[Federal Register Volume 60, Number 244 (Wednesday, December 20, 1995)]
[Rules and Regulations]
[Pages 65553-65566]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30617]
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DEPARTMENT OF THE TREASURY
26 CFR Parts 1, 301 and 602
[TD 8632]
RIN 1544-AM00
Section 482 Cost Sharing Regulations
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to qualified
cost sharing arrangements under section 482 of the Internal Revenue
Code. These regulations reflect changes to section 482 made by the Tax
Reform Act of 1986, and provide guidance to revenue agents and
taxpayers implementing the changes.
DATES: These regulations are effective January 1, 1996.
These regulations are applicable for taxable years beginning on or
after January 1, 1996.
FOR FURTHER INFORMATION CONTACT: Lisa Sams of the Office of Associate
Chief Counsel (International), IRS (202) 622-3840 (not a toll-free
number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations
have been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under
control number 1545-1364. Responses to these collections of information
are required to determine whether an intangible development arrangement
is a qualified cost sharing arrangement and who are the participants in
such arrangement.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number.
The estimated average annual burden per recordkeeper is 8 hours.
The estimated average annual burden per respondent is 0.5 hour.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,
DC 20224, and to the Office of Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information and
Regulatory Affairs, Washington, DC 20503.
Books and records relating to these collections of information must
be retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
Section 482 was amended by the Tax Reform Act of 1986, Public Law
99-514, 100 Stat. 2085, 2561, et. seq. (1986-3 C.B. (Vol. 1) 1, 478).
On January 30, 1992, a notice of proposed rulemaking concerning the
section 482 amendment in the context of cost sharing was published in
the Federal Register (INTL-0372-88, 57 FR 3571).
Written comments were received with respect to the notice of
proposed rulemaking, and a public hearing was held on August 31, 1992.
After consideration of all the comments, the proposed regulations under
section 482 are adopted as revised by this Treasury decision, and the
corresponding temporary regulations (which contain the cost sharing
regulations as in effect since 1968) are removed.
Explanation of Provisions
Introduction
The Tax Reform Act of 1986 (the Act) amended section 482 to require
that consideration for intangible property transferred in a controlled
transaction be commensurate with the income attributable to the
intangible. The Conference Committee report to the Act indicated that
in revising section 482, Congress did not intend to preclude the use of
bona fide research and development cost sharing arrangements as an
appropriate method of allocating income attributable to intangibles
among related parties. The Conference Committee report stated, however,
that in order for cost sharing arrangements to produce results
consistent with the commensurate-with-income standard, (a) a cost
sharer should be expected to bear its portion of all research and
development costs, on unsuccessful as well as successful products,
within an appropriate product area, and the costs of research and
development at all relevant development stages should be shared, (b)
the allocation of costs generally should be proportionate to profit as
determined before deduction for research and development, and (c) to
the extent that one party contributes funds toward research and
development at a significantly earlier point in time than another (or
is otherwise putting its funds at risk to a greater extent than the
other) that party should receive an appropriate return on its
investment. See H.R. Rep. 99-281, 99th Cong., 2d Sess. (1986) at II-
638.
[[Page 65554]]
The Conference Committee report to the Act recommended that the IRS
conduct a comprehensive study and consider whether the regulations
under section 482 (issued in 1968) should be modified in any respect.
The White Paper
In response to the Conference Committee's directive, the IRS and
the Treasury Department issued a study of intercompany pricing [Notice
88-123 (1988-2 C.B. 458)] on October 18, 1988 (the White Paper). The
White Paper suggested that most bona fide cost sharing arrangements
should have certain provisions. For example, the White Paper stated
that most product areas covered by cost sharing arrangements should be
within three-digit Standard Industrial Classification codes, that most
participants should be assigned exclusive geographic rights in
developed intangibles (and should predict benefits and divide costs
accordingly) and that marketing intangibles should be excluded from
bona fide cost sharing arrangements.
Comments on the White Paper indicated that, in practice, there was
a great deal of variety in the terms of bona fide cost sharing
arrangements, and that if the White Paper's suggestions were
incorporated in regulations, the regulations would unduly restrict the
availability of cost sharing.
The 1992 Proposed Regulations
The IRS issued proposed cost sharing regulations on January 30,
1992 (INTL-0372-88, 57 FR 3571). In general, the proposed regulations
allowed more flexibility than anticipated by the White Paper, relying
on anti-abuse tests rather than requiring standard cost sharing
provisions.
The proposed regulations stated that in order to be qualified, a
cost sharing arrangement had to meet the following five requirements:
(1) the arrangement had to have two or more eligible participants, (2)
the arrangement had to be recorded in writing contemporaneously with
the formation of the cost sharing arrangement, (3) the eligible
participants had to share the costs and risks of intangible development
in return for a specified interest in any intangible produced, (4) the
arrangement had to reflect a reasonable effort by each eligible
participant to share costs and risks in proportion to anticipated
benefits from using developed intangibles, and (5) the arrangement had
to meet certain administrative requirements. The key requirements were
that participants had to be eligible and that costs and risks had to be
proportionate to benefits.
Under the proposed regulations, only a controlled taxpayer that
would use developed intangibles in the active conduct of its trade or
business was eligible to participate in a cost sharing arrangement.
This requirement was considered necessary to ensure that controlled
foreign entities were not established simply to participate in cost
sharing arrangements without performing any other meaningful function,
and to ensure that each participant's share of anticipated benefits was
measurable.
The proposed regulations allowed costs to be divided based on any
measurement that would reasonably predict cost sharing benefits (e.g.,
anticipated units of production or anticipated sales). However, the
basis for measuring anticipated benefits and dividing costs was checked
by a cost-to-operating-income ratio. The method for dividing costs was
presumed to be unreasonable if a U.S. participant's ratio of shared
costs to operating income attributable to developed intangibles was
grossly disproportionate to the cost-to-operating-income ratio of the
other participants.
If a U.S. participant's cost-to-operating-income ratio was not
grossly disproportionate, a section 482 allocation could still be made
under three circumstances: (a) if the cost-to-operating-income ratio
was disproportionate (allocation of costs), (b) if the pool of costs
shared was too broad or too narrow, so that the U.S. participant was
paying for research that it would not use (allocation of costs), or (c)
if the cost-to-operating-income ratio was substantially
disproportionate, such that a transfer of an intangible could be deemed
to have occurred (allocation of income).
Under the proposed regulations, the IRS could also make an
allocation of income to reflect a buy-in or buy-out event, that is, a
transfer of an intangible that could occur, for example, when a
participant joined or left a cost sharing arrangement.
Comments on the 1992 Proposed Regulations
The 1992 proposed cost sharing regulations were generally well
received. However, there were five areas of particular concern to
commenters. The first was the mechanical use of cost-to-operating-
income ratios as a standard for measuring the reasonableness of an
effort to share costs in proportion to anticipated benefits. Commenters
noted that operating income attributable to developed intangibles was
difficult to measure, and that other bases for measuring benefits might
produce more reliable results. Commenters also believed that the ratios
might be overused, leading to adjustments to costs in every year, and
to many deemed transfers of intangibles. In addition, commenters stated
that the ratios did not provide any certainty that a cost sharing
arrangement would not be disregarded, since a ``grossly
disproportionate'' ratio was not numerically defined.
The second area of concern was the eligible participant
requirement. Commenters argued that separate research entities (with no
separate active trade or business) should be allowed to participate in
cost sharing arrangements, as should marketing affiliates. Commenters
also argued that transfers of intangibles to unrelated entities should
not disqualify a participant, and that foreign-to-foreign transfers
should not necessarily be monitored. Some comments also stated that
controlled entities should be able to participate even if their cost
sharing payments would be characterized differently for purposes of
foreign law.
The third area of concern was the regulations' requirement that
every participant be able to benefit from every intangible developed
under a cost sharing arrangement. Commenters stated that the
regulations should allow both single-product cost sharing arrangements
and umbrella cost sharing arrangements (i.e., cost sharing arrangements
under which a broad category of a controlled group's research and
development would be covered).
The fourth area of concern was the buy-in and buy-out rules. There
were some suggestions for clarifying and simplifying the rules. For
example, comments urged that the regulations provide that one
participant's abandonment of its rights would not necessarily confer
benefits on the other participants, and that a new participant need not
always make a buy-in payment when joining a cost sharing arrangement.
Suggestions for simplifying the rules generally consisted of proposed
safe harbors for valuing intangibles.
The final general area of concern was the administrative
requirements. Several commenters suggested that annual adjustments to
the method used to share costs should not be required. Commenters also
suggested that taxpayers not be required to attach their cost sharing
arrangements to their returns, and that the time period for producing
records be increased.
In addition to these general areas of concern, commenters noted
that there should be more guidance about when the IRS would deem a cost
sharing
[[Page 65555]]
arrangement to exist. Commenters also argued that existing cost sharing
arrangements should be grandfathered, or that there should be a longer
transition period. Commenters suggested that financial accounting rules
be used to calculate costs to be shared, and that the IRS address the
impact of currency fluctuations on the cost-to-operating-income ratios.
Finally, commenters asked that the regulations clarify that a cost
sharing arrangement would not be deemed to create a partnership or a
U.S. trade or business.
The Final Regulations
Without fundamentally altering the policies of the 1992 proposed
regulations, the final regulations reflect numerous modifications in
response to the comments described above. They also reflect the
approach of the final section 482 regulations relating to transfers of
tangible and intangible property.
Section 1.482-7(a)(1) defines a cost sharing arrangement as an
agreement for sharing costs in proportion to reasonably anticipated
benefits from the individual exploitation of interests in the
intangibles that are developed. In order to claim the benefits of the
safe harbor, a taxpayer must also satisfy certain formal requirements
(enumerated in Sec. 1.482-7(b)). The district director may apply the
cost sharing rules to any arrangement that in substance constitutes a
cost sharing arrangement, notwithstanding any failure to satisfy
particular requirements of the safe harbor. It is further provided that
a qualified cost sharing arrangement, or an arrangement treated in
substance as such, will not be treated as a partnership. (A
corresponding provision is added to Sec. 301.7701-3 pertaining to the
definition of a partnership.) Neither will a foreign participant be
treated as engaged in a trade or business within the United States
solely by virtue of its participation in such an arrangement.
