On December 31, 2008, the U.S. Treasury Department and the Internal Revenue Service (IRS) issued temporary regulations making fundamental changes to the 1996 rules governing qualified cost sharing arrangements (CSAs). These changes are relevant not only to taxpayers that rely on CSAs, but also to taxpayers that have never implemented a CSA, as Treasury and the IRS have provided for application of the principles of the new regulations to intangible development arrangements in general.
The new regulations are based on regulations proposed in 2005, which have been the subject of considerable discussion and controversy. The new regulations are generally effective as of January 5, 2009, subject to limited transition relief for certain pre-existing CSAs. The new regulations also were issued in proposed form and will be the subject of a public hearing scheduled for April 21, 2009.
The new regulations expand the range of circumstances under which buy-in payments are required in order to compensate CSA participants for contributing intangible property or other resources to the CSA, with minor changes from the approach set forth in the 2005 proposed regulations. The 2005 proposed regulations required buy-in payments for all “external contributions,” defined to include any resource or capability, whether or not constituting intangible property, reasonably anticipated to contribute to the development of the cost-shared intangibles. The 2005 proposed regulations determined the arm’s length charge for such contributions by means of a hypothesized “reference transaction,” in which all such resources and capabilities are provided on an exclusive and perpetual basis (effectively providing a conclusive presumption in this regard).
The new regulations modify some of the relevant nomenclature (e.g., “external contribution” has become “platform contribution”) but continue the basic 2005 approach that buy-ins may be required with respect to all “contributions,” including with respect to items generally not thought to constitute intangible property, such as research workforce in place, goodwill and going concern value. The new regulations eliminate the “reference transaction” construct, replacing it with a rebuttable presumption that all relevant resources, capabilities and rights are made available on an exclusive basis.
The new regulations adhere to the “investor model” set forth in the 2005 proposed regulations, under which each CSA participant is generally expected to earn a return on its aggregate investment of cash, intangible property and other resources in the CSA in line with a risk-adjusted discount rate for the entire CSA. This approach will significantly limit the returns that can be realized by a CSA participant that contributes cash and bears development risk but does not contribute pre-existing intangible property or other resources or capabilities. Such a participant effectively will earn only a discount rate on its cost contributions, with the bulk of non-routine profits being allocated to participants that contributed pre-existing intangible property or other resources or capabilities. The determination of an appropriate risk-adjusted discount rate will be particularly important under this approach, and can be expected to be the subject of considerable contention between taxpayers and the IRS. The new regulations provide expanded guidance concerning the determination and application of discount rates for this and other purposes.
In some respects, the new regulations allow greater flexibility in the design of a CSA than the 2005 proposed regulations would have allowed, but far less than has existed since 1996. The 2005 proposed regulations would have required CSA participants to divide the rights to exploit cost-shared intangibles into exclusive and perpetual rights for non-overlapping geographic territories. The new regulations continue to require non-overlapping exclusive and perpetual rights, but allow these rights to be divided on a territorial basis, a field-of-use basis or an appropriate unspecified basis, subject to certain restrictive conditions.
In an important concession to taxpayer criticism, the new regulations also provide more flexibility than the 2005 proposed regulations did with respect to the form of buy-in payments. The 2005 proposed regulations would have required buy-in payments for contributions of resources or capabilities acquired post-formation to take the same form as the payment for the underlying acquisition itself. The new regulations abandon this rule and allow the participants to choose the form of payment for any contribution, including post-formation acquisition contributions.
The new regulations narrow the return ratio range that is used for determining when the IRS generally will consider proposing periodic adjustments to buy-ins under “commensurate with income” (CWI) principles. The 2005 proposed regulations provided that periodic adjustments normally would be considered where a participant’s actual operating profits divided by the discounted present value of its investment in the CSA fell outside the range of 0.5 to 2.0. The new regulations narrow that range to 0.667 to 1.5, based on a view that a return ratio outside that range suggests the potential of non-arm’s length pricing at the time of the contribution of intangible property or other resources to the CSA. As with the 2005 proposed regulations, a narrower range applies in cases in which the taxpayer fails to substantially comply with documentation requirements (0.8 to 1.25 under the temporary regulations). Periodic adjustments likely will be considered with increased frequency under the new rules.
The preamble to the new regulations states that the IRS intends to issue a revenue procedure excluding from the periodic adjustment rules platform contribution transactions (i.e., contributions necessitating a buy-in) that are covered by an advance pricing agreement (APA). Such an exception would be premised on the view that the APA process may serve to overcome information asymmetries between the taxpayer and the government, thus eliminating a primary basis for application of the CWI rules. The IRS has defended the CWI rules as being consistent with the arm’s length standard on the basis that the rules allow the IRS, as the party with less information about the relevant transactions and assets, to use ex post results merely as a guide to determining what the reasonable ex ante expectations of the parties would have been (as opposed to using hindsight to deny the payor an appropriate return on bearing risk).
