tax notes international - Tuck School of Business - Dartmouth College

SPECIAL REPORTS
The investor model was a core principle of the proposed
regulations. A PCT payer, through cost sharing
and payments made in accordance with the PCT, is
investing for the term of the CSA activity and should
expect returns over time consistent with the riskiness of
that investment. Commentators, however, criticized the
investor model for stripping away risk returns from the
PCT payer.
The temporary regulations retain the investor model,
including the requirement to analyze the alternatives
realistically available to the taxpayer, but provide additional
guidance to explain that when the PCT payer
assumes risks, it accordingly enjoys the returns (or suffers
the detriments) that may result from those risks.
In doing a best method analysis, the relative reliability
of the application of a method depends on the degree
of consistency of the analysis with the assumption
that, as of the date of the PCT, each controlled participant’s
aggregate net investment in the CSA activity
(attributable to platform contributions, operating contributions,
and operating cost contributions) is reasonably
anticipated to earn a rate of return equal to the appropriate
discount rate for the controlled participant’s
CSA activity over the entire period of the CSA activity.
The regulation states that if the cost-shared intangibles
themselves are reasonably anticipated to contribute
to developing other intangibles, then the period that
is used includes the period, reasonably anticipated as of
the date of the PCT, of developing and exploiting the
indirectly benefited intangibles. The example in temp.
Treas. reg. section 1.482-7T(g)(2)(ii)(B) indicates that,
based on industry experience, the period does not need
to be infinite.
The relative reliability of a method also depends on
the degree of consistency of the analysis with the assumption
that uncontrolled taxpayers dealing at arm’s
length would have evaluated the terms of the transaction,
and entered into the transaction, only if no alternative
is preferable. This condition is not met, the regulation
states, when for any controlled participant the
total anticipated present value of its income attributable
to its entering into the CSA, as of the date of the
PCT, is less than the total anticipated present value of
its income that could be achieved through an alternative
arrangement realistically available to that controlled
participant.
The regulation states that realistic alternatives may
involve varying risk exposure and thus may be more
reliably evaluated using different discount rates. Determination
of the applicable discount rates obviously will
be important under these rules. In some circumstances,
the regulation states, a party may have less risk as a
licensee of intangibles needed in its operations, and so
require a lower discount rate than it would have by
entering into a CSA to develop the intangibles, which
may involve the party’s assumption of additional risk
in funding its cost contributions to the IDA. Similarly,
self-development of intangibles and licensing out may
be riskier for the licensor, and so require a higher discount
rate than entering into a CSA to develop the intangibles,
which would relieve the licensor of the obligation
to fund a portion of the IDCs of the IDA.
A discount rate should be used that most reliably
reflects the risk of the set of activities or transactions
based on all the information potentially available at the
time for which the present value calculation is to be
performed. The discount rate may differ among a company’s
various activities and transactions. The proposed
regulations indicated that the weighted average
cost of capital (WACC) of the taxpayer, or an uncontrolled
taxpayer, could provide the most reliable basis
for a discount rate if the CSA activity involves the
same risk as projects undertaken by the taxpayer, or
uncontrolled taxpayer, as a whole. In appropriate situations,
a company’s internal hurdle rate for projects of
comparable risk might provide a reliable basis for a
discount rate in the cost-sharing analysis.
Commentators criticized the proposed regulations
discount rate guidance. Some concluded that the proposed
regulations inappropriately emphasized the taxpayer’s
WACC as a basis for analysis. The specific references
to WACC and hurdle rates are eliminated, but
without any inference as to a WACC or a hurdle rate
being an appropriate discount rate, or an appropriate
starting rate in ascertaining a discount rate, depending
on the facts.
While the regulation discusses the possibility of using
different discount rates to reflect varying risk levels
— and that is important — there is little additional
guidance in the regulation in this regard. The taxpayer’s
or other taxpayers’ WACC and hurdle rates
seem to be lurking in the background, perhaps as default
rates. Taxpayers will need to carefully analyze
and document their discount rates. If the new regulation
is to work, this is the place where it will need to
work.
In an example, P and S form a CSA to develop intangible
X, which will be used in Product Y. P has a
platform contribution for which S commits to make a
PCT payment of 5 percent of its sales of Product Y. In
determining whether P had a more favorable realistic
alternative, the Service compares P’s anticipated posttax
discounted present value of the financial projections
under the CSA with P’s anticipated posttax discounted
present value of the financial projections
under a reasonably available alternative licensing arrangement.
In undertaking the analysis in the example,
the Service determines that because it would be funding
the entire development of the intangible, P takes
greater risk in the licensing scenario than in the costsharing
scenario. The Service concludes that because
464 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL
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