These regulations (provided in temporary Treasury regulation 1.482-7T,) usher in major changes to the prior cost sharing regulations (as provided in Treasury regulation 1.482-7), most of which are in line with the changes put forth in the proposed cost sharing regulations issued back in August of 2005.
Taxpayers with existing arrangements
For taxpayers with all of their anticipated cost sharing arrangements in place, these regulations may have minimal impact. Transition guidance for these temporary rules is provided in 1.482-7T(m). Generally speaking, the transition guidance states that taxpayers with cost sharing agreements (CSAs) in place on or before January 5 2009 will have their arrangements (both cost sharing transactions and buy-in transactions) analysed under the prior 1.482-7 regulations. This grandfathering of pre-existing CSAs will only apply to pre-existing CSAs that meet the contractual requirements set forth in 1.482-7(T)(k)(1).
If the written agreements already comply with these requirements, no further action will be necessary. If pre-existing arrangements do not meet the contractual requirements of 1.482-7(T)(k)(1), taxpayers will need to amend their existing agreements so they are compliant. This exercise must be completed by July 6 2009 to receive treatment under the old regulations.
Given the differences between the old regulations and the temporary regulations taxpayers with existing arrangements will probably want to ensure that those arrangements are grandfathered into the old regulatory regime. Therefore, one major implication for taxpayers with existing arrangements is that they need to make sure that they have agreements in place for those arrangements that comply with the requirements of 1.482-7(T)(k)(1).
Taxpayers should also note that buy-in transactions (now called platform contribution transactions or PCTs) associated with significant changes (made after January 5 2009) in the scope of a pre-existing arrangement will be evaluated under the temporary regulations for purposes of determining periodic adjustments.
As a side note, while these temporary regulations will not theoretically apply to appropriately documented pre-existing arrangements, the IRS clearly believes that many of the ideas (including those in the investor model) embedded in these temporary regulations inform a best method analysis even under the existing regulations. This was clear not only in the preamble to the 2005 proposed regulations, but also in the coordinated issue paper on cost sharing buy-ins released in 2006. Therefore, taxpayers with existing arrangements are well advised to understand the investor model, the realistic alternative principal, and the new methods so that they can evaluate potential exposures which allows them to effectively mitigate their risks.
Taxpayers considering new cost sharing arrangements
Getting realistic about expected benefits from cost sharing
As foretold by the proposed regulations, the temporary regulations rely heavily on the investor model framework. This framework holds that at the inception of the PCT transaction, all participants in a CSA should expect to earn a return on their total investments that is appropriate given the risk associated with each participant’s activities under the CSA. Another cornerstone of the temporary regulations is the realistic alternatives principle. This principle holds that each participant to a CSA (and accompanying PCT transactions) will only participate if they expect to earn a risk adjusted return that is at least as good as the return they could generate by not participating in the CSA.
When only one party has unique contributions that it can make to a cost sharing arrangement (for example, in the form of a unique intangible), entering into that arrangement is necessarily a zero-sum game (that is to say, any expected value gained by one participant must come out of the other’s share). In these cash box cost sharing situations (so called because one participant is not supplying anything unique, and in the prototypical case supplies only funding), any model that conveys positive expected value to the cash box participant upfront violates both the investor model and the realistic alternatives principle.
The investor model is violated because positive value will only accrue to the cash box investor upfront if its expected returns are more than a discount rate that appropriately reflect the risk of its investments. The realistic alternatives principle is violated because the potential number of cash box participants is large (in other words, when nothing unique is contributed, any party with sufficient cash could be a bidder for the rights to participate in the project). Theoretically, the owner of unique intangibles (in relation to a cash box) would always have an alternative of going to the bidder that requires the least upfront expected value, and any expected value would theoretically be bid away by potential cash box participants in a competitive market transaction.
As a practical matter, this means that methodologies providing cash box participants with unreasonably high expected returns will be rejected by the IRS. The number one target on the bad methodologies list is the old declining royalty method. With this method, starting values of the buy-in royalty are established either through a CPM (or TNMM) or through a CUT method, and then decline over a relatively short period of time based on intangible development cost stocks. Therefore, on a time zero projected basis, the application of this model frequently grants cash box participants with return rates well above any notion of reasonable (risk reflecting) discount rate.
This declining royalty method is specifically discussed in the temporary regulations within the context of examples. Example 4 in 1.482-7T(b)(5)(iii) presents the case of a taxpayer who uses a declining royalty method that ignores the intergenerational overlap of the technology being developed (and its ultimate dependence on the technology contributed to the CSA). This cautionary example concludes that the method used...is so unreliable and so contrary to provisions [of these temporary regulations] that [the parties to the CSA] could not reasonably conclude that they had contracted to make arm’s length PCT Payments...and thus could not reasonably conclude that their arrangement was a CSA.”
In this example, the Commissioner is not required to recognise the arrangement as a CSA. This example, along with others, makes it clear that the declining royalty model is not acceptable under the temporary regulations, and taxpayers are well advised to avoid utilising it in establishing PCT payments for new CSAs.
The codification of the investor model and the realistic alternatives principle do not mean that cost sharing should be avoided in all circumstances. In practice, the empirical implications of the investor model and realistic alternatives principle are at their most rigid in cash box situations (where the income method is most likely to be applied). As a first point, many taxpayers may be able to construct their arrangements (and to structure their fact patterns) so that they fall outside of the cash box model. If both parties to a CSA make non-routine contributions, the income method is not generally applicable. Rather, a residual profit split method is most probably applicable in these circumstances.
As a second point, even in cash box situations, taxpayers should not lose sight of the fact that properly applied, cost sharing should give rise to a true sharing of both the upsides and the downsides of intangible development efforts. A taxpayer’s bet on cost sharing is a bet on the long term success of intangible development efforts. If companies that prove to be successful in their intangible development efforts make that bet they will, over the long run, be able to realise substantially lower effective tax rates.
