Cost-Sharing And Transfer Pricing in the United States


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Discussion of the new Temporary U.S. Treasury Regulations that govern the sharing of costs between multinational enterprises with respect to the development of intellectual property.

Companies doing research and development (R&D) cross-border should be aware of the impact of these Temporary Regulations on their business.

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Cost-Sharing And Transfer Pricing in the United States

  1. 1. Cost Sharing Cost-Sharing in the U S U.S. An Overview of the U.S. Temporary Treasury Regulations §1.482-7T Verse Consulting LLC g November 2009
  2. 2. Agenda • What is Cost-Sharing? Cost-Sharing Defined Two Ways of Looking at IP Value Types of Buy-In Payments • Brief History of Cost-Sharing Regulations in the U.S. y g g • Key Changes in the 2009 Temporary Regulations • Potential Opportunities and Challenges for U.S. Multinationals M lti ti l
  3. 3. Cost-Sharing Defined • Cost-Sharing Arrangements (“CSAs”) enable two or more related parties to pool resources to develop intangible property (“IP”) and share i th costs, risks i t ibl t d h in the t i k and benefits of that IP in proportion to participants’ expected benefit(s). • Typically a CSA has two-key components: 1. A buy-in to compensate one or more entities for pre-existing IP and i ti IP; d 2. An ongoing cost-sharing system to share development of future IP.
  4. 4. Two Ways of Looking at IP Value • “Platform” intangibles Contributory value of existing IP does NOT decay significantly over time. time • Depreciating IP Contributory value C t ib t l of existing IP decays over some period. period
  5. 5. Types of Buy-In Payments • Royalty Expressed as a percentage of sales, value of royalty may decline over time depending on whether the IP is a “platform” intangible, or depreciates over time. • Lump sum May be paid as a lump sum. However, often paid as a declining royalty, with the present value of royalty payments being equal to the lump sum. y y y g • Installments Fixed payments over a set period of time.
  6. 6. Brief History of Cost-Sharing in the U.S. Key U.S. Developments Affecting Cost-sharing Coordinated Final Issue Paper on Amended cost-sharing Final cost- cost- Stock Based sharing sharing Compensation Commensurate Regulations Regulations With (stock Income options) ti ) Proposed Coordinated Standard cost-sharing Final Proposed Issue (CWI) Regulations Amended Revisions to Paper New cost- the Cost on CSA §1.482-7T 1968 White sharing Sharing Buy-in Regulations Regulations g Paper Regulations g Regulations Adjustments Issued 1968 1986 1988 1992 1995 1996 1998 2000 2002 2003 2005 2006 2007 2008 2009 Nestle Seagate DHL Xilinx Key Court Cases (Appeal Decision) GlaxoSmithKline
  7. 7. Key Changes in the 2009 Temporary Regulations • Clarify that Platform Contribution Transaction (“PCT”) includes “intangibles” not just § 936(h)(3)(B) intangibles, so the value of a contributed R&D workforce must be included in valuing the PCT; other intangibles (e.g., Goodwill and Going Concern value and business opportunity) are not expressly included; though 2009 Green Book would include GW/GCV Such intangibles may GW/GCV. may, however, be included depending upon the valuation method employed in determining PCT payment(s). Emphasis on “Business” valuation not IP valuation models. • Requires use of the “Investor Model” to determine “buy-ins” (PCT Payment) and mandates the upfront allocation of risk ( (contained in the 2005 proposed regulations) between PCT p p g ) Payor and PCT Payee.
