TEI comments on proposed cost sharing regulations: November 28, 2005.

• Position: Tax Executives Institute

On November 28, 2005, TEI filed the following comments on the proposed regulations relating to cost sharing arrangements under section 482 of the Internal Revenue Code. The Institute's comments were prepared under the aegis of its International Tax Committee, whose chair is John J. Herson of Neenah Paper Inc. The committee formed a task group, which was chaired by Janice L. Lucchesi of Akzo Nobel Inc. Dorothy C. Chao of Baxter International, Inc.; Todd A. Hauss of Lexmark International, Inc.; Deborah A. Lange of Oracle Corporation; Jeffrey J. Lonsdale of Lamar Hunt Family Companies, Lisa Norton of Amazon.com Inc.; Nancy A. Perks of Microsoft Corporation; Clisson Rexford of Akzo Nobel Inc.; Bradley Shumaker of Shell Oil Company; and Terilea J. Wielenga of Allergan, Inc. contributed materially to the preparation of the comments.

On August 22, 2005, the Internal Revenue Service and U.S. Department of Treasury issued 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 proposed regulations were published in the August 29, 2005, issue of the Federal Register (70 Fed. Reg. 51116), and the October 3, 2005, issue of the Internal Revenue Bulletin (200540 I.R.B. 625). A hearing is scheduled for December 16, 2005.

1. Background

   Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,400 members represent 2,800 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 daffy 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 these proposed regulations.

2. The Value of Cost Sharing Arrangements for Business

   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.

   For a variety of sound business reasons, many taxpayers choose to conduct certain cross-border activities under a cost sharing agreement whereby two or more parties conduct research and development activities and share the risks and rewards associated with that research. As a result, each participant has an ownership interest in the developed intangible and may exploit it without paying a royalty to any other participant or related party. Under the current regulations (which were promulgated in 1995), buy-in payments must be made to any participant that makes preexisting intangible property available to the arrangement.

   Broadly stated, businesses generally have three objectives for participating in such an arrangement. First, by pooling and sharing the cost of research and technical know-how among participants, all developed intangible property freely flows among the companies participating in the arrangement. This free flow of technology can occur without any additional contractual arrangements (i.e., legal costs); payments (i.e., administrative costs); or valuations (i.e., consulting costs). Second, by pooling and sharing these costs, participants optimize all available professional expertise and experience, thereby achieving significant economies of scale over what could be achieved by each company acting individually (resulting in significant cost savings). Finally, cost sharing arrangements are a cost effective way to develop and use intangible property among related companies.

   In 1986, 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).

   Cost sharing is important to many U.S.-based companies because it facilitates their ability to compete in an increasingly global marketplace. Cost sharing allows the centralized management and legal defense of a portfolio of valuable intellectual property rights, while allowing for the shared exploitation of those rights. In addition, the use of cost sharing agreements (CSAs) helps U.S. multinational corporations reduce the amount of foreign withholding taxes on related-party and third-party transactions. Thus, cost sharing enhances a U.S.-based multinational's ability to efficiently exploit its intellectual property on a global basis.

   Regrettably, the proposed regulations threaten to undermine congressional intent to permit companies to conduct their affairs in an effective and cost-efficient manner. The new rules proceed from an assumption that taxpayers use cost sharing abusively to disguise the transfer of intangible property outside the United States to an affiliate (often located in a tax haven) at a value substantially less than the fair market value of the intangible property. The regulations are intended to ensure that, where buy-in payments must be made to a participant transferring valuable external contributions to the other participants, such compensation is based on the arm's-length value of what is being transferred. The "investor model" approach prescribed in the proposed regulations, however, goes beyond ensuring that buy-in payments are based on an arm's-length analysis. The investor model requires that two separate transactions be analyzed (i.e., the buy-in payment and the cost sharing contribution) as though they were a single investment decision based on an expectation of a given overall return.

   TEI submits that, at best, this linking of the buy-in and cost sharing contribution analyses is unnecessary to address the IRS's concerns. At worst, it deprives a cost sharing participant a fair economic return once that participant has committed to making arm's-length buy-in payments.

   Cost sharing is a response to the business reality that many multinational taxpayers conduct their ongoing research and development (R&D) in multiple locations around the world. Scientists and engineers from different countries routinely collaborate in the development of new products and technologies. Much of the best scientific and engineering work now occurs outside the United States. In response to global competition, multinational companies routinely establish multiple R&D centers of excellence around the world, permitting development work to proceed on a 24/7 basis.

   As the cost and risks of R&D continue to climb, businesses increasingly cannot "go it alone." To remain globally competitive, U.S. businesses must share the costs, risks, and outcomes of ongoing research and development, without having to evaluate annually the actual vs. projected share of costs per participant and the appropriate vehicle for sharing the results of any successful technologies. Cost sharing permits a sharing of risks and outcomes, but obviates elaborate timesheets, tracking and charge-outs of expenses, and intercompany royalty payments and cross-license agreements. It permits multiple entities to spread risks, jointly fund centers of R&D excellence located in key countries, and benefit from the results.

   As more fully described below, the provisions in the proposed regulations to--

   * use the so-called investor model;

   * require complex valuation methods that may not provide in arm's-length results;

   * treat an existing R&D workforce in place as a contribution to a CSA requiring a buy-in;

   * require compensation for contributed intangibles over the entire life of the CSA;

   * require lump-sum buy-in payments for certain external contributions;

   * prohibit the contribution of make-or-sell rights;

   * permit the IRS to make one-way adjustments;

   * share results on an exclusive geographical basis;

   * share all costs of a CSA;

   * require inclusion of stock-based compensation in the costs to be shared;

   * comply with complex administrative rules; and

   * retroactively apply the valuation provisions in certain circumstances

   --will discourage companies from entering into new, and continuing to use existing, cost sharing arrangements. CSAs could become the method of last resort, even though they reflect business realities and permit the fair and efficient sharing of the risks, costs, and benefits of intangible development. In the extreme, the proposed regulations may discourage U.S.-based R&D, because they would create an incentive for locating R&D (and the premium profits that accompany R&D under the proposed regulations) outside the United States.

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