Are multinationals living in a new world? The U.S. temporary cost sharing regulations.

• Author: Garcia, Michelle

Introduction

It remains to be seen how much effect the January 5, 2009, U.S. Temporary Cost Sharing Regulations will have on multinational corporations (MNCs) with U.S. business operations. (1) While the Temporary Regulations at first glance only apply to cost sharing arrangements (CSAs), by amending Treas. Reg. [section] 1.482-4 (Intangible Property) and Temp. Reg. [section] 1.482-9T (Services), they leave the door open for the IRS to use the methods and best method considerations of Temp. Reg. [section] 1.482-7T, when establishing the arm's-length nature of these transactions.

In summary, the Temporary Regulations define new valuation methods for contributions of pre-existing rights and capabilities, such as any pre-existing intangibles, to the CSA. The Temporary Regulations define these contributions as "Platform Contribution Transactions" (PCTs). PCTs and activities giving rise to intangibles--Intangible Development Activities (IDA)--are defined very broadly. As a result of the new specified methods and best method guidance for valuing PCTs, a taxpayer can now expect to have audit discussions focused not only on the life of contributed intangibles but also on the intangible income forecasts the appropriate discount rates and alternatives to cost-sharing intangibles, such as licensing.

Taxpayers not participating or planning to participate in CSAs should nevertheless be highly attentive to the Temporary Regulations, as they provide new key concepts (e.g., PCTs, IDAs, the Investor Model, and the consideration of realistic alternatives) that may be applied to traditional tangible property, intangible, and services transactions. Specifically, the Internal Revenue Service has already applied some of these key concepts in auditing existing CSAs and section 936 conversions, and one might expect the IRS to extend its application to traditional cross-border transactions. The Temporary Regulations also provide some further guidance where there had not been much, or any, to certain approaches and issues such as multi-parameter analyses, acknowledgement that different payment structures carry risk profiles, use of nontraditional Treas. Reg. [section] 1.482 valuation methods, and appropriate discount rates.

This article explores the potential implications of the Temporary Regulations' key concepts to multinationals with U.S. operations. The key question is whether the Temporary Regulations formally launched a new world for all multinationals to live and operate in--whether or not they participate in a CSA.

Potential Implications of the CSA Regulations for IP Transactions

The IRS can use many of the concepts in the Temporary Regulations to introduce a broader scope and increase the computed value of IP and activities that create IP. Some of the definitions and concepts potentially impacting transfer pricing systems beyond CSAs include: (i) Platform Contribution Transactions, (ii) Intangible Development Activities, (iii) the Investor Model, and (iv) Realistic Alternatives. This article describes definitions and concepts of the Temporary Regulations and outline examples of their potential broad effect on U.S. transfer pricing.

1. Key Concepts of the Temporary Regulations

   A core concept that the Temporary Regulations introduce to the section 482 regulations is the Platform Contribution Transaction, or PCT. "A Platform Contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to contribute to developing cost shared intangibles." (2) This definition is purposely broad to capture a wide range of activities, even items that may not fall under a traditional definition of intangibles. Moreover, Treasury and the IRS believe, in many instances, PCTs play a role in developing future generations of IP from CSAs, (3) The Temporary Regulations attempt to capture the economic value of this phenomenon by taking this perspective into account in determining the useful life of PCTs.

   The Temporary Regulations also introduce the definition of Intangible Development Activities, or IDAs. The Temporary Regulations define IDAs as "the activity under the CSA of developing or attempting to develop reasonably anticipated cost shared intangibles." (4) Conceptually, IDAs include activities linked to IP, such as marketing, advertising, process improvement, and research & development. As with the PCT concept, however, the Temporary Regulations provide a broad and vague definition of IDAs. The broad scope of the IDA definition will force taxpayers with CSAs to think through and document their service activities, and identify whether they are IDAs or whether they are other service activities. If they fail to do so, they run the risk having the IRS define IDAs and other service costs for them.

   The Investor Model concept is central to the IRS approach to valuing pre-existing intangibles in PCTs. The basic premise of the Investor Model is that the expected returns associated with an investment should be consistent with the riskiness of that investment, as reflected in an "appropriate discount rate." In its application, the IRS views the payor of the PCT as the investor. If the expected returns of the PCT payor exceed an appropriate discount rate, the IRS may conclude that the taxpayer has undervalued the PCT. A corollary to the Investor Model is the concept of an evaluation of Realistic Alternatives, which is based on the concept that a taxpayer would not engage in a CSA on terms that are economically inferior to a Realistic Alternative. The primary example of a Realistic Alternative to a CSA is a licensing arrangement with the original IP owner funding all intangible development costs associated with the IP. While the Investor Model places a ceiling on the expected returns of the PCT payor (e.g., licensee or party buying into the IP), the evaluation of Realistic Alternatives is also meant to place a floor on the expected returns of the PCT payee (e.g., licensor or initial investor of the IP). The PCT payment is to be large enough to ensure that the expected return to the PCT payee is at least as great as its best Realistic Alternative. (5)

   The Investor Model and Realistic Alternatives concepts are not pricing or valuation methods, per se, but serve as general principles that must be evaluated in choosing the best method to value any PCT. The Temporary Regulations specify five PCT valuation methods: (i) the Comparable...