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Saturday, July 11, 2009


Section 482 of the Internal Revenue Code requires arms-length pricing for transactions occurring between commonly controlled taxpayers. A principal objective of these rules is to assure that a fair amount of income and thus tax occurs within the U.S. taxing jurisdiction - that is, it seeks to prevent the shifting of income out of the U.S., or deductions into the U.S., through the use of overcharging or undercharging for items between related entities situated in different jurisdictions. To assure proper payments for use of intangible property, arms-length pricing generally requires that the pricing be commensurate with the income generated from the intangible.

Use of intangibles outside of the U.S. by non-U.S. entities can often allow the non-U.S. entity to generate income that is not immediately (or ever) subject to U.S. tax. If a U.S. entity develops the intangible, but then transfers it outside the U.S. to a related entity, Section 367 and/or 482 can operate to create income for the U.S. entity. To avoid this income, taxpayers often enter into joint development arrangements with related entities. Such "cost sharing" arrangements allow the U.S. and non-U.S. entities to jointly develop, own, and then use the developed intangibles. Since they jointly developed the intangible, there is no need to transfer ownership or license use of the intangible from one entity to the other, so the impact of Sections 482 and 367 can be minimized.

Prior regulations under Section 482 acknowledged cost sharing as a valid planning mechanism. However, the regulations did not provide a lot of detail on what cost sharing arrangements would be respected by the IRS.

In recently issued regulations, the IRS has now put a lot of "meat on the bones" of its prior regulations. The regulations are a two-edged sword. On the one hand, they provide a lot more guidance on how to put together a cost-sharing arrangement that the IRS will respect. On the other hand, taxpayers that do not follow the new rules risk having their cost-sharing arrangements challenged.

For those that are interested but haven't had a chance to review the regulations yet, below are some of the highlights.

GENERAL RULE. The IRS will respect a cost-sharing arrangement if (1) cost sharing transactions (CST) are entered into, (2) platform contributions are compensated for, and (3) various compliance requirements are met.

CST TRANSACTIONS. This obligation requires that commonly controlled taxpayers have to contribute to intangible development costs (IDCs) in proportion to their shares of reasonably anticipated benefits (RAB shares) from the developed intangibles by entering into cost sharing transactions (CSTs). In plain English, this means that the commonly controlled participants involved in developing an intangible, must each contribute via cash or property a pro rata share of the costs of development, in proportion to each of their anticipated benefits from the intangible asset. IDCs include all costs, including cash-based compensation, that are identified with or reasonably allocable to the development of the intangible asset. IDC's exclude land and depreciable property acquisition costs, and also exclude interest costs and income taxes. If a cost relates to the development of an intangible and also to other business activities, then it must be reasonably allocated between the two activities.

DIVISION OF BENEFITS. The future benefits from the intangible must be divided up among the commonly controlled participants in only certain ways. First, they can divide up the benefits via allocation of various nonoverlapping geographical divisions of use. Second, and this is new, the division can be made by allocating various "fields of use" among the participants. Third, and also new, the IRS will allow for other division methods established by taxpayers if they meet certain requirements such as clear and unambiguous division, that the method is verifiable, the benefit allocations are non-overlapping, perpetual, and exclusive, and the results are reasonably predictable.

COMPENSATION FOR PLATFORM CONTRIBUTIONS. As noted above, participants must contribute to the cost of IDC development in proportion to their anticipated benefits. However, sometimes participants will make noncash contributions to the development by contributing resources, capabilities, or rights that were acquired outside of the development of the subject IDC. For example, one of the controlled entities may provide its own research scientists or intellectual property to the IDC development process. The cost-sharing rules require that the contributors of such "platform contributions" receive arms-length payments for such platform contributions from the other participants. The arms-length payments are computed using traditional Section 482 arms-length computation methods and principles, with some special rules thrown in for good measure. Note that platform contribution payments must commence shortly after they are incurred.

ADMINISTRATIVE REQUIREMENTS. In addition to meeting the above substantive requirements, a qualified cost-sharing arrangement must (a) have a cost-sharing written contract, entered into within 60 days of the parties incurring their first intangible development cost, that provides various terms set out in the regulations, (b) meet additional documentary requirements, (c) meet specified accounting and books & records requirements, and (d) file required disclosures with the IRS, including one within 90 days of the first incurred IDC, and then annually. Note that the above 60 day requirement under (a) is a trap for the unwary. Taxpayers that start work on jointly developing an intangible, but don't enter into their agreement within the required 60 day period, risk having their cost-sharing arrangement not being respected by the IRS.

The IRS has done a good job in fleshing out the requirements for cost-sharing arrangements for taxpayers. This will provide more comfort and certainty for taxpayers engaging in these type of arrangements. At the same time, it has imposed various obligations, including proper payments for platform contributions and misc. administrative requirements that must be complied with, so the certainty that is provided comes with compliance costs, and risks for those that don't fully comply with the new rules.

Treas.Regs. Section 1.482-7T

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