanted assets (that are reasonably anticipated to contribute to developing cost shared intangibles) and of unwanted assets (that will be abandoned immediately after the acquisition), an allocation of a portion of the acquisition price to the abandoned assets done for accounting purposes, under the proposed regulations, would not prevent the proper allocation of the entire acquisition price, in line with economic reality, to the wanted assets for purposes of PCT Payment valuation. Similarly, with respect to an acquisition of a target business consisting only of an in-process intangible and an experienced research team in place, an allocation of a portion of the acquisition price to “goodwill” for accounting purposes would not, under the proposed regulations, prevent the proper allocation of the entire acquisition price, in line with the economic reality, to the in-process intangible and experienced research team in place for purposes of PCT Payment valuation. On the other hand, if the target conducts an operating business with exploitation already at an advanced stage of the current generation of the intangible to be further developed under the CSA, then an accounting allocation to goodwill may suggest the need for further consideration of the reliability of an acquisition price method for valuing an external contribution whose value excluded the value of such existing goodwill.

h. Valuation Consistent With the Investor Model—Proposed § 1.482-7(g)(2)(viii)

As has been discussed, the proposed regulations require that PCT valuations be consistent with an investor model for cost sharing. Under the investor model, the amount charged in a PCT must be consistent with the assumption that each controlled participant is making a net aggregate investment, as of the date of a PCT, attributable to both external contributions and cost contributions, for purposes of achieving an anticipated return appropriate to the risks of the CSA over the entire term of development and exploitation of the intangibles resulting from the CSA.

The investor model is based on two key principles regarding PCT valuations. The first principle is that, ex ante, the aggregate investment in an IDA would be expected to yield a rate return equal to the appropriate discount rate for the CSA. If the anticipated rate of

return exceeds the appropriate discount rate for the CSA, either anticipated profits have been overstated or the amount of investment has been understated. If the projections of IDCs and profits are reliable, then the implication could be that the portion of the investment attributable to external contributions has been undervalued. Thus, a valuation method for PCTs is less likely to be reliable if it results in a rate of return to any controlled participant's aggregate investment that is not equal to the appropriate discount rate for the CSA.

The second principle is that, ex ante, the appropriate return to the aggregate investment in an IDA is measured over the entire period of development and exploitation of cost shared intangibles. Included in this principle is the concept that no part of the investment should be viewed as separately earning a return over a more limited period. As a general matter, successful completion of each step in a research program is a necessary condition for the completion of the program as a whole and its contribution continues over the entire life of the project. As an example, a project to develop a new commercial aircraft would not be considered successfully completed if all parts of the aircraft had been designed except the tail assembly. Neither does the fact that the tail assembly is completed last imply that its usefulness in the manufacture and sale of aircraft extends beyond the usefulness of any components completed earlier in the design process. Each step of the project continues to have value as long as the aircraft continues to be built and used. For this reason, each aspect of the research program must be viewed as contributing to the success of the program as a whole (and not just its success for some limited period of time). Thus, a valuation method for PCTs is likely to be less reliable if it assumes a useful life for any contribution to the CSA that does not extend through the entire anticipated period of development and exploitation.

The IRS has examined cases in which CSAs were entered into to utilize current generation intangibles as the base or platform for future generation intangibles, with buy-ins structured as declining royalties over the limited useful life of the current generation intangible. The structure of these buy-ins effectively diminish the value of the buy-in payments, such that the return to a controlled participant making the depressed buy-in payments has an expected return significantly in excess of the appropriate discount rate for the CSA. Furthermore, a buy-in based on declining royalties over a shortened useful life for the contributed intangibles, on its face, is not consistent with the principle that the return to the aggregate investment in an IDA should be measured over the entire period of development and exploitation of cost shared intangibles.

i. Coordination of Best Method Rule and Form of Payment—Proposed § 1.482-7(g)(2)(ix)

Any method for valuing the amount charged in a PCT under the proposed regulations, whether specified or unspecified, will assume a particular form of payment (method payment form) for PCT Payments. For example, as will be discussed, the proposed income method assumes contingent payments in the form of an applicable rate on sales or profits, and the market capitalization method assumes a lump sum method payment form. Except for PCT Payments in respect of PFAs, the proposed regulations allow taxpayers to convert the reasonably anticipated present value, as of the date of the PCT, of the total arm's length amount of all PCT Payments determined under the method payment form into another form of payment (specified payment form). For purposes of the best method rule of § 1.482-1(c), the analysis among competing methods will be undertaken without regard to whether their method payment forms corresponds to the taxpayer's specified payment form for PCT Payments. A best method analysis determines which valuation method is most reliable from the perspective of comparability, completeness and accuracy of the data, and reliability of the underlying assumptions. If the method payment form of the best method determined under this analysis differs from the taxpayer's specified payment form, then the Commissioner will effect a conversion of the best method results into the specified payment form on a reasonable basis, giving due regard to the taxpayer's conversion basis if the taxpayer's method was determined to be the best method as to its method payment form.

j. Coordination of the Valuations of Prior and Subsequent PCTs—Proposed § 1.482-7(g)(2)(x)

Cases may arise where, after the date of one PCT, another PCT is required for other resources or capabilities of a controlled participant which only as of a subsequent date are reasonably anticipated to contribute to the development of cost shared intangibles and therefore are external contributions only as of such subsequent date. In such cases where there are PCTs with different dates, coordination of the valuations of the prior and subsequent PCTs must be effected pursuant to a method that provides the most reliable measure of an arm's length result.

In some instances the coordination will be straightforward. As an example, in the case of a subsequent PCT entered into with respect to a PFA, the PCT Payments are determined based on the related acquisition, independent of any prior PCT. For purposes of determining PCT Payments under a prior PCT, the proposed regulations provide that the PCT Payments with respect to the subsequent PCT in this case are treated the same as unanticipated IDCs. A divergence between actual IDCs and IDCs anticipated on the date of a PCT does not change the method for determining PCT Payments with respect to that PCT. Accordingly, unanticipated payments under a subsequent PCT entered into with respect to a PFA will not affect the method for determining PCT Payments in respect of a prior PCT.

The coordination in other cases will depend on the facts and circumstances. If the external contributions that were the subjects of the respective prior and subsequent PCTs were nonroutine contributions, an approach which may be appropriate would be to determine PCT Payments both for the prior and subsequent PCTs going forward from the date of the subsequent PCT pursuant to a residual profit split method, as described in proposed § 1.482-7(g)(7). Such application of the residual profit split method would include as nonroutine contributions all of the following: the external contribution(s) that were the subject of the prior PCT(s), the external contribution that is the subject of the subsequent PCT, and the interests of the controlled participants in the portion of cost shared intangibles in process of development under the CSA that does not reflect any external contributions.

k. Proration of PCT Payments to the Extent Allocable to Other Business Activities—Proposed § 1.482-7(g)(2)(xi)

The proposed regulations provide that the otherwise applicable value of PCT Payments may need to be prorated between the CSA and any other business activities (other than current make-or-sell activities) to which the resource or capability that is the subject of the PCT is reasonably anticipated to contribute as of the date of the PCT. A proration will only be necessary if the method used for valuing the PCT Payment includes the value of the contribution of the resource or capability to the other business activities. For example, an application

of the acquisition price method is based on the full value of a resource or capability and therefore includes the value of any contributions to other business activities, whereas the CUT and CPM applications of the income method are based only on the sales or profits of exploiting cost shared intangibles, and therefore do not include any value of contributions to other business activities. For purposes of the best method rule under § 1.482-1(c), the reliability of the analysis under a method that requires proration is reduced relative to the reliability of an analysis under a method that does not require proration. Any proration must be done on a reasonable basis that reflects the relative economic values of the different business activities.

3. Comparable Uncontrolled Transaction (CUT) Method—Proposed § 1.482-7(g)(3)

The comparable uncontrolled transaction (CUT) method described in § 1.482-4(c), and the arm's length charge described in § 1.482-2(b)(3)(first sentence) based on a comparable uncontrolled transaction, 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. When applied in the manner described in § 1.482-4(c), or where a comparable uncontrolled transaction provides the most reliable measure of the arm's length charge described in § 1.482-2(b)(3)(first sentence), the CUT method, or the arm's length charge in the comparable uncontrolled transaction, will typically yield an arm's length total value for the external 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. A territorial CUT may also be reliably used to the extent the value of the PCT Payment under the territorial CUT is consistent with the RAB share of the worldwide external contribution value.

