Section 482 Cost Sharing Regulations

DEPARTMENT OF THE TREASURY

26 CFR Parts 1, 301 and 602

[TD 8632]

RIN 1544-AM00

Section 482 Cost Sharing Regulations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to qualified

cost sharing arrangements under section 482 of the Internal Revenue

Code. These regulations reflect changes to section 482 made by the Tax

Reform Act of 1986, and provide guidance to revenue agents and

taxpayers implementing the changes.

DATES: These regulations are effective January 1, 1996.

These regulations are applicable for taxable years beginning on or

after January 1, 1996.

FOR FURTHER INFORMATION CONTACT: Lisa Sams of the Office of Associate

Chief Counsel (International), IRS (202) 622-3840 (not a toll-free

number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations

have been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545-1364. Responses to these collections of information

are required to determine whether an intangible development arrangement

is a qualified cost sharing arrangement and who are the participants in

such arrangement.

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.

The estimated average annual burden per recordkeeper is 8 hours.

The estimated average annual burden per respondent is 0.5 hour.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,

DC 20224, and 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.

Books and records relating to these collections 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 was amended by the Tax Reform Act of 1986, Public Law

99-514, 100 Stat. 2085, 2561, et. seq. (1986-3 C.B. (Vol. 1) 1, 478).

On January 30, 1992, a notice of proposed rulemaking concerning the

section 482 amendment in the context of cost sharing was published in

the Federal Register (INTL-0372-88, 57 FR 3571).

Written comments were received with respect to the notice of

proposed rulemaking, and a public hearing was held on August 31, 1992.

After consideration of all the comments, the proposed regulations under

section 482 are adopted as revised by this Treasury decision, and the

corresponding temporary regulations (which contain the cost sharing

regulations as in effect since 1968) are removed.

Explanation of Provisions

Introduction

The Tax Reform Act of 1986 (the Act) amended section 482 to require

that consideration for intangible property transferred in a controlled

transaction be commensurate with the income attributable to the

intangible. The Conference Committee report to the Act indicated that

in revising section 482, Congress did not intend to preclude the use of

bona fide research and development cost sharing arrangements as an

appropriate method of allocating income attributable to intangibles

among related parties. The Conference Committee report stated, however,

that in order for cost sharing arrangements to produce results

consistent with the commensurate-with-income standard, (a) a cost

sharer should be expected to bear its portion of all research and

development costs, on unsuccessful as well as successful products,

within an appropriate product area, and the costs of research and

development at all relevant development stages should be shared, (b)

the allocation of costs generally should be proportionate to profit as

determined before deduction for research and development, and (c) to

the extent that one party contributes funds toward research and

development at a significantly earlier point in time than another (or

is otherwise putting its funds at risk to a greater extent than the

other) that party should receive an appropriate return on its

investment. See H.R. Rep. 99-281, 99th Cong., 2d Sess. (1986) at II-

638.

[[Page 65554]]

The Conference Committee report to the Act recommended that the IRS

conduct a comprehensive study and consider whether the regulations

under section 482 (issued in 1968) should be modified in any respect.

The White Paper

In response to the Conference Committee's directive, the IRS and

the Treasury Department issued a study of intercompany pricing [Notice

88-123 (1988-2 C.B. 458)] on October 18, 1988 (the White Paper). The

White Paper suggested that most bona fide cost sharing arrangements

should have certain provisions. For example, the White Paper stated

that most product areas covered by cost sharing arrangements should be

within three-digit Standard Industrial Classification codes, that most

participants should be assigned exclusive geographic rights in

developed intangibles (and should predict benefits and divide costs

accordingly) and that marketing intangibles should be excluded from

bona fide cost sharing arrangements.

Comments on the White Paper indicated that, in practice, there was

a great deal of variety in the terms of bona fide cost sharing

arrangements, and that if the White Paper's suggestions were

incorporated in regulations, the regulations would unduly restrict the

availability of cost sharing.

The 1992 Proposed Regulations

The IRS issued proposed cost sharing regulations on January 30,

1992 (INTL-0372-88, 57 FR 3571). In general, the proposed regulations

allowed more flexibility than anticipated by the White Paper, relying

on anti-abuse tests rather than requiring standard cost sharing

provisions.

The proposed regulations stated that in order to be qualified, a

cost sharing arrangement had to meet the following five requirements:

(1) the arrangement had to have two or more eligible participants, (2)

the arrangement had to be recorded in writing contemporaneously with

the formation of the cost sharing arrangement, (3) the eligible

participants had to share the costs and risks of intangible development

in return for a specified interest in any intangible produced, (4) the

arrangement had to reflect a reasonable effort by each eligible

participant to share costs and risks in proportion to anticipated

benefits from using developed intangibles, and (5) the arrangement had

to meet certain administrative requirements. The key requirements were

that participants had to be eligible and that costs and risks had to be

proportionate to benefits.

Under the proposed regulations, only a controlled taxpayer that

would use developed intangibles in the active conduct of its trade or

business was eligible to participate in a cost sharing arrangement.

This requirement was considered necessary to ensure that controlled

foreign entities were not established simply to participate in cost

sharing arrangements without performing any other meaningful function,

and to ensure that each participant's share of anticipated benefits was

measurable.

The proposed regulations allowed costs to be divided based on any

measurement that would reasonably predict cost sharing benefits (e.g.,

anticipated units of production or anticipated sales). However, the

basis for measuring anticipated benefits and dividing costs was checked

by a cost-to-operating-income ratio. The method for dividing costs was

presumed to be unreasonable if a U.S. participant's ratio of shared

costs to operating income attributable to developed intangibles was

grossly disproportionate to the cost-to-operating-income ratio of the

other participants.

If a U.S. participant's cost-to-operating-income ratio was not

grossly disproportionate, a section 482 allocation could still be made

under three circumstances: (a) if the cost-to-operating-income ratio

was disproportionate (allocation of costs), (b) if the pool of costs

shared was too broad or too narrow, so that the U.S. participant was

paying for research that it would not use (allocation of costs), or (c)

if the cost-to-operating-income ratio was substantially

disproportionate, such that a transfer of an intangible could be deemed

to have occurred (allocation of income).

Under the proposed regulations, the IRS could also make an

allocation of income to reflect a buy-in or buy-out event, that is, a

transfer of an intangible that could occur, for example, when a

participant joined or left a cost sharing arrangement.

Comments on the 1992 Proposed Regulations

The 1992 proposed cost sharing regulations were generally well

received. However, there were five areas of particular concern to

commenters. The first was the mechanical use of cost-to-operating-

income ratios as a standard for measuring the reasonableness of an

effort to share costs in proportion to anticipated benefits. Commenters

noted that operating income attributable to developed intangibles was

difficult to measure, and that other bases for measuring benefits might

produce more reliable results. Commenters also believed that the ratios

might be overused, leading to adjustments to costs in every year, and

to many deemed transfers of intangibles. In addition, commenters stated

that the ratios did not provide any certainty that a cost sharing

arrangement would not be disregarded, since a ``grossly

disproportionate'' ratio was not numerically defined.

The second area of concern was the eligible participant

requirement. Commenters argued that separate research entities (with no

separate active trade or business) should be allowed to participate in

cost sharing arrangements, as should marketing affiliates. Commenters

also argued that transfers of intangibles to unrelated entities should

not disqualify a participant, and that foreign-to-foreign transfers

should not necessarily be monitored. Some comments also stated that

controlled entities should be able to participate even if their cost

sharing payments would be characterized differently for purposes of

foreign law.

The third area of concern was the regulations' requirement that

every participant be able to benefit from every intangible developed

under a cost sharing arrangement. Commenters stated that the

regulations should allow both single-product cost sharing arrangements

and umbrella cost sharing arrangements (i.e., cost sharing arrangements

under which a broad category of a controlled group's research and

development would be covered).

The fourth area of concern was the buy-in and buy-out rules. There

were some suggestions for clarifying and simplifying the rules. For

example, comments urged that the regulations provide that one

participant's abandonment of its rights would not necessarily confer

benefits on the other participants, and that a new participant need not

always make a buy-in payment when joining a cost sharing arrangement.

Suggestions for simplifying the rules generally consisted of proposed

safe harbors for valuing intangibles.

The final general area of concern was the administrative

requirements. Several commenters suggested that annual adjustments to

the method used to share costs should not be required. Commenters also

suggested that taxpayers not be required to attach their cost sharing

arrangements to their returns, and that the time period for producing

records be increased.

In addition to these general areas of concern, commenters noted

that there should be more guidance about when the IRS would deem a cost

sharing

[[Page 65555]]

arrangement to exist. Commenters also argued that existing cost sharing

arrangements should be grandfathered, or that there should be a longer

transition period. Commenters suggested that financial accounting rules

be used to calculate costs to be shared, and that the IRS address the

impact of currency fluctuations on the cost-to-operating-income ratios.

Finally, commenters asked that the regulations clarify that a cost

sharing arrangement would not be deemed to create a partnership or a

U.S. trade or business.

The Final Regulations

Without fundamentally altering the policies of the 1992 proposed

regulations, the final regulations reflect numerous modifications in

response to the comments described above. They also reflect the

approach of the final section 482 regulations relating to transfers of

tangible and intangible property.

Section 1.482-7(a)(1) defines a cost sharing arrangement as an

agreement for sharing costs in proportion to reasonably anticipated

benefits from the individual exploitation of interests in the

intangibles that are developed. In order to claim the benefits of the

safe harbor, a taxpayer must also satisfy certain formal requirements

(enumerated in Sec. 1.482-7(b)). The district director may apply the

cost sharing rules to any arrangement that in substance constitutes a

cost sharing arrangement, notwithstanding any failure to satisfy

particular requirements of the safe harbor. It is further provided that

a qualified cost sharing arrangement, or an arrangement treated in

substance as such, will not be treated as a partnership. (A

corresponding provision is added to Sec. 301.7701-3 pertaining to the

definition of a partnership.) Neither will a foreign participant be

treated as engaged in a trade or business within the United States

solely by virtue of its participation in such an arrangement.

