Page 12 - Altera And Cost-Sharing Requirements Under Section 482 By Jerald David August

Several commentators had informed the government that they knew of no transactions between unrelated parties that required one party to pay or reimburse the other for amounts attributable to stock-based compensation.
January/February 2016
BUSINESS ENTITIES 15
Treatment of Buy-In Payments
The regulations set forth guidance on “buy-in” payments involving the devel- opment of intangibles under a CSA. When a controlled participant makes preexisting intangible property avail- able to a qualified cost-sharing arrange- ment, that participant is deemed to have transferred interests in the property to the other participant and the other par- ticipant must make a buy-in payment as consideration for the transferred intan- gibles.48 The buy-in payment, which can be made in the form of a lump-sum payment, installment payments, or roy- alties, is the arm’s-length charge for the use of the transferred intangibles.49 Reg. 1.482-7(g)(2) requires buy-in payments to be made in accordance with Regs. 1.482-1 and -4 thru -6.
Where the recipient of the intangi- bles fails to make an arm’s-length buy- in payment, the IRS may make appropriate allocations to reflect an arm’s-length payment for the trans- ferred intangibles.50 The IRS’ authori- ty to make Section 482 allocations is limited to situations where it is neces- sary to make each participant’s share of costs equal to its share of reasonably anticipated benefits or situations where it is necessary to ensure an arm’s-length buy-in payment for transferred preex- isting intangibles.51 The IRS’ Section 482 allocation will be adopted by the
courts unless it is demonstrated to be arbitrary, capricious, or involves an abuse of discretion. For a taxpayer to prevail in a Section 482 case, it must first demonstrate that the IRS’ Section 482 allocation is arbitrary, capricious, or unreasonable and prove that its treat- ment satisfies the arm’s-length stan- dard. If the second test is not satisfied, the court determines the proper allo- cation or amount of the required buy- in payment attributable to a CSA, for example.52
The Service’s Defeat in VERITAS
In the Veritas case, 53 VERITAS Software Holding, Ltd. (VSHL) was incorporated as an Irish corporation but maintained its tax residence in Bermuda based on its place of management. VSHL was a whol- ly owned subsidiary of VERITAS US. Shortly thereafter, VERITAS Software International, Ltd. (VSIL) was incorpo- rated as a resident of Ireland and a whol- ly owned subsidiary of VSHL.VERITAS Software, Ltd. (VERITAS UK) and VER- ITAS Software Asia Pacific Trading PTE, Ltd. (VERITAS Singapore), disregarded entities for U.S. income tax purposes, were also wholly owned by VSHL. In 2000 and 2001 VSHL, VSIL, VERITAS UK, and VERITAS Singapore (collec- tively, VERITAS Ireland) were sub- sidiaries of VERITAS US.
Effective 11/3/1999, VERITAS US assigned to VERITAS Ireland all of VERITAS US’ existing sales agreements with European-based sales subsidiaries. Also effective on that date, VERITAS US, VERITAS Operating Corp., VER- ITAS Ireland and another related affil- iate, entered into the Agreement for Sharing Research and Development Costs (RDA), and VERITAS US and VERITAS Ireland entered into the Technology License Agreement (TLA) and cost-sharing agreement (CSA). The RDA applied to research for soft- ware products and software manufac- turing processes. They also agreed to share the costs and risks of such R&D on a going-forward basis.
;In exchange for the rights granted by the TLA, VERITAS Ireland agreed to pay VERITAS US royalties. The TLA, which was amended on three occasions, specified the initial royalty rates, as well as a prepayment amount (i.e., a lump-sum buy-in payment). The TLA provided that the parties “shall adjust the royalty rate prospec- tively or retrospectively as necessary so that the rate will remain an arm’s- length rate.”
The controlled transaction was the taxpayer’s contribution of software to a cost-sharing arrangement between the taxpayer and its Irish subsidiary (a buy- in). The uncontrolled transactions were contracts between VERITAS US and equipment manufacturers that installed the software in their equipment. None of the uncontrolled transactions was identical to the buy-in transaction. With respect to the uncontrolled transac- tions, the taxpayer received royalties based on the selling prices of the equip- ment, while the buy-in payment was a lump sum. Also, the uncontrolled trans- actions involved particular products of the taxpayer, while the buy-in covered “broad rights for the full range of VER- ITAS US products.”
The taxpayer’s expert performed an elaborate economic analysis to derive an arm’s-length price for the buy-in from the uncontrolled transactions, using four factors:
COST-SHARING