4. Income Method—Proposed § 1.482-7(g)(4)

The income method, a new specified method under the proposed regulations, follows from the realistic alternatives principle. The income method determines PCT Payments in amounts such that the present value, as of the date of the PCT, to a controlled participant of entering into a CSA equals the present value of the PCT Payee's best realistic alternative.

The proposed regulations provide two specific (but nonexclusive) applications of the income method, one based on the comparable uncontrolled transaction (CUT) method of § 1.482-4(c), and the other based on the comparable profit method (CPM) of § 1.482-5. These applications may include certain simplifying assumptions and are meant to provide examples of possible applications of the general income method, not to exclude other possible applications of this method. Both applications compute the arm's length PCT Payment for each year as the product of an applicable rate on sales or profit. The

applicable rate

is equal to the

alternative rate

less the

cost contribution adjustment.

The alternative rate represents the rate on sales or profit which the PCT Payee could have earned by exploiting cost shared intangibles in the PCT Payor's territory if the PCT Payee alone had borne the risks and costs of developing the cost share intangibles. The CUT application determines the alternative rate from the perspective of a licensor as the royalty rate it would have charged under a license to exploit the cost shared intangibles in the territory, based on comparable third party license arrangements. The CPM application determines the alternative rate from the perspective of a licensee as the royalty rate it would have paid such that it earned only a market return for its routine contributions to the exploitation of the cost shared intangibles, based on comparable returns earned by uncontrolled taxpayers engaged in similar routine activities. The cost contribution adjustment is the reduction of the alternative rate to reflect the anticipated costs and risks the PCT Payor will take on by entering into the CSA.

The income method is typically used in cases where only one controlled participant, namely the PCT Payee, brings nonroutine contributions into the CSA. In such circumstances, the other controlled participant or participants, that is, the PCT Payors, essentially only commit to bearing their respective shares of anticipated IDCs and bring only routine contributions for purposes of exploiting cost shared intangibles. Under the investor model, what is essentially a routine financing investment by the PCT Payors in the development of intangibles, represented by bearing their share of anticipated IDCs, would be expected to earn an ex ante rate of return appropriate to the risks associated with the CSA and reflected in the discount rate. The cost contribution adjustment effectively represents the appropriate return to that routine financing investment, as of the date of the PCT, expressed as a rate on sales or profit.

The use of the applicable rate on sales or profit, determined as of the date of the PCT under the income method, also reflects the principle of consistency with the original contractual allocation of risk. Thus, while actual sales may depart from projections, the upfront risk allocation continues to be respected by use of the applicable rate determined as of the date of the PCT.

Under the CUT and CPM applications of the income method, any routine contributions that are external contributions (routine external contributions) are treated similarly to cost contributions.

The reliability of the income method may decrease if more than one controlled participant brings nonroutine contributions into the CSA.

5. Acquisition Price Method—Proposed § 1.482-7(g)(5)

The acquisition price method is an application of the CUT method pursuant to § 1.482-4(c) and the arm's length charge pursuant to § 1.482-2(b)(3). This method ordinarily applies only when substantially all of the nonroutine resources and capabilities of a recently acquired target's business constitute external contributions, that is, they are reasonably anticipated to contribute to developing cost shared intangibles. Thus, when these circumstances are present, this method may be expected to be appropriate for valuing PCT Payments for PFAs.

Under the acquisition price method, the arm's length charge to each PCT Payor is the product of the adjusted acquisition price, multiplied by such PCT Payor's RAB share. The adjusted acquisition price seeks to isolate that portion of the acquisition price of the target business attributable to the external contributions. The adjusted acquisition price is equal to the acquisition price of the target, increased by relevant liabilities, and decreased by the value of tangible property (separately accounted for under proposed § 1.482-7(d)) and by the value of any other resources and capabilities not covered by PCTs. The reliability of this method is reduced to the extent the acquisition price must be adjusted to take into account significant difficult-to-value tangible property or resources or capabilities of the target not covered by a PCT.

6. Market Capitalization Method—Proposed § 1.482-7(g)(6)

The market capitalization method is also an application of the CUT method pursuant to § 1.482-4(c) and the arm's

length charge pursuant to § 1.482-2(b)(3). This method ordinarily applies only when substantially all of the nonroutine resources and capabilities of the PCT Payee's business constitute external contributions, that is, they are reasonably anticipated to contribute to developing cost shared intangibles.

Under the market capitalization method, the arm's length charge to each PCT Payor is the product of the adjusted average market capitalization, multiplied by such PCT Payor's RAB share. The adjusted average market capitalization seeks to determine that portion of the market capitalization of the PCT Payee's business attributable to the external contributions. The adjusted average market capitalization is equal to the 60-day (ending on the date of the PCT) average of the daily market capitalizations of the PCT Payee, increased by liabilities, and decreased by the value of tangible property separately accounted for under proposed § 1.482-7(d) and by the value of any other resources and capabilities not covered by PCTs. The daily market capitalization is calculated on each day the PCT Payee's stock is actively traded as the total number of shares outstanding multiplied by the stock's closing price on that day (as adjusted, for example, for dividends, stock splits, and restructurings to the extent such adjustment can be done reliably). The reliability of this method is reduced to the extent the market capitalization must be adjusted to take into account significant difficult to value tangible property or resources or capabilities of the target not covered by a PCT. The reliability of this method is also reduced to the extent the 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 and capabilities for which reliable adjustments cannot be made.

7. Residual Profit Split Method—Proposed § 1.482-7(g)(7)

The proposed regulations provide needed guidance on the proper application of the residual profit split method (RPSM) of § 1.482-6 in the context of the development and exploitation of intangibles pursuant to a CSA. The guidance is necessary in order to implement the general principles of proposed § 1.482-7(g)(2), such as consistency with the upfront contractual terms and risk allocation under the CSA and with the investor model. A purported application of RPSM not in accordance with this guidance would constitute an unspecified method for purposes of the sections 482 and 6662(e) and (h) regulations.

Under the proposed regulations, the RPSM may not be applied where only one controlled participant makes significant nonroutine contributions to the development and exploitation of cost shared intangibles. (An RPSM in such a situation would be logically equivalent to the income method using an applicable rate on profit, and is best considered under that method.) The RPSM divides operating profit or loss before any expense or amortization on account of IDCs, routine external contributions, and nonroutine contributions, from developing and exploiting cost shared intangibles in a controlled participant's territory (territorial operating profit or loss) in three steps.

In the first step of the RPSM, each controlled participant is allocated an amount of income that is subtracted from its territorial operating profit or loss to provide a market return to its routine contributions, other than cost contributions (that is, a controlled participant's IDCs borne, gross of cost sharing payments made, and net of cost sharing payments received).

In the second step of the RPSM, each controlled participant is allocated a portion of the residual of its territorial profit or loss, after the first step allocation, attributable to its cost contributions. The second step cost contribution share is a fraction of such residual operating profit or loss. The numerator is the present value, determined as of the date of the PCTs, of the summation, over the entire period of developing and exploiting cost shared intangibles, of the total value of the territorial owner's total anticipated cost contributions. The denominator of the territorial owner's cost contribution fraction is the present value, determined as of the date of the PCTs, of the summation, over the same period, of the territorial owner's total anticipated territorial operating profits, reduced by a market return for routine contributions (other than cost contributions) to the relevant business activity in the territory.

The cost contribution share under the second step of the RPSM corresponds to the cost contribution adjustment under the income method. The cost contribution share under the RPSM, similar to the cost contribution adjustment under the income method, is a reflection of the investor model. What is essentially a routine financing investment in the development of intangibles by the controlled participants, represented by bearing their share of anticipated IDCs, would be expected to earn a return appropriate to the risks associated with the CSA. The cost contribution share effectively represents the appropriate return to that financing investment, as of the date of the PCTs, expressed as a share of territorial operating profit or loss.