Section 1.482-7(a)(2) restates the general rule of cost sharing in
a manner intended to emphasize its limitation on allocations: no
section 482 allocation will be made with respect to a qualified cost
sharing arrangement, except to make each controlled participant's share
of the intangible development costs equal to its share of reasonably
anticipated benefits.
Section 1.482-7(b) contains the requirements for a qualified cost
sharing arrangement. This provision substantially tracks the proposed
regulations. A modification was made in the second requirement which
now directs that the arrangement provide a method to calculate each
controlled participant's share of intangible development costs, based
on factors that can reasonably be expected to reflect anticipated
benefits. The new standard is intended to ensure that cost sharing
arrangements will not be disregarded by the IRS as long as the factors
upon which an estimate of benefits was based were reasonable, even if
the estimate proved to be inaccurate.
Section 1.482-7(b)(4) requires that a cost sharing arrangement be
set forth in writing and contain a number of specified provisions,
including the interest that each controlled participant will receive in
any intangibles developed pursuant to the arrangement. The intangibles
developed under a cost sharing arrangement are referred to as the
``covered intangibles.'' It is possible that the research activity
undertaken may result in development of intangible property that was
not foreseen at the inception of the cost sharing arrangement; any such
property is also included within the definition of the term covered
intangibles. The prescriptive rules in relation to the scope of the
intangible development area under the proposed regulations are
eliminated in favor of a flexible definition that encompasses any
research and development actually undertaken under the cost sharing
arrangement.
Section 1.482-7(c) provides rules for being a participant in a
qualified cost sharing arrangement. Unlike the proposed regulations,
the final regulations permit participation by unrelated persons, which
are referred to as ``uncontrolled participants.'' Controlled taxpayers
may be participants, referred to as ``controlled participants,'' if
they satisfy the conditions set forth in these rules. These
qualification rules replace the proposed regulations' concept of
``eligible participant.'' The tax treatment of controlled taxpayers
that do not qualify as controlled participants provided in Sec. 1.482-
7(c)(4) essentially tracks the treatment provided for ineligible
participants under the proposed regulations.
The requirements for being a controlled participant are basically
the same as in the proposed regulations. In particular, a controlled
participant must use or reasonably expect to use covered intangibles in
the active conduct of a trade or business. Thus, an entity that chiefly
provides services (e.g., as a contract researcher) may not be a
controlled participant. These provisions are necessary for the reason
that they are necessary to the proposed regulations: to prevent foreign
controlled entities from being established simply to participate in
cost sharing arrangements. In accordance with Sec. 1.482-7(c)(4)
mentioned above, service entities (such as contract researchers) may
furnish research and development services to the members of a qualified
cost sharing arrangement, with the appropriate consideration for such
assistance in the research and development undertaken in the intangible
development area being governed by the rules in Sec. 1.482-
4(f)(3)(iii) (Allocations with respect to assistance provided to the
owner). In the case of a controlled research entity, the appropriate
arm's length compensation would generally be determined under the
principles of Sec. 1.482-2(b) (Performance of services for another).
Each controlled participant would be deemed to incur as part of its
intangible development costs a share of such compensation equal to its
share of reasonably anticipated benefits.
As under the proposed regulations, the activity of another person
may be attributed to a controlled taxpayer for purposes of meeting the
active conduct requirement. However, modified language is adopted to be
more precise concerning the intended requirements for attribution.
These requirements were phrased in the proposed regulations as bearing
the risk and receiving the benefits of the attributed activity. Under
the final regulations, the attribution will be made only in cases in
which the controlled taxpayer exercises substantial managerial and
operational control over the attributed activities.
As under the proposed regulations, a principal purpose to use cost
sharing to accomplish a transfer or license of covered intangibles to
uncontrolled or controlled taxpayers will defeat satisfaction of the
active conduct requirement. However, a principal purpose will not be
implied where there are legitimate business reasons for subsequently
licensing covered intangibles.
The subgroup rules of the proposed regulations are eliminated.
Their major purpose is accomplished by a simpler provision (see the
discussion of Sec. 1.482-7(h)). In addition, the final regulations
treat all members of a consolidated group as a single participant.
Section 1.482-7(d) defines intangible development costs as
operating expenses other than depreciation and amortization expense,
plus an arm's length charge for tangible property made available to the
cost sharing arrangement. Costs to be shared include all costs relating
to the intangible development area, which, as noted, comprises any
research actually undertaken under the cost sharing
[[Page 65556]]
arrangement. As under the proposed regulations, the district director
may adjust the pool of costs shared in order to properly reflect costs
that relate to the intangible development area.
Section 1.482-7(e) defines anticipated benefits as additional
income generated or costs saved by the use of covered intangibles. The
pool of benefits may also be adjusted in order to properly reflect
benefits that relate to the intangible development area.
Section 1.482-7(f) governs cost allocations by the district
director in order to make a controlled participant's share of costs
equal to its share of reasonably anticipated benefits. Anticipated
benefits of uncontrolled participants will be excluded from anticipated
benefits in calculating the benefits shares of controlled participants.
A share of reasonably anticipated benefits will be determined using the
most reliable estimate of benefits. This rule echoes the best method
rule for determining the most reliable measure of an arm's length
result under Sec. 1.482-1(c).
The reliability of an estimate of benefits principally depends on
two factors: the reliability of the basis for measuring benefits used
and the reliability of the projections used. The cost-to-operating-
income ratio used in the proposed regulations to check the
reasonableness of an effort to share costs in proportion to anticipated
benefits has not been included in the final regulations. Rather, the
final regulations provide that an allocation of costs or income may be
made if the taxpayer did not use the most reliable estimate of
benefits, which depends on the facts and circumstances of each case.
Section 1.482-7(f)(3)(ii) provides that in estimating a controlled
participant's share of benefits, the most reliable basis for measuring
anticipated benefits must be used, taking into account the factors set
forth in Sec. 1.482-1(c)(2)(ii). The measurement basis used must be
consistent for all controlled participants. The regulations provide
that benefits may be measured directly or indirectly. In addition,
regardless of whether a direct or indirect basis of measurement is
employed, it may be necessary to make adjustments to account for
material differences in the activities that controlled participants
perform in connection with exploitation of covered intangibles, such as
between wholesale and retail distribution.
Section 1.482-7(f)(3)(iii) describes the scope of various indirect
bases for measuring benefits, such as units, sales, and operating
profit. Indirect bases other than those enumerated may be employed as
long as they bear a relationship to benefits.
Section 1.482-7(f)(3)(iv) discusses projections used to estimate
benefits. Projections required for this purpose generally include a
determination of the time period between the inception of the research
and development and the receipt of benefits, a projection of the time
over which benefits will be received, and a projection of the benefits
anticipated for each year in which it is anticipated that the
intangible will generate benefits. However, the regulations note that
in certain circumstances, current annual benefit shares may be used in
lieu of projections.
Section 1.482-7(f)(3)(iv)(B) states that a significant divergence
between projected and actual benefit shares may indicate that the
projections were not reliable. A significant divergence is defined as
divergence in excess of 20% between projected and actual benefit
shares. If there is a significant divergence, which is not due to an
unforeseeable event, then the district director may use actual benefits
as the most reliable basis for measuring benefits. Conversely, no
allocation will be made based on a divergence that is not considered
significant as long as the estimate is made using the most reliable
basis for measuring benefits.
For purposes of the 20% test, all non-U.S. controlled participants
are treated as a single controlled participant in order that a
divergence by a foreign controlled participant with a very small share
of the total costs will not necessarily trigger an allocation (section
1.482-7(f)(3)(iv)(D), Example 8, illustrates this rule). Section 1.482-
7(f)(3)(iv)(B) and (C) notes that adjustments among foreign controlled
participants will only be made if the adjustment will have a
substantial U.S. tax impact, for example, under subpart F.
Section 1.482-7(f)(4) states that cost allocations must be
reflected for tax purposes in the year in which costs were incurred.
This reflects a change from the rule in the 1992 proposed regulations,
which stated that cost allocations would be included in income in the
taxable year under review, even if the costs to be allocated were
incurred in a prior taxable year. The purpose of the change was to
match up cost adjustments with the year to which they relate in
accordance with the clear reflection of income principle of section
482.
Section 1.482-7(g) provides buy-in and buy-out rules that are
similar to the rules in the proposed regulations. However, some of the
clarifications suggested by commenters have been incorporated in these
rules. A ``substantially disproportionate'' cost-to-operating-income
ratio will no longer trigger an adjustment to income under these rules.
However, if, after any cost allocations authorized by Sec. 1.482-
7(a)(2), the economic substance of the arrangement is inconsistent with
the terms of the arrangement over a period of years (for example,
through a consistent pattern of one controlled participant bearing an
inappropriately high or low share of the cost of intangible
development), then the district director may impute an agreement
consistent with the course of conduct. In that case, one or more of the
participants would be deemed to own a greater interest in covered
intangibles than provided under the arrangement, and must receive buy-
in payments from the other participants.
The rules do not provide safe harbor methods for valuing
intangibles, but rely on the intangible valuation rules of Secs. 1.482-
1 and 1.482-4 through 1.482-6. To the extent some participants furnish
a disproportionately greater amount of existing intangibles to the
arrangement, they must be compensated by royalties by the participants
who furnish a disproportionately lesser amount of existing intangibles
to the arrangement. Buy-in payments owed are netted against payments
owing, and only the net payment is treated as a royalty. No implication
is intended that netting of cross royalties is permissible outside of
the qualified cost sharing safe harbor rules.
Section 1.482-7(h) provides rules regarding the character of
payments made pursuant to a qualified cost sharing arrangement. Cost
sharing payments received are generally treated as reductions of
research and development expense. A net approach is applied to foster
simplicity and generally preserve the character of items actually
incurred by a participant to the extent not reimbursed. In addition,
for purposes of the research credit determined under section 41, cost
sharing payments among controlled participants will be treated as
provided for intra-group transactions in Sec. 1.41-8(e). Finally, any
payment that in substance constitutes a cost sharing payment will be
treated as such, regardless of its characterization under foreign law.