  8. 8. Key Changes in the 2009 Temporary Regulations • “Make & Sell” Rights are not PCT intangibles. If transferred require additional compensation. See Treas. Reg. § 1.482- 7T(c)(4) • Broad definition of Intangible for PCT purposes preserves proposed regulations’ aggregation rule and the CPM approach. Aggregation rule aggregates separate PCT intangibles as it is intangibles, “more reliable” to value the aggregate versus separate components. Also, increases PCT, generally. See Treas. Reg. §1.482 7T(g)(2)(iv) §1 482-7T(g)(2)(iv) • Compulsory requirement to consider “realistic alternatives” for US and Foreign CSA participants (e.g., US Parent and Foreign Sub in our hypothetical). hypothetical)
  9. 9. Key Changes in the 2009 Temporary Regulations • Foreign Sub’s best realistic alternative would be licensing IP from an uncontrolled third-party, who bears all risk of IP development. development • US parent’s best realistic alternative would be to bear all risk of IP development and license developed IP to third-party. • PCT payment (“buy-in”) i th d lt b t t (“b i ”) is the delta between pre-tax income t i under the cost-sharing alternative and the hypothetical licensing alternative. PV of PCT PV of license i f PCT= f li income-PV of th i t PV f the intangible ibl development costs (“IDC”)
  10. 10. Key Changes in the 2009 Temporary Regulations • Licensing alternatives under Income Method based on either Comparable Uncontrolled Transaction (“CUT”) or Comparable Profits Method (“CPM”) ( CPM ). CUT may be difficult to implement/find in practice CPM approach may undervalue risk Foreign Sub undertakes vis-à- vis hypothetical licensing arrangement Ability to utilize different discount rates for hypothetical licensing and cost-sharing alternatives may be helpful in mitigating adverse impact on Foreign Sub from using CPM-based approach. p g g pp Foreign subsidiaries with substantial functionality and assets may be able to use Residual Profit Split Method (“RPSM”) to compensate Foreign Sub for “non-routine” intangible contribution by compensating for those functions and assets. ti f th f ti d t
  11. 11. Key Changes in the 2009 Temporary Regulations • Moving away from exclusive WACC-based approach in the Proposed Regulations, the Temporary Regulations allow use of different discount rates rates. Different assets may have different discount rates. Treas. Reg. § 1.482-7T(g))(2)(v)(A). Different “Realistic Alternatives” may have different discount Diff t “R li ti Alt ti ” h diff t di t rates, e.g., Cost-sharing vs. Licensing. Treas. Reg. § 1.482- 7T(g)(2)(v)(B). Different Revenue Streams may have different di Diff tR St h diff t discountt rates, e.g., royalty on sales vs. profit. Treas. Reg. § 1.482- 7T(g)(2)(v)(C).
  12. 12. Key Changes in the 2009 Temporary Regulations • Temporary regulations recognize that transfer pricing analyses are done on a pre-tax basis and capital market discount rate data are based on after tax rates As such, it may be necessary after-tax rates. such to “gross-up” for taxes or alternatively treat tax as an expense. See Treas. Reg. § 1.482-7T(g)(2)(v)(D). • Under the Temporary Regulations probability weighted probability-weighted projections should be used to project income from PCT- intangibles. Though this development is positive, careful consideration should be given to the projections utilized for PCT computation purposes and other types of projections, (e.g., FAS 142, management forecasts, etc.) as significant dichotomies between forecasts could be an Achilles’ heel for Taxpayers. p y
  13. 13. Key Changes in the 2009 Temporary Regulations • Probability-weighted projections while conceptually simple will in all likelihood prove more challenging in practice and, therefore, are likely to give rise to robust discussion with external regulators. Practice Note: As probability of failure risk increases, the PCT payment will likely be reduced; though the likelihood of tripping the Periodic Trigger under the commensurate-with- income rules increases, all things being equal, for successful projects. projects
  14. 14. Key Changes in the 2009 Temporary Regulations • Estimation of Useful Life. Temporary Regulations do not assume perpetual life for PCT intangibles; this is a change from prior guidance (e g CIP issued by the IRS in 2007) which used (e.g., a terminal-value calculation (derived from the Gordon Growth Model). See Example 1 in the regulations that suggests that the platform contribution relates only to the period that a product is based on the platform contribution. See Treas. Reg. § 1.481 7T(c)(5). 1 481-7T(c)(5) This should not be construed as indicating that the IRS’ position that platform contribution IP is short- lived. Instead it likely means “facts and circumstances” have to be carefully evaluated and considered in developing y p g assumptions related to useful lives.
  15. 15. Key Changes in the 2009 Temporary Regulations • Interquartile Range. Temporary Regulations’ provide guidance with respect to determining interquartile range of all potential outcomes from all potential outcomes from the interquartile ranges from of the all variables used to compute a PCT payment. See Treas. Reg. § 1.482-7T(g)(2)(ix) Example: Assume Income Method is “Best Method” and Best Method there are four different discount rates within the interquartile range of discount rates and four different profit margins within the interquartile range of routine returns no other returns, variable inputs, 16 alternative PCT payments would be computed. The interquartile range of those 16 computed values would be the applicable arm’s length range for the pp g g PCT payment.
  16. 16. Key Changes in the 2009 Temporary Regulations • Observation: By taking into consideration variation in market comparables for each input parameter for income-method based PCT computations and requiring a two step computation of the two-step interquartile range, it seems the resulting range will be narrower than what might have resulted under a single-step computation, as the second-step results in a narrowing of the interquartile second step range. It seems this approach may result in more “Periodic Triggers” under the commensurate-with-income (“CWI”) p provisions.