In the third step of the RPSM, the residual territorial profit or loss remaining after the first and second step allocations is divided among all the controlled participants based on the relative value, as of the date of the PCTs, of their nonroutine contributions. The relative value of the nonroutine contributions may be measured with reference to external benchmarks that reflect their fair market value, or with reference to estimated capitalized development costs as appropriately grown or discounted so that all contributions may be valued on a comparable dollar base as of the date of the PCTs.

Any amount of a controlled participant's territorial operating profit that is allocated to another controlled participant's nonroutine external contributions under the third step of the RPSM represents the amount of the PCT Payment due to that other controlled participant for its external contributions.

Under the RPSM, the determinations as of the date of the PCT of the second step cost contribution share and the third step relative nonroutine contribution values reflect the principle of consistency with the original contractual allocation of risk. Thus, while actual territorial operating profit or loss may depart from projections, the upfront risk allocation continues to be respected through the use of the cost contribution shares and relative nonroutine contribution values determined as of the date of the PCTs.

In applying the RPSM, any routine contributions that are external contributions (routine external contributions) are treated similarly to cost contributions.

The proposed regulations set forth comparability and reliability considerations appropriate for application of the RPSM in the CSA context.

8. Unspecified Methods—Proposed § 1.482-7(g)(8)

The proposed regulations also provide general rules applicable for methods not specified in proposed § 1.482-7(g)(3) through (7).

D. Coordination With the Arm's Length Standard—Proposed § 1.482-7(h)

Transactions in connection with a CSA must produce results consistent

with the arm's length standard. The proposed regulations, therefore, dispel the misconception that cost sharing is a safe harbor.

In accordance with § 1.482-1(b)(1), the proposed regulations provide guidance appropriate in the context of a CSA regarding “the results that

would have been realized

if uncontrolled taxpayers

had engaged

in the same transaction under the same circumstances.” (Emphasis added.) In a CSA where the resulting intangibles may only be exploited in a controlled participant's territory, the arm's length result would require a participant to bear IDCs only in proportion to the expected relative values of its territory, that is, in proportion to its respective RAB shares. The same is true for PCTs. Where a controlled participant brings external contributions into the arrangement, at arm's length that participant would only agree to make the external contributions if it received compensation from the other participants for the anticipated benefits to their respective territories attributable to the external contributions.

Therefore, the proposed regulations provide that a CSA, and the CSTs and PCTs required in connection with a CSA, produce results that are consistent with an arm's length result within the meaning of § 1.482-1(b) if, and only if, each controlled participant's IDC share equals its RAB share, and all other requirements are satisfied, including those with respect to PCT Payments.

The Treasury Department and IRS recognize that a CSA, as defined, represents only one possible arrangement pursuant to which parties may choose to share the costs, risks, and benefits of intangible development. Other arrangements, however, may involve a different division of costs, risks, and benefits than those arising pursuant to a CSA. Given such differences, the guidance under § 1.482-7 is not appropriate to evaluate what would have been arm's length results of those other arrangements when undertaken among controlled taxpayers. As discussed, in such cases the proposed regulations instead would point taxpayers to the guidance under the other provisions of the section 482 regulations to determine whether such arrangements achieve arm's length results.

E. Allocations by the Commissioner in Connection With CSAs—Proposed § 1.482-7(i)

1. Consolidation of Existing Allocation Provisions—Proposed § 1.482-7(i)(1) Through (4)

Proposed § 1.482-7(i) assembles in one section, provisions regarding allocations by the Commissioner that currently are spread throughout existing § 1.482-7, with conforming changes to reflect the terminology and framework of the proposed regulations. Thus, under § 1.482-7(i)(1), the Commissioner is generally authorized to 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.

Under proposed § 1.482-7(i)(2), the Commissioner may make appropriate adjustments to CSTs to bring IDC shares in line with RAB shares. Such adjustments include adding or removing costs from IDCs, allocating costs between the IDA and other business activities, improving the reliability of the benefits measurement basis used or the projections used to estimate RAB shares, and allocating among the controlled participants any unallocated territorial interests in cost shared intangibles. CST adjustments must be reflected in the year in which the IDCs are incurred, along with any appropriate allocation of arm's length interest to the date of payment.

Under proposed § 1.482-7(i)(3), the Commissioner may make appropriate allocations to adjust PCT Payments in accordance with the proposed regulations. Thus, the Commissioner may examine the taxpayer's method for determining the amount charged in a PCT in accordance with the provisions of the section 482 regulations as supplemented by proposed § 1.482-7(g). The Commissioner may either propose adjustments to the taxpayer's method or apply another method to adjust the results reported by the taxpayer consistent with an arm's length result.

Under proposed § 1.482-7(i)(4), the Commissioner may make appropriate allocations regarding changes in participation in accordance with proposed § 1.482-7(f).

2. Allocations When CSTs Are Consistently and Materially Disproportionate to RAB Shares—Proposed § 1.482-7(i)(5)

The fundamental requirement of a CSA with regard to CSTs is for the controlled participants to share IDCs in proportion to their respective RAB shares. Under proposed § 1.482-7(e)(1), 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. Such updates must reflect a comprehensive revision over the entire past and projected future period of intangible exploitation in light of the most current reliable data.

To the extent the controlled participants consistently and materially fail to bear IDC shares equal to their respective RAB shares, the Commissioner would be able to exercise its authority pursuant to existing § 1.482-1(d)(3)(ii)(B) (Identifying contractual terms) to impute an agreement that is consistent with the controlled participants' course of conduct. Thus, a participant that bears a disproportionately greater IDC share may be allocated an undivided interest in another territory or territories of exploitation of the cost shared intangibles, and would be allocated arm's length consideration from any other controlled participant whose IDC share is less than its RAB share over time.

Current § 1.482-7(g)(5) provides that these allocations be “after any cost allocations authorized by [§ 1.482-7(a)(2)]” is eliminated. Some have interpreted this reference to mean that the Commissioner must make cost allocations, and failure to do so would bar the Commissioner from making an allocation pursuant to existing § 1.482-7(g)(5). This interpretation, if accepted, defeats the expectation that controlled participants must themselves act consistently with their CST deal and maintain their RAB shares current for that purpose. No inference is intended regarding the outcome under the existing regulations.

3. Periodic Adjustments—Proposed § 1.482-7(i)(6)

In 1986, Congress indicated a significant degree of skepticism about related-party transfers of high-profit potential intangibles for relatively insignificant lump sum or royalty consideration that effectively place all the intangible development downside risk in one controlled taxpayer and all the upside profit potential in another. See H.R. Rep. 99-426, at 424-25 (1985). See also Notice 88-123 (the White Paper), 1988-2 C.B. 458, 472-74, 477-480. The legislative history also notes that it is especially difficult to obtain realistic comparables with respect to such intangibles because they seldom if ever are transferred to unrelated parties. See id.

The Commissioner's ability to evaluate controlled participants' deals

with regard to high-profit potential intangibles is hampered, not only by the absence of comparables, but by an asymmetry of information vis-a-vis the taxpayer. The taxpayer is in the best position to know its business and prospects. The Commissioner faces real challenges in ascertaining the reliability of the ex ante expectations of taxpayer's initial arrangements in light of significantly different ex post outcomes. While risk and uncertain outcomes are typically the hallmarks of high-profit potential intangibles, significantly different results raise concerns whether the form of the initial arrangement matches its substance. These concerns are particularly problematic given the information asymmetry between taxpayers and the IRS. Periodic adjustments effectively permit the IRS to impute an arm's length arrangement that appropriately reflects the profit potential of transferred intangibles where the IRS believes that the taxpayers' arrangement does not appropriately reflect such profit potential. Because the guidance on periodic adjustments is intended to address the problem of information asymmetry, and because it is exceedingly unlikely that a taxpayer would use information asymmetry for anything other than a tax-advantaged result, periodic adjustments of this type can only be exercised by the Commissioner.