This rule is intended to enable foreign entities to participate in cost
sharing arrangements with U.S. controlled participants even if foreign
law does not recognize cost sharing. This rule obviated the main reason
for the subgroup rules which, as noted, have accordingly been
eliminated.
[[Page 65557]]
Section 1.482-7(i) requires that controlled participants must use a
consistent accounting method for measuring costs and benefits, and must
translate foreign currencies on a consistent basis. To the extent that
the accounting method materially differs from U.S. generally accepted
accounting principles, any such material differences must be
documented, as provided in Sec. 1.482-7(j)(2)(iv).
Section 1.482-7(j) provides simplified recordkeeping and reporting
requirements. It is anticipated that many of the background documents
necessary for purposes of this section will be kept pursuant to section
6662(e) and the regulations thereunder.
Section 1.482-7(k) provides that this regulation is effective for
taxable years beginning on or after January 1, 1996.
Section 1.482-7(l) allows a one-year transition period for
taxpayers to conform their cost sharing arrangements with the
requirements of the final regulations. A longer period was not
considered necessary, given the increased flexibility and the reduced
number of administrative requirements of the final regulations.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to
these regulations, and, therefore, a Regulatory Flexibility Analysis is
not required. Pursuant to section 7805(f) of the Internal Revenue Code,
the notice of proposed rulemaking preceding these regulations was
submitted to the Small Business Administration for comment on its
impact on small business.
Drafting Information
The principal author of these regulations is Lisa Sams, Office of
Associate Chief Counsel (International), IRS. However, other personnel
from the IRS and Treasury Department participated in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 301
Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income
taxes, Penalties, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1, 301 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority for part 1 is amended by adding an entry
for section 1.482-7 to read as follows:
Authority: 26 U.S.C. 7805. * * *
Section 1.482-7 is also issued under 26 U.S.C. 482. * * *
Par. 2. Section 1.482-0 is amended by:
1. Removing the entry for Sec. 1.482-7T.
2. Adding the entry for Sec. 1.482-7 to read as follows:
Sec. 1.482-0 Outline of regulations under 482.
* * * * *
Sec. 1.482-7 Sharing of costs.
(a) In general.
(1) Scope and application of the rules in this section.
(2) Limitation on allocations.
(3) Cross references.
(b) Qualified cost sharing arrangement.
(c) Participant.
(1) In general.
(2) Active conduct of a trade or business.
(i) Trade or business.
(ii) Active conduct.
(iii) Examples.
(3) Use of covered intangibles in the active conduct of a trade
or business.
(i) In general.
(ii) Example.
(4) Treatment of a controlled taxpayer that is not a controlled
participant.
(i) In general.
(ii) Example.
(5) Treatment of consolidated group.
(d(d) Costs.
(1) Intangible development costs.
(2) Examples.
(e) Anticipated benefits.
(1) Benefits.
(2) Reasonably anticipated benefits.
(f) Cost allocations.
(1) In general.
(2) Share of intangible development costs.
(i) In general.
(ii) Example.
(3) Share of reasonably anticipated benefits.
(i) In general.
(ii) Measure of benefits.
(iii) Indirect bases for measuring anticipated benefits.
(A) Units used, produced or sold.
(B) Sales.
(C) Operating profit.
(D) Other bases for measuring anticipated benefits.
(E) Examples.
(iv) Projections used to estimate anticipated benefits.
(A) In general.
(B) Unreliable projections.
(C) Foreign-to-foreign adjustments.
(D) Examples.
(4) Timing of allocations.
(g) Allocations of income, deductions or other tax items to
reflect transfers of intangibles (buy-in).
(1) In general.
(2) Pre-existing intangibles.
(3) New controlled participant.
(4) Controlled participant relinquishes interests.
(5) Conduct inconsistent with the terms of a cost sharing
arrangement.
(6)Failure to assign interests under a qualified cost sharing
arrangement.
(7) Form of consideration.
(i) Lump sum payments.
(ii) Installment payments.
(iii) Royalties.
(8) Examples.e
(h) Character of payments made pursuant to a qualified cost
sharing arrangement.
(1) In general.
(2) Examples.
(i) Accounting requirements.
(j) Administrative requirements.
(1) In general.
(2) Documentation.
(3) Reporting requirements.
(k) Effective date.
(l) Transition rule.
* * * * *
Par. 3. Section 1.482-7 is added to read as follows:
Sec. 1.482-7 Sharing of costs.
(a) In general--(1) Scope and application of the rules in this
section. A cost sharing arrangement is an agreement under which the
parties agree to share the costs of development of one or more
intangibles in proportion to their shares of reasonably anticipated
benefits from their individual exploitation of the interests in the
intangibles assigned to them under the arrangement. A taxpayer may
claim that a cost sharing arrangement is a qualified cost sharing
arrangement only if the agreement meets the requirements of paragraph
(b) of this section. Consistent with the rules of Sec. 1.482-
1(d)(3)(ii)(B) (Identifying contractual terms), the district director
may apply the rules of this section to any arrangement that in
substance constitutes a cost sharing arrangement, notwithstanding a
failure to comply with any requirement of this section. A qualified
cost sharing arrangement, or an arrangement to which the district
director applies the rules of this section, will not be treated as a
partnership to which the rules of subchapter K apply. See
Sec. 301.7701-3(e) of this chapter. Furthermore, a participant that is
a foreign corporation or nonresident alien individual will not be
treated as engaged in trade or business within the United States solely
[[Page 65558]]
by reason of its participation in such an arrangement. See generally
Sec. 1.864-2(a).
(2) Limitation on allocations. The district director shall not make
allocations with respect to a qualified cost sharing arrangement except
to the extent necessary to make each controlled participant's share of
the costs (as determined under paragraph (d) of this section) of
intangible development under the qualified cost sharing arrangement
equal to its share of reasonably anticipated benefits attributable to
such development, under the rules of this section. If a controlled
taxpayer acquires an interest in intangible property from another
controlled taxpayer (other than in consideration for bearing a share of
the costs of the intangible's development), then the district director
may make appropriate allocations to reflect an arm's length
consideration for the acquisition of the interest in such intangible
under the rules of Secs. 1.482-1 and 1.482-4 through 1.482-6. See
paragraph (g) of this section. An interest in an intangible includes
any commercially transferable interest, the benefits of which are
susceptible of valuation. See Sec. 1.482-4(b) for the definition of an
intangible.
(3) Cross references. Paragraph (c) of this section defines
participant. Paragraph (d) of this section defines the costs of
intangible development. Paragraph (e) of this section defines the
anticipated benefits of intangible development. Paragraph (f) of this
section provides rules governing cost allocations. Paragraph (g) of
this section provides rules governing transfers of intangibles other
than in consideration for bearing a share of the costs of the
intangible's development. Rules governing the character of payments
made pursuant to a qualified cost sharing arrangement are provided in
paragraph (h) of this section. Paragraph (i) of this section provides
accounting requirements. Paragraph (j) of this section provides
administrative requirements. Paragraph (k) of this section provides an
effective date. Paragraph (l) provides a transition rule.
(b) Qualified cost sharing arrangement. A qualified cost sharing
arrangement must--
(1) Include two or more participants;
(2) Provide a method to calculate each controlled participant's
share of intangible development costs, based on factors that can
reasonably be expected to reflect that participant's share of
anticipated benefits;
(3) Provide for adjustment to the controlled participants' shares
of intangible development costs to account for changes in economic
conditions, the business operations and practices of the participants,
and the ongoing development of intangibles under the arrangement; and
(4) Be recorded in a document that is contemporaneous with the
formation (and any revision) of the cost sharing arrangement and that
includes--
(i) A list of the arrangement's participants, and any other member
of the controlled group that will benefit from the use of intangibles
developed under the cost sharing arrangement;
(ii) The information described in paragraphs (b)(2) and (b)(3) of
this section;
(iii) A description of the scope of the research and development to
be undertaken, including the intangible or class of intangibles
intended to be developed;
(iv) A description of each participant's interest in any covered
intangibles. A covered intangible is any intangible property that is
developed as a result of the research and development undertaken under
the cost sharing arrangement (intangible development area);
(v) The duration of the arrangement; and
(vi) The conditions under which the arrangement may be modified or
terminated and the consequences of such modification or termination,
such as the interest that each participant will receive in any covered
intangibles.
(c) Participant--(1) In general. For purposes of this section, a
participant is a controlled taxpayer that meets the requirements of
this paragraph (c)(1) (controlled participant) or an uncontrolled
taxpayer that is a party to the cost sharing arrangement (uncontrolled
participant). See Sec. 1.482-1(i)(5) for the definitions of controlled
and uncontrolled taxpayers. A controlled taxpayer may be a controlled
participant only if it--
(i) Uses or reasonably expects to use covered intangibles in the
active conduct of a trade or business, under the rules of paragraphs
(c)(2) and (c)(3) of this section;
(ii) Substantially complies with the accounting requirements
described in paragraph (i) of this section; and
(iii) Substantially complies with the administrative requirements
described in paragraph (j) of this section.
(2) Active conduct of a trade or business--(i) Trade or business.
The rules of Sec. 1.367(a)-2T(b)(2) apply in determining whether the
activities of a controlled taxpayer constitute a trade or business. For
this purpose, the term controlled taxpayer must be substituted for the
term foreign corporation.
(ii) Active conduct. In general, a controlled taxpayer actively
conducts a trade or business only if it carries out substantial
managerial and operational activities. For purposes only of this
paragraph (c)(2), activities carried out on behalf of a controlled
taxpayer by another person may be attributed to the controlled
taxpayer, but only if the controlled taxpayer exercises substantial
managerial and operational control over those activities.
(iii) Examples. The following examples illustrate this paragraph
(c)(2):
Example 1. Foreign Parent (FP) enters into a cost sharing
arrangement with its U.S. Subsidiary (USS) to develop a cheaper
process for manufacturing widgets. USS is to receive the right to
exploit the intangible to make widgets in North America, and FP is
to receive the right to exploit the intangible to make widgets in
the rest of the world. However, USS does not manufacture widgets;
rather, USS acts as a distributor for FP's widgets in North America.
