COST SHARING ARRANGEMENTS

The principal vehicle for structuring the sharing of costs and benefits of research and development (R&D) among the multiple members of a vertically integrated multinational corporation is a cost-sharing arrangement. The principal consequence of cost-sharing is that each participant in the arrangement is treated as the owner of any intangible property developed, and the income attributable to the intangible will inure to the owner's benefit. As a result, the "commensurate with income" requirement of Internal Revenue Code §482 is effectively avoided. The ultimate result is essentially a profit split between participants (and tax jurisdictions) on income attributable to the intangibles developed.

This memorandum is not intended to give you the ability to implement cost-sharing arrangements. Its scope is to give you an initial understanding of the regulatory developments in this field over the past two years and to be able to better understand the concepts and how they are used in this complex area of the law.

Although cost-sharing issues are generally considered transfer pricing issues, there are many tax considerations (e.g., R&D credits and character-of-income consequences) arising in cost-sharing arrangements that have little or no nexus with application of the arm's length standard under §482. Indeed, several issues must be carefully considered that reflect business concerns having nothing to do with taxes, because cost-sharing is not an artificial construct or creature of statute, but rather entails a business decision with real economic substance and consequence. For example, ability to currently fund R&D efforts is essential, and local law protection (or lack thereof) of intangibles may be critical.

I.  1995 Final Regulations

On December 19, 1995, the IRS issued final regulations under §482 (Treas. reg. §1.482-7) providing guidance with respect to cost-sharing arrangements. These regulations supplant regulations under reg. §1.482-2(d) issued in 1968 and proposed regulations §1.482-2(g) issued in 1992, and are effective for taxable years beginning on or after January 1, 1996. Although these regulations are more detailed and burdensome than the 1968 cost-sharing regulations, they are significantly more flexible and less arbitrary than the 1992 proposed regulations.

The regulations generally provide that two or more members of a group of controlled taxpayers may jointly develop intangible property pursuant to a qualified cost-sharing arrangement, and no allocation will be made under §482 with respect to a participant if the participant's share of the costs of developing the intangible is equal to its share of reasonably anticipated benefits to be derived from exploitation of that participant's interest in the intangible. Reg. §1.482-7(a). Moreover, if a participant's share of the costs of developing the intangible is not equal to its share of reasonably anticipated benefits, then the district director may generally make allocations solely with respect to correcting the disparity. Reg. §1.482-7(a)(2). Thus, allocations with respect to qualified cost-sharing arrangements will generally be made by adjusting cost shares, not by treating the controlled taxpayers as if intangible property were conveyed by one to the other subject to the rules of Treas. reg. sections 1.482-1 and 1.482-4. An interest in an intangible includes any commercially transferable interest the benefits of which are susceptible of valuation. Reg. §1.482-7(a)(2).

A. Scope and Application

A cost-sharing agreement means "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." Reg. §1.482-7(a)(1). Although a taxpayer may claim that a cost-sharing arrangement is a "qualified cost-sharing arrangement" only if the regulatory requirements are met, a substance-over-form rule provides that the district director may apply the cost-sharing rules if the arrangement in substance is a cost-sharing arrangement, even if the requirements of the regulations are not met. Reg. §1.482-7(a)(1). The regulations clarify that a qualified cost-sharing arrangement will not be treated as a partnership, nor will a foreign participant be treated as engaged in a U.S. trade or business solely by virtue of its participation. An issue not explicitly addressed is whether an arrangement structured as a partnership pursuant to §701, et seq., may nonetheless be recast as a cost-sharing arrangement and subjected to the rules of reg. §1.482-7. Presumably the answer is yes under the substance-over-form rule in reg. §1.482-7(a)(1).