Accordingly, taxpayers cannot exercise periodic adjustments of this type. This prohibition is necessary for proper administration of these rules. Moreover, taxpayers are not inappropriately disadvantaged by this rule because they have the ability to structure their related-party arrangements in line with the economic prospects of their business. A taxpayer can always protect itself against periodic adjustments by adopting an arrangement that appropriately reflects the profit potential and risks associated with an intangible transfer, which it is in the best position to evaluate in an economically realistic way. There are various forms of consideration that taxpayers at arm's length might adopt in the face of uncertainty and risk. In some cases, uncontrolled taxpayers might find that projections of anticipated profits are sufficiently reliable to fix the pricing for the transaction at the outset on the basis of those projections. In other cases the uncertainty in valuing intangible property might lead them to adopt from the outset contingent terms of different varieties and degrees that allow for adjustment in light of actual profit experience. This does not mean that the taxpayer must adopt an arrangement that tilts the risks in a way that necessarily always involves reporting income without regard to later actual results. For example, contingent arrangements may appropriately reflect profit potential and yet appropriately tie in with later outcomes. In such arrangements, less income may properly result if the outcomes are less successful than reasonably anticipated, or greater income will result if the outcomes are more successful. Taxpayers simply are in the best position to structure their arrangements upfront to accommodate a range of potential outcomes.

Proposed § 1.482-7(j)(6) provides guidance on how periodic adjustments may be made in the context of a CSA. The goal is to conform the results of CSTs and PCTs to the arm's length standard. In accordance with the 1986 legislative history, achieving that goal requires that the “income allocated among the parties reasonably reflect the actual economic activity undertaken by each” and that “to the extent, if any, that one party is actually contributing funds toward research and development at a significantly earlier point in time than the other, or is otherwise effectively putting its funds at risk to a greater extent than the other,

it would be expected that an appropriate return would be provided to such party to reflect its investment

.” H.R. Conf. Rep. No. 99-841 at II-638 (1986). (Emphasis supplied.)

The proposed regulations build the CSA periodic adjustment provisions upon the previously discussed investor model. The taxpayer's arrangement will be respected so long as a controlled participant's actually experienced return ratio (AERR), equal to the present value of its actually experienced operating profits from exploiting cost shared intangibles divided by its investment in the CSA (consisting of the present value sum of its cost contributions and PCT Payments), is within a specified periodic return ratio range (PRRR). The PRRR provides a band of comfort for actual return ratios of no more than 2 and no less than

1/2

(unless there is a failure to substantially comply with the administrative requirements of proposed § 1.482-7(k), in which case the comfort band consists of actual return ratios of no more than 1.5 and no less than .67). Results above or below these respective thresholds typically warrant a more thorough and detailed examination of the arm's length nature of the initial taxpayer arrangement, as well as a means to impute an alternative arrangement that more reliably reflects an arm's length result, as described below.

In determining a controlled participant's AERR, the present values of its operating profits and CSA investments are measured from the period beginning on the commencement of the CSA through the end of the year of adjustment. For these purposes, present values are determined using an applicable discount rate (ADR) appropriate to the risks associated with the given CSA, as the Commissioner may determine under the guidance of proposed § 1.482-7(g)(2)(vi). Where the stock of the PCT Payor, or another company that owns stock in the PCT Payor and is in a consolidated group with the PCT Payor for financial accounting purposes is publicly traded, the Commissioner may treat the ADR as equal to the publicly traded company's weighted average cost of capital, as determined pursuant to the capital asset pricing model, subject to the taxpayer's ability to show another discount rate is more appropriate in the facts and circumstances to the satisfaction of the Commissioner. Where there is no publicly traded company in the PCT Payor group, the ADR will be determined under the general principles applicable for discount rates, subject to such adjustments as the Commissioner determines is appropriate.

In determining the AERR and, thus, whether the AERR is within or without the PRRR, it is intended that the items entering into the computation (

e.g.

, operating profits, cost contributions, and PCT Payments) are those items as adjusted (including as the result of any prior IRS adjustments).

The guidance on periodic adjustments is not intended, for example, to systematically reallocate above-market returns after-the-fact, since such returns may in whole or in part reward legitimate ex ante risk-taking by CSA investors. Accordingly, an AERR outside the PRRR does not necessarily mean that adjustments will ultimately be warranted. Rather, the PRRR provides comfort to taxpayers that within the PRRR they will not be subject to periodic adjustments. If the AERR is outside the PRRR, the proposed regulations provide exceptions pursuant to which periodic adjustments will not be made where a taxpayer can demonstrate that its deal was nevertheless arm's length. These exceptions adapt the exceptions in existing § 1.482-4(f)(2)(ii), along with three additional exceptions appropriate in the CSA context. One exception effectively would avoid “start up” triggers from return ratios below the low end of the PRRR by delaying low end trigger testing until after the first five years of substantial exploitation of cost

shared intangibles resulting from the CSA. A similar exception would enable a taxpayer to avoid a low end trigger that it can establish to the satisfaction of the Commissioner results from the “cut off” from consideration of anticipated profits, cost contributions, or PCT Payments beyond the end of the year of adjustment. For purposes of the foregoing exception, the taxpayer may assume that the yearly average of past operating profits for the years up through the year of adjustment in which there has been substantial exploitation of cost shared intangibles will continue into the future. The third additional exception would enable a taxpayer to avoid a high end trigger that it can establish to the satisfaction of the Commissioner results from routine contributions to its profitability, or from nonroutine contributions, including its own external contributions.

In the event that the AERR is outside the PRRR, and no exception applies, then the Commissioner may adjust the taxpayer's PCT Payments to the level of an equivalent stream of contingent royalties as would be determined under a modified RPSM. The modified RPSM would vary depending on whether the periodic adjustment was triggered by an AERR above the high end or below the low end of the PRRR.

In the event of a trigger above the high end of the PRRR, the arrangement going forward beginning with the year of adjustment would effectively treat the past cost contribution shares of all controlled participants as bought out and would determine new fractions for cost contribution shares as of the start of the year of adjustment (if development activity is then continuing under the CSA). Prior cost contributions and operating profits, therefore, would not be taken into account in the second step of the modified RPSM. The relative valuation of nonroutine contributions, including external contributions, in the third step of the modified RPSM would still be determined as of the original date of the PCTs, but taking into account any data relevant to such relative valuation as may be available up through the date of the periodic adjustment.

In the event of a trigger below the low end of the PRRR, the arrangement going forward beginning with the year of adjustment would effectively recompute the original cost contribution share fractions by substituting projections as revised in light of actual experience up through the date of the periodic adjustment.

For these purposes only, the residual profit split method may be used even where only one controlled participant makes significant nonroutine contributions to the CSA Activity. (As mentioned above in the discussion of the residual profit split method, applying the residual profit split method in such a situation is logically equivalent to applying the income method using an applicable rate on profit. For convenience, the proposed regulations apply the residual profit split method to all periodic adjustments rather than separately describing an equivalent modified income method for the situation in which only one controlled participant makes significant nonroutine contributions to the CSA Activity.) If only one controlled participant provides all the external contributions and other nonroutine contributions, then the third step residual profit or loss belongs entirely to such controlled participant.

It should be emphasized that the Commissioner's determination whether or not to make periodic adjustments would be informed by whether the outcome as adjusted more reliably reflects an arm's length result.

F. Definitions and Special Rules—Proposed § 1.482-7(j)

Proposed § 1.482-7(j) provides definitions and special rules relevant to CSAs.

1. Controlled Participant—Proposed § 1.482-7(j)(1)(i)

The proposed regulations incorporate the existing definitions and examples with regard to a controlled participant with conforming changes to reflect the new framework and terminology. Thus, a controlled participant is a controlled taxpayer that is a party to the CSA contractual agreement that reasonably anticipates that it will derive benefits from exploiting one or more cost shared intangibles.

The proposed regulations dispense with the possibility of an uncontrolled participant in a CSA. The Treasury Department and the IRS are not aware of any uncontrolled participants in any CSAs. The elimination of uncontrolled participants simplified various provisions of the proposed regulations. The Treasury Department and the IRS request comments in this regard.

2. Cost Shared Intangible—Proposed § 1.482-7(j)(1)(ii)

The term

cost shared intangible

replaces the term

covered intangible

from existing § 1.482-7(b)(4)(iv). A cost shared intangible means any intangible developed or to be developed as a result of the IDA. Thus, cost shared intangibles include both the intangibles that are contemplated to result from the IDA as well as any which serendipitously may result from the IDA.

Cost shared intangibles include any portion thereof that may be attributable to an external contribution and, therefore, do not simply represent the incremental results of the IDA. For example, if a new generation software resulting from the IDA incorporates elements of the prior generation software, the cost shared intangible is the total result of the prior and subsequent contributions. No inference is intended as to the outcome under the existing regulations.

