tax notes international - Tuck School of Business - Dartmouth College

SPECIAL REPORTS
The licensing alternative is derived on the basis of a
functional and risk analysis of the cost-sharing alternative,
but with a shift of the risk of cost contributions to
the licensor. The licensing alternative also should assume
contractual provisions regarding nonoverlapping
divisional intangible interests, and regarding allocations
of other risks, that are consistent with the actual CSA
in accordance with the cost-sharing rules.
The temporary regulations describe both CUT-based
applications and CPM-based applications of the income
method. However, they differ from applications
described in the proposed regulations by equating the
cost-sharing and licensing alternatives of the PCT
payer using discount rates appropriate to those alternatives.
If the market-correlated risks as between the costsharing
and licensing alternatives are not materially
different, a reliable analysis may be possible by using
the same discount rates for both alternatives. Otherwise,
as recognized in the best method considerations
concerning discount rates, realistic alternatives having
the same reasonably anticipated present value may nevertheless
involve varying risk exposure and thus generally
are more reliably evaluated using different discount
rates. The discount rate for the cost-sharing alternative
will also depend on the form of the PCT payments
assumed (for example, lump sum, royalty on sales, and
royalty on divisional profit).
The temporary regulations clarify the opportunities,
depending on the facts and circumstances, for the PCT
payer to assume risks and accordingly to enjoy the returns
(or suffer the detriments) that may result from
those risks. For example, in addition to its cost contributions
to developing cost-shared intangibles, a PCT
payer may also make significant operating contributions,
such as existing marketing or manufacturing process
intangibles, as well as make significant operating
cost contributions toward further developing the intangibles.
To the extent parties to comparable transactions
undertake risks of similar scope and duration, the PCT
payer will be appropriately rewarded based on a
method that relies in whole or part on returns in the
comparable transactions under an application of the
income method whether based on a CUT or CPM.
Some commentators criticized the income method
as positing an unrealistic perpetual life. The income
method, the preamble states, is premised on the assumption
that, at arm’s length, an investor will make a
risky investment (for example, in a platform for developing
additional technology) only if the investor reasonably
anticipates that the present value of its reasonably
anticipated operational results will be increased at
least by a present value equal to the platform investment.
It may be that the technology is reasonably expected
to achieve an incremental improvement and results
for only a finite period. The period of enhanced
results that justifies the platform investment in those
circumstances effectively would correspond to a finite,
not a perpetual, life.
This is helpful. There is not an automatic assumption
of an infinite period. As noted in the best method
discussion, an example states that, based on industry
experience, the period may be limited to a finite period.
P and S in the example are confident that the
cost-shared product will be replaced by a new type of
genetic testing based on an unrelated technology after
10 years and that then, the cost-shared product will
have no further value. See temp. Treas. reg. section
1.482-7T(g)(2)(ii)(B), Example. In temp. Treas. reg. section
1.482-7T(g)(4)(vii), Example 3, one of the income
method examples, some cost-shared software will have
a five-year life. Thereafter it will be rendered obsolete
and unmarketable by obsolescence of the storage media
to which it relates.
Acquisition Price and Market Capitalization
Methods
The proposed regulations included guidance on the
acquisition price and market capitalization methods for
evaluating the arm’s-length charge in a PCT. Under the
acquisition price method, the arm’s-length charge for a
PCT is the adjusted acquisition price, that is, the acquisition
price increased by the value of the target’s liabilities
on the date of the acquisition, and decreased by
the value on that date of the target’s tangible property
and other resources and capabilities not covered by the
PCT.
Under the market capitalization method, the arm’slength
charge for a PCT is the adjusted average market
capitalization, that is, the average daily market capitalization
over the 60 days ending with the date of the
PCT, increased by the value of the PCT payee’s liabilities
on that date, and decreased on account of tangible
property and any other resources and capabilities of
the PCT payee not covered by the PCT.
Commentators questioned the reliability of these
methods in light of volatility of stock prices and lack
of correlation between stock prices and underlying assets,
for example, owing to control premiums or economics
of integration.
The IRS and Treasury recognize that these comments
point to considerations that, depending on the
facts and circumstances, will need to be taken into account
in a best method analysis that compares the reliability
of the results under application of these
methods as against the results under application of
other methods.
The temporary regulations retain the best method
considerations stated in the proposed regulations that
observed that reliability is reduced under these methods
if a substantial portion of the target’s nonroutine contributions
to business activities is not required to be
466 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL
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