Final regs. clarify cost sharing of R & D expenditures.

• Author: Carvey, Hannah Terhune
• Position: Research and development

In Dec. 19, 1995(1) and May 9, 1996(2) final regulations were issued governing qualified cost-sharing arrangements (QCSAs) under Sec. 482. The May 1996 final regulations made technical changes to the controlled participant qualification requirements contained in the December 1995 final regulations. The regulations bring closure to an area of regulatory unrest that has spanned a decade. This article reviews the final regulations and provides a checklist to prompt conformation of existing CSAs with the new standards.

CSAs are used to share the costs and benefits of research and development (R&D) activities between and among domestic and/for foreign parties, whether related or unrelated. Under a CSA, two or more participants contract to share R&D costs in exchange for an ownership interest in the intangibles developed through the collaboration.

Background

CSAs have existed for several decades. The Tax Reform Act of 1986 (TRA), Section 1231(e)(1), amended Sec. 482 to require that consideration for intangible property transferred in a controlled transaction be commensurate the income attributable to it. The TRA Conference Committee Report(3) indicated that in revising Sec. 482, Congress did not intend to preclude the use of R&D CSAs. Congress directed the IRS to conduct a comprehensive study and consider whether then-existing Sec. 482 regulations (issued in 1968) should be modified.

In 1988, the IRS and Treasury issued "A Study Of Intercompany Pricing"(4) (the "White Paper") which suggested that, to be valid, most CSAs must contain certain provisions. For example, most participants should be assigned exclusive geographic rights in developed intangibles,(5) and marketing intangibles should be excluded from bona fide CSAs.(6), Comments on the White Paper indicated that, in practice, there was great variety in the terms of CSAs.(7)

The IRS issued proposed cost-sharing regulations in January 1992.(8) In generally, they allowed more flexibility than had been anticipated and did not require CSAs to contain standard cost-sharing provisions. Although those rules were generally well-received, there were five areas of particular concern:

1. The mechanical use of cost-to-operating-income (cost/income) ratios as a standard for measuring the reasonableness of an effort to share costs in proportion to anticipated benefits.

2. The eligible participant requirement. Commenters argued that separate research entities (with no separate active trade or business) should be allowed to participate in CSAs, as should marketing affiliates.

3. The regulations, requirement that every participant be able to benefit from every intangible developed under a CSA. Commenters stated that the regulations should allow both single-product CSAs and unibrena CSAs (i.e., CSAs under which a broad category of a controlled group's R&D would be covered).

4. The buy-in.buy-out rules. Commenters urged that one participant's abandonment of its rights did not necessarily confer benefits on the remaining participants and that a new participant need not always make a buy-in payment when joining a CSA.

5. Commenters viewed the administrative requirements as burdensome.

   In addition, commenters noted that there should be more guidance as to when the IRS would deem a CSA to exist and argued that existing CSAs should be grandfathered or there should be a longer transition period. Finally, commenters asked that the regulations clarify that a CSA would not be deemed to create a partnership or a U.S. trade or business.(9)

   Without fundamentally altering the policies of the proposed regulations, the final regulations reflect numerous modifications in response to these comments. They also reflect the approach

   of the Sec. 482 regulations relating to transfers of tangible and intangible property.

   The final regulations do not specify whether marketing activities can be included in a QCSA. Although the White Paper expressly excluded marketing intangibles from CSAs, no such exclusion is contained in the final regulations or their preamble. Moreover, broad definitional language is used to describe covered intangibles. Therefore, it would not be unreasonable to conclude that marketing intangibles can be cost shared under the final regulations.

   What is a CSA?

   Generally, transfers of intangible property are governed by Regs. Sec. 1.482-4. According to Regs. Sec. 1.482-4(f)(3)(ii), only one person can be the developer or true economic owner of an undivided interest in intangible property. Thus, only the developer is entitled to profit from commercial exploitation of such property. Under Regs. Sec.1.482-4(f)(5), profits must meet a "commensurate with income" standard that requires that the original developer receive (1) payments equal to what an unrelated party would have received in the open market and (2) all (or almost all of the profit (or loss) resulting from the commercial exploitation of the property. Although Regs. Sec. 1.482-4(f)(3)(ii) states that there is only one developer of an intangible, Regs. Sec. 1.482-4(f)(3)(ii) acknowledges that more than one entity may assist in its creation. An "assister" may receive arm's-length compensation for the services it provides.