Because USS is simply a distributor of FP's widgets, USS does not
use or reasonably expect to use the manufacturing intangible in the
active conduct of its trade or business, and thus USS is not a
controlled participant.
Example 2. The facts are the same as in Example 1, except that
USS contracts to have widgets it sells in North America made by a
related manufacturer (that is not a controlled participant) using
USS' cheaper manufacturing process. USS purchases all the
manufacturing inputs, retains ownership of the work in process as
well as the finished product, and bears the risk of loss at all
times in connection with the operation. USS compensates the
manufacturer for the manufacturing functions it performs and
receives substantially all of the intangible value attributable to
the cheaper manufacturing process. USS exercises substantial
managerial and operational control over the manufacturer to ensure
USS's requirements are satisfied concerning the timing, quantity,
and quality of the widgets produced. USS uses the manufacturing
intangible in the active conduct of its trade or business, and thus
USS is a controlled participant.
(3) Use of covered intangibles in the active conduct of a trade or
business--(i) In general. A covered intangible will not be considered
to be used, nor will the controlled taxpayer be considered to
reasonably expect to use it, in the active conduct of the controlled
taxpayer's trade or business if a principal purpose for participating
in the arrangement is to obtain the intangible for transfer or license
to a controlled or uncontrolled taxpayer.
(ii) Example. The following example illustrates the absence of such
a principal purpose:
Example. Controlled corporations A, B, and C enter into a
qualified cost sharing arrangement for the purpose of developing a
new technology. Costs are shared equally
[[Page 65559]]
among the three controlled taxpayers. A, B, and C have the exclusive
rights to manufacture and sell products based on the new technology
in North America, South America, and Europe, respectively. When the
new technology is developed, C expects to use it to manufacture and
sell products in most of Europe. However, for sound business
reasons, C expects to license to an unrelated manufacturer the right
to use the new technology to manufacture and sell products within a
particular European country owing to its relative remoteness and
small size. In these circumstances, C has not entered into the
arrangement with a principal purpose of obtaining covered
intangibles for transfer or license to controlled or uncontrolled
taxpayers, because the purpose of licensing the technology to the
unrelated manufacturer is relatively insignificant in comparison to
the overall purpose of exploiting the European market.
(4) Treatment of a controlled taxpayer that is not a controlled
participant--(i) In general. If a controlled taxpayer that is not a
controlled participant (within the meaning of this paragraph (c))
provides assistance in relation to the research and development
undertaken in the intangible development area, it must receive
consideration from the controlled participants under the rules of
Sec. 1.482-4(f)(3)(iii) (Allocations with respect to assistance
provided to the owner). For purposes of paragraph (d) of this section,
such consideration is treated as an operating expense and each
controlled participant must be treated as incurring a share of such
consideration equal to its share of reasonably anticipated benefits (as
defined in paragraph (f)(3) of this section).
(ii) Example. The following example illustrates this paragraph
(c)(4):
Example. (i) U.S. Parent (USP), one foreign subsidiary (FS), and
a second foreign subsidiary constituting the group's research arm
(R+D) enter into a cost sharing agreement to develop manufacturing
intangibles for a new product line A. USP and FS are assigned the
exclusive rights to exploit the intangibles respectively in the
United States and Europe, where each presently manufactures and
sells various existing product lines. R+D, whose activity consists
solely in carrying out research for the group, is assigned the
rights to exploit the new technology in Asia, where no group member
presently operates, but which is reliably projected to be a major
market for product A. R+D will license the Asian rights to an
unrelated third party. It is reliably projected that the shares of
reasonably anticipated benefits of USP and FS (i.e., not taking R+D
into account) will be 66 \2/3\% and 33 \1/3\%, respectively. The
parties' agreement provides that USP and FS will reimburse 40% and
20%, respectively, of the intangible development costs incurred by
R+D with respect to the new intangible.
(ii) R+D does not qualify as a controlled participant within the
meaning of paragraph (c) of this section. Therefore, R+D is treated
as a service provider for purposes of this section and must receive
arm's length consideration for the assistance it is deemed to
provide to USP and FS, under the rules of Sec. 1.482-4(f)(3)(iii).
Such consideration must be treated as intangible development costs
incurred by USP and FS in proportion to their shares of reasonably
anticipated benefits (i.e., 66 \2/3\% and 33 \1/3\%, respectively).
R+D will not be considered to bear any share of the intangible
development costs under the arrangement.
(iii) The Asian rights nominally assigned to R+D under the
agreement must be treated as being held by USP and FS in accordance
with their shares of the intangible development costs (i.e., 66 \2/
3\% and 33 \1/3\%, respectively). See paragraph (g)(6) of this
section. Thus, since under the cost sharing agreement the Asian
rights are owned by R+D, the district director may make allocations
to reflect an arm's length consideration owed by R+D to USP and FS
for these rights under the rules of Secs. 1.482-1 and 1.482-4
through 1.482-6.
(5) Treatment of consolidated group. For purposes of this section,
all members of the same affiliated group (within the meaning of section
1504(a)) that join in the filing of a consolidated return for the
taxable year under section 1501 shall be treated as one taxpayer.
(d) Costs--(1) Intangible development costs. For purposes of this
section, a controlled participant's costs of developing intangibles for
a taxable year mean all of the costs incurred by that participant
related to the intangible development area, plus all of the cost
sharing payments it makes to other controlled and uncontrolled
participants, minus all of the cost sharing payments it receives from
other controlled and uncontrolled participants. Costs incurred related
to the intangible development area consist of the following items:
operating expenses as defined in Sec. 1.482-5(d)(3), other than
depreciation or amortization expense, plus (to the extent not included
in such operating expenses, as defined in Sec. 1.482-5(d)(3)) the
charge for the use of any tangible property made available to the
qualified cost sharing arrangement. If tangible property is made
available to the qualified cost sharing arrangement by a controlled
participant, the determination of the appropriate charge will be
governed by the rules of Sec. 1.482-2(c) (Use of tangible property).
Intangible development costs do not include the consideration for the
use of any intangible property made available to the qualified cost
sharing arrangement. See paragraph (g)(2) of this section. If a
particular cost contributes to the intangible development area and
other areas or other business activities, the cost must be allocated
between the intangible development area and the other areas or business
activities on a reasonable basis. In such a case, it is necessary to
estimate the total benefits attributable to the cost incurred. The
share of such cost allocated to the intangible development area must
correspond to covered intangibles' share of the total benefits. Costs
that do not contribute to the intangible development area are not taken
into account.
(2) Examples. The following examples illustrate this paragraph (d):
Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a qualified cost sharing arrangement to develop a better
mousetrap. USS and FP share the costs of FP's research and
development facility that will be exclusively dedicated to this
research, the salaries of the researchers, and reasonable overhead
costs attributable to the project. They also share the cost of a
conference facility that is at the disposal of the senior executive
management of each company but does not contribute to the research
and development activities in any measurable way. In this case, the
cost of the conference facility must be excluded from the amount of
intangible development costs.
Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a qualified cost sharing arrangement to develop a new device.
USP and FS share the costs of a research and development facility,
the salaries of researchers, and reasonable overhead costs
attributable to the project. USP also incurs costs related to field
testing of the device, but does not include them in the amount of
intangible development costs of the cost sharing arrangement. The
district director may determine that the field testing costs are
intangible development costs that must be shared.
(e) Anticipated benefits--(1) Benefits. Benefits are additional
income generated or costs saved by the use of covered intangibles.
(2) Reasonably anticipated benefits. For purposes of this section,
a controlled participant's reasonably anticipated benefits are the
aggregate benefits that it reasonably anticipates that it will derive
from covered intangibles.
(f) Cost allocations--(1) In general. For purposes of determining
whether a cost allocation authorized by paragraph (a)(2) of this
section is appropriate for a taxable year, a controlled participant's
share of intangible development costs for the taxable year under a
qualified cost sharing arrangement must be compared to its share of
reasonably anticipated benefits under the arrangement. A controlled
participant's share of intangible development costs is determined under
paragraph (f)(2) of this section. A controlled participant's share of
reasonably anticipated benefits under the arrangement is determined
under paragraph (f)(3) of this section. In
[[Page 65560]]
determining whether benefits were reasonably anticipated, it may be
appropriate to compare actual benefits to anticipated benefits, as
described in paragraph (f)(3)(iv) of this section.
(2) Share of intangible development costs--(i) In general. A
controlled participant's share of intangible development costs for a
taxable year is equal to its intangible development costs for the
taxable year (as defined in paragraph (d) of this section), divided by
the sum of the intangible development costs for the taxable year (as
defined in paragraph (d) of this section) of all the controlled
participants.
(ii) Example. The following example illustrates this paragraph
(f)(2):
Example. (i) U.S. Parent (USP), Foreign Subsidiary (FS), and
Unrelated Third Party (UTP) enter into a cost sharing arrangement to
develop new audio technology. In the first year of the arrangement,
the controlled participants incur $2,250,000 in the intangible
development area, all of which is incurred directly by USP. In the
first year, UTP makes a $250,000 cost sharing payment to USP, and FS
makes a $800,000 cost sharing payment to USP, under the terms of the
arrangement. For that year, the intangible development costs borne
by USP are $1,200,000 (its $2,250,000 intangible development costs
directly incurred, minus the cost sharing payments it receives of
$250,000 from UTP and $800,000 from FS); the intangible development
costs borne by FS are $800,000 (its cost sharing payment); and the
intangible development costs borne by all of the controlled
participants are $2,000,000 (the sum of the intangible development
costs borne by USP and FS of $1,200,000 and $800,000, respectively).
Thus, for the first year, USP's share of intangible development
costs is 60% ($1,200,000 divided by $2,000,000), and FS's share of
intangible development costs is 40% ($800,000 divided by
$2,000,000).
(ii) For purposes of determining whether a cost allocation
authorized by paragraph Sec. 1.482-7(a)(2) is appropriate for the
first year, the district director must compare USP's and FS's shares
of intangible development costs for that year to their shares of
reasonably anticipated benefits. See paragraph (f)(3) of this
section.