3. Interest In An Intangible—Proposed § 1.482-7(j)(1)(iii)

The proposed regulations employ the same general definition of an

interest in an intangible

found in existing § 1.482-7(a)(2). It should be noted, however, that the proposed regulations provide that the interests in cost shared intangibles must be divided among the controlled participants on a territorial basis. See proposed § 1.482-7(b)(1)(i) and (b)(4).

4. Benefits—Proposed § 1.482-7(j)(1)(iv)

The proposed regulations clarify the definition of

benefits

found in existing § 1.482-7(e)(1). Benefits means the sum of additional revenue generated, plus cost savings, minus any cost increases from exploiting cost shared intangibles.

5. Reasonably Anticipated Benefits—Proposed § 1.482-7(j)(1)(v)

The proposed regulations effectively employ the same definition of

reasonably anticipated benefits

found in existing § 1.482-7(e)(2).

6. Territorial Operating Profit or Loss—Proposed § 1.482-7(j)(1)(vi)

The proposed regulations define

territorial operating profit or loss

as the operating profit or loss as separately earned by each controlled participant in its geographic territory from the CSA Activity, determined before an expense (including amortization) on account of IDCs, routine external contributions, and nonroutine contributions.

7. CSA Activity—Proposed § 1.482-7(j)(1)(vii)

The proposed regulations define

CSA Activity

as the activity of developing and exploiting cost shared intangibles.

8. Consolidated Group—Proposed § 1.482-7(j)(2)(i)

In line with existing § 1.482-7(c)(3), the proposed regulations treat all members of a U.S. group filing consolidated income tax returns as one taxpayer for purposes of the CSA provisions. The proposed regulations

would also treat all members of a foreign fiscal unity as one taxpayer for these purposes.

9. No Trade or Business and Partnership—Proposed § 1.482-7(j)(2)(ii) and (iii)

In line with existing §§ 1.482-7(a)(1) and 301.7701-1(c), the proposed regulations provide that participation in a CSA, of itself, does not constitute a U.S. trade or business or result in the creation of a partnership for federal income tax purposes.

10. Character of Payments—Proposed § 1.482-7(j)(3)

In line with existing § 1.482-7(h), the proposed regulations provide ordering rules for characterizing cost sharing payments with regard to the items they reimburse. PCT Payments will be characterized consistently with the designation of the type of transaction involved in the RT. The proposed regulations continue to provide for the netting of PCT Payments made to, and received by, a controlled participant.

G. Administrative Provisions—Proposed § 1.482-7(k)

The proposed regulations include provisions to facilitate administration of, and compliance with, the cost sharing rules. Thus, under a CSA, the controlled participants must substantially comply with certain contractual, documentation, accounting, and reporting requirements. Similar requirements are spread throughout the existing regulations in § 1.482-7(b), (c)(1), (i), and (j). In the proposed regulations, the substantial compliance standard is included in proposed § 1.482-7(b)(1)(iv) through (vii), and the specific requirements are assembled together in § 1.482-7(k).

1. CSA Contractual Requirements—Proposed § 1.482-7(k)(1)

Under proposed § 1.482-7(k)(1)(i), a CSA must be recorded in writing in a contract that is contemporaneous with the formation (and any revision) of the CSA. The written CSA must incorporate the contractual provisions set forth in proposed § 1.482-7(k)(1)(ii). Proposed § 1.482-7(k)(1)(iii) provides that 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 to which such agreement (or revision) is to apply. By requiring that CSAs be memorialized contemporaneously with formation (or revision), the CSA contractual provisions are more likely to reliably reflect (without hindsight) the relative risks of the controlled participants.

2. CSA Documentation Requirements—Proposed § 1.482-7(k)(2)

Under proposed § 1.482-7(k)(2)(i), the controlled participants must timely update and maintain sufficient documentation to establish that the participants have met the contractual requirements of proposed § 1.482-7(k)(1). In addition, the controlled participants must timely update and maintain documentation sufficient to establish and support the items listed in proposed § 1.482-7(k)(2)(ii) regarding the ongoing implementation of the CSA, CSTs, and PCTs. Thus, each controlled participant must at timely intervals update and maintain the documentation required by proposed § 1.482-7(k)(2)(i) and (ii) on an ongoing basis from the outset of the formation of the CSA. To the extent that additional documentation is required by the new availability of information or the occurrence of post-formation events, each controlled participant must maintain such documentation in a manner such that the controlled participant retains and supplements (but does not replace) the documentation maintained from the outset.

Proposed § 1.482-7(k)(2)(iii), which replaces existing § 1.482-7(j)(2)(ii), cross-references proposed § 1.6662-6(d)(2)(iii)(D) for the coordination of the CSA documentation rules with the specified method documentation rules under the section 6662 transfer pricing penalty regulations. Proposed § 1.6662-6(d)(2)(iii)(D) provides that satisfaction of the CSA documentation requirements satisfies the specified method principal documentation requirements with respect to the CSTs and PCTs, other than the requirements to provide a description of the relevant organizational structure and an index of principal and background documents, provided that such documentation is sufficient to establish that the taxpayer reasonably concluded that its method and application provided the most reliable measure of an arm's length result. Each controlled participant must provide such documentation to the IRS within 30 days of a request, subject to extension in the Commissioner's discretion.

3. CSA Accounting Requirements—Proposed § 1.482-7(k)(3)

Proposed § 1.482-7(k)(3)(i) tracks the existing regulations in requiring that the controlled participants establish a consistent method of accounting, translate foreign currencies on a consistent basis, and explain any material differences from U.S. generally accepted accounting principles. Under proposed § 1.482-7(k)(3)(ii), controlled participants may not rely solely upon financial accounting rules to establish satisfaction of the accounting requirements. Rather, the method of accounting must clearly reflect income.

4. CSA Reporting Requirements—Proposed § 1.482-7(k)(4)

Proposed § 1.482-(7)(k)(4)(i) requires that each controlled participant must file with the Ogden Campus a statement regarding its participation in a CSA (CSA Statement). The CSA Statement must provide the information enumerated in proposed § 1.482-7(k)(4)(ii), including the earliest date that any IDC occurred, the date on which the controlled participants formed (or revised) the CSA, and (if different from the immediately preceding date) the date on which the controlled participants recorded the CSA (or revision) in accordance with the contemporaneous recordation requirement.

Pursuant to proposed § 1.482-7(k)(4)(iii)(A), each controlled participant must file an original CSA Statement with the IRS no later than 90 days after the first occurrence of an IDC to which the newly-formed CSA applies or, in the case of a taxpayer that became a controlled participant after the formation of the CSA, no later than 90 days after such taxpayer became a controlled participant. The CSA Statement 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.

In addition to the 90-day rule described above, proposed § 1.482-7(k)(4)(iii)(B) contains an annual reporting requirement. 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. Further, the annual reporting by the controlled participant must update the information reflected on the original CSA Statement by attaching a schedule that documents changes in such information over time. If a controlled participant does not file a U.S. income tax return, then it must ensure that the foregoing CSA Statement and updated schedule are attached to any Schedule M of Form 5471, to any Form 5472, or

to any Form 8865 with respect to that participant.

H. Effective Date and Transition Rule—Proposed §§ 1.482-7(l) and (m)

The proposed regulations are proposed to be applicable on the date of publication of the proposed regulations as a final regulation in the

Federal Register

. Thus, CSAs commencing on or after such date, and CSTs and PCTs occurring after such date with respect to CSAs existing as of the effective date, will be subject to § 1.482-7, as then finally revised. Conversely, other transactions not reasonably anticipated to contribute to developing intangibles pursuant to an arrangement constituting a CSA described in § 1.482-7(b)(1) or (5) will be subject to other applicable section 482 regulations. See proposed § 1.482-7(a)(3)(iii).

The proposed regulations provide transition rules under which an existing arrangement that constituted a qualified cost sharing arrangement under the regulations before the effective date will be considered a CSA and will be allowed an additional period to conform to the new rules with certain modifications. Although certain documentation requirements are delayed and certain substantive requirements concerning pre-effective date matters are relaxed for a grandfathered CSA described in the previous sentence, the controlled participants' CSTs and PCTs that occur after the effective date would have to comply with the substantive requirements of these regulations beginning immediately after such date. CSTs and PCTs occurring prior to the effective date are subject to these regulations only in the event that PCT Payments become subject to periodic adjustment under paragraph (i)(6) as a result of a subsequent PCT occurring on or after the effective date.