Methods available
The temporary regulations introduce a new method (relative to the specified intangible pricing methods provided in 1.482-4) called the income method. Stripped to its barest form, the income method calculates PCT payments by calculating the net present value of residual income (where residual income is the operating income earned by the PCT payor less returns assignable to its routine functions, including returns to any routine operating intangibles). The income method should only be used when only one party to the CSA makes non-routine contributions to the arrangement. Furthermore, in these cases, it is fair to assume that this will be the default method chosen by the IRS for cash box cost sharing structures.
Other specified methods are included in the temporary regulations. These include the comparable uncontrolled transaction method (which has a renewed focus on comparability of risk allocations and contract terms), the acquisition price method (which is largely intended for PCTs arising from post-CSA formation acquisitions), the market capitalisation method (where PCT payments are determined through reference to the market capitalisation of the taxpayer), and the residual profit split method (which is intended to be used only when more than one CSA participant makes non-routine contributions).
There still appears to be substantial grey area with respect to choice of methodology under certain fact patterns, much of which arises from the question “at what point does a participant make a non-routine contribution?” Different methods could yield widely varying estimates of appropriate PCT payments, so careful forethought in structuring cost sharing arrangements and careful analysis and documentation of methodological choice will be critical to the long term success of any cost sharing arrangement.
The importance of projections
The income method calculates the total value of buy-in payments based on the discounted value of projected residual income. The residual profit split method also relies on projections to determine the appropriate buy-in payment amount. Projections are also used to determine reasonably anticipated benefit (RAB) shares. The reliability of any method that relies on projections will, in part, be judged based on the reliability of the projections (if any) that underlie it. Whenever possible, taxpayers should use projections that have been compiled for management purposes. Projections made solely for tax purposes are deemed to be less reliable. Therefore, as a first point, taxpayers considering cost sharing arrangements should fully understand and evaluate the projections that it makes in the ordinary course of business in order to perform best method evaluations.
Secondly, taxpayers are well advised to thoroughly document the projections that are being used. This means more than just documenting the source of those projections. It also means documenting the assumptions and expectations underlying those projections. In doing so, a taxpayer should consider the answers to questions like:
· What do I expect the overall market potential to look like in each territory (or whatever division of interest employed) over the life of my cost sharing agreement. What drives these expectations?
· What do I expect my company’s market share to be in each territory? What assumptions are made about product pricing? Why are these assumptions reasonable?
· What do I expect the competitive response to my product to be? How is this reflected in projections? How long do I think it will take my product to establish itself in the market once it’s available for sale?
This list of questions is merely representative of the kinds of questions that taxpayers should address and document at the time that they enter into their CSA. Why? Under the temporary regulations, the IRS will use comparisons of actual results to projected results to determine whether or not adjustments may be made (both for PCT payments and for cost sharing payments). If the periodic adjustment mechanism is triggered, taxpayers will, in essence, be locked in to its effects for the remainder of the CSA. The periodic adjustment trigger is exceedingly blunt, and only becomes more so with the passage of time, making it very likely that the trigger could be pulled inappropriately, especially in the later years of the CSA.
With respect to PCT payments, taxpayers may be exempt from adjustments if experienced returns are outside of an acceptable range due to “extraordinary events beyond the control of the controlled participants that could not reasonably have been anticipated” at the time of inception (see 1.482-7T(i)(6)(vi)). While advisers might be sceptical that the IRS and taxpayers will ever see eye-to-eye on what was or was not reasonably anticipated, the taxpayer can only help their case with thorough projection documentation.
As an aside (but quite relevant to this discussion), the preamble to the temporary regulations explicitly states that a revenue procedure will be forthcoming that provides an exception to the periodic adjustment rules set forth in temporary regulations in the context of the advanced pricing agreement (APA) programme. Taxpayers who enter into an APA may negotiate an agreement that precludes the IRS from making PCT payment periodic adjustments.
By going through the APA process and securing an APA, taxpayers give the IRS an upfront chance to critically explore and evaluate information available at the time of the PCT. While this disclosure process (and indeed the APA process itself) may have certain downsides for some taxpayers, the elimination of periodic adjustments may be a huge upside for taxpayers. Taxpayers considering cost sharing arrangements should strongly consider whether or not they should enter into the arrangement outside of or within the APA process.
Discount rate considerations
The determination and documentation of appropriate discount rates for cost sharing participants has become especially critical in the temporary regulations. The temporary regulations explicitly recognise that different discount rates may apply in a cost sharing context relative to those that would pertain to a licensing transaction. They also recognise that CSAs may cover projects with risk profiles that are different than that of the company as a whole, and that the PCT payment form may influence appropriate discount rates. While all of these points are made, little guidance is provided beyond recognition of the possibility for differences in rates. Taxpayers should thoroughly analyse and document all of their discount rate choices if they wish to avoid IRS default rates (like the company’s overall weighted average cost of capital) upon audit.
The importance of documentation
The importance of certain aspects of CSA documentation is addressed above. Thorough documentation of these points and others (including, for instance, appropriate documentation of the anticipated cost sharing intangibles and intangible development activities) is especially important under the temporary regulations. In addition to penalty protection, thorough documentation may help deter the recharacterisation of CSA arrangements, the application of periodic adjustments (both directly in that the range that is used for periodic adjustment triggers is explicitly narrower for taxpayers who fail to maintain adequate documentation and indirectly in that thorough documentation may help put taxpayers into the periodic adjustment exception category), and other unwanted outcomes.
Mark Bronson (mark.bronson@ceterisgroup.com)