Section 1.482-7(a)(2) restates the general rule of cost sharing in

a manner intended to emphasize its limitation on allocations: no

section 482 allocation will be made with respect to a qualified cost

sharing arrangement, except to make each controlled participant's share

of the intangible development costs equal to its share of reasonably

anticipated benefits.

Section 1.482-7(b) contains the requirements for a qualified cost

sharing arrangement. This provision substantially tracks the proposed

regulations. A modification was made in the second requirement which

now directs that the arrangement provide a method to calculate each

controlled participant's share of intangible development costs, based

on factors that can reasonably be expected to reflect anticipated

benefits. The new standard is intended to ensure that cost sharing

arrangements will not be disregarded by the IRS as long as the factors

upon which an estimate of benefits was based were reasonable, even if

the estimate proved to be inaccurate.

Section 1.482-7(b)(4) requires that a cost sharing arrangement be

set forth in writing and contain a number of specified provisions,

including the interest that each controlled participant will receive in

any intangibles developed pursuant to the arrangement. The intangibles

developed under a cost sharing arrangement are referred to as the

``covered intangibles.'' It is possible that the research activity

undertaken may result in development of intangible property that was

not foreseen at the inception of the cost sharing arrangement; any such

property is also included within the definition of the term covered

intangibles. The prescriptive rules in relation to the scope of the

intangible development area under the proposed regulations are

eliminated in favor of a flexible definition that encompasses any

research and development actually undertaken under the cost sharing

arrangement.

Section 1.482-7(c) provides rules for being a participant in a

qualified cost sharing arrangement. Unlike the proposed regulations,

the final regulations permit participation by unrelated persons, which

are referred to as ``uncontrolled participants.'' Controlled taxpayers

may be participants, referred to as ``controlled participants,'' if

they satisfy the conditions set forth in these rules. These

qualification rules replace the proposed regulations' concept of

``eligible participant.'' The tax treatment of controlled taxpayers

that do not qualify as controlled participants provided in Sec. 1.482-

7(c)(4) essentially tracks the treatment provided for ineligible

participants under the proposed regulations.

The requirements for being a controlled participant are basically

the same as in the proposed regulations. In particular, a controlled

participant must use or reasonably expect to use covered intangibles in

the active conduct of a trade or business. Thus, an entity that chiefly

provides services (e.g., as a contract researcher) may not be a

controlled participant. These provisions are necessary for the reason

that they are necessary to the proposed regulations: to prevent foreign

controlled entities from being established simply to participate in

cost sharing arrangements. In accordance with Sec. 1.482-7(c)(4)

mentioned above, service entities (such as contract researchers) may

furnish research and development services to the members of a qualified

cost sharing arrangement, with the appropriate consideration for such

assistance in the research and development undertaken in the intangible

development area being governed by the rules in Sec. 1.482-

4(f)(3)(iii) (Allocations with respect to assistance provided to the

owner). In the case of a controlled research entity, the appropriate

arm's length compensation would generally be determined under the

principles of Sec. 1.482-2(b) (Performance of services for another).

Each controlled participant would be deemed to incur as part of its

intangible development costs a share of such compensation equal to its

share of reasonably anticipated benefits.

As under the proposed regulations, the activity of another person

may be attributed to a controlled taxpayer for purposes of meeting the

active conduct requirement. However, modified language is adopted to be

more precise concerning the intended requirements for attribution.

These requirements were phrased in the proposed regulations as bearing

the risk and receiving the benefits of the attributed activity. Under

the final regulations, the attribution will be made only in cases in

which the controlled taxpayer exercises substantial managerial and

operational control over the attributed activities.

As under the proposed regulations, a principal purpose to use cost

sharing to accomplish a transfer or license of covered intangibles to

uncontrolled or controlled taxpayers will defeat satisfaction of the

active conduct requirement. However, a principal purpose will not be

implied where there are legitimate business reasons for subsequently

licensing covered intangibles.

The subgroup rules of the proposed regulations are eliminated.

Their major purpose is accomplished by a simpler provision (see the

discussion of Sec. 1.482-7(h)). In addition, the final regulations

treat all members of a consolidated group as a single participant.

Section 1.482-7(d) defines intangible development costs as

operating expenses other than depreciation and amortization expense,

plus an arm's length charge for tangible property made available to the

cost sharing arrangement. Costs to be shared include all costs relating

to the intangible development area, which, as noted, comprises any

research actually undertaken under the cost sharing

[[Page 65556]]

arrangement. As under the proposed regulations, the district director

may adjust the pool of costs shared in order to properly reflect costs

that relate to the intangible development area.

Section 1.482-7(e) defines anticipated benefits as additional

income generated or costs saved by the use of covered intangibles. The

pool of benefits may also be adjusted in order to properly reflect

benefits that relate to the intangible development area.

Section 1.482-7(f) governs cost allocations by the district

director in order to make a controlled participant's share of costs

equal to its share of reasonably anticipated benefits. Anticipated

benefits of uncontrolled participants will be excluded from anticipated

benefits in calculating the benefits shares of controlled participants.

A share of reasonably anticipated benefits will be determined using the

most reliable estimate of benefits. This rule echoes the best method

rule for determining the most reliable measure of an arm's length

result under Sec. 1.482-1(c).

The reliability of an estimate of benefits principally depends on

two factors: the reliability of the basis for measuring benefits used

and the reliability of the projections used. The cost-to-operating-

income ratio used in the proposed regulations to check the

reasonableness of an effort to share costs in proportion to anticipated

benefits has not been included in the final regulations. Rather, the

final regulations provide that an allocation of costs or income may be

made if the taxpayer did not use the most reliable estimate of

benefits, which depends on the facts and circumstances of each case.

Section 1.482-7(f)(3)(ii) provides that in estimating a controlled

participant's share of benefits, the most reliable basis for measuring

anticipated benefits must be used, taking into account the factors set

forth in Sec. 1.482-1(c)(2)(ii). The measurement basis used must be

consistent for all controlled participants. The regulations provide

that benefits may be measured directly or indirectly. In addition,

regardless of whether a direct or indirect basis of measurement is

employed, it may be necessary to make adjustments to account for

material differences in the activities that controlled participants

perform in connection with exploitation of covered intangibles, such as

between wholesale and retail distribution.

Section 1.482-7(f)(3)(iii) describes the scope of various indirect

bases for measuring benefits, such as units, sales, and operating

profit. Indirect bases other than those enumerated may be employed as

long as they bear a relationship to benefits.

Section 1.482-7(f)(3)(iv) discusses projections used to estimate

benefits. Projections required for this purpose generally include a

determination of the time period between the inception of the research

and development and the receipt of benefits, a projection of the time

over which benefits will be received, and a projection of the benefits

anticipated for each year in which it is anticipated that the

intangible will generate benefits. However, the regulations note that

in certain circumstances, current annual benefit shares may be used in

lieu of projections.

Section 1.482-7(f)(3)(iv)(B) states that a significant divergence

between projected and actual benefit shares may indicate that the

projections were not reliable. A significant divergence is defined as

divergence in excess of 20% between projected and actual benefit

shares. If there is a significant divergence, which is not due to an

unforeseeable event, then the district director may use actual benefits

as the most reliable basis for measuring benefits. Conversely, no

allocation will be made based on a divergence that is not considered

significant as long as the estimate is made using the most reliable

basis for measuring benefits.

For purposes of the 20% test, all non-U.S. controlled participants

are treated as a single controlled participant in order that a

divergence by a foreign controlled participant with a very small share

of the total costs will not necessarily trigger an allocation (section

1.482-7(f)(3)(iv)(D), Example 8, illustrates this rule). Section 1.482-

7(f)(3)(iv)(B) and (C) notes that adjustments among foreign controlled

participants will only be made if the adjustment will have a

substantial U.S. tax impact, for example, under subpart F.

Section 1.482-7(f)(4) states that cost allocations must be

reflected for tax purposes in the year in which costs were incurred.

This reflects a change from the rule in the 1992 proposed regulations,

which stated that cost allocations would be included in income in the

taxable year under review, even if the costs to be allocated were

incurred in a prior taxable year. The purpose of the change was to

match up cost adjustments with the year to which they relate in

accordance with the clear reflection of income principle of section

482.

Section 1.482-7(g) provides buy-in and buy-out rules that are

similar to the rules in the proposed regulations. However, some of the

clarifications suggested by commenters have been incorporated in these

rules. A ``substantially disproportionate'' cost-to-operating-income

ratio will no longer trigger an adjustment to income under these rules.

However, if, after any cost allocations authorized by Sec. 1.482-

7(a)(2), the economic substance of the arrangement is inconsistent with

the terms of the arrangement over a period of years (for example,

through a consistent pattern of one controlled participant bearing an

inappropriately high or low share of the cost of intangible

development), then the district director may impute an agreement

consistent with the course of conduct. In that case, one or more of the

participants would be deemed to own a greater interest in covered

intangibles than provided under the arrangement, and must receive buy-

in payments from the other participants.

The rules do not provide safe harbor methods for valuing

intangibles, but rely on the intangible valuation rules of Secs. 1.482-

1 and 1.482-4 through 1.482-6. To the extent some participants furnish

a disproportionately greater amount of existing intangibles to the

arrangement, they must be compensated by royalties by the participants

who furnish a disproportionately lesser amount of existing intangibles

to the arrangement. Buy-in payments owed are netted against payments

owing, and only the net payment is treated as a royalty. No implication

is intended that netting of cross royalties is permissible outside of

the qualified cost sharing safe harbor rules.

Section 1.482-7(h) provides rules regarding the character of

payments made pursuant to a qualified cost sharing arrangement. Cost

sharing payments received are generally treated as reductions of

research and development expense. A net approach is applied to foster

simplicity and generally preserve the character of items actually

incurred by a participant to the extent not reimbursed. In addition,

for purposes of the research credit determined under section 41, cost

sharing payments among controlled participants will be treated as

provided for intra-group transactions in Sec. 1.41-8(e). Finally, any

payment that in substance constitutes a cost sharing payment will be

treated as such, regardless of its characterization under foreign law.

This rule is intended to enable foreign entities to participate in cost

sharing arrangements with U.S. controlled participants even if foreign

law does not recognize cost sharing. This rule obviated the main reason

for the subgroup rules which, as noted, have accordingly been

eliminated.

