RSM Resources

How cost-sharing arrangements work

RSM McGladrey | Transfer Pricing News | January 2006

Formallyprescribed by U.S. regulations issued on January 1, 1996, CSAs havebecome a popular vehicle for global businesses to develop and useintellectual property in a tax-efficient manner. CSAs may be used inconnection with various kinds of intellectual property, includingmanufacturing technology processes and know-how and marketingproperties, such as trademarks and trade names.

ACSA permits two or more companies to share the cost of developingintellectual property and to share proportionally in revenue andprofits resulting from exploiting such property. Under a CSA,multinational companies may be able to shift some revenue and profitsto jurisdictions that tax at a lower rate than the United States,resulting in higher earnings per share.

CSAs are formally recognized by many foreign taxauthorities and under international guidelines published by theOrganization for Economic Cooperation and Development. A CSA will berespected in the United States only if it meets certain requirements.Among these, the CSA must be pursuant to a written agreement anddisclosed in the U.S. income tax return.

Treasury concern with current regulations

TheTreasury is concerned that aggressive CSA use has resulted in loss ofU.S. tax revenue. A key aspect of these concerns involvesunder-valuation of “buy-in payments.”

Entering into a CSA typically involves one partycontributing pre-existing intellectual property to the agreement. Asecond party then pays the contributor for the value of theintellectual property. This is known as a buy-in payment.

Under current regulations, buy-in payment amountsare based on the value of the pre-existing intellectual property atinception of the CSA. If the pre-existing intellectual property isstill “on the laboratory bench” or not yet commercially successful, arelatively low value may be ascribed to the buy-in payment. If theintellectual property proves to be commercially successful, profitsshifted from the United States to the foreign tax jurisdiction may bequite large relative to the combined buy-in payment and cost-sharingpayments.

What proposed regulations would do

TheTreasury has introduced the “investor model” as a framework foraddressing quantitative elements of a CSA, including buy-in payments.The premise of this model is that the paying party should earn nogreater than a market rate of return from exploitation of theintellectual property. Any above-market returns should be realized bythe contributor. In this manner, the investor model limits the amountof income that can be shifted outside the United States tax net by U.S.developers of technology and other intellectual property.

As an adjunct to the investor model, buy-inpayments must account for the exclusive, perpetual and territorialright to enhance and develop the contributed intangible property. Thisrequirement limits taxpayers’ ability to place an unreasonably lowvalue on pre-existing contributed property based on the premise thatrights to the property are severely limited. The proposed regulationsintroduce a variety of new methods for valuing property contributed toa CSA.

The proposed regulations grant the IRS unilateralauthority to make allocations to adjust the results of a CSA if theyare inconsistent with arm’s length results. Taxpayers may avoid suchadjustments if CSA results fall within a safe harbor range of returns,generally defined as 50 percent to 200 percent of a market return, andif certain administrative requirements are met. Taxpayers have limitedrights to refute proposed adjustments based on facts and circumstances.

Additionally, the proposed regulations formalizethe IRS position that make-sell rights must be addressed separatelyoutside the CSA. That is, if a taxpayer wishes to cost share currenttechnology used to manufacture products and that also serves as aspringboard for development of derivative technologies, a royalty mustbe charged for make-sell rights outside the CSA. The taxpayer must alsocharge a separate buy-in payment for the right to develop derivativetechnologies within the CSA. Finally, the proposed regulationsincorporate the IRS position that intangible development costs mustinclude all costs in cash or kind, including stock-based compensation.

These regulations are proposed to become effectivefor CSAs commencing on or after the date final regulations arepublished in the Federal Register, expected later this year.Pre-existing CSAs will remain generally subject to the 1996 regulation.Grandfathered CSAs may become subject to new regulations if certainchanges to the agreement occur or if the taxpayer fails to comply withthe transition rules.

Our recommendation to our clients

Proposedregulations contain provisions giving the IRS broad and unilateralauthority to make allocations to adjust CSA results after the fact.Although we expect some provisions to be diluted in final regulations,CSAs will likely become less attractive as a tax optimization vehicle.

If your company is considering implementing a CSA,you may wish to consider doing so quickly. This may allow you toqualify for treatment under transition rules and more liberal 1996regulations.