The preamble to the new regulations also states that Treasury and the IRS considered providing a similar exception to the periodic adjustment rules for cases in which taxpayers complied with heightened contemporaneous documentation requirements, and that comments are invited on whether or how such a documentation-based exception could be developed.
Pricing Methods and Discount Rates
Like the 2005 proposed regulations, the new regulations provide guidance on specific pricing methods (including the controversial income, acquisition price and market capitalization methods, as well as limits on the application of the residual profit split method). The new regulations also provide guidance on the determination of appropriate risk-adjusted discount rates used for such purposes as applying the investor model and computing present values under the periodic adjustment rules described above. In both of these areas, the new regulations are broadly consistent with the 2005 proposed regulations, but modify the approach in several respects. Of particular note, the new regulations eliminate the focus in the 2005 proposed regulations on a taxpayer’s weighted average cost of capital or hurdle rate in determining the appropriate discount rate for participation in a CSA, and also address differences between pre- and post-tax discount rates.
Impact on Non-CSA Arrangements
In addition to the possibility that the cost sharing regulations may be applied to certain intangible development arrangements meeting some, but not all, of the requirements under the regulations, the new regulations also provide for a much broader application of the principles of the regulations to nonconforming intangible development arrangements in general. Specifically, the new regulations modify the current general rules dealing with transfers of intangibles and controlled services transactions (Treas. Reg. § 1.482-4 and -9) to provide specifically for “consideration of the principles, methods, comparability, and reliability considerations” set forth in the new CSA regulations in determining the best method for pricing intangible development arrangements subject to these other rules. Thus, even if the IRS decides not to treat a nonconforming co-development arrangement as a CSA, it may nonetheless apply certain of the general rules and principles applicable to CSAs in determining the arm’s length result of the nonconforming arrangement.
The ramifications of this general application of the new regulations’ principles are unclear, but this general application is consistent with the IRS’s apparent (and controversial) view that the new regulations are consistent with general transfer pricing principles. Indeed, a number of IRS releases in recent years have included elements of the new regulations in interpreting and applying general principles (e.g., 2007 and 2008 Large and Mid-Size Business directives on section 936 conversions, 2007 advice memorandum on the CWI rules, 2007 coordinated issue paper on CSAs). In addition, the Organisation for Economic Co-operation and Development’s September 2008 discussion draft on “business restructurings” includes some of the same themes, such as an emphasis on realistically available alternatives; broader scope of circumstances requiring “buy in” or “buy out” payments; and general orientation toward reducing the return allocable to entities that bear risk without having “control,” performing other key activities or contributing resources other than cash. By explicitly providing for general application of the principles of the new regulations, Treasury and the IRS appear to have confirmed their view that the regulations are consistent with other developments in the transfer pricing area. This general application of the principles of the new regulations also may represent another effort on the part of the IRS to further one of its main stated goals in its recent guidance activities in the area, to provide for similar tax treatment of economically similar arrangements, regardless of structure.
The new regulations generally apply as of January 5, 2009, (the date on which the regulations were published in the Federal Register) and, as temporary regulations, will expire in three years. Pre-existing CSAs may obtain grandfather relief, provided that certain contract and administrative requirements are satisfied (including the requirement that existing contracts be amended within six months to conform to the new regulations’ contract provisions). The all-purpose grandfathering termination provisions of the 2005 proposed regulations have been rejected in favor of narrower provisions that may produce additional payment obligations in certain circumstances involving a material change in the scope of the CSA. However, given that the IRS appears to have concluded that much of the content of the new regulations is implicit in the current 1996 regulations, and that benefits of grandfathering are subject to termination in the event of a material change in scope, it remains to be seen how valuable this grandfathering will prove to be as a practical matter.
Although the new regulations include some helpful clarifications, simplifications and additional flexibility relative to the 2005 proposed regulations, the basic approach is the same and has now been given effect in the form of temporary regulations. As a result, CSAs will be considerably less beneficial and practical than they have been in the past for companies with research resources and capabilities centered in the United States. On the other hand, these same provisions will make CSAs considerably more attractive for taxpayers with substantial foreign research resources or capabilities.
Taxpayers that have relied on CSAs under the 1996 regulations must consider whether and how such reliance will be viable in the future under the new regulations. Even taxpayers that have never entered into a CSA should consider the implications of the application of the principles of the new regulations to other intangible development arrangements.