[[Page 65557]]

Section 1.482-7(i) requires that controlled participants must use a

consistent accounting method for measuring costs and benefits, and must

translate foreign currencies on a consistent basis. To the extent that

the accounting method materially differs from U.S. generally accepted

accounting principles, any such material differences must be

documented, as provided in Sec. 1.482-7(j)(2)(iv).

Section 1.482-7(j) provides simplified recordkeeping and reporting

requirements. It is anticipated that many of the background documents

necessary for purposes of this section will be kept pursuant to section

6662(e) and the regulations thereunder.

Section 1.482-7(k) provides that this regulation is effective for

taxable years beginning on or after January 1, 1996.

Section 1.482-7(l) allows a one-year transition period for

taxpayers to conform their cost sharing arrangements with the

requirements of the final regulations. A longer period was not

considered necessary, given the increased flexibility and the reduced

number of administrative requirements of the final regulations.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information

The principal author of these regulations is Lisa Sams, Office of

Associate Chief Counsel (International), IRS. However, other personnel

from the IRS and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income

taxes, Penalties, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1, 301 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority for part 1 is amended by adding an entry

for section 1.482-7 to read as follows:

Authority: 26 U.S.C. 7805. * * *

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

Par. 2. Section 1.482-0 is amended by:

1. Removing the entry for Sec. 1.482-7T.

2. Adding the entry for Sec. 1.482-7 to read as follows:

Sec. 1.482-0 Outline of regulations under 482.

* * * * *

Sec. 1.482-7 Sharing of costs.

(a) In general.

(1) Scope and application of the rules in this section.

(2) Limitation on allocations.

(3) Cross references.

(b) Qualified cost sharing arrangement.

(c) Participant.

(1) In general.

(2) Active conduct of a trade or business.

(i) Trade or business.

(ii) Active conduct.

(iii) Examples.

(3) Use of covered intangibles in the active conduct of a trade

or business.

(i) In general.

(ii) Example.

(4) Treatment of a controlled taxpayer that is not a controlled

participant.

(i) In general.

(ii) Example.

(5) Treatment of consolidated group.

(d(d) Costs.

(1) Intangible development costs.

(2) Examples.

(e) Anticipated benefits.

(1) Benefits.

(2) Reasonably anticipated benefits.

(f) Cost allocations.

(1) In general.

(2) Share of intangible development costs.

(i) In general.

(ii) Example.

(3) Share of reasonably anticipated benefits.

(i) In general.

(ii) Measure of benefits.

(iii) Indirect bases for measuring anticipated benefits.

(A) Units used, produced or sold.

(B) Sales.

(C) Operating profit.

(D) Other bases for measuring anticipated benefits.

(E) Examples.

(iv) Projections used to estimate anticipated benefits.

(A) In general.

(B) Unreliable projections.

(C) Foreign-to-foreign adjustments.

(D) Examples.

(4) Timing of allocations.

(g) Allocations of income, deductions or other tax items to

reflect transfers of intangibles (buy-in).

(1) In general.

(2) Pre-existing intangibles.

(3) New controlled participant.

(4) Controlled participant relinquishes interests.

(5) Conduct inconsistent with the terms of a cost sharing

arrangement.

(6)Failure to assign interests under a qualified cost sharing

arrangement.

(7) Form of consideration.

(i) Lump sum payments.

(ii) Installment payments.

(iii) Royalties.

(8) Examples.e

(h) Character of payments made pursuant to a qualified cost

sharing arrangement.

(1) In general.

(2) Examples.

(i) Accounting requirements.

(j) Administrative requirements.

(1) In general.

(2) Documentation.

(3) Reporting requirements.

(k) Effective date.

(l) Transition rule.

* * * * *

Par. 3. Section 1.482-7 is added to read as follows:

Sec. 1.482-7 Sharing of costs.

(a) In general--(1) Scope and application of the rules in this

section. A cost sharing arrangement is an agreement under which the

parties agree to share the costs of development of one or more

intangibles in proportion to their shares of reasonably anticipated

benefits from their individual exploitation of the interests in the

intangibles assigned to them under the arrangement. A taxpayer may

claim that a cost sharing arrangement is a qualified cost sharing

arrangement only if the agreement meets the requirements of paragraph

(b) of this section. Consistent with the rules of Sec. 1.482-

1(d)(3)(ii)(B) (Identifying contractual terms), the district director

may apply the rules of this section to any arrangement that in

substance constitutes a cost sharing arrangement, notwithstanding a

failure to comply with any requirement of this section. A qualified

cost sharing arrangement, or an arrangement to which the district

director applies the rules of this section, will not be treated as a

partnership to which the rules of subchapter K apply. See

Sec. 301.7701-3(e) of this chapter. Furthermore, a participant that is

a foreign corporation or nonresident alien individual will not be

treated as engaged in trade or business within the United States solely

[[Page 65558]]

by reason of its participation in such an arrangement. See generally

Sec. 1.864-2(a).

(2) Limitation on allocations. The district director shall not make

allocations with respect to a qualified cost sharing arrangement except

to the extent necessary to make each controlled participant's share of

the costs (as determined under paragraph (d) of this section) of

intangible development under the qualified cost sharing arrangement

equal to its share of reasonably anticipated benefits attributable to

such development, under the rules of this section. If a controlled

taxpayer acquires an interest in intangible property from another

controlled taxpayer (other than in consideration for bearing a share of

the costs of the intangible's development), then the district director

may make appropriate allocations to reflect an arm's length

consideration for the acquisition of the interest in such intangible

under the rules of Secs. 1.482-1 and 1.482-4 through 1.482-6. See

paragraph (g) of this section. An interest in an intangible includes

any commercially transferable interest, the benefits of which are

susceptible of valuation. See Sec. 1.482-4(b) for the definition of an

intangible.

(3) Cross references. Paragraph (c) of this section defines

participant. Paragraph (d) of this section defines the costs of

intangible development. Paragraph (e) of this section defines the

anticipated benefits of intangible development. Paragraph (f) of this

section provides rules governing cost allocations. Paragraph (g) of

this section provides rules governing transfers of intangibles other

than in consideration for bearing a share of the costs of the

intangible's development. Rules governing the character of payments

made pursuant to a qualified cost sharing arrangement are provided in

paragraph (h) of this section. Paragraph (i) of this section provides

accounting requirements. Paragraph (j) of this section provides

administrative requirements. Paragraph (k) of this section provides an

effective date. Paragraph (l) provides a transition rule.

(b) Qualified cost sharing arrangement. A qualified cost sharing

arrangement must--

(1) Include two or more participants;

(2) Provide a method to calculate each controlled participant's

share of intangible development costs, based on factors that can

reasonably be expected to reflect that participant's share of

anticipated benefits;

(3) Provide for adjustment to the controlled participants' shares

of intangible development costs to account for changes in economic

conditions, the business operations and practices of the participants,

and the ongoing development of intangibles under the arrangement; and

(4) Be recorded in a document that is contemporaneous with the

formation (and any revision) of the cost sharing arrangement and that

includes--

(i) A list of the arrangement's participants, and any other member

of the controlled group that will benefit from the use of intangibles

developed under the cost sharing arrangement;

(ii) The information described in paragraphs (b)(2) and (b)(3) of

this section;

(iii) A description of the scope of the research and development to

be undertaken, including the intangible or class of intangibles

intended to be developed;

(iv) A description of each participant's interest in any covered

intangibles. A covered intangible is any intangible property that is

developed as a result of the research and development undertaken under

the cost sharing arrangement (intangible development area);

(v) The duration of the arrangement; and

(vi) The conditions under which the arrangement may be modified or

terminated and the consequences of such modification or termination,

such as the interest that each participant will receive in any covered

intangibles.

(c) Participant--(1) In general. For purposes of this section, a

participant is a controlled taxpayer that meets the requirements of

this paragraph (c)(1) (controlled participant) or an uncontrolled

taxpayer that is a party to the cost sharing arrangement (uncontrolled

participant). See Sec. 1.482-1(i)(5) for the definitions of controlled

and uncontrolled taxpayers. A controlled taxpayer may be a controlled

participant only if it--

(i) Uses or reasonably expects to use covered intangibles in the

active conduct of a trade or business, under the rules of paragraphs

(c)(2) and (c)(3) of this section;

(ii) Substantially complies with the accounting requirements

described in paragraph (i) of this section; and

(iii) Substantially complies with the administrative requirements

described in paragraph (j) of this section.

(2) Active conduct of a trade or business--(i) Trade or business.

The rules of Sec. 1.367(a)-2T(b)(2) apply in determining whether the

activities of a controlled taxpayer constitute a trade or business. For

this purpose, the term controlled taxpayer must be substituted for the

term foreign corporation.

(ii) Active conduct. In general, a controlled taxpayer actively

conducts a trade or business only if it carries out substantial

managerial and operational activities. For purposes only of this

paragraph (c)(2), activities carried out on behalf of a controlled

taxpayer by another person may be attributed to the controlled

taxpayer, but only if the controlled taxpayer exercises substantial

managerial and operational control over those activities.

(iii) Examples. The following examples illustrate this paragraph

(c)(2):

Example 1. Foreign Parent (FP) enters into a cost sharing

arrangement with its U.S. Subsidiary (USS) to develop a cheaper

process for manufacturing widgets. USS is to receive the right to

exploit the intangible to make widgets in North America, and FP is

to receive the right to exploit the intangible to make widgets in

the rest of the world. However, USS does not manufacture widgets;

rather, USS acts as a distributor for FP's widgets in North America.

Because USS is simply a distributor of FP's widgets, USS does not

use or reasonably expect to use the manufacturing intangible in the

active conduct of its trade or business, and thus USS is not a

controlled participant.

Example 2. The facts are the same as in Example 1, except that

USS contracts to have widgets it sells in North America made by a

related manufacturer (that is not a controlled participant) using

USS' cheaper manufacturing process. USS purchases all the

manufacturing inputs, retains ownership of the work in process as

well as the finished product, and bears the risk of loss at all

times in connection with the operation. USS compensates the

manufacturer for the manufacturing functions it performs and

receives substantially all of the intangible value attributable to

the cheaper manufacturing process. USS exercises substantial

managerial and operational control over the manufacturer to ensure

USS's requirements are satisfied concerning the timing, quantity,

and quality of the widgets produced. USS uses the manufacturing

intangible in the active conduct of its trade or business, and thus

USS is a controlled participant.