(3) Share of reasonably anticipated benefits--(i) In general. A
controlled participant's share of reasonably anticipated benefits under
a qualified cost sharing arrangement is equal to its reasonably
anticipated benefits (as defined in paragraph (e)(2) of this section),
divided by the sum of the reasonably anticipated benefits (as defined
in paragraph (e)(2) of this section) of all the controlled
participants. The anticipated benefits of an uncontrolled participant
will not be included for purposes of determining each controlled
participant's share of anticipated benefits. A controlled participant's
share of reasonably anticipated benefits will be determined using the
most reliable estimate of reasonably anticipated benefits. In
determining which of two or more available estimates is most reliable,
the quality of the data and assumptions used in the analysis must be
taken into account, consistent with Sec. 1.482-1(c)(2)(ii) (Data and
assumptions). Thus, the reliability of an estimate will depend largely
on the completeness and accuracy of the data, the soundness of the
assumptions, and the relative effects of particular deficiencies in
data or assumptions on different estimates. If two estimates are
equally reliable, no adjustment should be made based on differences in
the results. The following factors will be particularly relevant in
determining the reliability of an estimate of anticipated benefits--
(A) The reliability of the basis used for measuring benefits, as
described in paragraph (f)(3)(ii) of this section; and
(B) The reliability of the projections used to estimate benefits,
as described in paragraph (f)(3)(iv) of this section.
(ii) Measure of benefits. In order to estimate a controlled
participant's share of anticipated benefits from covered intangibles,
the amount of benefits that each of the controlled participants is
reasonably anticipated to derive from covered intangibles must be
measured on a basis that is consistent for all such participants. See
paragraph (f)(3)(iii)(E), Example 8, of this section. Anticipated
benefits are measured either on a direct basis, by reference to
estimated additional income to be generated or costs to be saved by the
use of covered intangibles, or on an indirect basis, by reference to
certain measurements that reasonably can be assumed to be related to
income generated or costs saved. Such indirect bases of measurement of
anticipated benefits are described in paragraph (f)(3)(iii) of this
section. A controlled participant's anticipated benefits must be
measured on the most reliable basis, whether direct or indirect. In
determining which of two bases of measurement of reasonably anticipated
benefits is most reliable, the factors set forth in Sec. 1.482-
1(c)(2)(ii) (Data and assumptions) must be taken into account. It
normally will be expected that the basis that provided the most
reliable estimate for a particular year will continue to provide the
most reliable estimate in subsequent years, absent a material change in
the factors that affect the reliability of the estimate. Regardless of
whether a direct or indirect basis of measurement is used, adjustments
may be required to account for material differences in the activities
that controlled participants undertake to exploit their interests in
covered intangibles. See Example 6 of paragraph (f)(3)(iii)(E) of this
section.
(iii) Indirect bases for measuring anticipated benefits. Indirect
bases for measuring anticipated benefits from participation in a
qualified cost sharing arrangement include the following:
(A) Units used, produced or sold. Units of items used, produced or
sold by each controlled participant in the business activities in which
covered intangibles are exploited may be used as an indirect basis for
measuring its anticipated benefits. This basis of measurement will be
more reliable to the extent that each controlled participant is
expected to have a similar increase in net profit or decrease in net
loss attributable to the covered intangibles per unit of the item or
items used, produced or sold. This circumstance is most likely to arise
when the covered intangibles are exploited by the controlled
participants in the use, production or sale of substantially uniform
items under similar economic conditions.
(B) Sales. Sales by each controlled participant in the business
activities in which covered intangibles are exploited may be used as an
indirect basis for measuring its anticipated benefits. This basis of
measurement will be more reliable to the extent that each controlled
participant is expected to have a similar increase in net profit or
decrease in net loss attributable to covered intangibles per dollar of
sales. This circumstance is most likely to arise if the costs of
exploiting covered intangibles are not substantial relative to the
revenues generated, or if the principal effect of using covered
intangibles is to increase the controlled participants' revenues (e.g.,
through a price premium on the products they sell) without affecting
their costs substantially. Sales by each controlled participant are
unlikely to provide a reliable basis for measuring benefits unless each
controlled participant operates at the same market level (e.g.,
manufacturing, distribution, etc.).
(C) Operating profit. Operating profit of each controlled
participant from the activities in which covered intangibles are
exploited may be used as an indirect basis for measuring its
anticipated benefits. This basis of measurement will be more reliable
to the extent that such profit is largely attributable to the use of
covered intangibles, or if the share of profits attributable to the use
of covered intangibles is expected to be similar for each controlled
participant. This circumstance is most likely to arise when covered
intangibles are integral to the activity that generates the profit and
[[Page 65561]]
the activity could not be carried on or would generate little profit
without use of those intangibles.
(D) Other bases for measuring anticipated benefits. Other bases for
measuring anticipated benefits may, in some circumstances, be
appropriate, but only to the extent that there is expected to be a
reasonably identifiable relationship between the basis of measurement
used and additional income generated or costs saved by the use of
covered intangibles. For example, a division of costs based on employee
compensation would be considered unreliable unless there were a
relationship between the amount of compensation and the expected income
of the controlled participants from the use of covered intangibles.
(E) Examples. The following examples illustrate this paragraph
(f)(3)(iii):
Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) both
produce a feedstock for the manufacture of various high-performance
plastic products. Producing the feedstock requires large amounts of
electricity, which accounts for a significant portion of its
production cost. FP and USS enter into a cost sharing arrangement to
develop a new process that will reduce the amount of electricity
required to produce a unit of the feedstock. FP and USS currently
both incur an electricity cost of X% of its other production costs
and rates for each are expected to remain similar in the future. How
much the new process, if it is successful, will reduce the amount of
electricity required to produce a unit of the feedstock is
uncertain, but it will be about the same amount for both companies.
Therefore, the cost savings each company is expected to achieve
after implementing the new process are similar relative to the total
amount of the feedstock produced. Under the cost sharing arrangement
FP and USS divide the costs of developing the new process based on
the units of the feedstock each is anticipated to produce in the
future. In this case, units produced is the most reliable basis for
measuring benefits and dividing the intangible development costs
because each participant is expected to have a similar decrease in
costs per unit of the feedstock produced.
Example 2. The facts are the same as in Example 1, except that
USS pays X% of its other production costs for electricity while FP
pays 2X% of its other production costs. In this case, units produced
is not the most reliable basis for measuring benefits and dividing
the intangible development costs because the participants do not
expect to have a similar decrease in costs per unit of the feedstock
produced. The district director determines that the most reliable
measure of benefit shares may be based on units of the feedstock
produced if FP's units are weighted relative to USS' units by a
factor of 2. This reflects the fact that FP pays twice as much as
USS as a percentage of its other production costs for electricity
and, therefore, FP's savings per unit of the feedstock would be
twice USS's savings from any new process eventually developed.
Example 3. The facts are the same as in Example 2, except that
to supply the particular needs of the U.S. market USS manufactures
the feedstock with somewhat different properties than FP's
feedstock. This requires USS to employ a somewhat different
production process than does FP. Because of this difference, it will
be more costly for USS to adopt any new process that may be
developed under the cost sharing agreement. In this case, units
produced is not the most reliable basis for measuring benefit
shares. In order to reliably determine benefit shares, the district
director offsets the reasonably anticipated costs of adopting the
new process against the reasonably anticipated total savings in
electricity costs.
Example 4. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a cost sharing arrangement to develop new anesthetic drugs. USP
obtains the right to use any resulting patent in the U.S. market,
and FS obtains the right to use the patent in the European market.
USP and FS divide costs on the basis of anticipated operating profit
from each patent under development. USP anticipates that it will
receive a much higher profit than FS per unit sold because drug
prices are uncontrolled in the U.S., whereas drug prices are
regulated in many European countries. In this case, the controlled
taxpayers' basis for measuring benefits is the most reliable.
Example 5. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)
both manufacture and sell fertilizers. They enter into a cost
sharing arrangement to develop a new pellet form of a common
agricultural fertilizer that is currently available only in powder
form. Under the cost sharing arrangement, USS obtains the rights to
produce and sell the new form of fertilizer for the U.S. market
while FP obtains the rights to produce and sell the fertilizer for
the rest of the world. The costs of developing the new form of
fertilizer are divided on the basis of the anticipated sales of
fertilizer in the participants' respective markets.
(ii) If the research and development is successful the pellet
form will deliver the fertilizer more efficiently to crops and less
fertilizer will be required to achieve the same effect on crop
growth. The pellet form of fertilizer can be expected to sell at a
price premium over the powder form of fertilizer based on the
savings in the amount of fertilizer that needs to be used. If the
research and development is successful, the costs of producing
pellet fertilizer are expected to be approximately the same as the
costs of producing powder fertilizer and the same for both FP and
USS. Both FP and USS operate at approximately the same market
levels, selling their fertilizers largely to independent
distributors.
(iii) In this case, the controlled taxpayers' basis for
measuring benefits is the most reliable.
Example 6. The facts are the same as in Example 5, except that
FP distributes its fertilizers directly while USS sells to
independent distributors. In this case, sales of USS and FP are not
the most reliable basis for measuring benefits unless adjustments
are made to account for the difference in market levels at which the
sales occur.
Example 7. Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a cost sharing arrangement to develop materials that will be
used to train all new entry-level employees. FP and USS determine
that the new materials will save approximately ten hours of training
time per employee. Because their entry-level employees are paid on
differing wage scales, FP and USS decide that they should not divide
costs based on the number of entry-level employees hired by each.
Rather, they divide costs based on compensation paid to the entry-
level employees hired by each. In this case, the basis used for
measuring benefits is the most reliable because there is a direct
relationship between compensation paid to new entry-level employees
and costs saved by FP and USS from the use of the new training
materials.
Example 8. U.S. Parent (USP), Foreign Subsidiary 1 (FS1) and
Foreign Subsidiary 2 (FS2) enter into a cost sharing arrangement to
develop computer software that each will market and install on
customers' computer systems. The participants divide costs on the
basis of projected sales by USP, FS1, and FS2 of the software in
their respective geographic areas. However, FS1 plans for sound
business reasons not only to sell but also to license the software,
and FS1's licensing income (which is a percentage of the licensees'
sales) is not counted in the projected benefits. In this case, the
basis used for measuring the benefits of each participant is not the
most reliable because all of the benefits received by participants
are not taken into account. In order to reliably determine benefit
shares, FS1's projected benefits from licensing must be included in
the measurement on a basis that is the same as that used to measure
its own and the other participants' projected benefits from sales
(e.g., all participants might measure their benefits on the basis of
operating profit).
