By:
Robert D. Whoriskey
New York
The final Internal Revenue Code Section 482 regulations relating to cost sharing arrangements for the research and development of intangible technology under Reg. § 1.482-7 were issued on December 19, 1995, effective January 1, 1996. These regulations directly affect arrangements between domestic and foreign affiliates. However, under Reg. § 1.482-7T, certain existing qualified cost sharing arrangements are given until January 1, 1997, to conform with the regulations.
Proposed cost sharing regulations had been issued on January 30, 1994, and were premised, in substantial part on changes to Section 482 imposed by the Tax Reform Act of 1986, requiring that consideration for intangible property transferred in a controlled transfer be commensurate with the income attributable to the transfer. The preamble to the final regulations states, in part, that the final regulations were issued "without fundamentally altering the policies of the 1992 proposed regulations . . ."
In fact, the final regulations relating to cost sharing arrangements have made a number of substantive changes from the 1992 proposed regulations. Like the 1992 proposed regulations, the final regulations allude, in passing, to an arm's-length standard, but focus more on the anticipated and actual financial benefits flowing to controlled participants, as measured proportionately by their respective costs and involvement in the research and development project(s) involved. Furthermore, the final regulations generally offer more flexibility for the crafting of qualified cost sharing arrangements and appear to allow some latitude in design, based upon internal financial and management considerations.
The final regulations, as did the 1992 proposed regulations, differentiate between a cost sharing arrangement and a "qualified" cost sharing arrangement. The 1992 proposed regulations followed the requirements of a cost sharing arrangement in proportion to benefits. The final regulations are more flexible, as they contemplate arrangements in proportion to reasonably anticipated benefits.
Qualified Arrangements. A qualified cost sharing arrangement is defined by the final regulations in detail, and explicitly embraces more favorable tax consequences than a nonqualified cost sharing arrangement. A qualified arrangement: (i) will not be treated as a partnership under subchapter K; (ii) will not cause a participant that is a foreign corporation or nonresident alien individual to be treated as engaged in a trade or business within the United States, solely by reason of its participation in the arrangement; and (iii) will not result in allocations by the IRS, within the cost sharing arrangement, except to the extent necessary to make each controlled participant's share of the costs of intangible development under the qualified arrangement equal to its share of "reasonably anticipated benefits" attributable to such development efforts.
Qualified Cost Sharing. The definition of a qualified cost sharing arrangement is derived, for the most part, from the 1992 proposed regulations. A qualified cost sharing arrangement must: (i) include two or more participants, including unrelated persons, except that, consistent with the 1992 proposed regulations, all controlled participants under the final regulations must use, or reasonably be expected to use, covered intangibles in the active conduct of a trade or business; (ii) provide a method to calculate each controlled participant's share of intangible development costs, based on factors that can reasonably be expected to reflect that participant's benefits, even (unlike the 1992 proposed regulations) if the estimate subsequently proves to be inaccurate; (iii) provide for adjustment to the controlled participant's shares of intangible development costs to account for change in economic conditions, the business operations and practices of the participants, and the ongoing development of intangibles under the arrangement; and (iv) be recorded in a document that is contemporaneous with the formation (and any revisions) of the cost sharing arrangement, including a number of detailed requirements, such as a designation of participants that will benefit from the cost sharing arrangement, a description of the research effort to be undertaken, the duration of the arrangement, and other factors.
The concept of a participant being associated with the active conduct of a trade or business would seem to exclude as a participant a U.S. holding company acting on behalf of its operating subsidiaries, for example, that entered into a cost sharing arrangement with a foreign participant.
The core of the final regulations deals with the computation of anticipated costs, reasonably anticipated benefits, and cost allocations.
Anticipated costs include operating expenses related to intangible development, plus cost sharing payments to other participants, less payments received from participants. Also included is a charge for tangible property made available to the cost sharing arrangement by a participant.
Benefits are broadly defined in terms of additional income generated and costs saved by the use of covered intangibles. "Reasonably anticipated benefits" are determined by using the "most reliable" estimate of benefits. The reliability of an estimate of benefits under the Regulations depends upon two factors: (i) the reliability of the basis for measuring benefits used and (ii) the reliability of the projections used.
20% Standard. A significant divergence between projected and actual benefit shares under the final regulations will mean that some projections will not be regarded as reliable. A significant divergence is defined by the final regulations as a divergence in excess of 20% between projected and actual benefit shares. If there is a significant divergence, which is due to an unforeseeable event, then the IRS may use actual benefits realized as the most reliable basis for measuring benefits.
Cost Allocations. The final regulations provide that cost allocations must be reflected for tax purposes, in the year in which costs were incurred, a change from the proposed regulations, which provided for recognition of cost allocations during the taxable year under review, even if incurred in a prior year.
Under the proposed regulations, the IRS could have adjusted income annually if there was a substantially disproportionate cost-to-income ratio. The final regulations provide that there will be an adjustment to a participant's income only if the economic substance of the arrangement is inconsistent with the substance of the arrangement over several years.