(3) Use of covered intangibles in the active conduct of a trade or

business--(i) In general. A covered intangible will not be considered

to be used, nor will the controlled taxpayer be considered to

reasonably expect to use it, in the active conduct of the controlled

taxpayer's trade or business if a principal purpose for participating

in the arrangement is to obtain the intangible for transfer or license

to a controlled or uncontrolled taxpayer.

(ii) Example. The following example illustrates the absence of such

a principal purpose:

Example. Controlled corporations A, B, and C enter into a

qualified cost sharing arrangement for the purpose of developing a

new technology. Costs are shared equally

[[Page 65559]]

among the three controlled taxpayers. A, B, and C have the exclusive

rights to manufacture and sell products based on the new technology

in North America, South America, and Europe, respectively. When the

new technology is developed, C expects to use it to manufacture and

sell products in most of Europe. However, for sound business

reasons, C expects to license to an unrelated manufacturer the right

to use the new technology to manufacture and sell products within a

particular European country owing to its relative remoteness and

small size. In these circumstances, C has not entered into the

arrangement with a principal purpose of obtaining covered

intangibles for transfer or license to controlled or uncontrolled

taxpayers, because the purpose of licensing the technology to the

unrelated manufacturer is relatively insignificant in comparison to

the overall purpose of exploiting the European market.

(4) Treatment of a controlled taxpayer that is not a controlled

participant--(i) In general. If a controlled taxpayer that is not a

controlled participant (within the meaning of this paragraph (c))

provides assistance in relation to the research and development

undertaken in the intangible development area, it must receive

consideration from the controlled participants under the rules of

Sec. 1.482-4(f)(3)(iii) (Allocations with respect to assistance

provided to the owner). For purposes of paragraph (d) of this section,

such consideration is treated as an operating expense and each

controlled participant must be treated as incurring a share of such

consideration equal to its share of reasonably anticipated benefits (as

defined in paragraph (f)(3) of this section).

(ii) Example. The following example illustrates this paragraph

(c)(4):

Example. (i) U.S. Parent (USP), one foreign subsidiary (FS), and

a second foreign subsidiary constituting the group's research arm

(R+D) enter into a cost sharing agreement to develop manufacturing

intangibles for a new product line A. USP and FS are assigned the

exclusive rights to exploit the intangibles respectively in the

United States and Europe, where each presently manufactures and

sells various existing product lines. R+D, whose activity consists

solely in carrying out research for the group, is assigned the

rights to exploit the new technology in Asia, where no group member

presently operates, but which is reliably projected to be a major

market for product A. R+D will license the Asian rights to an

unrelated third party. It is reliably projected that the shares of

reasonably anticipated benefits of USP and FS (i.e., not taking R+D

into account) will be 66 \2/3\% and 33 \1/3\%, respectively. The

parties' agreement provides that USP and FS will reimburse 40% and

20%, respectively, of the intangible development costs incurred by

R+D with respect to the new intangible.

(ii) R+D does not qualify as a controlled participant within the

meaning of paragraph (c) of this section. Therefore, R+D is treated

as a service provider for purposes of this section and must receive

arm's length consideration for the assistance it is deemed to

provide to USP and FS, under the rules of Sec. 1.482-4(f)(3)(iii).

Such consideration must be treated as intangible development costs

incurred by USP and FS in proportion to their shares of reasonably

anticipated benefits (i.e., 66 \2/3\% and 33 \1/3\%, respectively).

R+D will not be considered to bear any share of the intangible

development costs under the arrangement.

(iii) The Asian rights nominally assigned to R+D under the

agreement must be treated as being held by USP and FS in accordance

with their shares of the intangible development costs (i.e., 66 \2/

3\% and 33 \1/3\%, respectively). See paragraph (g)(6) of this

section. Thus, since under the cost sharing agreement the Asian

rights are owned by R+D, the district director may make allocations

to reflect an arm's length consideration owed by R+D to USP and FS

for these rights under the rules of Secs. 1.482-1 and 1.482-4

through 1.482-6.

(5) Treatment of consolidated group. For purposes of this section,

all members of the same affiliated group (within the meaning of section

1504(a)) that join in the filing of a consolidated return for the

taxable year under section 1501 shall be treated as one taxpayer.

(d) Costs--(1) Intangible development costs. For purposes of this

section, a controlled participant's costs of developing intangibles for

a taxable year mean all of the costs incurred by that participant

related to the intangible development area, plus all of the cost

sharing payments it makes to other controlled and uncontrolled

participants, minus all of the cost sharing payments it receives from

other controlled and uncontrolled participants. Costs incurred related

to the intangible development area consist of the following items:

operating expenses as defined in Sec. 1.482-5(d)(3), other than

depreciation or amortization expense, plus (to the extent not included

in such operating expenses, as defined in Sec. 1.482-5(d)(3)) the

charge for the use of any tangible property made available to the

qualified cost sharing arrangement. If tangible property is made

available to the qualified cost sharing arrangement by a controlled

participant, the determination of the appropriate charge will be

governed by the rules of Sec. 1.482-2(c) (Use of tangible property).

Intangible development costs do not include the consideration for the

use of any intangible property made available to the qualified cost

sharing arrangement. See paragraph (g)(2) of this section. If a

particular cost contributes to the intangible development area and

other areas or other business activities, the cost must be allocated

between the intangible development area and the other areas or business

activities on a reasonable basis. In such a case, it is necessary to

estimate the total benefits attributable to the cost incurred. The

share of such cost allocated to the intangible development area must

correspond to covered intangibles' share of the total benefits. Costs

that do not contribute to the intangible development area are not taken

into account.

(2) Examples. The following examples illustrate this paragraph (d):

Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) enter

into a qualified cost sharing arrangement to develop a better

mousetrap. USS and FP share the costs of FP's research and

development facility that will be exclusively dedicated to this

research, the salaries of the researchers, and reasonable overhead

costs attributable to the project. They also share the cost of a

conference facility that is at the disposal of the senior executive

management of each company but does not contribute to the research

and development activities in any measurable way. In this case, the

cost of the conference facility must be excluded from the amount of

intangible development costs.

Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter

into a qualified cost sharing arrangement to develop a new device.

USP and FS share the costs of a research and development facility,

the salaries of researchers, and reasonable overhead costs

attributable to the project. USP also incurs costs related to field

testing of the device, but does not include them in the amount of

intangible development costs of the cost sharing arrangement. The

district director may determine that the field testing costs are

intangible development costs that must be shared.

(e) Anticipated benefits--(1) Benefits. Benefits are additional

income generated or costs saved by the use of covered intangibles.

(2) Reasonably anticipated benefits. For purposes of this section,

a controlled participant's reasonably anticipated benefits are the

aggregate benefits that it reasonably anticipates that it will derive

from covered intangibles.

(f) Cost allocations--(1) In general. For purposes of determining

whether a cost allocation authorized by paragraph (a)(2) of this

section is appropriate for a taxable year, a controlled participant's

share of intangible development costs for the taxable year under a

qualified cost sharing arrangement must be compared to its share of

reasonably anticipated benefits under the arrangement. A controlled

participant's share of intangible development costs is determined under

paragraph (f)(2) of this section. A controlled participant's share of

reasonably anticipated benefits under the arrangement is determined

under paragraph (f)(3) of this section. In

[[Page 65560]]

determining whether benefits were reasonably anticipated, it may be

appropriate to compare actual benefits to anticipated benefits, as

described in paragraph (f)(3)(iv) of this section.

(2) Share of intangible development costs--(i) In general. A

controlled participant's share of intangible development costs for a

taxable year is equal to its intangible development costs for the

taxable year (as defined in paragraph (d) of this section), divided by

the sum of the intangible development costs for the taxable year (as

defined in paragraph (d) of this section) of all the controlled

participants.

(ii) Example. The following example illustrates this paragraph

(f)(2):

Example. (i) U.S. Parent (USP), Foreign Subsidiary (FS), and

Unrelated Third Party (UTP) enter into a cost sharing arrangement to

develop new audio technology. In the first year of the arrangement,

the controlled participants incur $2,250,000 in the intangible

development area, all of which is incurred directly by USP. In the

first year, UTP makes a $250,000 cost sharing payment to USP, and FS

makes a $800,000 cost sharing payment to USP, under the terms of the

arrangement. For that year, the intangible development costs borne

by USP are $1,200,000 (its $2,250,000 intangible development costs

directly incurred, minus the cost sharing payments it receives of

$250,000 from UTP and $800,000 from FS); the intangible development

costs borne by FS are $800,000 (its cost sharing payment); and the

intangible development costs borne by all of the controlled

participants are $2,000,000 (the sum of the intangible development

costs borne by USP and FS of $1,200,000 and $800,000, respectively).

Thus, for the first year, USP's share of intangible development

costs is 60% ($1,200,000 divided by $2,000,000), and FS's share of

intangible development costs is 40% ($800,000 divided by

$2,000,000).

(ii) For purposes of determining whether a cost allocation

authorized by paragraph Sec. 1.482-7(a)(2) is appropriate for the

first year, the district director must compare USP's and FS's shares

of intangible development costs for that year to their shares of

reasonably anticipated benefits. See paragraph (f)(3) of this

section.

(3) Share of reasonably anticipated benefits--(i) In general. A

controlled participant's share of reasonably anticipated benefits under

a qualified cost sharing arrangement is equal to its reasonably

anticipated benefits (as defined in paragraph (e)(2) of this section),

divided by the sum of the reasonably anticipated benefits (as defined

in paragraph (e)(2) of this section) of all the controlled

participants. The anticipated benefits of an uncontrolled participant

will not be included for purposes of determining each controlled

participant's share of anticipated benefits. A controlled participant's

share of reasonably anticipated benefits will be determined using the

most reliable estimate of reasonably anticipated benefits. In

determining which of two or more available estimates is most reliable,

the quality of the data and assumptions used in the analysis must be

taken into account, consistent with Sec. 1.482-1(c)(2)(ii) (Data and

assumptions). Thus, the reliability of an estimate will depend largely

on the completeness and accuracy of the data, the soundness of the

assumptions, and the relative effects of particular deficiencies in

data or assumptions on different estimates. If two estimates are

equally reliable, no adjustment should be made based on differences in

the results. The following factors will be particularly relevant in

determining the reliability of an estimate of anticipated benefits--

(A) The reliability of the basis used for measuring benefits, as

described in paragraph (f)(3)(ii) of this section; and

(B) The reliability of the projections used to estimate benefits,

as described in paragraph (f)(3)(iv) of this section.