(iv) Projections used to estimate anticipated benefits--(A) In
general. The reliability of an estimate of anticipated benefits also
depends upon the reliability of projections used in making the
estimate. Projections required for this purpose generally include a
determination of the time period between the inception of the research
and development and the receipt of benefits, a projection of the time
over which benefits will be received, and a projection of the benefits
anticipated for each year in which it is anticipated that the
intangible will generate benefits. A projection of the relevant basis
for measuring anticipated benefits may require a projection of the
factors that underlie it. For example, a projection of operating
profits may require a projection of sales, cost of sales, operating
expenses, and other factors that affect operating profits. If it is
anticipated that there will be significant variation among controlled
participants in the timing of their receipt of benefits, and
consequently
[[Page 65562]]
benefit shares are expected to vary significantly over the years in
which benefits will be received, it may be necessary to use the present
discounted value of the projected benefits to reliably determine each
controlled participant's share of those benefits. If it is not
anticipated that benefit shares will significantly change over time,
current annual benefit shares may provide a reliable projection of
anticipated benefit shares. This circumstance is most likely to occur
when the cost sharing arrangement is a long-term arrangement, the
arrangement covers a wide variety of intangibles, the composition of
the covered intangibles is unlikely to change, the covered intangibles
are unlikely to generate unusual profits, and each controlled
participant's share of the market is stable.
(B) Unreliable projections. A significant divergence between
projected benefit shares and actual benefit shares may indicate that
the projections were not reliable. In such a case, the district
director may use actual benefits as the most reliable measure of
anticipated benefits. If benefits are projected over a period of years,
and the projections for initial years of the period prove to be
unreliable, this may indicate that the projections for the remaining
years of the period are also unreliable and thus should be adjusted.
Projections will not be considered unreliable based on a divergence
between a controlled participant's projected benefit share and actual
benefit share if the amount of such divergence for every controlled
participant is less than or equal to 20% of the participant's projected
benefit share. Further, the district director will not make an
allocation based on such divergence if the difference is due to an
extraordinary event, beyond the control of the participants, that could
not reasonably have been anticipated at the time that costs were
shared. For purposes of this paragraph, all controlled participants
that are not U.S. persons will be treated as a single controlled
participant. Therefore, an adjustment based on an unreliable projection
will be made to the cost shares of foreign controlled participants only
if there is a matching adjustment to the cost shares of controlled
participants that are U.S. persons. Nothing in this paragraph
(f)(3)(iv)(B) will prevent the district director from making an
allocation if the taxpayer did not use the most reliable basis for
measuring anticipated benefits. For example, if the taxpayer measures
anticipated benefits based on units sold, and the district director
determines that another basis is more reliable for measuring
anticipated benefits, then the fact that actual units sold were within
20% of the projected unit sales will not preclude an allocation under
this section.
(C) Foreign-to-foreign adjustments. Notwithstanding the limitations
on adjustments provided in paragraph (f)(3)(iv)(B) of this section,
adjustments to cost shares based on an unreliable projection also may
be made solely among foreign controlled participants if the variation
between actual and projected benefits has the effect of substantially
reducing U.S. tax.
(D) Examples. The following examples illustrate this paragraph
(f)(3)(iv):
Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a cost sharing arrangement to develop a new car model.
The participants plan to spend four years developing the new model
and four years producing and selling the new model. USS and FP
project total sales of $4 billion and $2 billion, respectively, over
the planned four years of exploitation of the new model. Cost shares
are divided for each year based on projected total sales. Therefore,
USS bears 66\2/3\% of each year's intangible development costs and
FP bears 33\1/3\% of such costs.
(ii) USS typically begins producing and selling new car models a
year after FP begins producing and selling new car models. The
district director determines that in order to reflect USS' one-year
lag in introducing new car models, a more reliable projection of
each participant's share of benefits would be based on a projection
of all four years of sales for each participant, discounted to
present value.
Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a cost sharing arrangement to develop new and improved
household cleaning products. Both participants have sold household
cleaning products for many years and have stable market shares. The
products under development are unlikely to produce unusual profits
for either participant. The participants divide costs on the basis
of each participant's current sales of household cleaning products.
In this case, the participants' future benefit shares are reliably
projected by current sales of cleaning products.
Example 3. The facts are the same as in Example 2, except that
FS's market share is rapidly expanding because of the business
failure of a competitor in its geographic area. The district
director determines that the participants' future benefit shares are
not reliably projected by current sales of cleaning products and
that FS's benefit projections should take into account its growth in
sales.
Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a cost sharing arrangement to develop synthetic fertilizers and
insecticides. FP and USS share costs on the basis of each
participant's current sales of fertilizers and insecticides. The
market shares of the participants have been stable for fertilizers,
but FP's market share for insecticides has been expanding. The
district director determines that the participants' projections of
benefit shares are reliable with regard to fertilizers, but not
reliable with regard to insecticides; a more reliable projection of
benefit shares would take into account the expanding market share
for insecticides.
Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter
into a cost sharing arrangement to develop new food products,
dividing costs on the basis of projected sales two years in the
future. In year 1, USP and FS project that their sales in year 3
will be equal, and they divide costs accordingly. In year 3, the
district director examines the participants' method for dividing
costs. USP and FS actually accounted for 42% and 58% of total sales,
respectively. The district director agrees that sales two years in
the future provide a reliable basis for estimating benefit shares.
Because the differences between USP's and FS's actual and projected
benefit shares are less than 20% of their projected benefit shares,
the projection of future benefits for year 3 is reliable.
Example 6. The facts are the same as in Example 5, except that
the in year 3 USP and FS actually accounted for 35% and 65% of total
sales, respectively. The divergence between USP's projected and
actual benefit shares is greater than 20% of USP's projected benefit
share and is not due to an extraordinary event beyond the control of
the participants. The district director concludes that the
projection of anticipated benefit shares was unreliable, and uses
actual benefits as the basis for an adjustment to the cost shares
borne by USP and FS.
Example 7. U.S. Parent (USP), a U.S. corporation, and its
foreign subsidiary (FS) enter a cost sharing arrangement in year 1.
They project that they will begin to receive benefits from covered
intangibles in years 4 through 6, and that USP will receive 60% of
total benefits and FS 40% of total benefits. In years 4 through 6,
USP and FS actually receive 50% each of the total benefits. In
evaluating the reliability of the participants' projections, the
district director compares these actual benefit shares to the
projected benefit shares. Although USP's actual benefit share (50%)
is within 20% of its projected benefit share (60%), FS's actual
benefit share (50%) is not within 20% of its projected benefit share
(40%). Based on this discrepancy, the district director may conclude
that the participants' projections were not reliable and may use
actual benefit shares as the basis for an adjustment to the cost
shares borne by USP and FS.
Example 8. Three controlled taxpayers, USP, FS1 and FS2 enter
into a cost sharing arrangement. FS1 and FS2 are foreign. USP is a
United States corporation that controls all the stock of FS1 and
FS2. The participants project that they will share the total
benefits of the covered intangibles in the following percentages:
USP 50%; FS1 30%; and FS2 20%. Actual benefit shares are as follows:
USP 45%; FS1 25%; and FS2 30%. In evaluating the reliability of the
participants' projections, the district director compares these
actual benefit shares to the projected benefit shares. For this
purpose, FS1 and FS2 are treated as a single participant. The actual
benefit share received by USP (45%) is within 20% of its projected
benefit share
[[Page 65563]]
(50%). In addition, the non-US participants' actual benefit share (55%)
is also within 20% of their projected benefit share (50%).
Therefore, the district director concludes that the participants'
projections of future benefits were reliable, despite the fact that
FS2's actual benefit share (30%) is not within 20% of its projected
benefit share (20%).
Example 9. The facts are the same as in Example 8. In addition,
the district director determines that FS2 has significant operating
losses and has no earnings and profits, and that FS1 is profitable
and has earnings and profits. Based on all the evidence, the
district director concludes that the participants arranged that FS1
would bear a larger cost share than appropriate in order to reduce
FS1's earnings and profits and thereby reduce inclusions USP
otherwise would be deemed to have on account of FS1 under subpart F.
Pursuant to Sec. 1.482-7 (f)(3)(iv)(C), the district director may
make an adjustment solely to the cost shares borne by FS1 and FS2
because FS2's projection of future benefits was unreliable and the
variation between actual and projected benefits had the effect of
substantially reducing USP's U.S. income tax liability (on account
of FS1 subpart F income).
Example 10. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a cost sharing arrangement in 1996 to develop a new
treatment for baldness. USS's interest in any treatment developed is
the right to produce and sell the treatment in the U.S. market while
FP retains rights to produce and sell the treatment in the rest of
the world. USS and FP measure their anticipated benefits from the
cost sharing arrangement based on their respective projected future
sales of the baldness treatment. The following sales projections are
used:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1997.................................................... 5 10
1998.................................................... 20 20
1999.................................................... 30 30
2000.................................................... 40 40
2001.................................................... 40 40
2002.................................................... 40 40
2003.................................................... 40 40
2004.................................................... 20 20
2005.................................................... 10 10
2006.................................................... 5 5
------------------------------------------------------------------------
(B) In 1997, the first year of sales, USS is projected to have
lower sales than FP due to lags in U.S. regulatory approval for the
baldness treatment. In each subsequent year USS and FP are projected
to have equal sales. Sales are projected to build over the first
three years of the period, level off for several years, and then
decline over the final years of the period as new and improved
baldness treatments reach the market.
(ii) To account for USS's lag in sales in the first year, the
present discounted value of sales over the period is used as the
basis for measuring benefits. Based on the risk associated with this
venture, a discount rate of 10 percent is selected. The present
discounted value of projected sales is determined to be
approximately $154.4 million for USS and $158.9 million for FP. On
this basis USS and FP are projected to obtain approximately 49.3%
and 50.7% of the benefit, respectively, and the costs of developing
the baldness treatment are shared accordingly.
