The document discusses key changes in the 2009 temporary U.S. Treasury regulations regarding cost-sharing arrangements between related parties. Some of the major changes include: clarifying that platform contribution transactions include intangibles beyond just patents; requiring the use of an investor model to determine buy-in payments; allowing different discount rates to be used in valuations; and reducing the safe harbors for commensurate with income provisions, increasing the likelihood of periodic adjustments. The regulations provide more guidance but also increase complexity and potential challenges for multinational companies regarding cost-sharing arrangements.

1. Cost Sharing
Cost-Sharing in the U S
U.S.
An Overview of the U.S.
Temporary Treasury Regulations
§1.482-7T
Verse Consulting LLC
g
November 2009

2. Agenda
• What is Cost-Sharing?
Cost-Sharing Defined
Two Ways of Looking at IP Value
Types of Buy-In Payments
• Brief History of Cost-Sharing Regulations in the U.S.
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• Key Changes in the 2009 Temporary Regulations
• Potential Opportunities and Challenges for U.S.
Multinationals
M lti ti l

3. Cost-Sharing Defined
• Cost-Sharing Arrangements (“CSAs”) enable two or
more related parties to pool resources to develop
intangible property (“IP”) and share i th costs, risks
i t ibl t d h in the t i k
and benefits of that IP in proportion to participants’
expected benefit(s).
• Typically a CSA has two-key components:
1. A buy-in to compensate one or more entities for
pre-existing IP and
i ti IP; d
2. An ongoing cost-sharing system to share
development of future IP.

4. Two Ways of Looking at IP Value
• “Platform” intangibles
Contributory value
of existing IP does
NOT decay
significantly over
time.
time
• Depreciating IP
Contributory value
C t ib t l
of existing IP
decays over some
period.
period

5. Types of Buy-In Payments
• Royalty
Expressed as a percentage of sales, value of royalty may
decline over time depending on whether the IP is a
“platform” intangible, or depreciates over time.
• Lump sum
May be paid as a lump sum.
However, often paid as a declining royalty, with the present
value of royalty payments being equal to the lump sum.
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• Installments
Fixed payments over a set period of time.

6. Brief History of Cost-Sharing in the U.S.
Key U.S. Developments Affecting Cost-sharing
Coordinated
Final Issue Paper on
Amended cost-sharing
Final cost- cost- Stock Based
sharing sharing Compensation
Commensurate Regulations Regulations
With (stock
Income options)
ti )
Proposed Coordinated
Standard cost-sharing Final Proposed Issue
(CWI) Regulations Amended Revisions to Paper New
cost- the Cost on CSA §1.482-7T
1968 White sharing Sharing Buy-in Regulations
Regulations
g Paper Regulations
g Regulations Adjustments Issued
1968 1986 1988 1992 1995 1996 1998 2000 2002 2003 2005 2006 2007 2008 2009
Nestle Seagate DHL Xilinx
Key Court Cases (Appeal
Decision)
GlaxoSmithKline

7. Key Changes in the 2009
Temporary Regulations
• Clarify that Platform Contribution Transaction (“PCT”) includes
“intangibles” not just § 936(h)(3)(B) intangibles, so the value of a
contributed R&D workforce must be included in valuing the PCT;
other intangibles (e.g., Goodwill and Going Concern value and
business opportunity) are not expressly included; though 2009
Green Book would include GW/GCV Such intangibles may
GW/GCV. may,
however, be included depending upon the valuation method
employed in determining PCT payment(s). Emphasis on
“Business” valuation not IP valuation models.
• Requires use of the “Investor Model” to determine “buy-ins”
(PCT Payment) and mandates the upfront allocation of risk
(
(contained in the 2005 proposed regulations) between PCT
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Payor and PCT Payee.

