tax notes international - Tuck School of Business - Dartmouth College

SPECIAL REPORTS
the intangible development costs incurred on an ongoing
basis and any contribution of existing resources
and capabilities. The alternatives realistically available
to the participants must be considered. Most commentators
criticized the model on the grounds that its valuation
principles are too restrictive.
Taxpayers may need to amend their written agreements,
as described in temp. Treas. reg. section 1.482-
7T(k)(1), for CSAs existing before the effective date of
the new regulations. If the taxpayer has no agreement
in place that complies with these requirements by July
6, 2009, the taxpayer’s CSA may not be grandfathered.
A CSA statement will also need to be filed by September
2, 2009.
One final introductory note: The Ninth Circuit has
yet to make a decision in Xilinx. That decision could
ultimately have an important effect on these regulations.
General
Several commentators questioned whether and how
the proposed regulations conformed to the arm’s-length
standard and the commensurate with income rules. In
response, the preamble states that the temporary regulations
provide further guidance on the evaluation of
the arm’s-length results of cost-sharing transactions
(CSTs) and PCTs. The regulations address the material
functional and risk allocations in the context of a CSA,
including the reasonably anticipated duration of the
commitments, the intended scope of the intangible development,
the degree and uncertainty of profit potential
of the intangibles to be developed, and the extent
of platform and other contributions of resources, capabilities,
and rights to the development and exploitation
of cost-shared intangibles (CSA activity).
If available data concerning uncontrolled transactions
reflect, or may be reasonably adjusted to reflect,
similar facts and circumstances concerning a CSA,
they may be the basis for application of the comparable
uncontrolled transaction method to value the
CST and PCT results. Because of the difficulty of finding
data that reliably reflect these facts and circumstances,
the preamble states, the temporary regulations
also provide for other methods. Those include the income,
acquisition price, market capitalization, and residual
profit-split methods.
The temporary regulations also provide taxpayers
with more flexibility in designing some aspects of
CSAs.
R&D Cost Sharing That Is Not a CSA
The proposed regulations defined the contractual
terms, risk allocations, and other material provisions of
a CSA covered by the cost-sharing rules. While other
intangible development arrangements might in general
be referred to as cost-sharing arrangements, they were
not treated as CSAs by the proposed regulations unless
either: (1) the taxpayer substantially complied with the
CSA administrative requirements and reasonably concluded
that its arrangement was a CSA; or (2) the taxpayer
substantially complied with the CSA administrative
requirements and the IRS determined that the
CSA rules should be applied to the arrangement.
The IRS and Treasury continue to believe that these
rules, provided for CSAs, should apply only to the intended
transactions. The rules are to be applied only to
the defined scope of intangible development arrangements
and to apply no more broadly or narrowly than
intended. Thus, this portion of the proposed regulations
was adopted.
Nonconforming arrangements are governed by other
provisions of the section 482 regulations. Intangible
development arrangements, including partnerships, outside
the scope of the cost-sharing rules are governed by
the transfers of intangible rules or the controlled services
provisions, as appropriate. Nevertheless, the preamble
states that the methods and best method considerations
under the cost-sharing rules may be adapted
for purposes of evaluating nonconforming intangible
development arrangements.
Four examples illustrate these rules. In Example 1,
P and S execute an agreement that purports to be a
CSA, but they fail to enter into a PCT for some relevant
software. P and S substantially complied with the
contractual requirements and the documentation, accounting,
and reporting requirements and thus have
met the administrative requirements. However, because
they did not enter into a PCT for software that was
reasonably anticipated to contribute to the development
of the cost-shared product, they cannot reasonably conclude
that their arrangement is a CSA. Nevertheless,
the arrangement between P and S closely resembles a
CSA. If the Service concludes that the CSA rules provide
the most reliable measure of an arm’s-length result,
the Service may apply the CSA rules and treat P
and S as entering into a PCT for the software. Or the
Service may conclude that other provisions in the section
482 rules apply.
In Example 2, the facts are the same as in Example
1, except that P and S enter into and implement a PCT
for the software. The Service determines that the PCT
payments for the software were not arm’s length. However,
P and S reasonably concluded that their arrangement
is a CSA. The Service must apply the CSA rules
and make an adjustment to the PCT payments as appropriate.
In Example 3, the facts are the same as in Example
1, except that P and S enter into a PCT for the software.
The agreement provides for a fixed consideration
of $50 million per year for four years, payable at the
end of each year. The agreement satisfies the arm’slength
standard; however, S actually pays P consideration
at the end of each year in the form of four annual
royalties equal to 2 percent of sales. P and S
failed to implement the terms of their agreement and
460 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL
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