1. Qualified Cost-Sharing Arrangement

A cost-sharing arrangement will be considered qualified only if it includes two or more participants, is recorded in a document (that is contemporaneous with its formation) that contains several important provisions of the cost-sharing arrangement, specifies the intangibles to be developed, provides a method to calculate each participant's share of the costs of intangible development based on factors that reasonably reflect each participant's share of anticipated benefits, and includes an adjustment mechanism to account for changes in future circumstances.

The provisions of the cost-sharing arrangement that must be set forth in the agreement include:

• The arrangement's participants, and all members of the controlled group that will benefit from the intangibles developed. This implies that a member of a controlled group may benefit from the intangibles developed despite that the member is not a participant and does not share in the costs incurred. Presumably this contemplates licensing of the developed intangibles to nonparticipating members of the controlled group, and is used for deciding the benefits reasonably anticipated by the licensor.
  
• The method to calculate each participant's share of the costs, and the adjustment mechanism to account for future changes.
  
• A description of the scope of R&D to be undertaken.
  
• A description of each participant's interest in "covered intangibles".
  
• The duration of the arrangement.
  
• The conditions for, and consequences of, any modification or end of the arrangement.

2. Who Can Participate

A participant may be a controlled taxpayer or an uncontrolled taxpayer. Additional final regulations governing cost-sharing arrangements were issued by the IRS on May 9, 1996, amending the final regulations released by the IRS on December 19, 1995. The principal change in these final regulations relates to rules governing which related parties can participate in a qualified cost-sharing arrangement. Under the 1992 proposed regulations and the 1995 final regulations, a controlled taxpayer could participate in a qualified cost-sharing arrangement only if it would use or expect to use the intangibles in the active conduct of a trade or business. However, the proposed regulations softened this active conduct rule somewhat, providing that a member of a group of controlled taxpayers could participate in a qualified cost-sharing arrangement on behalf of, and could satisfy the active conduct rule based on activities done by, one or more other members of the group (a cost-sharing subgroup). The participating subgroup member could then transfer or license the intangibles developed under the arrangement to the nonparticipating subgroup member(s). The proposed regulations would have measured benefits in such case by the benefits of the entire subgroup exploiting the intangibles.

The December 1995 final regulations deleted the subgroup rules, and in so doing sent an implicit message that the IRS wished to discourage cost-sharing arrangements. Taxpayers commented that the change would prevent participation by entities that wouldn't "use" the covered intangibles in the active conduct of a trade or business, and would force them to amend existing arrangements to include as a participant every operating company that predictably would be using covered intangibles. In addition, many entities would have been prevented from participating under the principal purpose prohibition, pursuant to which a participant was considered to fail the active conduct test if a principal purpose for participating in the arrangement was to obtain the intangible for transfer or license to another party. This licensing restriction also created doubts as to the ability of software companies to cost-share, given that their end product is generally licensed, not sold.

The preamble to the May 1996 final regulations explains that the principal reason for the active conduct rule was to ensure that the controlled participant would derive benefits from the intangibles that could be reliably measured. Having concluded that the active conduct rule is not necessary to police the benefit rule, these new regulations eliminate the active conduct rules contained in Treas. Reg. §1.482-7(c)(2) and (3). The regulations provide instead that a controlled taxpayer may participate if it reasonably anticipates that it will derive benefits from the use of covered intangibles.

This new standard will make cost-sharing an option for many taxpayers that could not satisfy the active conduct rules, and suggests that the IRS is no longer discouraging cost-sharing arrangements. While apparently licensing of the intangibles developed in the cost-sharing arrangement is allowed, there is no explicit recognition of the right of a holding company to use the intangibles via a contract manufacturing arrangement. However, given the IRS' intent to remove unwarranted restrictions in this area, any latent ambiguity should be resolved in favor of maximum flexibility.

