Page 6 - Altera And Cost-Sharing Requirements Under Section 482 By Jerald David August

Section 482 and
Cost-Sharing Arrangements Pertaining to Intangibles
A CSA involves the participants’ agree- ment of sharing of costs and expenses attributable to R&D of intangible prop- erty in exchange for obtaining a share of the profits (or loss) with respect to developed intangible property. Since multiple taxing jurisdictions may be implicated, it is important to determine from the outset whether the CSA will be respected by all relevant taxing author- ities in avoiding double taxation, that the developers will be treated as co- owners of the developed technology, and that the buy-in (and buy-out) pay- ments and resulting allocations of prof- it and percentage of ownership will be respected.
The CSA regulations were first announced in proposed form in 1966.24 In 1968 final CSA regulations were issued that were, unlike the pro- posed regulations, reduced to a single paragraph.25 Eighteen years later, Con- gress added the “commensurate with income” standard in adding a sentence in Section 482. Next was the publica- tion by the Service of its Section 482 “White Paper” in 1988 which expressed concern about CSAs and the need for
more formal guidance.26 The 1988 White Paper concluded, inter alia, that Congress intended for the commen- surate with income standard to work consistently with the arm’s-length stan- dard and with international transfer pricing norms and treaty obligations. After receiving comments, including criticisms, and recommendations with respect to the 1988 White Paper, pro- posed regulations were issued in 1992.27
1992 Proposed Regulations. With respect to a “qualified” CSA, five require- ments had to be met under the 1992 proposed regulations:
1. The arrangement had to have two or more eligible participants.
2. The arrangement had to be record- ed in writing contemporaneously with the formation of the cost shar- ing arrangement.
3. The eligible participants had to share the costs and risks of intangible development in return for a speci- fied interest in any intangible pro- duced.
4. The arrangement had to reflect a rea- sonable effort by each eligible par- ticipant to share costs and risks in proportion to anticipated benefits from using developed intangibles.
5. The arrangement had to meet cer- tain administrative requirements. The key requirements were that par- ticipants had to be eligible and that costs and risks had to be propor- tionate to benefits. In addition, only a controlled taxpayer that would use developed intangibles in the active conduct of its trade or business was eligible to participate in a CSA. The rational for this requirement was to ensure that controlled foreign enti- ties were not established solely to participate in a CSA without per- forming any other meaningful func- tion, and to ensure that each participant’s share of anticipated benefits was measurable.
The proposed regulations for CSAs allowed costs to be divided based on any measurement that would reason- ably predict cost-sharing benefits (e.g., anticipated units of production or antic- ipated sales).28 However, the basis for measuring anticipated benefits and dividing costs was tested by a cost-to- operating-income ratio. The method for dividing costs was presumed to be unreasonable where 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:
1. If the cost-to-operating-income ratio was disproportionate (allocation of costs).
2. 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).
3. Or, if the cost-to-operating-income ratio was substantially dispropor- tionate, such that a transfer of an intangible could be deemed to have occurred (allocation of income). Under the 1992 proposed regulations,
the IRS could also make an allocation of income to reflect a buy-in or buy-out
COST-SHARING
January/February 2016
BUSINESS ENTITIES 9