Proposed cost sharing regulations.

Author:Ugai, Brian C.

April 14, 2009

On April 14, 2009, Tax Executives Institute filed the following comments with the Internal Revenue Service and the U.S. Department of the Treasury on proposed regulations under section 482 of the Internal Revenue Code, relating to the methods to be used to determine taxable income in connection with a cost sharing agreement. The comments were prepared under the aegis of TEI's International Tax Committee, whose chair is Brian C Ugai of Starbucks Coffee Company; other members contributing to the project were Dorothy C. Chao of Baxter International, Inc., Roslyn G. Grigoleit of Dover Corporation, Helena Klumpp of Baxter International, Inc., Janice L. Lucchesi of Akzo Nobel Inc., and Clisson Rexford, Akzo Nobel Inc. Mary L. Fahey, TEI General Counsel, serves as legal staff liaison to the International Tax Committee.

On December 31, 2008, the Internal Revenue Service (IRS) and U.S. Department of Treasury issued re-proposed regulations under section 482 of the Internal Revenue Code, relating to the methods to be used to determine taxable income in connection with a cost sharing agreement. Temporary regulations issued at the same time are effective January 5, 2009, and replace the existing Treasury Regulations issued in 1995.

The re-proposed regulations were published in the January 5, 2009, issue of the Federal Register (74 Fed. Reg. 236), and the February 14, 2009, issue of the Internal Revenue Bulletin (2009-7 I.R.B. 561) (hereinafter referred to as the "2008 regulations"). TEI has requested to testify at the hearing on the 2008 regulations scheduled for April 21, 2009.


Tax Executives Institute is the preeminent association of business tax executives in North America. Our approximately 7,000 members represent 3,200 of the leading corporations in the United States, Canada, Europe, and Asia. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring a balanced and practical perspective to the issues raised by the 2008 regulations.

In General

Section 482 of the Internal Revenue Code authorizes the Secretary of the Treasury to "distribute, apportion, or allocate gross income, deductions, credits, or allowances" among related parties if it is determined necessary to prevent the "evasion of taxes or clearly to reflect the income" of the entities. In 1986, section 482 was amended to provide that, in the case of any transfer or license of an intangible (such as a copyright, trademark, or patent), the income with respect to such transfer or license must be "commensurate with the income" from that intangible. See Tax Reform Act of 1986, Pub. L. No. 99-514, [section] 1231(e)(1), amending I.R.C. [section] 482. At that time, Congress recognized cost sharing agreements as a valid means of intercompany pricing:

In revising section 482, the conferees do not intend to preclude the use of certain bona fide research and development cost-sharing arrangements as an appropriate method of allocating income attributable to intangibles among related parties, if and to the extent such agreements are consistent with the purposes of this provision that the income allocated among the parties reasonably reflect the actual economic activity undertaken by each. H.R. Rep. No. 99-841, 99th Cong., 2d Sess. II-638 (1986).

TEI commends the government for responding to comments on the workability of the August 2005 proposed regulations (hereinafter the "2005 regulations"). The 2008 regulations are generally an improvement over the 2005 regulations, especially in respect of the transition and grandfather rules.

The most dramatic improvement in the 2008 regulations is in respect of the use of the discount rate. The earlier regulations implied that the weighted average cost of capital (WACC) would likely be the most reliable rate; in some circumstances, the 2005 regulations stated, the company's internal hurdle rates might be the appropriate rate.

In response to comments about the undue emphasis on the WACC and hurdle rates, the IRS and Treasury have eliminated these references. Rather, the 2008 regulations provide that the appropriate discount rate may vary between realistic alternatives and the forms of payment, recognizing the use of risk-adjusted rates, different rates for different activities, and differences between pre- and post-tax discount rates.

The 2008 regulations also provide more flexibility in the division of rights among participants, permitting taxpayers to have non-overlapping, exclusive divisions of rights not only on a territorial basis, but also on fields of use and certain other bases. The Institute remains concerned, however, that the 2008 regulations remain too restrictive in this regard.