  17. 17. Key Changes in the 2009 Temporary Regulations • Territorial Interests. To provide taxpayers with more flexibility in designing qualifying divisional interests, the temporary regulations permit use of a new basis – the field of use division of interests – in addition to the territorial basis. Further, the regulations also authorize other non-overlapping divisional interests provided that the basis used meets four criteria: (1) The basis must clearly and unambiguously divide ll interests i cost shared i t di id all i t t in t h d intangibles among th controlled ibl the t ll d participants; (2) the consistent use of such basis can be dependably verified from the records maintained by the controlled participants; (3) the rights of the controlled p g participants to exploit cost shared intangibles p p g are non-overlapping, exclusive, and perpetual; and (4) the resulting benefits associated with each controlled participant's interest in cost shared intangibles are predictable with reasonable reliability. See Treas. Reg 1.482-7T(b)(4) Treas Reg. § 1 482 7T(b)(4)
  18. 18. Key Changes in the 2009 Temporary Regulations • Use of Residual Profit Split Method (“RPSM”). Temporary regulations permit use of RPSM provided that both parties to the CSA make non-routine contributions of the development and/or exploitation of th cost-shared i t l it ti f the t h d intangibles. ibl Example: US Parent provides platform contributions for the development of the cost-shared intangibles and the Foreign Sub S b separately d t l develops non-routine marketing i t l ti k ti intangibles ibl to facilitate exploitation of the cost-shared intangibles. In this instance RPSM could be utilized. If, however, Foreign Sub shares development costs or simply makes payments payments, RPSM may not be used by either party.
  19. 19. Key Changes in the 2009 Temporary Regulations • Two-Stage Allocation. Temporary Regulations’ eliminate three- stage approach of proposed regulations. First stage determines the discounted value of non-routine residual profits (after all CST payments and other intangible development costs) within each division/territory. Second stage allocates non-routine residual profit in each division/territory among the controlled participants that made platform or operating contributions for the benefit of the CSA activity, based on the relative value of each contribution. Allocation of non-routine residual profit can b made on th All ti f ti id l fit be d the basis of capitalized cost or external benchmarks. See Treas. Reg. § 1.482-7T(g)(7)(i)
  20. 20. Key Changes in the 2009 Temporary Regulations Observation: Due to the inherent subjectivity associated with use of RPSM, IRS will likely scrutinize the allocation of non-routine residual profit. An Advance Pricing Agreement (“APA”) may be th only way t obtain certainty i thi b the l to bt i t i t in this regard. The Preamble notes that IRS intends to issue guidance that provides that Periodic Adjustments will not be made where PCTs are covered under an APA APA.
  21. 21. Key Changes in the 2009 Temporary Regulations • Post-Formation Acquisitions (“PFA”). Temporary Regulations eliminate “special form of payment” rule of the proposed regulations. PFAs continue to be an area of importance and th IRS will lik l continue it efforts t re- i t d the ill likely ti its ff t to allocate financial statement goodwill to other platform contributions (e.g., in-process R&D, workforce-in-place, existing intellectual property or other intangible property) The property, property). Temporary Regulations do not, however, address Financial Statement goodwill, though they do observe that valuations for financial accounting purposes may be a useful starting point but are not conclusive. Examples in the Temporary Regulations illustrate the interplay between financial statement goodwill and p platform contributions. See Treas. Reg. § 1.482-7T(g)(2)(vii) g (g)( )( )
  22. 22. Key Changes in the 2009 Temporary Regulations • Intangible Development Costs (“IDC”) and Reasonably Anticipated Benefit (“RAB”). Temporary regulations increase the amount of documentation required with respect to IDC & RAB. RAB • Commensurate-with-Income provisions (“CWI”). The Temporary Regulations reduce the safe harbors in the Proposed Regulations b fift R l ti by fifty-percent, increasing th lik lih d of t i i the likelihood f Taxpayers’ having a “Periodic Trigger” under the Temporary Regulations. In the event the Periodic Trigger is tripped, Foreign Sub would be limited to a return on its routine functions and PCT payments. See Treas. Reg. §§ 1.482-7T(i)(6) and 1.482- 7T(i)(6)(v)
  23. 23. Key Changes in the 2009 Temporary Regulations • CWI Trigger: A Mechanical Test. Initially tripped when (1) PV of Foreign Sub actual operating income from all its activities associated with the development and exploitation of the cost- shared i t h d intangibles over (2) PV of it PCT and cost-sharing ibl f its d t h i payments is less that 0.667 or greater than 1.5. For public companies, PV is determined using the weighted-average cost of capital (“WACC”) as of the “Periodic Trigger” date; unless the ( WACC ) Periodic Trigger Taxpayer establishes an alternative discount rate better reflects the degree of risk as of the Trigger date. [Note: If adequate documentation is not maintained the “Periodic Trigger” Periodic Trigger thresholds are reduced to 0.8 and 1.25, respectively.] There are some exceptions that may apply in certain circumstances to mitigate the impact of the Periodic Trigger. See Treas. Reg. § g p gg g 1.482-7T(i)(6)(iv)(B) and (vi)
  24. 24. Key Changes in the 2009 Temporary Regulations • Other Arrangements. The Temporary Regulations’ make coordinating amendments to other regulations under Section 482; this effectively exports the Investor Model to other provisions of the regulations to address non-CSA based transfers of intangibles under either the services regulations in Treas. Reg. § 1.482-9T(m)(3) or the general intangibles provisions of Treas. Reg. § 1.482-4T(g)(3), for example. This is a departure from the predecessor regulations’ that contained a binary construct for being a “QCSA.” It will be interesting to see how the Investor Model is applied in other non CSA contexts non-CSA over time and how this impacts the Arm’s Length standard vis-à- vis Article 9 of US Income Tax Treaties.