The regulations, as revised, also provide that if a controlled participant transfers covered intangibles to another controlled taxpayer, the participant's benefits will be measured with reference to the transferee's benefits rather than with reference to any consideration paid by the transferee (i.e., "look through" treatment for reliably measuring benefits). Finally, the May 1996 regulations clarify that the documentation requirements of Treas. Reg. §1.482-7(j)(2) will satisfy the principal document requirement of Treas. Reg. §1.6662-6(d)(2)(iii)(B) with respect to a qualified cost-sharing arrangement.

Because of these new final regulations, the cost-sharing option is much more flexible and should be given careful consideration by taxpayers that have previously rejected cost-sharing due to the active conduct requirements. For taxpayers that are currently participating in a cost-sharing arrangement, consideration should be given to their options under the new, more liberal, participation rules with an eye to maximizing the benefits of cost-sharing (e.g., (1) by adding additional cost-sharing participants that were originally excluded or (2) by excluding existing participants that will use the intangibles developed in favor of licensing the intangibles to them via a holding company).

B. Costs and Benefits

A controlled participant's costs of developing intangibles include all costs incurred in the intangible development area, plus cost-sharing payments made to other participants and minus all cost-sharing payments received from other participants. Reg. §1.482-7(d)(1). These costs include operating expenses and amounts charged for tangible property. Costs incurred that contribute not only to the development of covered intangibles, but also to other intangibles or business activities, must be allocated on a reasonable basis, consistent with the covered intangible's proportionate share of the total benefits attributable to the cost incurred.

Benefits are defined to be all additional income generated or costs saved by using the covered intangibles. Reg. §1.482-7(e)(1). Reasonably anticipated benefits are the aggregate benefits a participant reasonably anticipates it will derive from covered intangibles. Reg. §1.482-7(e)(2).

1. Cost/Benefit Allocation

The heart of the regulations is contained in the "cost allocation" rules in reg. §1.482-7(f). The general goal of a cost-sharing arrangement is to measure each participant's share of costs incurred by reference to that participant's reasonably anticipated benefits. A controlled participant's share of intangible development costs is equal to the costs actually borne by the participant divided by the sum of all controlled participants' costs. Reg. §1.482-7(f)(2)(i). A controlled participant's share of reasonably anticipated benefits is equal to all of the benefits the participant reasonably anticipates it will derive from the covered intangibles divided by the total benefits reasonably anticipated by all controlled participants. Reg. §1.482-7(f)(3)(i). This calculation must be made by using the most reliable estimate of reasonably anticipated benefits, allowing for the quality of the data and assumptions used in the analysis. Reg. §1.482-7(f)(3)(i). This standard is derived from the best-method rule contained in reg. §1.482-1(c)(1) ("The arm's length result of a controlled transaction must be decided under the method that, under the facts and circumstances, provides the most reliable measure of an arm's length result"), and, like the best-method rule, creates equal amounts of flexibility and uncertainty for taxpayers.

Consistent with reg. §1.482-1(c)(2)(ii), the reliability of an estimate will depend on the completeness and accuracy of the data, the soundness of the assumptions, and the effect of deficiencies in data and assumptions on an estimate. Reg. §1.482-7(f)(3)(i). If two estimates are equally reliable, no adjustment should be made based on differences in the results obtained. Reg. §1.482-7(f)(3)(i). In essence, this rule precludes the IRS from establishing a preference for an estimate based on whether it will support an allocation, basically creating a range of appropriate results, consistent with the arm's length range provisions of reg. §1.482-1(e), within which taxpayers will be insulated from adjustment to their cost shares.

In deciding the reliability of an estimate of anticipated benefits, the regulations set forth two factors considered the most important for purposes of assessing the reliability of an estimate:

• The reliability of the basis used for measuring benefits (Reg. §1.482-7(f)(3)(i)(A).); and
  
• The reliability of the projections used to estimate benefits (Reg. §1.482-7(f)(3)(i)(B).).

