Follow-up comments on cost-sharing regulations.

The following comments were filed with the U.S. Department of the Treasury and the Internal Revenue Service on October 20, 2006. They were prepared under the aegis of TEI's International Tax Committee, whose chair is Janice L. Lucchesi of Akzo Nobel Inc.

This letter follows up on our August 4, 2006, meeting at which Tax Executives Institute committed to provide additional comments on the proposed cost sharing regulations, supplementing the Institute's November 28, 2005, submission. As always, TEI appreciates the government's continuing willingness to work with taxpayers to make the cost sharing rules more administrable.

We address specific issues discussed on August 4th, including additional examples on the use of a discount rate, alternatives to the geographic exclusivity requirement, proposed changes to the example of a workforce-in-place, and exceptions to the periodic adjustment requirement. In addition, TEI's position on other issues--transition rule changes, an additional example of the use of make-or-sell rights, a possible range of discount rates, and the development of a possible "angel" list of routine cost sharing agreements--is still being developed.

Use of a Project-Specific Discount Rate

In determining the discount rate to be used to test whether a Periodic Adjustment is required, the proposed regulations demonstrate a preference for using the overall weighted average cost of capital (WACC) of the company if it is publicly traded. Prop. Reg. [section] 1.482-7(i)(6) provides that the applicable discount rate (ADR) will be the WACC of the PCT Payor if it (or its consolidated group parent) is publicly traded in the United States, unless the Commissioner determines (or the participants establish to the Commissioner's satisfaction) that another discount rate better reflects the degree of risk of the CSA activity.

During our meeting, the IRS stated that the use of the ADR for publicly traded companies is intended to prompt the IRS examination team to scrutinize a transaction; it is not intended to require that an adjustment be automatically made. The government invited TEI to submit examples of the use of other discount rates to clarify this intent.

The following examples--which demonstrate the use of risk-adjusted hurdle rates and cash flows--should be added to the regulations:

Example (1) [use of risk-adjusted hurdle rate]. USPharm, a publicly traded U.S. pharmaceutical company, enters into a CSA with FPharm, its wholly owned foreign subsidiary. USPharm and its affiliates, including FPharm, are engaged in the development, manufacture, and sale of many pharmaceutical products, both commercialized and in the R&D pipeline stage. USPharm had been developing a specific drug compound called T. Under the agreement, both controlled participants agree to share future research costs of developing T. USPharm's consistent practice has been to use a risk-adjusted hurdle rate to evaluate its potential R&D projects (including the development of T) and determine which will receive funding. This risk-adjusted hurdle rate is considerably higher than USPharm's WACC, representing the higher risk of developing a single drug compared with the aggregate risk of a diversified portfolio of development, manufacturing, sales, marketing, and other activities. In other words, because the WACC compensates only certain types of risk (most notably, "systematic risk"), it would not compensate FPharm for the risk of failure of T if it were not "probabilistically adjusted" to account for well-documented and quantifiable failure risks in FPharm's industry.

FPharm is a PCT Payor and meets the definition of a publicly traded company under Prop. Reg. [section] 1.482-7(i)(6)(iv)(B). The use of USPharm's WACC results in a Periodic Trigger. The use of USPharm's WACC, however, does not properly reflect the degree of risk of the CSA activity because the WACC does not incorporate the "non-systematic" risks--such as product failure risks --that a third-party investor would clearly account for when investing in a project such as the development of T. If USPharm's risk-adjusted hurdle rate had been used instead of its WACC, no Periodic Trigger would have occurred. The Commissioner therefore determines that under all the relevant facts and circumstances, no Periodic Adjustment occurs because such an adjustment does not reasonably reflect an arm's-length result.

Example (2) [use of risk-adjusted cash flows]. The facts are the same as in Example (1), except that instead of using a risk-adjusted hurdle rate, USPharm uses risk-adjusted cash flows in conjunction with its WACC as a discount rate to determine the net present value (NPV) of each of its R&D projects. Therefore, the [intangible development costs] IDCs incurred by FPharm must be similarly probabilistically adjusted for the risk of failure that is borne by FPharm. The Commissioner determines that the use of risk-adjusted cash flows and a WACC discount rate will generate the same NPV as the application of a risk-adjusted hurdle rate to non-risk-adjusted cash flows. Based on this methodology, no Periodic Trigger would have occurred. The Commissioner therefore determines that a Periodic Adjustment will not be made because the outcome of such an adjustment does not reasonably reflect an arm's-length result under all the relevant facts and circumstances.

Example (3) [use of risk-adjusted cash flows in clinical trials]. The facts are the same as in Example (1), except that instead of using a risk-adjusted hurdle rate, USPharm uses risk-adjusted cash flows in conjunction with its WACC as a discount rate to determine the net present value (NPV) of each of its R&D projects. T is in phase I of clinical trials. USPharm has determined that in its industry, phase I clinical trials generally have a 50-percent probability of success; phase II trials, a 60-percent probability of success; and phase III, an 80-percent probability of success. The cumulative probability of success--taking into account all three phases of the clinical trials--is 50% x 60% x 80% = 24%.

To obtain risk-adjusted cash flows, USPharm applies this 24-percent cumulative probability of success against the cash flows projected to result if T were successful. USPharm then discounts these risk-adjusted cash flows using its WACC.

The Commissioner determines that the use of risk-adjusted cash flows and a WACC discount rate will generate the same NPV as the application of a risk-adjusted hurdle rate to non-risk-adjusted cash flows. Based on this methodology, no Periodic Trigger would have occurred. The Commissioner therefore determines that a Periodic Adjustment will not be made because the outcome of such an adjustment does not reasonably reflect an arm's-length result under all the relevant facts and circumstances.

TEI believes that the inclusion of these examples is consistent with the following statement in the preamble: "The appropriate 'price' of undertaking a risky...