Comments On The 1992 Proposed Regulations
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains final regulations relating to qualified cost sharing arrangements under section 482 of the Internal Revenue Code. These regulations reflect changes to section 482 made by the Tax Reform Act of 1986, and provide guidance to revenue agents and taxpayers implementing the changes.
DATES: These regulations are effective January 1, 1996.
These regulations are applicable for taxable years beginning on or after January 1, 1996.
FOR FURTHER INFORMATION CONTACT: Lisa Sams of the Office of Associate Chief Counsel (International), IRS (202) 622-3840 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
PAPERWORK REDUCTION ACT
The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-1364. Responses to these collections of information are required to determine whether an intangible development arrangement is a qualified cost sharing arrangement and who are the participants in such arrangement.
An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.
The estimated average annual burden per recordkeeper is 8 hours. The estimated average annual burden per respondent is 0.5 hour.
Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.
Books and records relating to these collections of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.
BACKGROUND
Section 482 was amended by the Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 2085, 2561, et. seq. (1986-3 C.B. (Vol. 1) 1, 478). On January 30, 1992, a notice of proposed rulemaking concerning the section 482 amendment in the context of cost sharing was published in the Federal Register (INTL-0372-88, 57 FR 3571).
Written comments were received with respect to the notice of proposed rulemaking, and a public hearing was held on August 31, 1992. After consideration of all the comments, the proposed regulations under section 482 are adopted as revised by this Treasury decision, and the corresponding temporary regulations (which contain the cost sharing regulations as in effect since 1968) are removed.
EXPLANATION OF PROVISIONS
The Tax Reform Act of 1986 (the Act) amended section 482 to require that consideration for intangible property transferred in a controlled transaction be commensurate with the income attributable to the intangible. The Conference Committee report to the Act indicated that in revising section 482, Congress did not intend to preclude the use of bona fide research and development cost sharing arrangements as an appropriate method of allocating income attributable to intangibles among related parties. The Conference Committee report stated, however, that in order for cost sharing arrangements to produce results consistent with the commensurate-with-income standard, (a) a cost sharer should be expected to bear its portion of all research and development costs, on unsuccessful as well as successful products, within an appropriate product area, and the costs of research and development at all relevant development stages should be shared, (b) the allocation of costs generally should be proportionate to profit as determined before deduction for research and development, and (c) to the extent that one party contributes funds toward research and development at a significantly earlier point in time than another (or is otherwise putting its funds at risk to a greater extent than the other) that party should receive an appropriate return on its investment. See H.R. Rep. 99-281, 99th Cong., 2d Sess. (1986) at II-638.
The Conference Committee report to the Act recommended that the IRS conduct a comprehensive study and consider whether the regulations under section 482 (issued in 1968) should be modified in any respect.
In response to the Conference Committee's directive, the IRS and the Treasury Department issued a study of intercompany pricing [Notice 88-123 (1988-2 C.B. 458)] on October 18, 1988 (the White Paper). The White Paper suggested that most bona fide cost sharing arrangements should have certain provisions. For example, the White Paper stated that most product areas covered by cost sharing arrangements should be within three-digit Standard Industrial Classification codes, that most participants should be assigned exclusive geographic rights in developed intangibles (and should predict benefits and divide costs accordingly) and that marketing intangibles should be excluded from bona fide cost sharing arrangements.
Comments on the White Paper indicated that, in practice, there was a great deal of variety in the terms of bona fide cost sharing arrangements, and that if the White Paper's suggestions were incorporated in regulations, the regulations would unduly restrict the availability of cost sharing.
The IRS issued proposed cost sharing regulations on January 30, 1992 (INTL-0372-88, 57 FR 3571). In general, the proposed regulations allowed more flexibility than anticipated by the White Paper, relying on anti-abuse tests rather than requiring standard cost sharing provisions.
The proposed regulations stated that in order to be qualified, a cost sharing arrangement had to meet the following five requirements: (1) the arrangement had to have two or more eligible participants, (2) the arrangement had to be recorded in writing contemporaneously with the formation of the cost sharing arrangement, (3) the eligible participants had to share the costs and risks of intangible development in return for a specified interest in any intangible produced, (4) the arrangement had to reflect a reasonable effort by each eligible participant to share costs and risks in proportion to anticipated benefits from using developed intangibles, and (5) the arrangement had to meet certain administrative requirements. The key requirements were that participants had to be eligible and that costs and risks had to be proportionate to benefits.