  25. 25. Key Changes in the 2009 Temporary Regulations • Compulsory contract requirements. Temporary Regulations impose fairly extensive documentation requirements upon CSA participants including detailed contractual provisions that must g be substantively complied with in order for the arrangement to be treated as a CSA under the Temporary Regulations. Under the Temporary regulations, participants must include the nature of the activities, risks, and benefits to be borne by and inure to the respective participants’ in the CSA as part of the initial contract. Moreover, there’s a 60-day grace period from the effective date to the existence of a “contemporaneous contract.” contemporaneous contract See Treas. Reg. § 1.482-7T(k)(1) Trust-me-its-in-there days are over.
  26. 26. Key Changes in the 2009 Temporary Regulations • Compulsory Documentation, Accounting and Reporting requirements. Documentation requirements under the Temporary Regulations are considerably more extensive than those under the 1995 regulations. Under the Temporary Regulations, specific documentation with respect to PCTs must be maintained—at all times—not just when the tax-return is filed. Detailed transition rules exist for CSA’s in effect prior to January 5, 2009. See Treas. Reg. § 1.482-7T(k)(2)-(4)
  27. 27. Key Changes in the 2009 Temporary Regulations • Effective Date. Temporary Regulations are effective on January 5, 2009, except where a transition rule modifies the effective date, e.g., pre-January 5th CSAs, which will be subject to g y j specific transition rules. See Treas. Reg. § 1.482-7T(m) For tax years beginning after January 5, 2009, taxpayers must satisfy the new documentation requirements under Treas. Reg. § 1.482-7T(k) for purposes of satisfying the Section 6662 documentation requirements.
  28. 28. Potential Opportunities for U.S. Multinationals • While requirements under the Temporary cost-sharing Regulations are strict, opportunities remain for multinational enterprises to use CSAs to achieve: Cost-savings through operational and tax-efficiencies from alignment of IP ownership with regional business operations Reduction of audit risk from multilateral APA and thorough analysis of facts and circumstances.
  29. 29. Potential Challenges for U.S. Multinationals • Under OECD Guidelines a Cost Contribution Arrangement (“CCA”) is broader by definition than a CSA (OECD 8.7). Posits that CCA payment should be remunerated with a “routine return” only, conflicting with US’ CWI-construct. Under the Temporary Regulations rights must be exclusive, exclusive perpetual and have non-overlapping territory while under OECD there is no obligation for the CCA to be exclusive, perpetual or have non-overlapping territorial interests. • Investor model appears to attract more profit into the U.S; may conflict with Arm’s Length result in Article 9 of U.S. treaties. • Expanded U S documentation requirements could lead other U.S. taxing authorities to request U.S. documentation.
  30. 30. Contact us Verse Consulting LLC 1200 Smith Street, Suite 1600 Houston, T H t Texas 77002 713-353-3964 (main) 713-353-4601 (fax) ( ) info [at] verseconsulting [dot] com
  31. 31. The Fine Print • Not to be repurposed or sold. • This presentation is provided for information purposes only and is not intended to constitute tax advice which may be relied upon to avoid penalties under any federal, state, local or other tax statutes or regulations, and do not resolve any tax issues in your favor. Upon request, we can provide you with express written tax advice after necessary factual development and subject to such conditions and qualifications as we may deem appropriate under the circumstances. i t