2. Reliability of the Basis Used for Measuring Benefits

As to the reliability of the basis used to measure benefits, the regulations require that the amount of benefits of each controlled participant must be measured on a consistent basis. Reg. §1.482-7(f)(3)(ii). If a controlled participant transfers covered intangibles to another controlled taxpayer, the participant's benefits will be measured with reference to the transferee's benefits rather than with reference to any consideration paid by the transferee. Anticipated benefits may be measured directly or indirectly. Reg. §1.482-7(f)(3)(ii). A direct basis estimates the additional income generated or costs saved by using covered intangibles, while an indirect basis estimates benefits based on measures that are reasonably related to income generated or costs saved. Reg. §1.482-7(f)(3)(ii). The regulations require that anticipated benefits be measured using the most reliable basis for estimate; therefore, again consistent with best-method rule under reg. §1.482- 1(c)(1), no fixed preference is set forth for direct or indirect bases. However, once the most reliable basis is decided, the regulations note that that basis will normally continue to provide the most reliable estimate in future years as well, absent a material change in the factors that effect reliability of the estimate. Despite whether a direct or indirect measure is used, adjustments may be required to account for material differences in the activities that controlled participants engage in to exploit their interests in covered intangibles.

The regulations describe no direct bases for measuring benefit, but include four indirect bases to measure benefit:

• Units used, produced, or sold (Reg. §1.482-7(f)(3)(iii)(A).);
  
• Sales (Reg. §1.482-7(f)(3)(iii)(B).);
  
• Operating profit (Reg. §1.482-7(f)(3)(iii)(C).); and
  
• Other bases to measure anticipated benefit (Reg. §1.482-7(f)(3)(iii)(D).).

The focus of discussion of these measures is the facts and circumstances under which each measure provides the most reliable basis to measure anticipated benefits, and no preference for any particular measure is evidenced. For example, the regulations provide that units will be a more reliable basis if each participant expects to have a similar increase in net profit or decrease in net loss attributable to the covered intangible per unit of the item(s) used, produced, or sold. Sales, on the other hand, will be a more reliable basis if each participant expects to have a similar amount of profit attributable to covered intangibles per dollar of sales. Operating profit as a basis to measure benefit will be more reliable if profit is largely attributable to use of the intangible (i.e., it is a "high profit intangible"), or if the share of profit attributable to the intangible is expected to be similar for each participant. Finally, other bases to measure benefit are possible, but only if there is a relationship between the basis of benefit measure and the additional income generated or costs saved by using covered intangibles. Thus, a distinct nexus between the basis for measurement and the amount of benefit should be established, or the IRS may consider the basis to be unreliable.

3. Reliability of Projections Used To Estimate Benefits

The second factor, the reliability of projections used to estimate benefits (Reg. §1.482-7(f)(3)(iv)(A)) is broken into three elements:

• Projections of the time that will elapse between the inception of the R&D and the receipt of benefits;
  
• Projections of the time over which benefits will be received; and
  
• Projections of the measure of each participant's benefits for each year during which it is anticipated that benefits will be generated.

The regulations say that these projections may, in turn, be based on other projections (e.g., operating profit projections will be based on projections of sales, costs, and operating expenses). Reg. §1.482-7(f)(3)(iv)(A).

Further, if benefit shares are expected to vary significantly over the years in which benefits will be received due to variations among participants in the timing of their receipt of benefits, a calculation of the discounted value of projected benefits may be needed. Reg. §1.482-7(f)(3)(iv)(A).

These rules are particularly relevant to pharmaceutical manufacturers, given the widely different regulatory hurdles that must be met in different jurisdictions to bring a product to market. If it appears that benefit shares will not materially shift over time, the current annual benefit shares in the product area may provide a reliable projection of future benefit shares. Reg. §1.482-7(f)(3)(iv)(A).