The proposed regulations specify circumstances under which the grandfathered status of pre-effective date arrangements would terminate. Accordingly, an otherwise grandfathered arrangement would cease to be so grandfathered from the earliest of a failure of the controlled participants to substantially comply with the regulations as transitionally modified, a material change in the scope of the CSA as contemplated in the underlying contractual arrangement (such as a material expansion of the activities undertaken in the CSA beyond those undertaken as of the effective date), or a 50 percent change in the beneficial ownership of the interests in cost shared intangibles.

I. Changes to Other Provisions

The proposed regulations make conforming changes to § 1.367(a)-1T, § 1.861-17, and §§ 1.482-1

et seq.

of the section 482 regulations to reflect the new terminology and framework of the CSA provisions.

The proposed regulations redesignate current § 1.482-7 as § 1.482-7A which would continue to apply for dates prior to the publication of this document as a final regulation in the

Federal Register

and to the extent applicable under the transition rule of proposed § 1.482-7(m).

The proposed regulations add examples to § 1.482-8 to illustrate the application of the best method rule in connection with the new specified methods under proposed § 1.482-7(g).

As previously stated, proposed § 1.6662-6(d)(2)(iii)(D) coordinates the CSA documentation requirements of proposed § 1.482-7(k)(2) with the specified method documentation requirements of the section 6662 transfer pricing penalty regulations.

In line with the penultimate sentence of existing § 1.482-7(a)(1) and proposed § 1.482-7(j)(2)(iii), proposed § 301.7701-1(c) provides that participation in a CSA, of itself, does not give rise to a separate entity.

Special Analysis

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has been determined also 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 few small entities are expected to enter into cost sharing agreements, as defined herein, and that for those that do, the burdens imposed under proposed § 1.482-7(b)(1)(iv) through (vii) and (k) would be minimal. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f), this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any electronic or written comments (a signed original and eight (8) copies) that are submitted timely to the IRS. The Treasury Department and the IRS specifically request comments on the clarity of the proposed regulations and how they may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for November 16, 2005, at 10 a.m., in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance more than 30 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the

FOR FURTHER INFORMATION CONTACT

section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit electronic or written comments and an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by October 26, 2005. A period of 10 minutes will be allotted to each person for making comments.

An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is Jeffrey L. Parry of the Office of Chief Counsel (International). However, other personnel from the Treasury Department and the IRS 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.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 301 are proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1.

The authority citation for part 1 is amended by adding an entry in numerical order to read, in part, as follows:

Authority:

26 U.S.C. 7805 * * *

Section 1.482-7A also issued under 26 U.S.C. 482. * * *

Par 2.

Section 1.367(a)-1T is amended by revising the second sentence of paragraph (d)(3) to read as follows:

§ 1.367(a)-1T

Transfers to foreign corporations subject to section 367(a): In general (temporary).

(d) * * *

(3)

Transfer.

* * * A person's entering into a cost sharing arrangement under § 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). * * *

Par. 3.

Section 1.482-7 is redesignated § 1.482-7A and an undesignated centerheading preceding § 1.482-7A is added to read as follows:

Regulations applicable on or before the date of publication of this document as a final regulation in the

Federal Register

.

Par. 4.

Section 1.482-0 is amended by revising the entry for § 1.482-7 to read as follows:

§ 1.482-0

Outline of regulations under section 482.

§ 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 preliminary or contemporaneous 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.

(iii) Controlled transactions not in connection with a CSA.

(b) Cost sharing arrangement (CSA).

(1) In general.

(2) CSTs.

(i) In general.

(ii) Example.

(3) PCTs.

(i) In general.

(ii) External contributions.

(iii) PCT Payments.

(iv) Reference transaction (RT).

(v) PFAs.

(vi) Form of payment.

(A) In general.

(B) PFAs.

(C) No PCT Payor stock.

(vii) Date of a PCT.

(viii) Examples.

(4) Territorial division of interests.

(i) In general.

(ii) Examples.

(5) CSAs in substance or form .

(i) CSAs in substance.

(ii) CSAs in form.

(iii) Example.

(6) Treatment of CSAs.

(c) Make-or-sell rights excluded.

(1) In general.

(2) Examples.

(d) Intangible development costs (IDCs).

(1) Costs included in IDCs.

(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 benefit shares (RAB shares).

(1) In general.

(2) Measure of benefits.

(i) In general.

(ii) Indirect bases for measuring 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.

(g) Supplemental guidance on methods applicable to PCTs.

(1) In general.

(2) General principles.

(i) In general.

(ii) Valuation consistent with upfront contractual terms and risk allocations.

(iii)Projections.

(iv) Realistic alternatives.

(A) In general.

(B) Examples.

(v) Aggregation of transactions.

(vi) Discount rate.

(A) In general.

(B) Examples.

(vii) Accounting principles.

(A) In general.

(B) Examples.

(viii) Valuation consistent with the investor model.

(A) In general.

(B) Example.

(ix) Coordination of best method rule and form of payment.

(x) Coordination of the valuations or prior and subsequent PCTs.

(xi) Proration of PCT Payments to the extent allocable to other business activities.

(3) Comparable uncontrolled transaction method.

(4) Income method.

(i) In general.

(ii) Determination of arm's length charge.

(A) In general.

(B) Example.

(iii) Application of income method using a CUT.

(A) In general.

(B) Determination of arm's length charge.

(

1

) In general.

(

2

) Applicable rate.

(

3

) Alternative rate.

(

4

) Cost contribution adjustment.

(C) Example.

(iv) Application of income method using CPM.

(A) In general.

(B) Determination of arm's length charge based on sales.

(

1

) In general.

(

2

) Applicable rate.

(

3

) Alternative rate.

(

4

) Cost contribution adjustment.

(C) Determination of arm's length charge based on profit.

(

1

) In general.

(

2

) Alternative rate.

(

3

) Cost contribution adjustment.

(D) Example.

(v) Routine external contributions.

(vi) Comparability and reliability considerations.

(A) In general.

(B) Application of the income method using a CUT.

(C) Application of the income method using CPM.

(5) Acquisition price method.

(i) In general.

(ii) Determination of arm's length charge.

(iii) Adjusted acquisition price.

(iv) Reliability and comparability considerations.

(v) Example.

(6) Market capitalization method.

(i) In general.

(ii) Determination of arm's length charge.

(iii) Average market capitalization.

(iv) Adjusted average market capitalization.

(v) Reliability and comparability considerations.

(vi) Examples.

(7) Residual profit split.

(i) In general.

(ii) Appropriate share of profits and losses.

(iii) Profit split.

(A) In general.

(B) Allocate income to routine contributions other than cost contributions.

(C) Allocate residual profit.

(

1

) In general.

(

2

) Cost contribution share of residual profit or loss.

(

3

) Nonroutine contribution share of residual profit or loss.

(

4

) Determination of PCT Payments.

(

5

) Routine external contributions.

(iv) Comparability and reliability considerations.

(A) In general.

(B) Comparability.

(C) Data and assumptions.

(D) Other factors affecting reliability.

(v) Example.

(8) Unspecified methods.

(h) Coordination with the arm's length standard.

(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 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.

(vi) Exceptions to periodic adjustments.

(A) Transactions involving the same external contributions as in the PCT.

(B) Results not reasonably anticipated.

(C) Reduced AERR does not cause Periodic Trigger.

(D) Increased AERR does not cause Periodic Trigger.

(E) 10-year period.

(F) 5-year period.

(vii) Examples.

(viii) Documentation.

(j) Definitions and special rules.

(1) Definitions.

(2) Special rules.

(i) Consolidated group.

(ii) Trade or business.

(iii) Partnership.

(3) Character.

(i) In general.

(ii) PCT Payments.

(iii) Examples.

(k) CSA contractual, documentation, accounting, and reporting requirements.

(1) CSA contractual requirements.

(i) In general.

(ii) Contractual provisions.

(iii) Meaning of contemporaneous.

