Proposed regulations on methods to determine taxable income in connection with a cost sharing agreement: Tax Executives Institute, Inc. submitted the following comments to The Internal Revenue Service and the U.S. Department of the Treasury on March 7, 2007.

On August 4, 2006, representatives of Tax Executives Institute met with you to discuss the proposed cost sharing regulations. At that meeting, TEI committed to provide additional comments on the proposed regulations.

That process began on October 16, 2006, when we provided 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 this letter, we address several other issues, including the use of a range of discount risks, entrepreneurial risk, and transition rule changes, and provide an additional example of the use of make-or-sell rights.

Tax Executives Institute appreciates the government's continuing willingness to work with taxpayers to make the cost sharing rules more administrable.

Use of a Range of Discount Rates

During our August 4th meeting, the IRS asked whether a range of discount rates should be used when converting future or past amounts into a present value for purposes of calculating a preliminary or contemporaneous transaction (PCT). The finance literature on the cost of capital, as well as industry practice, suggests that the cost of capital for nearly any asset, including intangible assets, is almost never conceived of as a single number. While a single number must necessarily be used to discount a cash-flow stream to a single present value, this number is nearly always chosen from a range of reasonable cost of capital estimates. There is no universally accepted economic model for use in deriving the cost of capital for a given asset. Rather, there are many different, generally accepted cost of capital models. The multiplicity of models produces a corresponding multiplicity of cost of capital estimates--for the same asset.

The three most popular cost of capital models are (i) the capital asset pricing model (CAPM); (ii) the Fama-French Model, also known as the three-factor model; and (iii) the Gordon model. A review of the data published by Ibbotson Associates (which is the finance industry standard for cost of capital estimates) demonstrates that for most industries there is substantial variation in the capital cost estimates produced by the three models mentioned above.

For example, even at the one-digit SIC Code level, for SIC Code 1 (mining and construction), the three models produce the following estimates for the equity cost of capital:

* CAPM = 12.14% * Fama-French = 14.13% * Gordon = 19.46% This variation is especially remarkable, since the large number of firms in this sample (183 firms) should generally reduce the variation among the capital cost estimates.

For these reasons, TEI believes that the regulations should not require the mandatory use of a particular discount rate or range of discount rates, but supports the concept of using a range of discount rates as a safe harbor.

Entrepreneurial Projects

Prop. Reg. [section] 1.482-7(i)(6) should be clarified to recognize that the determination of the appropriate return to be earned by the PCT Payor should take into account the particular risks of the project invested in, and not automatically default to a single weighted average cost of capital (WACC) for the PCT Payor as a whole. Statistical studies confirm that "risky" assets on average have returns that are higher than "riskless" assets. Rational investors demand a premium in return for holding such assets. Therefore, Prop. Reg. [section] 1.482-7(i)(6) must account for the risk assumed by entrepreneurial projects.

Moreover, a major variable in a WACC calculation formula is the cost of equity capital used in the model. A well-recognized shortfall in CAPM--perhaps the most common of the methods above--however, is the inability of the model to fully...