The regulations also address problems with unreliable projections, interjecting a commensurate-with-income type rule for cost-sharing arrangements under which the district director may look to actual benefits as a more reliable measure of anticipated benefits if there is a significant divergence between projected and actual benefit shares. Reg. §1.482-7(f)(3)(iv)(B). Although this hindsight rule is cause for substantial concern, it is somewhat mitigated by a safe harbor rule under which projections will not be considered unreliable because of differences between projected benefit shares and actual benefit shares if the difference is less than or equal to 20 percent of the participant's projected benefit share. No allocation based on this divergence will be made if the difference is due to an extraordinary event, beyond the control of the controlled participants, which could not reasonably have been anticipated at the time costs were shared. The relief afforded by these two exceptions is limited to allocations based on the unreliability of projections. Thus, the district director may nonetheless propose an allocation based on a Service determination that a different basis to measure benefits (e.g., sales vs. operating profits) provides a more reliable estimate of anticipated benefits. Because, as previously stated, no adjustment may be made if the different benefit measures are equally reliable, the issue of the reliability of the benefit measure is perhaps the most critical issue.

The final rule in reg. §1.482-7(f) provides, consistent with the statute of limitations, that any allocation made by the district director under that subsection must be reflected for tax purposes in the year in which the costs were incurred. Reg. §1.482-7(f)(4). Presumably, this rule prevents the IRS from adjusting in a later year for costs shared incorrectly in a prior closed year. This is a welcome change from the 1992 proposed regulations, which provided that an allocation 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. Prop. reg. §1.482-2(g)(4)(iii).

C. Buy-In and Buy-Out Rules

The final regulations also contain buy-in and buy-out rules that are largely consistent with the proposed regulations. Under reg. §1.482-7(g), if a controlled participant makes intangible property available to a qualified cost-sharing arrangement, the other controlled participants must compensate the contributing member by way of a buy-in payment, and the district director may make an allocation under reg. §1.482-1 and -4 through -6 if such payment is not made. Accordingly, the general principles set forth in reg. §1.482-1 (including the best-method rule, comparability analysis, and the arm's length range), and the specific intangible property valuation principles contained in reg. §1.482-4 (including the periodic adjustment provisions), will be particularly relevant to deciding the amount to be charged for a buy-in. A payment due from a participant will be netted against any payment owed to a participant from other controlled participants. The preamble notes that this netting rule does not apply in other contexts; that is, it does not permit netting of royalty payment obligations in cross-licensing situations.

A change in participants' interests in covered intangibles is also considered a transfer of an intangible for which the district director may impose an arm's length charge pursuant to the rules contained in reg. §1.482-1 and sections 1.482-4 through 1.482- 6. Reg. §1.482-7(g)(1). A change in a participant's interest occurs if a new participant joins the arrangement (Reg. §1.482-7(g)(3)) or a participant transfers, abandons, or relinquishes its interest (or part of its interest) to the benefit of another participant. Reg. §1.482-7(g)(4). Further, if a participant bears a share of the costs of development that is consistently and materially greater or lesser than its share of reasonably anticipated benefits, the district director may impute an agreement consistent with the participants' course of conduct, such that the participant that bore the disproportionately greater share of costs will be considered to have received a proportionately greater interest in the covered intangibles. Reg. §1.482-7(g)(5). Then, the participant that bore a disproportionately greater share of costs must receive an arm's length payment from any controlled participant(s) that bore a disproportionately lesser share of costs (as compared to its share of reasonably anticipated benefits). Reg. §1.482-7(g)(5). This rule undermines the basic rule discussed above, i.e., that if a participant's share of the costs of developing an intangible are not equal to its share of reasonably anticipated benefits, the district director may make allocations solely by adjusting cost shares.