(ii) Measure of benefits. In order to estimate a controlled

participant's share of anticipated benefits from covered intangibles,

the amount of benefits that each of the controlled participants is

reasonably anticipated to derive from covered intangibles must be

measured on a basis that is consistent for all such participants. See

paragraph (f)(3)(iii)(E), Example 8, of this section. Anticipated

benefits are measured either on a direct basis, by reference to

estimated additional income to be generated or costs to be saved by the

use of covered intangibles, or on an indirect basis, by reference to

certain measurements that reasonably can be assumed to be related to

income generated or costs saved. Such indirect bases of measurement of

anticipated benefits are described in paragraph (f)(3)(iii) of this

section. A controlled participant's anticipated benefits must be

measured on the most reliable basis, whether direct or indirect. In

determining which of two bases of measurement of reasonably anticipated

benefits is most reliable, the factors set forth in Sec. 1.482-

1(c)(2)(ii) (Data and assumptions) must be taken into account. It

normally will be expected that the basis that provided the most

reliable estimate for a particular year will continue to provide the

most reliable estimate in subsequent years, absent a material change in

the factors that affect the reliability of the estimate. Regardless of

whether a direct or indirect basis of measurement is used, adjustments

may be required to account for material differences in the activities

that controlled participants undertake to exploit their interests in

covered intangibles. See Example 6 of paragraph (f)(3)(iii)(E) of this

section.

(iii) Indirect bases for measuring anticipated benefits. Indirect

bases for measuring anticipated benefits from participation in a

qualified cost sharing arrangement include the following:

(A) Units used, produced or sold. Units of items used, produced or

sold by each controlled participant in the business activities in which

covered intangibles are exploited may be used as an indirect basis for

measuring its anticipated benefits. This basis of measurement will be

more reliable to the extent that each controlled participant is

expected to have a similar increase in net profit or decrease in net

loss attributable to the covered intangibles per unit of the item or

items used, produced or sold. This circumstance is most likely to arise

when the covered intangibles are exploited by the controlled

participants in the use, production or sale of substantially uniform

items under similar economic conditions.

(B) Sales. Sales by each controlled participant in the business

activities in which covered intangibles are exploited may be used as an

indirect basis for measuring its anticipated benefits. This basis of

measurement will be more reliable to the extent that each controlled

participant is expected to have a similar increase in net profit or

decrease in net loss attributable to covered intangibles per dollar of

sales. This circumstance is most likely to arise if the costs of

exploiting covered intangibles are not substantial relative to the

revenues generated, or if the principal effect of using covered

intangibles is to increase the controlled participants' revenues (e.g.,

through a price premium on the products they sell) without affecting

their costs substantially. Sales by each controlled participant are

unlikely to provide a reliable basis for measuring benefits unless each

controlled participant operates at the same market level (e.g.,

manufacturing, distribution, etc.).

(C) Operating profit. Operating profit of each controlled

participant from the activities in which covered intangibles are

exploited may be used as an indirect basis for measuring its

anticipated benefits. This basis of measurement will be more reliable

to the extent that such profit is largely attributable to the use of

covered intangibles, or if the share of profits attributable to the use

of covered intangibles is expected to be similar for each controlled

participant. This circumstance is most likely to arise when covered

intangibles are integral to the activity that generates the profit and

[[Page 65561]]

the activity could not be carried on or would generate little profit

without use of those intangibles.

(D) Other bases for measuring anticipated benefits. Other bases for

measuring anticipated benefits may, in some circumstances, be

appropriate, but only to the extent that there is expected to be a

reasonably identifiable relationship between the basis of measurement

used and additional income generated or costs saved by the use of

covered intangibles. For example, a division of costs based on employee

compensation would be considered unreliable unless there were a

relationship between the amount of compensation and the expected income

of the controlled participants from the use of covered intangibles.

(E) Examples. The following examples illustrate this paragraph

(f)(3)(iii):

Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) both

produce a feedstock for the manufacture of various high-performance

plastic products. Producing the feedstock requires large amounts of

electricity, which accounts for a significant portion of its

production cost. FP and USS enter into a cost sharing arrangement to

develop a new process that will reduce the amount of electricity

required to produce a unit of the feedstock. FP and USS currently

both incur an electricity cost of X% of its other production costs

and rates for each are expected to remain similar in the future. How

much the new process, if it is successful, will reduce the amount of

electricity required to produce a unit of the feedstock is

uncertain, but it will be about the same amount for both companies.

Therefore, the cost savings each company is expected to achieve

after implementing the new process are similar relative to the total

amount of the feedstock produced. Under the cost sharing arrangement

FP and USS divide the costs of developing the new process based on

the units of the feedstock each is anticipated to produce in the

future. In this case, units produced is the most reliable basis for

measuring benefits and dividing the intangible development costs

because each participant is expected to have a similar decrease in

costs per unit of the feedstock produced.

Example 2. The facts are the same as in Example 1, except that

USS pays X% of its other production costs for electricity while FP

pays 2X% of its other production costs. In this case, units produced

is not the most reliable basis for measuring benefits and dividing

the intangible development costs because the participants do not

expect to have a similar decrease in costs per unit of the feedstock

produced. The district director determines that the most reliable

measure of benefit shares may be based on units of the feedstock

produced if FP's units are weighted relative to USS' units by a

factor of 2. This reflects the fact that FP pays twice as much as

USS as a percentage of its other production costs for electricity

and, therefore, FP's savings per unit of the feedstock would be

twice USS's savings from any new process eventually developed.

Example 3. The facts are the same as in Example 2, except that

to supply the particular needs of the U.S. market USS manufactures

the feedstock with somewhat different properties than FP's

feedstock. This requires USS to employ a somewhat different

production process than does FP. Because of this difference, it will

be more costly for USS to adopt any new process that may be

developed under the cost sharing agreement. In this case, units

produced is not the most reliable basis for measuring benefit

shares. In order to reliably determine benefit shares, the district

director offsets the reasonably anticipated costs of adopting the

new process against the reasonably anticipated total savings in

electricity costs.

Example 4. U.S. Parent (USP) and Foreign Subsidiary (FS) enter

into a cost sharing arrangement to develop new anesthetic drugs. USP

obtains the right to use any resulting patent in the U.S. market,

and FS obtains the right to use the patent in the European market.

USP and FS divide costs on the basis of anticipated operating profit

from each patent under development. USP anticipates that it will

receive a much higher profit than FS per unit sold because drug

prices are uncontrolled in the U.S., whereas drug prices are

regulated in many European countries. In this case, the controlled

taxpayers' basis for measuring benefits is the most reliable.

Example 5. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)

both manufacture and sell fertilizers. They enter into a cost

sharing arrangement to develop a new pellet form of a common

agricultural fertilizer that is currently available only in powder

form. Under the cost sharing arrangement, USS obtains the rights to

produce and sell the new form of fertilizer for the U.S. market

while FP obtains the rights to produce and sell the fertilizer for

the rest of the world. The costs of developing the new form of

fertilizer are divided on the basis of the anticipated sales of

fertilizer in the participants' respective markets.

(ii) If the research and development is successful the pellet

form will deliver the fertilizer more efficiently to crops and less

fertilizer will be required to achieve the same effect on crop

growth. The pellet form of fertilizer can be expected to sell at a

price premium over the powder form of fertilizer based on the

savings in the amount of fertilizer that needs to be used. If the

research and development is successful, the costs of producing

pellet fertilizer are expected to be approximately the same as the

costs of producing powder fertilizer and the same for both FP and

USS. Both FP and USS operate at approximately the same market

levels, selling their fertilizers largely to independent

distributors.

(iii) In this case, the controlled taxpayers' basis for

measuring benefits is the most reliable.

Example 6. The facts are the same as in Example 5, except that

FP distributes its fertilizers directly while USS sells to

independent distributors. In this case, sales of USS and FP are not

the most reliable basis for measuring benefits unless adjustments

are made to account for the difference in market levels at which the

sales occur.

Example 7. Foreign Parent (FP) and U.S. Subsidiary (USS) enter

into a cost sharing arrangement to develop materials that will be

used to train all new entry-level employees. FP and USS determine

that the new materials will save approximately ten hours of training

time per employee. Because their entry-level employees are paid on

differing wage scales, FP and USS decide that they should not divide

costs based on the number of entry-level employees hired by each.

Rather, they divide costs based on compensation paid to the entry-

level employees hired by each. In this case, the basis used for

measuring benefits is the most reliable because there is a direct

relationship between compensation paid to new entry-level employees

and costs saved by FP and USS from the use of the new training

materials.

Example 8. U.S. Parent (USP), Foreign Subsidiary 1 (FS1) and

Foreign Subsidiary 2 (FS2) enter into a cost sharing arrangement to

develop computer software that each will market and install on

customers' computer systems. The participants divide costs on the

basis of projected sales by USP, FS1, and FS2 of the software in

their respective geographic areas. However, FS1 plans for sound

business reasons not only to sell but also to license the software,

and FS1's licensing income (which is a percentage of the licensees'

sales) is not counted in the projected benefits. In this case, the

basis used for measuring the benefits of each participant is not the

most reliable because all of the benefits received by participants

are not taken into account. In order to reliably determine benefit

shares, FS1's projected benefits from licensing must be included in

the measurement on a basis that is the same as that used to measure

its own and the other participants' projected benefits from sales

(e.g., all participants might measure their benefits on the basis of

operating profit).