Under the proposed regulations, only a controlled taxpayer that would use developed intangibles in the active conduct of its trade or business was eligible to participate in a cost sharing arrangement. This requirement was considered necessary to ensure that controlled foreign entities were not established simply to participate in cost sharing arrangements without performing any other meaningful function, and to ensure that each participant's share of anticipated benefits was measurable.
The proposed regulations allowed costs to be divided based on any measurement that would reasonably predict cost sharing benefits (e.g., anticipated units of production or anticipated sales). However, the basis for measuring anticipated benefits and dividing costs was checked by a cost-to-operating-income ratio. The method for dividing costs was presumed to be unreasonable if a U.S. participant's ratio of shared costs to operating income attributable to developed intangibles was grossly disproportionate to the cost-to-operating-income ratio of the other participants.
If a U.S. participant's cost-to-operating-income ratio was not grossly disproportionate, a section 482 allocation could still be made under three circumstances: (a) if the cost-to-operating-income ratio was disproportionate (allocation of costs), (b) if the pool of costs shared was too broad or too narrow, so that the U.S. participant was paying for research that it would not use (allocation of costs), or (c) if the cost-to-operating-income ratio was substantially disproportionate, such that a transfer of an intangible could be deemed to have occurred (allocation of income).
Under the proposed regulations, the IRS could also make an allocation of income to reflect a buy-in or buy-out event, that is, a transfer of an intangible that could occur, for example, when a participant joined or left a cost sharing arrangement.
COMMENTS ON THE 1992 PROPOSED REGULATIONS
The 1992 proposed cost sharing regulations were generally well received. However, there were five areas of particular concern to commenters. The first was the mechanical use of cost-to-operating-income ratios as a standard for measuring the reasonableness of an effort to share costs in proportion to anticipated benefits. Commenters noted that operating income attributable to developed intangibles was difficult to measure, and that other bases for measuring benefits might produce more reliable results. Commenters also believed that the ratios might be overused, leading to adjustments to costs in every year, and to many deemed transfers of intangibles. In addition, commenters stated that the ratios did not provide any certainty that a cost sharing arrangement would not be disregarded, since a "grossly disproportionate" ratio was not numerically defined.
The second area of concern was the eligible participant requirement. Commenters argued that separate research entities (with no separate active trade or business) should be allowed to participate in cost sharing arrangements, as should marketing affiliates. Commenters also argued that transfers of intangibles to unrelated entities should not disqualify a participant, and that foreign-to-foreign transfers should not necessarily be monitored. Some comments also stated that controlled entities should be able to participate even if their cost sharing payments would be characterized differently for purposes of foreign law.
The third area of concern was the regulations' requirement that every participant be able to benefit from every intangible developed under a cost sharing arrangement. Commenters stated that the regulations should allow both single-product cost sharing arrangements and umbrella cost sharing arrangements (i.e., cost sharing arrangements under which a broad category of a controlled group's research and development would be covered).
The fourth area of concern was the buy-in and buy-out rules. There were some suggestions for clarifying and simplifying the rules. For example, comments urged that the regulations provide that one participant's abandonment of its rights would not necessarily confer benefits on the other participants, and that a new participant need not always make a buy-in payment when joining a cost sharing arrangement. Suggestions for simplifying the rules generally consisted of proposed safe harbors for valuing intangibles.
The final general area of concern was the administrative requirements. Several commenters suggested that annual adjustments to the method used to share costs should not be required. Commenters also suggested that taxpayers not be required to attach their cost sharing arrangements to their returns, and that the time period for producing records be increased.
In addition to these general areas of concern, commenters noted that there should be more guidance about when the IRS would deem a cost sharing arrangement to exist. Commenters also argued that existing cost sharing arrangements should be grandfathered, or that there should be a longer transition period. Commenters suggested that financial accounting rules be used to calculate costs to be shared, and that the IRS address the impact of currency fluctuations on the cost-to-operating-income ratios. Finally, commenters asked that the regulations clarify that a cost sharing arrangement would not be deemed to create a partnership or a U.S. trade or business.