   An exception to the foregoing reflects congressional intent that has existed since the 1960. Reg. Sec. 1.482-7(a)(1) permits two or more intangible property, and to benefit from the commercial exploitation of the intangibles developed under the CSA. If two or more parties enter into a QCSA (as defined under Regs. Sec. 1.482-7(b)), they are not subject to Regs. Sec. 1.482-4.

   According to Regs. Sec. 1.482-7(a)(1) a CSA is an agreement under which the parties agree to share development costs 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 CSA is a QCSA only if certain requirements under Regs. Sec. 1.482-7(b)(b) are met. However, the district director may apply the cost-sharing rules to any arrangement that in substance constitutes a CSA, notwithstanding any failure to satisfy particular regulatory requirements.

   A CSA differs from both traditional licensing arrangements and from partnership structures. Under a CSA, the costs and risks of R&D are shared up front. Consequently, participants are not required to pay royalties for the subsequent use of any intangibles developed under the arrangement, as in the case of traditional licensing arrangements. Unlike a partnership, CSA participants are not required to pool profits earned through exploitation of developed intangibles. Regs. Sec. 1.482-7(a)(1) clarifies that a QCSA will not be treated as a partnership, nor will a foreign participant be treated as engaged in a trade or business within the U.S., solely by virture of its participation in a QCSA.

   One of the primary advantages of a CSA is to reduce transfer pricing disputes with the IRS. However, use of a QCSA does not eliminate all transfer pricing issues; in effect, it substitutes one set of issues for another. Nevertheless, the scope of an IRS examination of a CSA should be limited to the appropriateness of the cost-sharing methodology used and the amount of any buy-in/buy-out payments (discussed below). Under Regs. Sec. 1.482-7(a)(2), the IRS may make allocations, but only to the extent necessary to make each controlled participant's share of intangible development costs (IDCs) equal to its share of reasonably anticipated benefits. 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), the district director may make appropriate allocatlons to reflect an arm's-length charge for the acquisition of the interest.

   Reg. Sec. 1.482-7(a)(1) and (2) indicate that if a CSA is not a QCSA, the IRS may disregard it. The net result is that the transfer of the underlying technology is potentially subject to the Sec. 367(d) superroyalty provisions and to the Sec. 482 deemed royalty, provisions. In addition, there may be an exposure to a finding of partnership status for tax purposes, as well as a taxable U.S. trade or business presence in the case of a foreign participant. Partnership classification may lead to other unintended results. As a practical matter, a CSA which probably be respected, but the IRS is likely to impose reallocations.

   Structuring a QCSA

   Any two or more entities, controlled or uncontrolled,(10) may enter into a CSA. When uncontrolled participants are involved, it is assumed that they will bargain at arm's length. Consequently, it is rather easy for two uncontrolled participants to enter into a QCSA - they must comply only with the contemporaneous documentation requirements contained in Regs. Sec. 1.482-7(b)(4).

   However, transfers between related parties are assumed not to be at arms length. Regs. Sec. 1.482-7(c)(1)(ii) provides that a controlled participant must meet the administrative and reporting requirements of Regs. Sec. 1.482-7(j) and must reasonably anticipate that it will derive benefits from the use of covered intangibles.

   According to Regs. Sec. 1.482-7(b)(1)-(4), a QCSA must:

1. Include two or more participants.

2. Provide a method to calculate each controlled participants share of IDCs, based on factors that can reasonably be expected to reflect each participant's share of anticipated benefits.

3. Provide for adjustment to the controlled participants, shares of IDCs to account for changes in economic conditions, the participants, business operations and practices and the ongoing development of intangibles under the arrangement.

4. Be recorded in a document that is contemporaneous with the formation (and any revision) of the CSA that includes:

   * A list of the arrangements participants, and any other member of the controlled group that will benefit from the use of...