(iv) Projections used to estimate anticipated benefits--(A) In

general. The reliability of an estimate of anticipated benefits also

depends upon the reliability of projections used in making the

estimate. Projections required for this purpose generally include a

determination of the time period between the inception of the research

and development and the receipt of benefits, a projection of the time

over which benefits will be received, and a projection of the benefits

anticipated for each year in which it is anticipated that the

intangible will generate benefits. A projection of the relevant basis

for measuring anticipated benefits may require a projection of the

factors that underlie it. For example, a projection of operating

profits may require a projection of sales, cost of sales, operating

expenses, and other factors that affect operating profits. If it is

anticipated that there will be significant variation among controlled

participants in the timing of their receipt of benefits, and

consequently

[[Page 65562]]

benefit shares are expected to vary significantly over the years in

which benefits will be received, it may be necessary to use the present

discounted value of the projected benefits to reliably determine each

controlled participant's share of those benefits. If it is not

anticipated that benefit shares will significantly change over time,

current annual benefit shares may provide a reliable projection of

anticipated benefit shares. This circumstance is most likely to occur

when the cost sharing arrangement is a long-term arrangement, the

arrangement covers a wide variety of intangibles, the composition of

the covered intangibles is unlikely to change, the covered intangibles

are unlikely to generate unusual profits, and each controlled

participant's share of the market is stable.

(B) Unreliable projections. A significant divergence between

projected benefit shares and actual benefit shares may indicate that

the projections were not reliable. In such a case, the district

director may use actual benefits as the most reliable measure of

anticipated benefits. If benefits are projected over a period of years,

and the projections for initial years of the period prove to be

unreliable, this may indicate that the projections for the remaining

years of the period are also unreliable and thus should be adjusted.

Projections will not be considered unreliable based on a divergence

between a controlled participant's projected benefit share and actual

benefit share if the amount of such divergence for every controlled

participant is less than or equal to 20% of the participant's projected

benefit share. Further, the district director will not make an

allocation based on such divergence if the difference is due to an

extraordinary event, beyond the control of the participants, that could

not reasonably have been anticipated at the time that costs were

shared. For purposes of this paragraph, all controlled participants

that are not U.S. persons will be treated as a single controlled

participant. Therefore, an adjustment based on an unreliable projection

will be made to the cost shares of foreign controlled participants only

if there is a matching adjustment to the cost shares of controlled

participants that are U.S. persons. Nothing in this paragraph

(f)(3)(iv)(B) will prevent the district director from making an

allocation if the taxpayer did not use the most reliable basis for

measuring anticipated benefits. For example, if the taxpayer measures

anticipated benefits based on units sold, and the district director

determines that another basis is more reliable for measuring

anticipated benefits, then the fact that actual units sold were within

20% of the projected unit sales will not preclude an allocation under

this section.

(C) Foreign-to-foreign adjustments. Notwithstanding the limitations

on adjustments provided in paragraph (f)(3)(iv)(B) of this section,

adjustments to cost shares based on an unreliable projection also may

be made solely among foreign controlled participants if the variation

between actual and projected benefits has the effect of substantially

reducing U.S. tax.

(D) Examples. The following examples illustrate this paragraph

(f)(3)(iv):

Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)

enter into a cost sharing arrangement to develop a new car model.

The participants plan to spend four years developing the new model

and four years producing and selling the new model. USS and FP

project total sales of $4 billion and $2 billion, respectively, over

the planned four years of exploitation of the new model. Cost shares

are divided for each year based on projected total sales. Therefore,

USS bears 66\2/3\% of each year's intangible development costs and

FP bears 33\1/3\% of such costs.

(ii) USS typically begins producing and selling new car models a

year after FP begins producing and selling new car models. The

district director determines that in order to reflect USS' one-year

lag in introducing new car models, a more reliable projection of

each participant's share of benefits would be based on a projection

of all four years of sales for each participant, discounted to

present value.

Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter

into a cost sharing arrangement to develop new and improved

household cleaning products. Both participants have sold household

cleaning products for many years and have stable market shares. The

products under development are unlikely to produce unusual profits

for either participant. The participants divide costs on the basis

of each participant's current sales of household cleaning products.

In this case, the participants' future benefit shares are reliably

projected by current sales of cleaning products.

Example 3. The facts are the same as in Example 2, except that

FS's market share is rapidly expanding because of the business

failure of a competitor in its geographic area. The district

director determines that the participants' future benefit shares are

not reliably projected by current sales of cleaning products and

that FS's benefit projections should take into account its growth in

sales.

Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter

into a cost sharing arrangement to develop synthetic fertilizers and

insecticides. FP and USS share costs on the basis of each

participant's current sales of fertilizers and insecticides. The

market shares of the participants have been stable for fertilizers,

but FP's market share for insecticides has been expanding. The

district director determines that the participants' projections of

benefit shares are reliable with regard to fertilizers, but not

reliable with regard to insecticides; a more reliable projection of

benefit shares would take into account the expanding market share

for insecticides.

Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter

into a cost sharing arrangement to develop new food products,

dividing costs on the basis of projected sales two years in the

future. In year 1, USP and FS project that their sales in year 3

will be equal, and they divide costs accordingly. In year 3, the

district director examines the participants' method for dividing

costs. USP and FS actually accounted for 42% and 58% of total sales,

respectively. The district director agrees that sales two years in

the future provide a reliable basis for estimating benefit shares.

Because the differences between USP's and FS's actual and projected

benefit shares are less than 20% of their projected benefit shares,

the projection of future benefits for year 3 is reliable.

Example 6. The facts are the same as in Example 5, except that

the in year 3 USP and FS actually accounted for 35% and 65% of total

sales, respectively. The divergence between USP's projected and

actual benefit shares is greater than 20% of USP's projected benefit

share and is not due to an extraordinary event beyond the control of

the participants. The district director concludes that the

projection of anticipated benefit shares was unreliable, and uses

actual benefits as the basis for an adjustment to the cost shares

borne by USP and FS.

Example 7. U.S. Parent (USP), a U.S. corporation, and its

foreign subsidiary (FS) enter a cost sharing arrangement in year 1.

They project that they will begin to receive benefits from covered

intangibles in years 4 through 6, and that USP will receive 60% of

total benefits and FS 40% of total benefits. In years 4 through 6,

USP and FS actually receive 50% each of the total benefits. In

evaluating the reliability of the participants' projections, the

district director compares these actual benefit shares to the

projected benefit shares. Although USP's actual benefit share (50%)

is within 20% of its projected benefit share (60%), FS's actual

benefit share (50%) is not within 20% of its projected benefit share

(40%). Based on this discrepancy, the district director may conclude

that the participants' projections were not reliable and may use

actual benefit shares as the basis for an adjustment to the cost

shares borne by USP and FS.

Example 8. Three controlled taxpayers, USP, FS1 and FS2 enter

into a cost sharing arrangement. FS1 and FS2 are foreign. USP is a

United States corporation that controls all the stock of FS1 and

FS2. The participants project that they will share the total

benefits of the covered intangibles in the following percentages:

USP 50%; FS1 30%; and FS2 20%. Actual benefit shares are as follows:

USP 45%; FS1 25%; and FS2 30%. In evaluating the reliability of the

participants' projections, the district director compares these

actual benefit shares to the projected benefit shares. For this

purpose, FS1 and FS2 are treated as a single participant. The actual

benefit share received by USP (45%) is within 20% of its projected

benefit share

[[Page 65563]]

(50%). In addition, the non-US participants' actual benefit share (55%)

is also within 20% of their projected benefit share (50%).

Therefore, the district director concludes that the participants'

projections of future benefits were reliable, despite the fact that

FS2's actual benefit share (30%) is not within 20% of its projected

benefit share (20%).

Example 9. The facts are the same as in Example 8. In addition,

the district director determines that FS2 has significant operating

losses and has no earnings and profits, and that FS1 is profitable

and has earnings and profits. Based on all the evidence, the

district director concludes that the participants arranged that FS1

would bear a larger cost share than appropriate in order to reduce

FS1's earnings and profits and thereby reduce inclusions USP

otherwise would be deemed to have on account of FS1 under subpart F.

Pursuant to Sec. 1.482-7 (f)(3)(iv)(C), the district director may

make an adjustment solely to the cost shares borne by FS1 and FS2

because FS2's projection of future benefits was unreliable and the

variation between actual and projected benefits had the effect of

substantially reducing USP's U.S. income tax liability (on account

of FS1 subpart F income).

Example 10. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS)

enter into a cost sharing arrangement in 1996 to develop a new

treatment for baldness. USS's interest in any treatment developed is

the right to produce and sell the treatment in the U.S. market while

FP retains rights to produce and sell the treatment in the rest of

the world. USS and FP measure their anticipated benefits from the

cost sharing arrangement based on their respective projected future

sales of the baldness treatment. The following sales projections are

used:

Sales

[In millions of dollars]

------------------------------------------------------------------------

Year USS FP

------------------------------------------------------------------------

1997.................................................... 5 10

1998.................................................... 20 20

1999.................................................... 30 30

2000.................................................... 40 40

2001.................................................... 40 40

2002.................................................... 40 40

2003.................................................... 40 40

2004.................................................... 20 20

2005.................................................... 10 10

2006.................................................... 5 5

------------------------------------------------------------------------

(B) In 1997, the first year of sales, USS is projected to have

lower sales than FP due to lags in U.S. regulatory approval for the

baldness treatment. In each subsequent year USS and FP are projected

to have equal sales. Sales are projected to build over the first

three years of the period, level off for several years, and then

decline over the final years of the period as new and improved

baldness treatments reach the market.

(ii) To account for USS's lag in sales in the first year, the

present discounted value of sales over the period is used as the

basis for measuring benefits. Based on the risk associated with this

venture, a discount rate of 10 percent is selected. The present

discounted value of projected sales is determined to be

approximately $154.4 million for USS and $158.9 million for FP. On

this basis USS and FP are projected to obtain approximately 49.3%

and 50.7% of the benefit, respectively, and the costs of developing

the baldness treatment are shared accordingly.