The 2008 regulations also eliminate the requirement that the consideration for platform contributions acquired in a post-formation acquisition be in the same form as the third-party transaction in which the platform contribution was acquired.

Finally, the 2008 regulations provide more favorable grandfathering rules for existing cost sharing arrangements (CSAs) by eliminating the termination triggers of the 2005 regulations. Pre-existing CSAs will generally continue to be governed by the 1995 regulations as long as taxpayers amend the intercompany agreement to conform to certain administrative requirements by July 6, 2009, and the participants' activities "substantially" comply with the 2008 regulations. The 2008 regulations also limit application of the 1995 periodic adjustment rules to a material change in scope and apply the periodic adjustment rules to platform contributions that occur on or after a material expansion in the scope of the CSA.

Regrettably, the 2008 regulations retain significant aspects of the 2005 rules. Thus, the regulations continue to rely heavily on the investor model and, although some changes have been made, treat a workforce-in-place as an intangible requiring a platform contribution transaction (PCT). TEI discussed its concerns about these provisions extensively in its submissions on the 2005 regulations and will not reiterate them here. We remain willing, however, to elaborate on our concerns should the government wish to revisit the issue.

Exceptions to the Periodic Adjustments

In the preamble to the 2008 regulations, the IRS and Treasury announced their intention to issue a revenue procedure that will provide an exception to periodic adjustments--similar to the exceptions provided in Temp. Reg. [section] 1.482-7T(i)(6)(vi)--in the context of an advance pricing agreement (APA). The guidance will provide that no periodic adjustments will be made in any year based on a "Trigger PCT" that is a covered transaction under the APA. 2009-7 I.R.B. at 468. The rationale for this exception is that--

An APA process generally is contemporaneous with a taxpayer's original transactions and involves transparency concerning a taxpayer's upfront efforts to conform to the arm's length standard. Thus, the APA process may overcome the asymmetry in information addressed by the periodic adjustment provisions, eliminating a primary basis for a CWI ]commensurate with income] adjustment. Comments were requested on whether and how a documentation exception could be adapted to the purposes of the CWI principle. 2009-7 I.R.B. at 469.

TEI recommends that the revenue procedure include an exception to periodic adjustments, not only in the context of an APA, but also for taxpayers in the Compliance Assurance Process (CAP) program. Like the APA process, CAP involves transparency concerning a taxpayer's upfront efforts to conform to the arm's-length standard. According to Arm. 2005-87, 2005-2 C.B. 1144--

The CAP requires extensive cooperation between the Service and participating taxpayers. Throughout the tax year, these taxpayers are expected to engage in full disclosure of information concerning their completed business transactions and their proposed return treatment of all material issues.... Significant aspects of the CAP include:

* Communication of information about completed transactions in a manner that is timely and allows a meaningful analysis of material items affecting the tax return;... [and]

* The sharing of all relevant data and positions between the Service and the taxpayer.

Because the CAP process is not characterized by the information asymmetry that concerns the IRS and Treasury in the context of a Coordinated Issue Case (CIC) audit--rather, CAP involves the same contemporaneous transparency and degree of explanation as an APA--an exception for CAP is appropriate.

CSTs and PCTs

Temp. Reg. [section] 1.482-7T(b)(1)(i) provides that--

All controlled participants must commit to, and in fact, engage in cost sharing transactions (CSTs). In CSTs, the controlled participants make payments to each other (CST Payments) as appropriate, so that in each taxable year each controlled participant's IDC [intangible development cost] share is in proportion to its respective RAB [reasonably anticipated benefit] share. Temp. Reg. [section] 1.482-7T(b)(1)(ii) provides that--

All controlled participants must commit to, and in fact, engage in platform contributions pursuant to paragraph (c) of this section. In a PCT, each other controlled participant (PCT Payor) is obligated to, and must in fact...

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