Any unassigned interests in a covered intangible will be deemed to be owned by each of the controlled participants in an amount equal to its share of the development costs. Reg. §1.482-7(g)(6). Therefore, if a geographic market is unassigned by the cost-sharing arrangement, and that market is ultimately exploited by one of the controlled participants or another related party, then an arm's length payment must be made to each of the deemed owners consistent with the value of the geographic rights in the intangible. The regulations also provide that the consideration for a buy-in or buy-out may take any of three forms: lump sum payments, installment payments, and royalties. Reg. §1.482-7(g)(7)

D. Character of Payments

Consistent with the proposed regulations, payments made under a qualified cost-sharing arrangement will be considered as costs of developing intangibles of the payor and as reimbursements of such costs of the payee. Reg. §1.482-7(h)(1). Any payment made that is not pursuant to a qualified cost-sharing arrangement and is not a buy-in or buy-out payment under reg. §1.482-7(g) is considered a payment for the transfer of an interest in intangibles subject to the general rules of reg. §1.482-1 and reg. §§1.482-4 through 1.482-6. Finally, a payment that in substance is a cost-sharing payment will be treated as such, despite a different characterization under foreign law. This rule would appear to allow affiliates to participate in a cost-sharing arrangement even if prohibited by foreign law, while a payment can be made.

E. Documentation, Reporting, and Other Administrative Rules

The regulations also contain several accounting and administrative rules. First, controlled participants must use a consistent method of accounting to measure costs and benefits, and must translate foreign currencies in a consistent manner. Reg. §1.482-7(i). Second, and extremely important, documentation and reporting requirements are imposed for all controlled participants. Reg. §1.482-7(j). The documentation requirement mandates that a controlled participant maintain sufficient documentation to establish that it qualifies as a participant in a qualified cost-sharing arrangement under the rules discussed above, and it must maintain the document drafted contemporaneously with the formation of the cost-sharing arrangement. Reg. §1.482-7(j)(2). Documents also must be maintained that explain the total amount of costs, the cost borne by each controlled participant, a description of the method used (including the projections used to estimate benefits and an explanation of why the method was selected), the accounting method used, and information relating to prior research conducted, tangible and intangible property made available to the arrangement, and valuation of intangibles. Reg. §1.482-7(j)(2). This documentation must be provided within 30 days of an IRS request (unless the district director grants an extension). Reg. §1.482-7(j)(2).

These documentation requirements are consistent with the documentation that would be required to avoid a penalty under §6662(e) and the regulations thereunder. Indeed, as noted above, the principal document requirement of reg. §1.6662-6(d)(2)(iii)(B) will be satisfied if the documentation requirements of reg. §1.482-7(j)(2) are met. A reporting requirement is also imposed by the regulations, under which a controlled participant must attach to its income tax return a statement designating itself as a participant in a qualified cost-sharing arrangement and listing the other controlled participants. Reg. §1.482-7(j)(3). This reporting requirement is similar to the reporting requirements imposed under reg. §1.6662- 6T(d)(2)(iii)(D) and (3)(iii)(C).

F. One-Year Transition Period

The regulations close with a transitional rule, under which a cost-sharing arrangement will be considered a qualified cost-sharing arrangement under these regulations if the arrangement was a bona fide cost-sharing arrangement under the 1968 regulations and the arrangement is amended to conform with the new regulations within one year. Reg. §1.482-7(1).

G. Remaining Concerns

The final regulations have addressed many concerns and objections to the proposed regulations raised by taxpayers in comments. Three particularly problematic rules have been deleted -- the rule governing the allowable scope of R&D, the active conduct (and anti-licensing) rules regarding which entities may participate in a qualified cost-sharing arrangement, and the cost/income ratio that purported to use operating income as a test of whether costs were shared in proportion to anticipated benefits. However, perhaps the most fundamental concern raised by these regulations is not the explicit rules but rather the IRS's view of cost-sharing as a safe harbor granted at the discretion of the commissioner. Although the term "safe harbor" is not found anywhere in the regulations, it is used four times in the preamble, most notably in the following:

§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 developed. To claim the benefits of the safe harbor, a taxpayer must also satisfy certain formal requirements (enumerated in reg. §1.482-7(b)). The district director may apply the cost-sharing rules to any arrangement that in substance is a cost-sharing arrangement, despite any failure to satisfy particular requirements of the safe harbor.