8. Key Changes in the 2009
Temporary Regulations
• “Make & Sell” Rights are not PCT intangibles. If transferred
require additional compensation. See Treas. Reg. § 1.482-
7T(c)(4)
• Broad definition of Intangible for PCT purposes preserves
proposed regulations’ aggregation rule and the CPM approach.
Aggregation rule aggregates separate PCT intangibles as it is
intangibles,
“more reliable” to value the aggregate versus separate
components. Also, increases PCT, generally. See Treas. Reg.
§1.482 7T(g)(2)(iv)
§1 482-7T(g)(2)(iv)
• Compulsory requirement to consider “realistic alternatives” for
US and Foreign CSA participants (e.g., US Parent and Foreign
Sub in our hypothetical).
hypothetical)

9. Key Changes in the 2009
Temporary Regulations
• Foreign Sub’s best realistic alternative would be licensing IP
from an uncontrolled third-party, who bears all risk of IP
development.
development
• US parent’s best realistic alternative would be to bear all risk of
IP development and license developed IP to third-party.
• PCT payment (“buy-in”) i th d lt b t
t (“b i ”) is the delta between pre-tax income
t i
under the cost-sharing alternative and the hypothetical licensing
alternative.
PV of PCT PV of license i
f PCT= f li income-PV of th i t
PV f the intangible
ibl
development costs (“IDC”)

10. Key Changes in the 2009
Temporary Regulations
• Licensing alternatives under Income Method based on either
Comparable Uncontrolled Transaction (“CUT”) or Comparable
Profits Method (“CPM”)
( CPM ).
CUT may be difficult to implement/find in practice
CPM approach may undervalue risk Foreign Sub undertakes vis-à-
vis hypothetical licensing arrangement
Ability to utilize different discount rates for hypothetical licensing
and cost-sharing alternatives may be helpful in mitigating adverse
impact on Foreign Sub from using CPM-based approach.
p g g pp
Foreign subsidiaries with substantial functionality and assets may
be able to use Residual Profit Split Method (“RPSM”) to
compensate Foreign Sub for “non-routine” intangible contribution by
compensating for those functions and assets.
ti f th f ti d t

11. Key Changes in the 2009
Temporary Regulations
• Moving away from exclusive WACC-based approach in the
Proposed Regulations, the Temporary Regulations allow use of
different discount rates
rates.
Different assets may have different discount rates. Treas.
Reg. § 1.482-7T(g))(2)(v)(A).
Different “Realistic Alternatives” may have different discount
Diff t “R li ti Alt ti ” h diff t di t
rates, e.g., Cost-sharing vs. Licensing. Treas. Reg. § 1.482-
7T(g)(2)(v)(B).
Different Revenue Streams may have different di
Diff tR St h diff t discountt
rates, e.g., royalty on sales vs. profit. Treas. Reg. § 1.482-
7T(g)(2)(v)(C).

12. Key Changes in the 2009
Temporary Regulations
• Temporary regulations recognize that transfer pricing analyses
are done on a pre-tax basis and capital market discount rate
data are based on after tax rates As such, it may be necessary
after-tax rates. such
to “gross-up” for taxes or alternatively treat tax as an expense.
See Treas. Reg. § 1.482-7T(g)(2)(v)(D).
• Under the Temporary Regulations probability weighted
probability-weighted
projections should be used to project income from PCT-
intangibles. Though this development is positive, careful
consideration should be given to the projections utilized for PCT
computation purposes and other types of projections, (e.g., FAS
142, management forecasts, etc.) as significant dichotomies
between forecasts could be an Achilles’ heel for Taxpayers.
p y

13. Key Changes in the 2009
Temporary Regulations
• Probability-weighted projections while conceptually simple will in
all likelihood prove more challenging in practice and, therefore,
are likely to give rise to robust discussion with external
regulators.
Practice Note: As probability of failure risk increases, the
PCT payment will likely be reduced; though the likelihood of
tripping the Periodic Trigger under the commensurate-with-
income rules increases, all things being equal, for successful
projects.
projects

14. Key Changes in the 2009
Temporary Regulations
• Estimation of Useful Life. Temporary Regulations do not
assume perpetual life for PCT intangibles; this is a change from
prior guidance (e g CIP issued by the IRS in 2007) which used
(e.g.,
a terminal-value calculation (derived from the Gordon Growth
Model).
See Example 1 in the regulations that suggests that the
platform contribution relates only to the period that a product
is based on the platform contribution. See Treas. Reg. §
1.481 7T(c)(5).
1 481-7T(c)(5) This should not be construed as indicating
that the IRS’ position that platform contribution IP is short-
lived. Instead it likely means “facts and circumstances” have
to be carefully evaluated and considered in developing
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assumptions related to useful lives.

