Contents - AL-Tax

40 3 Overview and Critique of Existing Transfer Pricing MethodsTaking as given a particular buy-in payment, one can determine which of thesetwo options yields a higher NPV. Alternatively, one can treat the buy-in paymentas a variable and derive a minimum payment by (a) equating the NPVs associatedwith each option (taking into account USP’s projected development expenses undereach scenario, licensing fees, etc.), and (b) solving for the unknown (the minimumbuy-in payment). Moreover, it is not sufficient that USP have an incentive to enterinto a cost-sharing arrangement; the net present value of joining for each prospectiveparticipant must be positive. One can derive a maximum buy-in payment for eachparticipant that does not make external contributions using the same analytics.However, the proposed regulations do not take this more nuanced approach.Instead, they convert the cost-sharing arrangement into a de facto licensing arrangementby brute force under the income method, applied in conjunction with thecomparable uncontrolled transaction method. Participants’ incentives to enter intoa cost-sharing arrangement, and the cost-sharing option in substance, are taken offthe table entirely.The mechanics are slightly different when one applies the income method in conjunctionwith the comparable profits method. However, such applications produceat least as draconian an allocation of intangible income. Moreover, the comparableprofits variant of the income method eliminates non-U.S. participants’ incentivesto invest not only in cost-shared intangibles, but all independently developed,territory-specific intangible assets as well. With a return capped at some arbitrarilydetermined “routine” level, non-U.S. cost-sharing participants would earn a negativeNPV if they invested in the development of any intangible assets, cost-sharedor otherwise, inasmuch as the cash flows generated thereby would flow directly toUSP. 39Clearly, regulations that require affiliated companies to agree to and abide byterms that third parties would never negotiate cannot be considered arm’s length.Correspondingly, regulations that do not permit commonly controlled companiesto enter into collaborative research joint ventures, while third parties routinely doso, cannot be considered arm’s length. As such, the 2005 proposed cost-sharingregulations’ income method is markedly inconsistent with the arm’s length standard.In short, the income method incorporated into the 2005 proposed cost-sharingregulations, and embroidered on in the CIP, flagrantly violates the foundationalarm’s length principle, as well as the U.S. transfer pricing regulations’ strictureagainst recharacterizing the form of an intercompany transaction if the parties39 There are more narrowly defined problems with the mechanics of the income method as well. Asdescribed in Example 1.482-7(g)(4)(iii)(C) of the proposed regulations, the ratio of cost-sharingpayments to sales is calculated by separately discounting projected cost-sharing payments andprojected sales. Therefore, contrary to what one would logically expect, the more risky the researchproject jointly undertaken, the smaller the discount from an arm’s length royalty charge for rightsto pre-existing intellectual property. Moreover, because cost-sharing payments are made over ashorter period of time than royalty payments, the should be calculated on a lump-sum basis (thatis, using the discounted present value of projected royalty payments as well), rather than on acontingency basis, as the proposed regulations contemplate.