This perception of cost-sharing as a gift bestowed by the Treasury Department also is reflected in reg. §1.482-7(h), which provides that payments made or received by a taxpayer pursuant to a cost-sharing arrangement that is not "qualified" will be subject to the provisions of reg. §§1.482-1 and 1.482-4 through 1.482- 6. Although the intent of this rule is not entirely clear, it would appear that nonqualified cost-sharing arrangements would, by default, be subject to the legal ownership rules in reg. §1.482- 4(f)(3). In essence, this means that the IRS need not respect cost-sharing arrangements that fall outside the narrow bounds of qualified cost-sharing arrangements. This narrow, parochial, and arbitrary approach to cost-sharing is arguably inconsistent with some basic tenets of the §482 regulations, specifically reg. §1.482-1(d)(3)(ii) and (iii) governing analysis of contractual arrangements and risk allocation. It also arguably exceeds the secretary's statutory mandate under reg. §482, which is to make adjustments as necessary to prevent evasion and to clearly reflect income. Nowhere does the statute suggest that the secretary can mandate how controlled taxpayers may conduct business; rather, the secretary may propose allocations based on the substance of the taxpayers' dealings and the arm's length standard.

II.   Cost Contribution Arrangements Under the OECD Draft Transfer Pricing Report

On March 8, 1995, the OECD Committee on Fiscal Affairs released a draft transfer pricing report that addressed, among other subjects, the rules governing related party "cost contribution arrangements." The OECD draft report guidelines are significantly less specific than the U.S. rules, but no direct conflicts are apparent. The first noticeable difference in approach is in the term of art itself – Cost "Contribution" Arrangements – which are described as situations in which "members of an MNE group acting in concert jointly produce or provide goods, intangible property, and/or services, or jointly acquire goods, intangible property or services from a third party." The report notes that while "cost contribution arrangements more commonly cover services and R&D, they need not be limited to these categories and could exist for any joint acquisition or provision of products, intangible property, or service." This description is a good deal broader than the restrictive IRS notion of an agreement under which two or more members of a group of controlled taxpayers jointly develop intangible property.

Cost contribution arrangements include situations in which associated enterprises jointly develop intangible property for each participant to use for its own purposes, and situations in which the arrangement contemplates not only joint development but also joint exploitation, in effect a joint venture model. A question that arises here is whether under a joint venture model cost contribution arrangement the participants have an "interest" in covered intangibles for purposes of the U.S. regulations, in that their exploitation rights would not be separable from the exploitation rights of other participants.

The OECD report also differentiates between cost-sharing arrangements and cost funding arrangements. Cost-sharing arrangements are agreements under which participants agree to share the actual costs of the joint activity, whereas cost funding arrangements involve the contribution of an amount up front based on a "genuine estimate" of what the costs of the joint activity will be. As explained, the "difference between cost-sharing and cost funding is the way in which a project is financed and possibly in the timing of deductions." Given the U.S. regulations' focus on costs being commensurate with anticipated benefits, it is unlikely that an arrangement to share estimated costs or budgeted costs would pass muster for U.S. purposes.

The OECD report provides, consistent with the arm's length principle (and the U.S. regulations), that costs should be borne in proportion to benefit. Costs are generally contemplated to include direct and indirect net costs of successful and unsuccessful research, including overhead and costs of a capital nature (based on the relative use of the asset), but excluding subsidies or tax incentives. Benefits are evaluated consistent with the expected benefits of the joint activity, measured by reference to sales or some other test of benefit, if there is a reasonable connection between the allocation factor (e.g., sales) and the expected benefit. The key standard here is that cost allocations should be based on the most accurate measure of benefit and burdens, which is very similar to the rule contained in the U.S. regulations to the effect that benefits will be determined using the most reliable estimate of reasonably anticipated benefits. It is also similar to the best method rule contained in the 1993 temporary regulations ("most accurate measure of an arm's length result").