(iii) (A) In the year 2002 the district director examines the

cost sharing arrangement. USS and FP have obtained the following

sales results through the year 2001:

Sales

[In millions of dollars]

------------------------------------------------------------------------

Year USS FP

------------------------------------------------------------------------

1997.................................................... 0 17

1998.................................................... 17 35

1999.................................................... 25 41

2000.................................................... 38 41

2001.................................................... 39 41

------------------------------------------------------------------------

(B) USS's sales initially grew more slowly than projected while

FP's sales grew more quickly. In each of the first three years of

the period the share of total sales of at least one of the parties

diverged by over 20% from its projected share of sales. However, by

the year 2001 both parties' sales had leveled off at approximately

their projected values. Taking into account this leveling off of

sales and all the facts and circumstances, the district director

determines that it is appropriate to use the original projections

for the remaining years of sales. Combining the actual results

through the year 2001 with the projections for subsequent years, and

using a discount rate of 10%, the present discounted value of sales

is approximately $141.6 million for USS and $187.3 million for FP.

This result implies that USS and FP obtain approximately 43.1% and

56.9%, respectively, of the anticipated benefits from the baldness

treatment. Because these benefit shares are within 20% of the

benefit shares calculated based on the original sales projections,

the district director determines that, based on the difference

between actual and projected benefit shares, the original

projections were not unreliable. No adjustment is made based on the

difference between actual and projected benefit shares.

Example 11. (i) The facts are the same as in Example 10, except

that the actual sales results through the year 2001 are as follows:

Sales

[In millions of dollars]

------------------------------------------------------------------------

Year USS FP

------------------------------------------------------------------------

1997.................................................... 0 17

1998.................................................... 17 35

1999.................................................... 25 44

2000.................................................... 34 54

2001.................................................... 36 55

------------------------------------------------------------------------

(ii) Based on the discrepancy between the projections and the

actual results and on consideration of all the facts, the district

director determines that for the remaining years the following sales

projections are more reliable than the original projections:

Sales

[In millions of dollars]

------------------------------------------------------------------------

Year USS FP

------------------------------------------------------------------------

2002................................................... 36 55

2003................................................... 36 55

2004................................................... 18 28

2005................................................... 9 14

2006................................................... 4.5 7

------------------------------------------------------------------------

(iii) Combining the actual results through the year 2001 with

the projections for subsequent years, and using a discount rate of

10%, the present discounted value of sales is approximately $131.2

million for USS and $229.4 million for FP. This result implies that

USS and FP obtain approximately 35.4% and 63.6%, respectively, of

the anticipated benefits from the baldness treatment. These benefit

shares diverge by greater than 20% from the benefit shares

calculated based on the original sales projections, and the district

director determines that, based on the difference between actual and

projected benefit shares, the original projections were unreliable.

The district director adjusts costs shares for each of the taxable

years under examination to conform them to the recalculated shares

of anticipated benefits.

(4) Timing of allocations. If the district director reallocates

costs under the provisions of this paragraph (f), the allocation must

be reflected for tax purposes in the year in which the costs were

incurred. When a cost sharing payment is owed by one member of a

qualified cost sharing arrangement to another member, the district

director may make appropriate allocations to reflect an arm's length

rate of interest for the time value of money, consistent with the

provisions of Sec. 1.482-2(a) (Loans or advances).

(g) Allocations of income, deductions or other tax items to reflect

transfers of intangibles (buy-in)--(1) In general. A controlled

participant that makes intangible property available to a qualified

cost sharing arrangement will be treated as having transferred

interests in such property to the other controlled participants, and

such other controlled participants must make buy-in payments to it, as

provided in paragraph (g)(2) of this section. If the other controlled

participants fail to make such payments, the district director may make

appropriate allocations, under the provisions of Secs. 1.482-1 and

1.482-4 through 1.482-6, to reflect an arm's length consideration for

the transferred intangible property. Further, if a group of controlled

taxpayers participates in a qualified cost sharing arrangement, any

change in the controlled participants' interests in covered

intangibles, whether by reason of entry of a new participant or

otherwise by reason of transfers (including deemed transfers) of

interests among existing participants, is a transfer

[[Page 65564]]

of intangible property, and the district director may make appropriate

allocations, under the provisions of Secs. 1.482-1 and 1.482-4 through

1.482-6, to reflect an arm's length consideration for the transfer. See

paragraphs (g) (3), (4), and (5) of this section. Paragraph (g)(6) of

this section provides rules for assigning unassigned interests under a

qualified cost sharing arrangement.

(2) Pre-existing intangibles. If a controlled participant makes

pre-existing intangible property in which it owns an interest available

to other controlled participants for purposes of research in the

intangible development area under a qualified cost sharing arrangement,

then each such other controlled participant must make a buy-in payment

to the owner. The buy-in payment by each such other controlled

participant is the arm's length charge for the use of the intangible

under the rules of Secs. 1.482-1 and 1.482-4 through 1.482-6,

multiplied by the controlled participant's share of reasonably

anticipated benefits (as defined in paragraph (f)(3) of this section).

A controlled participant's payment required under this paragraph (g)(2)

is deemed to be reduced to the extent of any payments owed to it under

this paragraph (g)(2) from other controlled participants. Each payment

received by a payee will be treated as coming pro rata out of payments

made by all payors. See paragraph (g)(8), Example 4, of this section.

Such payments will be treated as consideration for a transfer of an

interest in the intangible property made available to the qualified

cost sharing arrangement by the payee. Any payment to or from an

uncontrolled participant in consideration for intangible property made

available to the qualified cost sharing arrangement will be shared by

the controlled participants in accordance with their shares of

reasonably anticipated benefits (as defined in paragraph (f)(3) of this

section). A controlled participant's payment required under this

paragraph (g)(2) is deemed to be reduced by such a share of payments

owed from an uncontrolled participant to the same extent as by any

payments owed from other controlled participants under this paragraph

(g)(2). See paragraph (g)(8), Example 5, of this section.

(3) New controlled participant. If a new controlled participant

enters a qualified cost sharing arrangement and acquires any interest

in the covered intangibles, then the new participant must pay an arm's

length consideration, under the provisions of Secs. 1.482-1 and 1.482-4

through 1.482-6, for such interest to each controlled participant from

whom such interest was acquired.

(4) Controlled participant relinquishes interests. A controlled

participant in a qualified cost sharing arrangement may be deemed to

have acquired an interest in one or more covered intangibles if another

controlled participant transfers, abandons, or otherwise relinquishes

an interest under the arrangement, to the benefit of the first

participant. If such a relinquishment occurs, the participant

relinquishing the interest must receive an arm's length consideration,

under the provisions of Secs. 1.482-1 and 1.482-4 through 1.482-6, for

its interest. If the controlled participant that has relinquished its

interest subsequently uses that interest, then that participant must

pay an arm's length consideration, under the provisions of Secs. 1.482-

1 and 1.482-4 through 1.482-6, to the controlled participant that

acquired the interest.

(5) Conduct inconsistent with the terms of a cost sharing

arrangement. If, after any cost allocations authorized by paragraph

(a)(2) of this section, a controlled participant bears costs of

intangible development that over a period of years are consistently and

materially greater or lesser than its share of reasonably anticipated

benefits, then the district director may conclude that the economic

substance of the arrangement between the controlled participants is

inconsistent with the terms of the cost sharing arrangement. In such a

case, the district director may disregard such terms and impute an

agreement consistent with the controlled participants' course of

conduct, under which a controlled participant that bore a

disproportionately greater share of costs received additional interests

in covered intangibles. See Sec. 1.482-1(d)(3)(ii)(B) (Identifying

contractual terms) and Sec. 1.482- 4(f)(3)(ii) (Identification of

owner). Accordingly, that participant must receive an arm's length

payment from any controlled participant whose share of the intangible

development costs is less than its share of reasonably anticipated

benefits over time, under the provisions of Secs. 1.482-1 and 1.482-4

through 1.482-6.

(6) Failure to assign interests under a qualified cost sharing

arrangement. If a qualified cost sharing arrangement fails to assign an

interest in a covered intangible, then each controlled participant will

be deemed to hold a share in such interest equal to its share of the

costs of developing such intangible. For this purpose, if cost shares

have varied materially over the period during which such intangible was

developed, then the costs of developing the intangible must be measured

by their present discounted value as of the date when the first such

costs were incurred.

(7) Form of consideration. The consideration for an acquisition

described in this paragraph (g) may take any of the following forms:

(i) Lump sum payments. For the treatment of lump sum payments, see

Sec. 1.482-4(f)(5) (Lump sum payments);

(ii) Installment payments. Installment payments spread over the

period of use of the intangible by the transferee, with interest

calculated in accordance with Sec. 1.482-2(a) (Loans or advances); and

(iii) Royalties. Royalties or other payments contingent on the use

of the intangible by the transferee.

(8) Examples. The following examples illustrate allocations

described in this paragraph (g):

Example 1. In year one, four members of a controlled group enter

into a cost sharing arrangement to develop a commercially feasible

process for capturing energy from nuclear fusion. Based on a

reliable projection of their future benefits, each cost sharing

participant bears an equal share of the costs. The cost of

developing intangibles for each participant with respect to the

project is approximately $1 million per year. In year ten, a fifth

member of the controlled group joins the cost sharing group and

agrees to bear one-fifth of the future costs in exchange for part of

the fourth member's territory reasonably anticipated to yield

benefits amounting to one-fifth of the total benefits. The fair

market value of intangible property within the arrangement at the

time the fifth company joins the arrangement is $45 million. The new

member must pay one-fifth of that amount (that is, $9 million total)

to the fourth member from whom it acquired its interest in covered

intangibles.

Example 2. U.S. Subsidiary (USS), Foreign Subsidiary (FS) and

Foreign Parent (FP) enter into a cost sharing arrangement to develop

new products within the Group X product line. USS manufactures and

sells Group X products in North America, FS manufactures and sells

Group X products in South America, and FP manufactures and sells

Group X products in the rest of the world. USS, FS and FP project

that each will manufacture and sell a third of the Group X products

under development, and they share costs on the basis of projected

sales of manufactured products. When the new Group X products are

developed, however, USS ceases to manufacture Group X products, and

FP sells its Group X products to USS for resale in the North

American market. USS earns a return on its resale activity that is

appropriate given its function as a distributor, but does not earn a

return attributable to exploiting covered intangibles. The district

director determines that USS' share of the costs (one-third) was

greater than its share of reasonably anticipated benefits (zero) and

that it has transferred an interest in the intangibles for which it

should receive a payment from FP, whose share of the

[[Page 65565]]

intangible development costs (one-third) was less than its share of

reasonably anticipated benefits over time (two-thirds). An

allocation is made under Secs. 1.482-1 and 1.482-4 through 1.482-6

from FP to USS to recognize USS' one-third interest in the

intangibles. No allocation is made from FS to USS because FS did not

exploit USS' interest in covered intangibles.