(A) In general.

(B) Example.

(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 date.

(m) Transition rule.

(1) In general.

(2) Termination of grandfather status.

(3) Transitional modification of applicable provisions.

Par. 5.

Section 1.482-1 is amended by:

1. Revising the second sentence of paragraph (b)(2)(i).

2. Revising the last sentence of paragraph (c)(1).

The revisions read as follows:

§ 1.482-1

Allocation of income and deductions among taxpayers.

(b) * * *

(2) * * *

(i) * * * Section 1.482-7 provides the methods to be used to evaluate whether a cost sharing arrangement produces results consistent with an arm's length result.

(c) * * *

(1) * * * See § 1.482-7 for the applicable methods in the case of a cost sharing arrangement.

Par. 6.

Section 1.482-4 is amended by

1. Redesignating paragraph (f)(3)(iv) as paragraph (f)(3)(v).

2. Adding a new paragraph (f)(3)(iv).

The addition reads as follows:

§ 1.482-4

Methods to determine taxable income in connection with a transfer of intangible property.

(f) * * *

(3) * * *

(iv)

Cost sharing arrangements.

The rules in this paragraph (f)(3) regarding ownership and assistance with respect to cost shared intangibles and cost sharing arrangements will apply only as provided in § 1.482-7.

Par. 7.

Section 1.482-5 is amended by revising the last sentence of paragraph (c)(2)(iv) to read as follows:

§ 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 § 1.482-7(d)(3)(i)) among the tested party and comparable parties.

Par. 8.

Section 1.482-7 is revised to read as follows:

§ 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 § 1.482-1, except as those provisions are modified in this section.

(1)

RAB share method for cost sharing transactions (CSTs).

The controlled participants that are parties to a cost sharing transaction (CST), as described in paragraph (b)(2) of this section, must share the intangible development costs (IDCs) of the cost shared intangibles in proportion to their shares of reasonably anticipated benefits (RAB shares). See paragraph (j)(1) of this section for the definitions of controlled participant, cost shared intangible, benefits, and reasonably anticipated benefits, and paragraphs (d) and (e) of this section regarding IDCs and RAB shares, respectively.

(2)

Methods for preliminary or contemporaneous transactions (PCTs).

The arm's length amount charged in a preliminary or contemporaneous transaction (PCT), as described in paragraph (b)(3) of this section, must be determined under the method or methods under the other section or sections of the section 482 regulations, as supplemented by paragraph (g) of this section, applicable to the reference transaction (RT) reflected by the PCT. See § 1.482-1(b)(2)(ii) (Selection of category of method applicable to

transaction), paragraph (b)(3)(iv) of this section (Reference transaction), 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 the cost shared intangibles, it must receive consideration from the other controlled participants under the rules of § 1.482-4(f)(3)(iii) (Allocations with respect to assistance provided to the owner). Such consideration will be treated as an intangible development cost for purposes of paragraph (d) of this section.

(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 §§ 1.482-1 and 1.482-4 through 1.482-6.

(iii)

Controlled transactions not in connection with a CSA.

This section does not apply to a controlled transaction reasonably anticipated to contribute to developing intangibles pursuant to an arrangement that is not a CSA described in paragraph (b)(1) or paragraph (b)(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 section 482 regulations without regard to this section. 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) 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)(ii) of this section, the arrangement must be analyzed under other applicable sections of the section 482 regulations 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 section 482 regulations.

(b)

Cost sharing arrangement (CSA)—(1) In general.

A CSA to which the provisions of this section apply is a contractual agreement to share the costs of developing one or more intangibles under which the controlled participants—

(i) At the outset of the arrangement divide among themselves all interests in cost shared intangibles on a territorial basis as described in paragraph (b)(4) of this section;

(ii) Enter into and effect CSTs covering all IDCs and PCTs covering all external contributions, as described in paragraphs (b)(2) and (b)(3) of this section, for purposes of developing the cost shared intangibles under the CSA;

(iii) As a result, individually own and exploit their respective interests in the cost shared intangibles without any further obligation to compensate one another for such interests;

(iv) Substantially comply with the CSA contractual requirements that are described in paragraph (k)(1) of this section;

(v) Substantially comply with the CSA documentation requirements that are described in paragraph (k)(2) of this section;

(vi) Substantially comply with the CSA accounting requirements that are described in paragraph (k)(3) of this section; and

(vii) Substantially comply with the CSA reporting requirements that are described in paragraph (k)(4) of this section.

(2)

CSTs

—(i)

In general.

CSTs are controlled transactions between or among controlled participants in which such participants share the IDCs of one or more cost shared intangibles in proportion to their respective RAB shares from their individual exploitation of their interests in the cost shared intangibles that they obtain under the CSA. Cost sharing payments may not be paid in shares of stock in the payor. See paragraphs (b)(4), (d), and (e) of this section for the rules regarding interests in cost shared intangibles, IDCs, and RAB shares, respectively.

(ii)

Example.

The following example illustrates the principles of this paragraph (b)(2):

Example.

Companies C and D, who are members of the same controlled group, enter into a CSA that is described in paragraph (b)(1) of this section. In the first year of the CSA, C and D conduct the IDA, 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, C and D will bear amounts of total IDCs in accordance with their respective RAB shares.

(3)

PCTs

—(i)

In general.

A PCT is a controlled transaction in which each other controlled participant (PCT Payor) is obligated to compensate a controlled participant (PCT Payee) for an external contribution of the PCT Payee.

(ii)

External contributions.

An external contribution consists of the rights set forth under the reference transaction (RT) in any resource or capability that is reasonably anticipated to contribute to developing cost shared intangibles and that a PCT Payee has developed, maintained, or acquired externally to (whether prior to or during the course of) the CSA. For purposes of this section, external contributions do not include rights in depreciable tangible property or land, and do not include rights in other resources acquired by IDCs. See paragraphs (b)(2) and (d)(1) of this section.

(iii)

PCT Payments.

The arm's length amount of the compensation due under a PCT (PCT Payment) will be determined under a method pursuant to paragraphs (a)(2) and (g) of this section applicable to the RT, as described in paragraph (b)(3)(iv) of this section. The applicable method will yield a value for the compensation obligation of each PCT Payor consistent with the product of the combined value to all controlled participants of the external contribution that is the subject of the PCT multiplied by the PCT Payor's RAB share.

(iv)

Reference transaction (RT).

An RT is a transaction providing the benefits of all rights (RT Rights), exclusively and perpetually, in a resource or capability described in paragraph (b)(3)(ii) of this section, excluding any rights to exploit an existing intangible without further development. See paragraph (c) of this section (Make-or-sell rights excluded). If a resource or capability is reasonably anticipated to contribute both to developing or exploiting cost shared intangibles and to other business activities of the PCT Payee, other than exploiting an existing intangible without further development, then the PCT Payment that would otherwise be determined with reference to the RT (which generally presumes a provision of exclusive and perpetual rights) may need to be prorated as described in

paragraph (g)(2)(xi) of this section. For purposes of § 1.482-1(b)(2)(ii) and paragraph (a)(2) of this section, the controlled participants must include the type of transaction involved in the RT as part of the documentation of the RT required under paragraph (k)(2)(ii)(H) of this section. If different economically equivalent types of RTs are possible with respect to the relevant resource or capability, the controlled participants may designate the type of transaction involved in the RT. If the controlled participants fail to make this designation in their documentation, the Commissioner may make a designation consistent with the RT and other facts and circumstances. While the PCT Payee and PCT Payors must enter into the PCT providing for the relevant compensation obligation, they are not required to actually enter into the RT that is referenced for purposes of determining the magnitude of the compensation obligation under the PCT.

(v)

PFAs.

A post formation acquisition (PFA) is an external contribution that is acquired by a controlled participant in an uncontrolled transaction that takes place after the formation of the CSA and that as of the date of acquisition is reasonably anticipated to contribute to developing cost shared intangibles. Resources or capabilities may be acquired in a PFA either directly, or indirectly through the acquisition of an interest in an entity or tier of entities.

(vi)

Form of payment

—(A)

In general.