The report notes that in assessing benefit the expectation of profit making capacity must be commercially realistic, requiring that the joint activities be "closely related to the needs and interests of each participant." This rule precludes arrangements that are overly broad. Simultaneously the report provides that an arrangement that is too narrow in scope may not be commercially realistic, such as when resources necessary to exploit a jointly developed intangible are excluded. Under those circumstances, the report concludes that there should be "sound business reasons" for excluding such resources.

The report imposes no strict requirement of a written agreement, but notes that failure to put the agreement in writing will make it more difficult to verify the existence and bona fides of the agreement, which could affect whether a tax authority gives any credence to the arrangement. Accordingly, the report recommends that the terms of the agreement, including the method for sharing costs, be set forth with specificity and precision in a written, binding contract, and tax administrations are encouraged to provide guidance as to the written form that will be deemed acceptable. In addition, documentation establishing that the conduct of the participants was consistent, over a period of years, with the terms of the agreement will be important. The report also recommends that:

• Associated enterprises that expect to benefit from the joint activity should participate;
  
• Costs should be decided based on generally accepted accounting principles;
  
• Participants should have full access to the joint activity;
  
• No other payments should be made to compensate for the joint activity;
  
• Changes that have an effect on the benefits of participants should be considered as soon as possible; and
  
• The consequences of a participant entering or withdrawing from the agreement should be addressed.

The report concludes with a discussion of buy in and buy out rules, noting that payment is not always called for, such as when the entrance (or withdrawal) of a participant produces no detriment (or benefit) to the other participants. This determination must be made on a case by case basis.

IV. Working With the Final Regulations

Now that the cost-sharing landscape is (somewhat) more settled, U.S. and foreign multinationals with substantial R&D functions should revisit this issue. For those who are not currently cost-sharing, careful consideration should be given to the potential benefits of moving ownership of intangible property offshore. For those who are currently participating in a cost-sharing arrangement, consideration should be given to (1) whether their arrangement comports with the final regulations under reg. §1.482-7, (2) whether the benefits currently obtained by cost-sharing can be enhanced due to the increased flexibility of the final regulations, and (3) whether cost-sharing should be abandoned in favor of an alternative approach to creating, developing, and utilizing intangible property.

To properly evaluate the consequences of cost-sharing, taxpayers should first determine where R&D activities are being conducted, which party(ies) is/are bearing the costs, and which party(ies) is/are reaping the benefits. This process is basically the functional analysis called for in any transfer pricing inquiry. At this point, a careful study should be conducted as to the consequences of licensing versus cost-sharing versus contract research, specifically addressing:

• Short and long term cash flow effects;
  
• Deductibility of cost-sharing payments or royalties, and withholding taxes imposed, in the relevant jurisdictions;
  
• Availability of R&D credits in the relevant jurisdictions;
  
• Protection of intangibles under the law of the relevant jurisdictions;
  
• The effect on the character and source of income and the allocation of deductions, and the consequent effects on subpart F income and foreign tax credits; and
  
• Buy in obligations.

This is a complex analysis involving tax, financial, and other business considerations, and often will involve comparing apples to oranges. But with the help of various programs and mathematical models, it is not an impossible task, and the rewards of the right choice can be substantial.

V. Conclusion

Generally the IRS regulations are an evenhanded package of rules that adequately address revenue concerns without, for the most part, impinging unnecessarily on the options available to taxpayers. In keeping with the final §482 regulations issued in 1994, these regulations are generally consistent with the principles of the transfer pricing "trinity" – i.e., flexibility, comparability, and documentation. Given that comparability is irrelevant in this context, profit split principles (i.e., costs shared proportional to anticipated benefits) are inserted as a substitute. It remains to be seen how the OECD and foreign tax authorities will respond to the final U.S. cost-sharing regulations.