Example 3. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and

Foreign Subsidiary 2 (FS2) enter into a cost sharing arrangement to

develop a cure for the common cold. Costs are shared USP-50%, FS1-

40% and FS2-10% on the basis of projected units of cold medicine to

be produced by each. After ten years of research and development,

FS1 withdraws from the arrangement, transferring its interests in

the intangibles under development to USP in exchange for a lump sum

payment of $10 million. The district director may review this lump

sum payment, under the provisions of Sec. 1.482-4(f)(5), to ensure

that the amount is commensurate with the income attributable to the

intangibles.

Example 4. (i) Four members A, B, C, and D of a controlled group

form a cost sharing arrangement to develop the next generation

technology for their business. Based on a reliable projection of

their future benefits, the participants agree to bear shares of the

costs incurred during the term of the agreement in the following

percentages: A 40%; B 15%; C 25%; and D 20%. The arm's length

charges, under the rules of Secs. 1.482-1 and 1.482-4 through 1.482-

6, for the use of the existing intangible property they respectively

make available to the cost sharing arrangement are in the following

amounts for the taxable year: A 80X; B 40X; C 30X; and D 30X. The

provisional (before offsets) and final buy-in payments/receipts

among A, B, C, and D are shown in the table as follows:

------------------------------------------------------------------------

A B C D

------------------------------------------------------------------------

Payments........................

Receipts........................ 48 34 22.5 24

---------------------------------------

Final........................... 8 13

------------------------------------------------------------------------

(ii) The first row/first column shows A's provisional buy-in

payment equal to the product of 100X (sum of 40X, 30X, and 30X) and

A's share of anticipated benefits of 40%. The second row/first

column shows A's provisional buy-in receipts equal to the sum of the

products of 80X and B's, C's, and D's anticipated benefits shares

(15%, 25%, and 20%, respectively). The other entries in the first

two rows of the table are similarly computed. The last row shows the

final buy-in receipts/payments after offsets. Thus, for the taxable

year, A and B are treated as receiving the 8X and 13X, respectively,

pro rata out of payments by C and D of 15X and 6X, respectively.

Example 5. A and B, two members of a controlled group form a

cost sharing arrangement with an unrelated third party C to develop

a new technology useable in their respective businesses. Based on a

reliable projection of their future benefits, A and B agree to bear

shares of 60% and 40%, respectively, of the costs incurred during

the term of the agreement. A also makes available its existing

technology for purposes of the research to be undertaken. The arm's

length charge, under the rules of Secs. 1.482-1 and 1.482-4 through

1.482-6, for the use of the existing technology is 100X for the

taxable year. Under its agreement with A and B, C must make a

specified cost sharing payment as well as a payment of 50X for the

taxable year on account of the pre- existing intangible property

made available to the cost sharing arrangement. B's provisional buy-

in payment (before offsets) to A for the taxable year is 40X (the

product of 100X and B's anticipated benefits share of 40%). C's

payment of 50X is shared provisionally between A and B in accordance

with their shares of reasonably anticipated benefits, 30X (50X times

60%) to A and 20X (50X times 40%) to B. B's final buy-in payment

(after offsets) is 20X (40X less 20X). A is treated as receiving the

70X total provisional payments (40X plus 30X) pro rata out of the

final payments by B and C of 20X and 50X, respectively.

(h) Character of payments made pursuant to a qualified cost sharing

arrangement--(1) In general. Payments made pursuant to a qualified cost

sharing arrangement (other than payments described in paragraph (g) of

this section) generally will be considered costs of developing

intangibles of the payor and reimbursements of the same kind of costs

of developing intangibles of the payee. For purposes of this paragraph

(h), a controlled participant's payment required under a qualified cost

sharing arrangement is deemed to be reduced to the extent of any

payments owed to it under the arrangement from other controlled or

uncontrolled participants. Each payment received by a payee will be

treated as coming pro rata out of payments made by all payors. Such

payments will be applied pro rata against deductions for the taxable

year that the payee is allowed in connection with the qualified cost

sharing arrangement. Payments received in excess of such deductions

will be treated as in consideration for use of the tangible property

made available to the qualified cost sharing arrangement by the payee.

For purposes of the research credit determined under section 41, cost

sharing payments among controlled participants will be treated as

provided for intra-group transactions in Sec. 1.41-8(e). Any payment

made or received by a taxpayer pursuant to an arrangement that the

district director determines not to be a qualified cost sharing

arrangement, or a payment made or received pursuant to paragraph (g) of

this section, will be subject to the provisions of Secs. 1.482-1 and

1.482-4 through 1.482-6. Any payment that in substance constitutes a

cost sharing payment will be treated as such for purposes of this

section, regardless of its characterization under foreign law.

(2) Examples. The following examples illustrate this paragraph (h):

Example 1. U.S. Parent (USP) and its wholly owned Foreign

Subsidiary (FS) form a cost sharing arrangement to develop a

miniature widget, the Small R. Based on a reliable projection of

their future benefits, USP agrees to bear 40% and FS to bear 60% of

the costs incurred during the term of the agreement. The principal

costs in the intangible development area are operating expenses

incurred by FS in Country Z of 100X annually, and operating expenses

incurred by USP in the United States also of 100X annually. Of the

total costs of 200X, USP's share is 80X and FS's share is 120X, so

that FS must make a payment to USP of 20X. This payment will be

treated as a reimbursement of 20X of USP's operating expenses in the

United States. Accordingly, USP's Form 1120 will reflect an 80X

deduction on account of activities performed in the United States

for purposes of allocation and apportionment of the deduction to

source. The Form 5471 for FS will reflect a 100X deduction on

account of activities performed in Country Z, and a 20X deduction on

account of activities performed in the United States.

Example 2. The facts are the same as in Example 1, except that

the 100X of costs borne by USP consist of 5X of operating expenses

incurred by USP in the United States and 95X of fair market value

rental cost for a facility in the United States. The depreciation

deduction attributable to the U.S. facility is 7X. The 20X net

payment by FS to USP will first be applied in reduction pro rata of

the 5X deduction for operating expenses and the 7X depreciation

deduction attributable to the U.S. facility. The 8X remainder will

be treated as rent for the U.S. facility.

(i) Accounting requirements. The accounting requirements of this

paragraph are that the controlled

[[Page 65566]]

participants in a qualified cost sharing arrangement must use a

consistent method of accounting to measure costs and benefits, and must

translate foreign currencies on a consistent basis.

(j) Administrative requirements--(1) In general. The administrative

requirements of this paragraph consist of the documentation

requirements of paragraph (j)(2) of this section and the reporting

requirements of paragraph (j)(3) of this section.

(2) Documentation. A controlled participant must maintain

sufficient documentation to establish that the requirements of

paragraphs (b)(4) and (c)(1) of this section have been met, as well as

the additional documentation specified in this paragraph (j)(2), and

must provide any such documentation to the Internal Revenue Service

within 30 days of a request (unless an extension is granted by the

district director). Documents necessary to establish the following must

also be maintained--

(i) The total amount of costs incurred pursuant to the arrangement;

(ii) The costs borne by each controlled participant;

(iii) A description of the method used to determine each controlled

participant's share of the intangible development costs, including the

projections used to estimate benefits, and an explanation of why that

method was selected;

(iv) The accounting method used to determine the costs and benefits

of the intangible development (including the method used to translate

foreign currencies), and, to the extent that the method materially

differs from U.S. generally accepted accounting principles, an

explanation of such material differences; and

(v) Prior research, if any, undertaken in the intangible

development area, any tangible or intangible property made available

for use in the arrangement, by each controlled participant, and any

information used to establish the value of pre-existing and covered

intangibles.

(3) Reporting requirements. A controlled participant must attach to

its U.S. income tax return a statement indicating that it is a

participant in a qualified cost sharing arrangement, and listing the

other controlled participants in the arrangement. A controlled

participant that is not required to file a U.S. income tax return must

ensure that such a statement is attached to Schedule M of any Form 5471

or to any Form 5472 filed with respect to that participant.

(k) Effective date. This section is effective for taxable years

beginning on or after January 1, 1996.

(l) Transition rule. A cost sharing arrangement will be considered

a qualified cost sharing arrangement, within the meaning of this

section, if, prior to January 1, 1996, the arrangement was a bona fide

cost sharing arrangement under the provisions of Sec. 1.482-7T (as

contained in the 26 CFR part 1 edition revised as of April 1, 1995),

but only if the arrangement is amended, if necessary, to conform with

the provisions of this section by December 31, 1996.

Sec. 1.482-7T [Removed]

Par. 4. Section 1.482-7T is removed.

PART 301--PROCEDURE AND ADMINISTRATION

Par. 5. The authority for part 301 continues to read in part as

follows:

Authority: 26 U.S.C. 7805. * * *

Par. 6. Section 301.7701-3 is amended by adding paragraph (e) to

read as follows:

Sec. 301.7701-3 Partnerships.

* * * * *

(e) Qualified cost sharing arrangements. A qualified cost sharing

arrangement that is described in Sec. 1.482-7 of this chapter and any

arrangement that is treated by the Service as a qualified cost sharing

arrangement under Sec. 1.482-7 of this chapter is not classified as a

partnership for purposes of the Internal Revenue Code. See Sec. 1.482-7

of this chapter for the proper treatment of qualified cost sharing

arrangements.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 7. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 8. In Sec. 602.101, paragraph (c) is amended by adding an

entry to the table in numerical order to read as follows:

``1.482-7..................................................1545-1364''.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: November 30, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-30617 Filed 12-19-95; 8:45 am]

BILLING CODE 4830-01-U