(iii) (A) In the year 2002 the district director examines the
cost sharing arrangement. USS and FP have obtained the following
sales results through the year 2001:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1997.................................................... 0 17
1998.................................................... 17 35
1999.................................................... 25 41
2000.................................................... 38 41
2001.................................................... 39 41
------------------------------------------------------------------------
(B) USS's sales initially grew more slowly than projected while
FP's sales grew more quickly. In each of the first three years of
the period the share of total sales of at least one of the parties
diverged by over 20% from its projected share of sales. However, by
the year 2001 both parties' sales had leveled off at approximately
their projected values. Taking into account this leveling off of
sales and all the facts and circumstances, the district director
determines that it is appropriate to use the original projections
for the remaining years of sales. Combining the actual results
through the year 2001 with the projections for subsequent years, and
using a discount rate of 10%, the present discounted value of sales
is approximately $141.6 million for USS and $187.3 million for FP.
This result implies that USS and FP obtain approximately 43.1% and
56.9%, respectively, of the anticipated benefits from the baldness
treatment. Because these benefit shares are within 20% of the
benefit shares calculated based on the original sales projections,
the district director determines that, based on the difference
between actual and projected benefit shares, the original
projections were not unreliable. No adjustment is made based on the
difference between actual and projected benefit shares.
Example 11. (i) The facts are the same as in Example 10, except
that the actual sales results through the year 2001 are as follows:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1997.................................................... 0 17
1998.................................................... 17 35
1999.................................................... 25 44
2000.................................................... 34 54
2001.................................................... 36 55
------------------------------------------------------------------------
(ii) Based on the discrepancy between the projections and the
actual results and on consideration of all the facts, the district
director determines that for the remaining years the following sales
projections are more reliable than the original projections:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
2002................................................... 36 55
2003................................................... 36 55
2004................................................... 18 28
2005................................................... 9 14
2006................................................... 4.5 7
------------------------------------------------------------------------
(iii) Combining the actual results through the year 2001 with
the projections for subsequent years, and using a discount rate of
10%, the present discounted value of sales is approximately $131.2
million for USS and $229.4 million for FP. This result implies that
USS and FP obtain approximately 35.4% and 63.6%, respectively, of
the anticipated benefits from the baldness treatment. These benefit
shares diverge by greater than 20% from the benefit shares
calculated based on the original sales projections, and the district
director determines that, based on the difference between actual and
projected benefit shares, the original projections were unreliable.
The district director adjusts costs shares for each of the taxable
years under examination to conform them to the recalculated shares
of anticipated benefits.
(4) Timing of allocations. If the district director reallocates
costs under the provisions of this paragraph (f), the allocation must
be reflected for tax purposes in the year in which the costs were
incurred. When a cost sharing payment is owed by one member of a
qualified cost sharing arrangement to another member, the district
director may make appropriate allocations to reflect an arm's length
rate of interest for the time value of money, consistent with the
provisions of Sec. 1.482-2(a) (Loans or advances).
(g) Allocations of income, deductions or other tax items to reflect
transfers of intangibles (buy-in)--(1) In general. A controlled
participant that makes intangible property available to a qualified
cost sharing arrangement will be treated as having transferred
interests in such property to the other controlled participants, and
such other controlled participants must make buy-in payments to it, as
provided in paragraph (g)(2) of this section. If the other controlled
participants fail to make such payments, the district director may make
appropriate allocations, under the provisions of Secs. 1.482-1 and
1.482-4 through 1.482-6, to reflect an arm's length consideration for
the transferred intangible property. Further, if a group of controlled
taxpayers participates in a qualified cost sharing arrangement, any
change in the controlled participants' interests in covered
intangibles, whether by reason of entry of a new participant or
otherwise by reason of transfers (including deemed transfers) of
interests among existing participants, is a transfer
[[Page 65564]]
of intangible property, and the district director may make appropriate
allocations, under the provisions of Secs. 1.482-1 and 1.482-4 through
1.482-6, to reflect an arm's length consideration for the transfer. See
paragraphs (g) (3), (4), and (5) of this section. Paragraph (g)(6) of
this section provides rules for assigning unassigned interests under a
qualified cost sharing arrangement.
(2) Pre-existing intangibles. If a controlled participant makes
pre-existing intangible property in which it owns an interest available
to other controlled participants for purposes of research in the
intangible development area under a qualified cost sharing arrangement,
then each such other controlled participant must make a buy-in payment
to the owner. The buy-in payment by each such other controlled
participant is the arm's length charge for the use of the intangible
under the rules of Secs. 1.482-1 and 1.482-4 through 1.482-6,
multiplied by the controlled participant's share of reasonably
anticipated benefits (as defined in paragraph (f)(3) of this section).
A controlled participant's payment required under this paragraph (g)(2)
is deemed to be reduced to the extent of any payments owed to it under
this paragraph (g)(2) from other controlled participants. Each payment
received by a payee will be treated as coming pro rata out of payments
made by all payors. See paragraph (g)(8), Example 4, of this section.
Such payments will be treated as consideration for a transfer of an
interest in the intangible property made available to the qualified
cost sharing arrangement by the payee. Any payment to or from an
uncontrolled participant in consideration for intangible property made
available to the qualified cost sharing arrangement will be shared by
the controlled participants in accordance with their shares of
reasonably anticipated benefits (as defined in paragraph (f)(3) of this
section). A controlled participant's payment required under this
paragraph (g)(2) is deemed to be reduced by such a share of payments
owed from an uncontrolled participant to the same extent as by any
payments owed from other controlled participants under this paragraph
(g)(2). See paragraph (g)(8), Example 5, of this section.
(3) New controlled participant. If a new controlled participant
enters a qualified cost sharing arrangement and acquires any interest
in the covered intangibles, then the new participant must pay an arm's
length consideration, under the provisions of Secs. 1.482-1 and 1.482-4
through 1.482-6, for such interest to each controlled participant from
whom such interest was acquired.
(4) Controlled participant relinquishes interests. A controlled
participant in a qualified cost sharing arrangement may be deemed to
have acquired an interest in one or more covered intangibles if another
controlled participant transfers, abandons, or otherwise relinquishes
an interest under the arrangement, to the benefit of the first
participant. If such a relinquishment occurs, the participant
relinquishing the interest must receive an arm's length consideration,
under the provisions of Secs. 1.482-1 and 1.482-4 through 1.482-6, for
its interest. If the controlled participant that has relinquished its
interest subsequently uses that interest, then that participant must
pay an arm's length consideration, under the provisions of Secs. 1.482-
1 and 1.482-4 through 1.482-6, to the controlled participant that
acquired the interest.
(5) Conduct inconsistent with the terms of a cost sharing
arrangement. If, after any cost allocations authorized by paragraph
(a)(2) of this section, a controlled participant bears costs of
intangible development that over a period of years are consistently and
materially greater or lesser than its share of reasonably anticipated
benefits, then the district director may conclude that the economic
substance of the arrangement between the controlled participants is
inconsistent with the terms of the cost sharing arrangement. In such a
case, the district director may disregard such terms and impute an
agreement consistent with the controlled participants' course of
conduct, under which a controlled participant that bore a
disproportionately greater share of costs received additional interests
in covered intangibles. See Sec. 1.482-1(d)(3)(ii)(B) (Identifying
contractual terms) and Sec. 1.482- 4(f)(3)(ii) (Identification of
owner). Accordingly, that participant must receive an arm's length
payment from any controlled participant whose share of the intangible
development costs is less than its share of reasonably anticipated
benefits over time, under the provisions of Secs. 1.482-1 and 1.482-4
through 1.482-6.
(6) Failure to assign interests under a qualified cost sharing
arrangement. If a qualified cost sharing arrangement fails to assign an
interest in a covered intangible, then each controlled participant will
be deemed to hold a share in such interest equal to its share of the
costs of developing such intangible. For this purpose, if cost shares
have varied materially over the period during which such intangible was
developed, then the costs of developing the intangible must be measured
by their present discounted value as of the date when the first such
costs were incurred.
(7) Form of consideration. The consideration for an acquisition
described in this paragraph (g) may take any of the following forms:
(i) Lump sum payments. For the treatment of lump sum payments, see
Sec. 1.482-4(f)(5) (Lump sum payments);
(ii) Installment payments. Installment payments spread over the
period of use of the intangible by the transferee, with interest
calculated in accordance with Sec. 1.482-2(a) (Loans or advances); and
(iii) Royalties. Royalties or other payments contingent on the use
of the intangible by the transferee.
(8) Examples. The following examples illustrate allocations
described in this paragraph (g):
Example 1. In year one, four members of a controlled group enter
into a cost sharing arrangement to develop a commercially feasible
process for capturing energy from nuclear fusion. Based on a
reliable projection of their future benefits, each cost sharing
participant bears an equal share of the costs. The cost of
developing intangibles for each participant with respect to the
project is approximately $1 million per year. In year ten, a fifth
member of the controlled group joins the cost sharing group and
agrees to bear one-fifth of the future costs in exchange for part of
the fourth member's territory reasonably anticipated to yield
benefits amounting to one-fifth of the total benefits. The fair
market value of intangible property within the arrangement at the
time the fifth company joins the arrangement is $45 million. The new
member must pay one-fifth of that amount (that is, $9 million total)
to the fourth member from whom it acquired its interest in covered
intangibles.
Example 2. U.S. Subsidiary (USS), Foreign Subsidiary (FS) and
Foreign Parent (FP) enter into a cost sharing arrangement to develop
new products within the Group X product line. USS manufactures and
sells Group X products in North America, FS manufactures and sells
Group X products in South America, and FP manufactures and sells
Group X products in the rest of the world. USS, FS and FP project
that each will manufacture and sell a third of the Group X products
under development, and they share costs on the basis of projected
sales of manufactured products. When the new Group X products are
developed, however, USS ceases to manufacture Group X products, and
FP sells its Group X products to USS for resale in the North
American market. USS earns a return on its resale activity that is
appropriate given its function as a distributor, but does not earn a
return attributable to exploiting covered intangibles. The district
director determines that USS' share of the costs (one-third) was
greater than its share of reasonably anticipated benefits (zero) and
that it has transferred an interest in the intangibles for which it
should receive a payment from FP, whose share of the
[[Page 65565]]
intangible development costs (one-third) was less than its share of
reasonably anticipated benefits over time (two-thirds). An
allocation is made under Secs. 1.482-1 and 1.482-4 through 1.482-6
from FP to USS to recognize USS' one-third interest in the
intangibles. No allocation is made from FS to USS because FS did not
exploit USS' interest in covered intangibles.