Without fundamentally altering the policies of the 1992 proposed regulations, the final regulations reflect numerous modifications in response to the comments described above. They also reflect the approach of the final section 482 regulations relating to transfers of tangible and intangible property.
Section 1.482-7(a)(1) defines a cost sharing arrangement as an agreement for sharing costs in proportion to reasonably anticipated benefits from the individual exploitation of interests in the intangibles that are developed. In order to claim the benefits of the safe harbor, a taxpayer must also satisfy certain formal requirements (enumerated in section 1.482-7(b)). The district director may apply the cost sharing rules to any arrangement that in substance constitutes a cost sharing arrangement, notwithstanding any failure to satisfy particular requirements of the safe harbor. It is further provided that a qualified cost sharing arrangement, or an arrangement treated in substance as such, will not be treated as a partnership. (A corresponding provision is added to section 301.7701-3 pertaining to the definition of a partnership.) Neither will a foreign participant be treated as engaged in a trade or business within the United States solely by virtue of its participation in such an arrangement.
Section 1.482-7(a)(2) restates the general rule of cost sharing in a manner intended to emphasize its limitation on allocations: no section 482 allocation will be made with respect to a qualified cost sharing arrangement, except to make each controlled participant's share of the intangible development costs equal to its share of reasonably anticipated benefits.
Section 1.482-7(b) contains the requirements for a qualified cost sharing arrangement. This provision substantially tracks the proposed regulations. A modification was made in the second requirement which now directs that the arrangement provide a method to calculate each controlled participant's share of intangible development costs, based on factors that can reasonably be expected to reflect anticipated benefits. The new standard is intended to ensure that cost sharing arrangements will not be disregarded by the IRS as long as the factors upon which an estimate of benefits was based were reasonable, even if the estimate proved to be inaccurate.
Section 1.482-7(b)(4) requires that a cost sharing arrangement be set forth in writing and contain a number of specified provisions, including the interest that each controlled participant will receive in any intangibles developed pursuant to the arrangement. The intangibles developed under a cost sharing arrangement are referred to as the "covered intangibles." It is possible that the research activity undertaken may result in development of intangible property that was not foreseen at the inception of the cost sharing arrangement; any such property is also included within the definition of the term covered intangibles. The prescriptive rules in relation to the scope of the intangible development area under the proposed regulations are eliminated in favor of a flexible definition that encompasses any research and development actually undertaken under the cost sharing arrangement.
Section 1.482-7(c) provides rules for being a participant in a qualified cost sharing arrangement. Unlike the proposed regulations, the final regulations permit participation by unrelated persons, which are referred to as "uncontrolled participants." Controlled taxpayers may be participants, referred to as "controlled participants," if they satisfy the conditions set forth in these rules. These qualification rules replace the proposed regulations' concept of "eligible participant." The tax treatment of controlled taxpayers that do not qualify as controlled participants provided in section 1.482-7(c)(4) essentially tracks the treatment provided for ineligible participants under the proposed regulations.
The requirements for being a controlled participant are basically the same as in the proposed regulations. In particular, a controlled participant must use or reasonably expect to use covered intangibles in the active conduct of a trade or business. Thus, an entity that chiefly provides services (e.g., as a contract researcher) may not be a controlled participant. These provisions are necessary for the reason that they are necessary to the proposed regulations: to prevent foreign controlled entities from being established simply to participate in cost sharing arrangements. In accordance with section 1.482-7(c)(4) mentioned above, service entities (such as contract researchers) may furnish research and development services to the members of a qualified cost sharing arrangement, with the appropriate consideration for such assistance in the research and development undertaken in the intangible development area being governed by the rules in section 1.482-4(f)(3)(iii) (Allocations with respect to assistance provided to the owner). In the case of a controlled research entity, the appropriate arm's length compensation would generally be determined under the principles of section 1.482-2(b) (Performance of services for another). Each controlled participant would be deemed to incur as part of its intangible development costs a share of such compensation equal to its share of reasonably anticipated benefits.
