tax notes international - Tuck School of Business - Dartmouth College

covered by a PCT and, in the case of the market capitalization
method, if the facts and circumstances demonstrate
the likelihood of a material divergence between
the PCT payee’s average market capitalization
and the value of its underlying resources, capabilities,
and rights for which reliable adjustments cannot be
made.
Residual Profit-Split and Other Methods
The temporary regulations conform the modified
residual profit-split method from the proposed regulations
to the changes made to the income method.
Other unspecified methods also may be used, but they
must be acceptable under general and cost-sharing best
method considerations. They also must consider the
realistic alternatives to the transaction.
Form of Payment
The proposed regulations provided that the form of
payment selected for any PCT had to be specified no
later than the date of the PCT. In the case of a postformation
acquisition, the consideration under the PCT
had to be paid in the same form as the consideration
in the uncontrolled transaction in which the postformation
acquisition was made. An example indicated that
acquisitions for stock were considered to be for a fixed
form of payment. The temporary regulations do not
retain the special rule for postformation acquisitions.
Subsequent acquisitions remain an important source of
platform contributions that occasion the requirement of
PCT compensation. Controlled participants may
choose the form of payment for these PCTs.
The temporary regulations incorporate rules to ensure
that a contingent form for PCT payments is applied
properly by both taxpayers and the IRS. A CSA
contractual provision that provides for payments for a
PCT to be contingent on the exploitation of costshared
intangibles will be respected as consistent with
economic substance only if the allocation between the
controlled participants of the risks attendant on this
form of payment is determinable before the outcomes
of the allocation that would have materially affected
the PCT pricing are known or reasonably knowable.
The contingent payment provision must clearly and
unambiguously specify the basis on which the obligations
are to be determined.
Periodic Adjustments
The proposed regulations used the commensurate
with income provisions so that the Service can make
periodic adjustments for an open tax year and all subsequent
years of the CSA activity in the event of a periodic
trigger. A periodic trigger arose if the PCT payer
realized, over the period beginning with the earliest
date on which the intangible development occurred
through the end of the adjustment year, an actually
experienced return ratio (AERR) of the present value
of its total territorial operating profits divided by the
present value of its investment consisting of the sum of
SPECIAL REPORTS
its cost contributions plus PCT payments, outside the
periodic return ratio range (PRRR) of between 0.5 and
2. The Service would use an applicable discount rate,
which in the case of some publicly traded entities
would be their WACC, unless the Service determined,
or the controlled participants established, that another
discount rate better reflected the degree of risk of the
CSA activity.
Commentators offered several criticisms of the periodic
adjustment rules. Some considered the periodic
adjustment rules to be inconsistent with the arm’slength
standard and, through hindsight, to strip away
returns for risk. Other commentators said taxpayers
should have the same ability as the Service to make
periodic adjustments.
The IRS and Treasury reaffirm that the commensurate
with income principle is consistent, and periodic
adjustments are to be administered consistently, with
the arm’s-length standard. Accordingly, the temporary
regulations continue to provide for periodic adjustments
along lines similar to those in the intangible
transfers portion of the section 482 regulations, as
adapted for the cost-sharing context.
In an important narrowing, the temporary regulations
provide that a periodic trigger occurs if the
AERR falls outside the PRRR of between 0.667 and
1.5 (or between 0.8 and 1.25 if the taxpayer has not
substantially complied with the documentation requirements).
The preamble states that this is intended to
isolate situations in which the actual results suggest the
potential of an absence of arm’s-length pricing as of
the date of the PCT.
The IRS and Treasury believe that the periodic trigger
under the temporary regulations more realistically
targets the threshold at which periodic adjustment scrutiny
is appropriate. In determining whether to make
any periodic adjustments, the Service will consider
whether the outcome as adjusted more reliably reflects
an arm’s-length result under all relevant facts and circumstances.
Periodic adjustments will not be made if the controlled
participants establish to the satisfaction of the
Service that all the conditions described in one of the
exceptions below will apply regarding a trigger PCT.
The first exception is that the same platform contribution
was furnished to an uncontrolled taxpayer under
substantially the same circumstances as those of
the relevant trigger PCT and with a similar form of
payment as the trigger PCT. This applies only if the
transaction served as the basis for the application of
the CUT method in the first year and all subsequent
years in which substantial PCT payments relating to
the trigger PCT were required to be paid. The amount
of the PCT payments in the first year must have been
at arm’s length.
TAX NOTES INTERNATIONAL FEBRUARY 2, 2009 • 467
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