Example 3. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and
Foreign Subsidiary 2 (FS2) enter into a cost sharing arrangement to
develop a cure for the common cold. Costs are shared USP-50%, FS1-
40% and FS2-10% on the basis of projected units of cold medicine to
be produced by each. After ten years of research and development,
FS1 withdraws from the arrangement, transferring its interests in
the intangibles under development to USP in exchange for a lump sum
payment of $10 million. The district director may review this lump
sum payment, under the provisions of Sec. 1.482-4(f)(5), to ensure
that the amount is commensurate with the income attributable to the
intangibles.
Example 4. (i) Four members A, B, C, and D of a controlled group
form a cost sharing arrangement to develop the next generation
technology for their business. Based on a reliable projection of
their future benefits, the participants agree to bear shares of the
costs incurred during the term of the agreement in the following
percentages: A 40%; B 15%; C 25%; and D 20%. The arm's length
charges, under the rules of Secs. 1.482-1 and 1.482-4 through 1.482-
6, for the use of the existing intangible property they respectively
make available to the cost sharing arrangement are in the following
amounts for the taxable year: A 80X; B 40X; C 30X; and D 30X. The
provisional (before offsets) and final buy-in payments/receipts
among A, B, C, and D are shown in the table as follows:
------------------------------------------------------------------------
A B C D
------------------------------------------------------------------------
Payments........................ <40> <21> <37.5> <30>
Receipts........................ 48 34 22.5 24
---------------------------------------
Final........................... 8 13 <15> <6>
------------------------------------------------------------------------
(ii) The first row/first column shows A's provisional buy-in
payment equal to the product of 100X (sum of 40X, 30X, and 30X) and
A's share of anticipated benefits of 40%. The second row/first
column shows A's provisional buy-in receipts equal to the sum of the
products of 80X and B's, C's, and D's anticipated benefits shares
(15%, 25%, and 20%, respectively). The other entries in the first
two rows of the table are similarly computed. The last row shows the
final buy-in receipts/payments after offsets. Thus, for the taxable
year, A and B are treated as receiving the 8X and 13X, respectively,
pro rata out of payments by C and D of 15X and 6X, respectively.
Example 5. A and B, two members of a controlled group form a
cost sharing arrangement with an unrelated third party C to develop
a new technology useable in their respective businesses. Based on a
reliable projection of their future benefits, A and B agree to bear
shares of 60% and 40%, respectively, of the costs incurred during
the term of the agreement. A also makes available its existing
technology for purposes of the research to be undertaken. The arm's
length charge, under the rules of Secs. 1.482-1 and 1.482-4 through
1.482-6, for the use of the existing technology is 100X for the
taxable year. Under its agreement with A and B, C must make a
specified cost sharing payment as well as a payment of 50X for the
taxable year on account of the pre- existing intangible property
made available to the cost sharing arrangement. B's provisional buy-
in payment (before offsets) to A for the taxable year is 40X (the
product of 100X and B's anticipated benefits share of 40%). C's
payment of 50X is shared provisionally between A and B in accordance
with their shares of reasonably anticipated benefits, 30X (50X times
60%) to A and 20X (50X times 40%) to B. B's final buy-in payment
(after offsets) is 20X (40X less 20X). A is treated as receiving the
70X total provisional payments (40X plus 30X) pro rata out of the
final payments by B and C of 20X and 50X, respectively.
(h) Character of payments made pursuant to a qualified cost sharing
arrangement--(1) In general. Payments made pursuant to a qualified cost
sharing arrangement (other than payments described in paragraph (g) of
this section) generally will be considered costs of developing
intangibles of the payor and reimbursements of the same kind of costs
of developing intangibles of the payee. For purposes of this paragraph
(h), a controlled participant's payment required under a qualified cost
sharing arrangement is deemed to be reduced to the extent of any
payments owed to it under the arrangement from other controlled or
uncontrolled participants. Each payment received by a payee will be
treated as coming pro rata out of payments made by all payors. Such
payments will be applied pro rata against deductions for the taxable
year that the payee is allowed in connection with the qualified cost
sharing arrangement. Payments received in excess of such deductions
will be treated as in consideration for use of the tangible property
made available to the qualified cost sharing arrangement by the payee.
For purposes of the research credit determined under section 41, cost
sharing payments among controlled participants will be treated as
provided for intra-group transactions in Sec. 1.41-8(e). Any payment
made or received by a taxpayer pursuant to an arrangement that the
district director determines not to be a qualified cost sharing
arrangement, or a payment made or received pursuant to paragraph (g) of
this section, will be subject to the provisions of Secs. 1.482-1 and
1.482-4 through 1.482-6. Any payment that in substance constitutes a
cost sharing payment will be treated as such for purposes of this
section, regardless of its characterization under foreign law.
(2) Examples. The following examples illustrate this paragraph (h):
Example 1. U.S. Parent (USP) and its wholly owned Foreign
Subsidiary (FS) form a cost sharing arrangement to develop a
miniature widget, the Small R. Based on a reliable projection of
their future benefits, USP agrees to bear 40% and FS to bear 60% of
the costs incurred during the term of the agreement. The principal
costs in the intangible development area are operating expenses
incurred by FS in Country Z of 100X annually, and operating expenses
incurred by USP in the United States also of 100X annually. Of the
total costs of 200X, USP's share is 80X and FS's share is 120X, so
that FS must make a payment to USP of 20X. This payment will be
treated as a reimbursement of 20X of USP's operating expenses in the
United States. Accordingly, USP's Form 1120 will reflect an 80X
deduction on account of activities performed in the United States
for purposes of allocation and apportionment of the deduction to
source. The Form 5471 for FS will reflect a 100X deduction on
account of activities performed in Country Z, and a 20X deduction on
account of activities performed in the United States.
Example 2. The facts are the same as in Example 1, except that
the 100X of costs borne by USP consist of 5X of operating expenses
incurred by USP in the United States and 95X of fair market value
rental cost for a facility in the United States. The depreciation
deduction attributable to the U.S. facility is 7X. The 20X net
payment by FS to USP will first be applied in reduction pro rata of
the 5X deduction for operating expenses and the 7X depreciation
deduction attributable to the U.S. facility. The 8X remainder will
be treated as rent for the U.S. facility.
(i) Accounting requirements. The accounting requirements of this
paragraph are that the controlled
[[Page 65566]]
participants in a qualified cost sharing arrangement must use a
consistent method of accounting to measure costs and benefits, and must
translate foreign currencies on a consistent basis.
(j) Administrative requirements--(1) In general. The administrative
requirements of this paragraph consist of the documentation
requirements of paragraph (j)(2) of this section and the reporting
requirements of paragraph (j)(3) of this section.
(2) Documentation. A controlled participant must maintain
sufficient documentation to establish that the requirements of
paragraphs (b)(4) and (c)(1) of this section have been met, as well as
the additional documentation specified in this paragraph (j)(2), and
must provide any such documentation to the Internal Revenue Service
within 30 days of a request (unless an extension is granted by the
district director). Documents necessary to establish the following must
also be maintained--
(i) The total amount of costs incurred pursuant to the arrangement;
(ii) The costs borne by each controlled participant;
(iii) A description of the method used to determine each controlled
participant's share of the intangible development costs, including the
projections used to estimate benefits, and an explanation of why that
method was selected;
(iv) The accounting method used to determine the costs and benefits
of the intangible development (including the method used to translate
foreign currencies), and, to the extent that the method materially
differs from U.S. generally accepted accounting principles, an
explanation of such material differences; and
(v) Prior research, if any, undertaken in the intangible
development area, any tangible or intangible property made available
for use in the arrangement, by each controlled participant, and any
information used to establish the value of pre-existing and covered
intangibles.
(3) Reporting requirements. A controlled participant must attach to
its U.S. income tax return a statement indicating that it is a
participant in a qualified cost sharing arrangement, and listing the
other controlled participants in the arrangement. A controlled
participant that is not required to file a U.S. income tax return must
ensure that such a statement is attached to Schedule M of any Form 5471
or to any Form 5472 filed with respect to that participant.
(k) Effective date. This section is effective for taxable years
beginning on or after January 1, 1996.
(l) Transition rule. A cost sharing arrangement will be considered
a qualified cost sharing arrangement, within the meaning of this
section, if, prior to January 1, 1996, the arrangement was a bona fide
cost sharing arrangement under the provisions of Sec. 1.482-7T (as
contained in the 26 CFR part 1 edition revised as of April 1, 1995),
but only if the arrangement is amended, if necessary, to conform with
the provisions of this section by December 31, 1996.
Sec. 1.482-7T [Removed]
Par. 4. Section 1.482-7T is removed.
PART 301--PROCEDURE AND ADMINISTRATION
Par. 5. The authority for part 301 continues to read in part as
follows:
Authority: 26 U.S.C. 7805. * * *
Par. 6. Section 301.7701-3 is amended by adding paragraph (e) to
read as follows:
Sec. 301.7701-3 Partnerships.
* * * * *
(e) Qualified cost sharing arrangements. A qualified cost sharing
arrangement that is described in Sec. 1.482-7 of this chapter and any
arrangement that is treated by the Service as a qualified cost sharing
arrangement under Sec. 1.482-7 of this chapter is not classified as a
partnership for purposes of the Internal Revenue Code. See Sec. 1.482-7
of this chapter for the proper treatment of qualified cost sharing
arrangements.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 7. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 8. In Sec. 602.101, paragraph (c) is amended by adding an
entry to the table in numerical order to read as follows:
``1.482-7..................................................1545-1364''.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: November 30, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-30617 Filed 12-19-95; 8:45 am]
BILLING CODE 4830-01-U