As under the proposed regulations, the activity of another person may be attributed to a controlled taxpayer for purposes of meeting the active conduct requirement. However, modified language is adopted to be more precise concerning the intended requirements for attribution. These requirements were phrased in the proposed regulations as bearing the risk and receiving the benefits of the attributed activity. Under the final regulations, the attribution will be made only in cases in which the controlled taxpayer exercises substantial managerial and operational control over the attributed activities.
As under the proposed regulations, a principal purpose to use cost sharing to accomplish a transfer or license of covered intangibles to uncontrolled or controlled taxpayers will defeat satisfaction of the active conduct requirement. However, a principal purpose will not be implied where there are legitimate business reasons for subsequently licensing covered intangibles.
The subgroup rules of the proposed regulations are eliminated. Their major purpose is accomplished by a simpler provision (see the discussion of section 1.482-7(h)). In addition, the final regulations treat all members of a consolidated group as a single participant.
Section 1.482-7(d) defines intangible development costs as operating expenses other than depreciation and amortization expense, plus an arm's length charge for tangible property made available to the cost sharing arrangement. Costs to be shared include all costs relating to the intangible development area, which, as noted, comprises any research actually undertaken under the cost sharing arrangement. As under the proposed regulations, the district director may adjust the pool of costs shared in order to properly reflect costs that relate to the intangible development area.
Section 1.482-7(e) defines anticipated benefits as additional income generated or costs saved by the use of covered intangibles. The pool of benefits may also be adjusted in order to properly reflect benefits that relate to the intangible development area.
Section 1.482-7(f) governs cost allocations by the district director in order to make a controlled participant's share of costs equal to its share of reasonably anticipated benefits. Anticipated benefits of uncontrolled participants will be excluded from anticipated benefits in calculating the benefits shares of controlled participants. A share of reasonably anticipated benefits will be determined using the most reliable estimate of benefits. This rule echoes the best method rule for determining the most reliable measure of an arm's length result under section 1.482-1(c).
The reliability of an estimate of benefits principally depends on two factors: the reliability of the basis for measuring benefits used and the reliability of the projections used. The cost-to-operating-income ratio used in the proposed regulations to check the reasonableness of an effort to share costs in proportion to anticipated benefits has not been included in the final regulations. Rather, the final regulations provide that an allocation of costs or income may be made if the taxpayer did not use the most reliable estimate of benefits, which depends on the facts and circumstances of each case.
Section 1.482-7(f)(3)(ii) provides that in estimating a controlled participant's share of benefits, the most reliable basis for measuring anticipated benefits must be used, taking into account the factors set forth in section 1.482-1(c)(2)(ii). The measurement basis used must be consistent for all controlled participants. The regulations provide that benefits may be measured directly or indirectly. In addition, regardless of whether a direct or indirect basis of measurement is employed, it may be necessary to make adjustments to account for material differences in the activities that controlled participants perform in connection with exploitation of covered intangibles, such as between wholesale and retail distribution.
Section 1.482-7(f)(3)(iii) describes the scope of various indirect bases for measuring benefits, such as units, sales, and operating profit. Indirect bases other than those enumerated may be employed as long as they bear a relationship to benefits.
Section 1.482-7(f)(3)(iv) discusses projections used to estimate benefits. Projections required for this purpose generally include a determination of the time period between the inception of the research and development and the receipt of benefits, a projection of the time over which benefits will be received, and a projection of the benefits anticipated for each year in which it is anticipated that the intangible will generate benefits. However, the regulations note that in certain circumstances, current annual benefit shares may be used in lieu of projections.
Section 1.482-7(f)(3)(iv)(B) states that a significant divergence between projected and actual benefit shares may indicate that the projections were not reliable. A significant divergence is defined as divergence in excess of 20% between projected and actual benefit shares. If there is a significant divergence, which is not due to an unforeseeable event, then the district director may use actual benefits as the most reliable basis for measuring benefits. Conversely, no allocation will be made based on a divergence that is not considered significant as long as the estimate is made using the most reliable basis for measuring benefits.