The consideration under a PCT for an external contribution other than a PFA may take one or a combination of both of the following forms—

(

1

) Payments of a fixed amount, either paid in a lump sum payment or in installment payments spread over a specified period, with interest calculated in accordance with § 1.482-2(a) (Loans or advances); or

(

2

) Payments contingent on the exploitation of cost shared intangibles by the PCT Payor. The form of payment selected for any PCT, including the basis and structure of the payments, must be specified no later than the date of that PCT.

(B)

PFAs.

The consideration under a PCT for a PFA must be paid in the same form as the uncontrolled transaction in which the PFA was acquired.

(C)

No PCT Payor Stock.

PCT Payments may not be paid in shares of stock in the PCT Payor.

(vii)

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 the external contribution is reasonably anticipated to contribute to developing cost shared intangibles.

(viii)

Examples.

The following examples illustrate the principles of this paragraph (b)(3). In each example, Companies P and S are members of the same controlled group, and execute a CSA that is described in paragraph (b)(1) of this section. The examples are as follows:

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 the RT rights in version 1.0 constitute an external contribution of Company P for which compensation is due from Company S pursuant to a PCT. The applicable method and determination of the arm's length compensation due pursuant to the PCT will be based on the RT. The controlled participants designate the RT as a transfer of intangibles that would otherwise be governed by § 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 § 1.482-4 as supplemented by paragraph (g) of this section. The RT in this case is the perpetual and exclusive provision of the benefit of all rights in version 1.0, other than the rights described in paragraph (c) of this section (Make-or-sell rights excluded). This includes the exclusive right to use version 1.0 for purposes of research and the right to exploit any products that incorporated the platform technology of version 1.0, and would cover a term extending as long as the uncontrolled taxpayer were to continue to exploit future versions of XYZ or any other product based on the version 1.0 platform. Though Company P and Company S are not required to actually enter into the transaction described by the RT, the value of the compensation obligation of Company S for the PCT will reflect the full value of the external contribution defined by the RT, 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 its research team that has successfully developed a number of other vaccines to the project. The expertise and existing integration of the research team is a unique resource or capability of Company P which is reasonably anticipated to contribute to the development of Vaccine Z and therefore the RT Rights in the research team constitute an external contribution for which compensation is due from Company S as part of a PCT. The applicable method and determination of the arm's length compensation due pursuant to the PCT will be based on the RT. The controlled parties designate the RT as a provision of services that would otherwise be governed by § 1.482-2(b)(3)(first sentence) 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 § 1.482-2(b)(3)(first sentence) as supplemented by paragraph (g) of this section. The RT in this case is the perpetual and exclusive provision of the benefits by Company P of its research team to the development of Vaccine Z by the uncontrolled party. 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. Though Company P and Company S are not required to actually enter into the transaction described by the RT, the value of the compensation obligation of Company S for the PCT will reflect the full value of provision of services described in the RT, as limited by Company S's RAB share.

Example 3.

In Year 1, Company P and Company S execute a CSA under which they will share the IDCs for developing Product X. In Year 3, Company P acquires technology intangibles that it anticipates will contribute to the development of Product X from an uncontrolled party for a lump sum consideration. Because the technology intangibles are reasonably anticipated to contribute to the development on the date of the acquisition and the acquisition is an uncontrolled transaction that takes place after the formation of the CSA, the RT Rights in the technology intangibles are an external contribution acquired as part of a PFA. Accordingly, Company P and Company S must enter into a PCT in which Company S compensates Company P for the RT Rights in the technology intangibles and pursuant to paragraph (b)(3)(vi)(B) of this section, the form of payment of the PCT must mirror the lump sum form of payment of the PFA.

Example 4.

Assume the same facts as in

Example 3.

In Year 4 Company P acquires Company X in a tax-free stock-for-stock acquisition. Company X is a start-up technology company with negligible amounts of tangible property and liabilities. Company X joins in the filing of a U.S. consolidated income tax return with USP and is treated as one taxpayer with Company P under paragraph (j)(2)(i) of this section. Accordingly, under paragraph (b)(3)(v) of this section, Company P's acquisition of the stock of Company X will be treated as an indirect acquisition of the resources and capabilities of Company X. The in-process technology and workforce of Company X acquired by Company P are reasonably anticipated to contribute to the development of product Z and therefore the RT Rights in the in-process technology and workforce of Company X are external contributions for which compensation is due to Company P from Company S under a PCT. Furthermore, because these external contributions were acquired by Company P in an uncontrolled transaction that took place after the formation of the CSA, they are also PFAs. Accordingly, the consideration due from S under the PCT must be paid in the same form of payment as Company's P acquisition of Company X, which was done in a lump sum payment.

Therefore, consideration for the PCT must be paid in a lump sum.

(4)

Territorial division of interests

—(i)

In general.

Pursuant to paragraph (b)(1)(i) of this section, at the outset of the CSA the controlled participants must divide among themselves 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 must be entitled to the perpetual and exclusive right to the profits from transactions of any member of the controlled group that includes the controlled participant with uncontrolled taxpayers regarding property or services for use, consumption, or disposition in such controlled participant's territory or territories, to the extent that such profits are attributable to cost shared intangibles. Absent the controlled participant's or other member of its controlled group's actual knowledge or reason to know otherwise, for purposes of the preceding sentence such use, consumption, or disposition of property or services will be considered to occur at the location(s) to which notices and other communications to the uncontrolled taxpayer(s) are to be provided in accordance with the contractual provisions of the relevant transactions.

(ii)

Example.

The following example illustrates the principles of this paragraph (b)(4):

Example.

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)(i) 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, intercompany compensation must be provided for between P and S to ensure that S realizes all the cost shared intangible profits from sales of product Z to customers in such proximate areas, even though the manufacturing is done by P in the United States. The pricing of such intercompany compensation must also ensure that P realizes an appropriate manufacturing return for its efforts. Benefits projected with respect to such sales will be included for purposes of estimating S's, but not P's, RAB share.

(5)

CSAs in substance or form

—(i)

CSAs in substance.

The Commissioner may apply, consistently with the rules of § 1.482-1(d)(3)(ii)(B) (Identifying contractual terms), the rules of this section to any arrangement that in substance constitutes a CSA described in paragraphs (b)(1)(i) through (iii) of this section, notwithstanding a failure to comply with any requirement of this section.

(ii)

CSAs in form.

Provided the requirements of paragraphs (b)(1)(iv) through (vii) are met with respect to an arrangement among controlled taxpayers,

(A) The Commissioner must apply the rules of this section to any such arrangement that the controlled taxpayers reasonably concluded to be a CSA, as described in paragraph (b)(1) of this section; and

(B) Otherwise, the Commissioner may apply the rules of this section to any other such arrangement.

(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. The examples are as follows:

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 CSA by which they agree to proportionally share the costs and risks of developing a formula for P-Ves. The 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 for P-Cap and the software are reasonably anticipated to contribute to the development of P-Ves and therefore are external contributions for which compensation is due from S as part of PCTs. Though P and S enter into a PCT for the P-Cap patent, 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 formal requirements of paragraphs (b)(1)(iv) through (vii) of this section. However, because they did not enter into a PCT, as required under paragraph (b)(1)(i) of this section, for the software that was reasonably anticipated to be critical to the development of P-Ves, they cannot reasonably conclude that their arrangement was a CSA. Accordingly, the Commissioner is not required under paragraph (b)(5)(ii)(A) of this section to apply the rules of this section to their arrangement. Nevertheless, pursuant to paragraph (b)(5)(ii)(B), 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)(i) of this section, and make any appropriate allocations under paragraph (i) of this section. Alternatively, the Commissioner may decide that the arrangement is not a CSA described in paragraph (b)(1) of this section and therefore that this section's provisions do not apply in determining whether the arrangement reaches arm's length results. In this case, the arrangement would be analyzed under the methods under the section 482 regulations, without regard to this section, to determine whether the arrangement reaches such results.

Example 2.

The facts are the same as

Example 1

except that P and S do enter into a PCT for the software. Although 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 paragraphs (b)(1)(iv) through (vii) and reasonably concluded their arrangement is a CSA, pursuant to paragraph (b)(5)(ii)(A) 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.

(6)

Treatment of CSAs.

See § 301.7701-1(c) of this chapter for the treatment of CSAs for purposes of the Internal Revenue Code.

(c)

Make-or-sell rights excluded

—(1)

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