For purposes of the 20% test, all non-U.S. controlled participants are treated as a single controlled participant in order that a divergence by a foreign controlled participant with a very small share of the total costs will not necessarily trigger an allocation (section 1.482-7(f)(3)(iv)(D), Example 8, illustrates this rule). Section 1.482-7(f)(3)(iv)(B) and (C) notes that adjustments among foreign controlled participants will only be made if the adjustment will have a substantial U.S. tax impact, for example, under subpart F.
Section 1.482-7(f)(4) states that cost allocations must be reflected for tax purposes in the year in which costs were incurred. This reflects a change from the rule in the 1992 proposed regulations, which stated that cost allocations would be included in income in the taxable year under review, even if the costs to be allocated were incurred in a prior taxable year. The purpose of the change was to match up cost adjustments with the year to which they relate in accordance with the clear reflection of income principle of section 482.
Section 1.482-7(g) provides buy-in and buy-out rules that are similar to the rules in the proposed regulations. However, some of the clarifications suggested by commenters have been incorporated in these rules. A "substantially disproportionate" cost-to-operating-income ratio will no longer trigger an adjustment to income under these rules. However, if, after any cost allocations authorized by section 1.482-7(a)(2), the economic substance of the arrangement is inconsistent with the terms of the arrangement over a period of years (for example, through a consistent pattern of one controlled participant bearing an inappropriately high or low share of the cost of intangible development), then the district director may impute an agreement consistent with the course of conduct. In that case, one or more of the participants would be deemed to own a greater interest in covered intangibles than provided under the arrangement, and must receive buy-in payments from the other participants.
The rules do not provide safe harbor methods for valuing intangibles, but rely on the intangible valuation rules of section section 1.482-1 and 1.482-4 through 1.482-6. To the extent some participants furnish a disproportionately greater amount of existing intangibles to the arrangement, they must be compensated by royalties by the participants who furnish a disproportionately lesser amount of existing intangibles to the arrangement. Buy-in payments owed are netted against payments owing, and only the net payment is treated as a royalty. No implication is intended that netting of cross royalties is permissible outside of the qualified cost sharing safe harbor rules.
Section 1.482-7(h) provides rules regarding the character of payments made pursuant to a qualified cost sharing arrangement. Cost sharing payments received are generally treated as reductions of research and development expense. A net approach is applied to foster simplicity and generally preserve the character of items actually incurred by a participant to the extent not reimbursed. In addition, for purposes of the research credit determined under section 41, cost sharing payments among controlled participants will be treated as provided for intra-group transactions in section 1.41-8(e). Finally, any payment that in substance constitutes a cost sharing payment will be treated as such, regardless of its characterization under foreign law. This rule is intended to enable foreign entities to participate in cost sharing arrangements with U.S. controlled participants even if foreign law does not recognize cost sharing. This rule obviated the main reason for the subgroup rules which, as noted, have accordingly been eliminated.
Section 1.482-7(i) requires that controlled participants must use a consistent accounting method for measuring costs and benefits, and must translate foreign currencies on a consistent basis. To the extent that the accounting method materially differs from U.S. generally accepted accounting principles, any such material differences must be documented, as provided in section 1.482-7(j)(2)(iv).
Section 1.482-7(j) provides simplified recordkeeping and reporting requirements. It is anticipated that many of the background documents necessary for purposes of this section will be kept pursuant to section 6662(e) and the regulations thereunder.
Section 1.482-7(k) provides that this regulation is effective for taxable years beginning on or after January 1, 1996.
Section 1.482-7(l) allows a one-year transition period for taxpayers to conform their cost sharing arrangements with the requirements of the final regulations. A longer period was not considered necessary, given the increased flexibility and the reduced number of administrative requirements of the final regulations.
SPECIAL ANALYSES
It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.
DRAFTING INFORMATION
The principal author of these regulations is Lisa Sams, Office of Associate Chief Counsel (International), IRS. However, other personnel from the IRS and Treasury Department participated in their development.
LIST OF SUBJECTS
26 CFR PART 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR PART 301
Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.
26 CFR PART 602
Reporting and recordkeeping requirements.
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