15. Key Changes in the 2009
Temporary Regulations
• Interquartile Range. Temporary Regulations’ provide guidance
with respect to determining interquartile range of all potential
outcomes from all potential outcomes from the interquartile
ranges from of the all variables used to compute a PCT
payment. See Treas. Reg. § 1.482-7T(g)(2)(ix)
Example: Assume Income Method is “Best Method” and
Best Method
there are four different discount rates within the interquartile
range of discount rates and four different profit margins
within the interquartile range of routine returns no other
returns,
variable inputs, 16 alternative PCT payments would be
computed. The interquartile range of those 16 computed
values would be the applicable arm’s length range for the
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PCT payment.

16. Key Changes in the 2009
Temporary Regulations
• Observation: By taking into consideration variation in market
comparables for each input parameter for income-method based
PCT computations and requiring a two step computation of the
two-step
interquartile range, it seems the resulting range will be narrower
than what might have resulted under a single-step computation,
as the second-step results in a narrowing of the interquartile
second step
range. It seems this approach may result in more “Periodic
Triggers” under the commensurate-with-income (“CWI”)
p
provisions.

17. Key Changes in the 2009
Temporary Regulations
• Territorial Interests. To provide taxpayers with more flexibility in
designing qualifying divisional interests, the temporary regulations
permit use of a new basis – the field of use division of interests – in
addition to the territorial basis. Further, the regulations also authorize
other non-overlapping divisional interests provided that the basis used
meets four criteria: (1) The basis must clearly and unambiguously
divide ll interests i cost shared i t
di id all i t t in t h d intangibles among th controlled
ibl the t ll d
participants; (2) the consistent use of such basis can be dependably
verified from the records maintained by the controlled participants; (3)
the rights of the controlled p
g participants to exploit cost shared intangibles
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are non-overlapping, exclusive, and perpetual; and (4) the resulting
benefits associated with each controlled participant's interest in cost
shared intangibles are predictable with reasonable reliability. See
Treas. Reg 1.482-7T(b)(4)
Treas Reg. § 1 482 7T(b)(4)

18. Key Changes in the 2009
Temporary Regulations
• Use of Residual Profit Split Method (“RPSM”). Temporary
regulations permit use of RPSM provided that both parties to the
CSA make non-routine contributions of the development and/or
exploitation of th cost-shared i t
l it ti f the t h d intangibles.
ibl
Example: US Parent provides platform contributions for the
development of the cost-shared intangibles and the Foreign
Sub
S b separately d
t l develops non-routine marketing i t
l ti k ti intangibles
ibl
to facilitate exploitation of the cost-shared intangibles. In this
instance RPSM could be utilized. If, however, Foreign Sub
shares development costs or simply makes payments
payments,
RPSM may not be used by either party.

19. Key Changes in the 2009
Temporary Regulations
• Two-Stage Allocation. Temporary Regulations’ eliminate three-
stage approach of proposed regulations.
First stage determines the discounted value of non-routine
residual profits (after all CST payments and other intangible
development costs) within each division/territory.
Second stage allocates non-routine residual profit in each
division/territory among the controlled participants that made
platform or operating contributions for the benefit of the CSA
activity, based on the relative value of each contribution.
Allocation of non-routine residual profit can b made on th
All ti f ti id l fit be d the
basis of capitalized cost or external benchmarks. See Treas.
Reg. § 1.482-7T(g)(7)(i)

20. Key Changes in the 2009
Temporary Regulations
Observation: Due to the inherent subjectivity associated
with use of RPSM, IRS will likely scrutinize the allocation of
non-routine residual profit. An Advance Pricing Agreement
(“APA”) may be th only way t obtain certainty i thi
b the l to bt i t i t in this
regard. The Preamble notes that IRS intends to issue
guidance that provides that Periodic Adjustments will not be
made where PCTs are covered under an APA APA.

21. Key Changes in the 2009
Temporary Regulations
• Post-Formation Acquisitions (“PFA”). Temporary
Regulations eliminate “special form of payment” rule of the
proposed regulations. PFAs continue to be an area of
importance and th IRS will lik l continue it efforts t re-
i t d the ill likely ti its ff t to
allocate financial statement goodwill to other platform
contributions (e.g., in-process R&D, workforce-in-place, existing
intellectual property or other intangible property) The
property, property).
Temporary Regulations do not, however, address Financial
Statement goodwill, though they do observe that valuations for
financial accounting purposes may be a useful starting point but
are not conclusive. Examples in the Temporary Regulations
illustrate the interplay between financial statement goodwill and
p
platform contributions. See Treas. Reg. § 1.482-7T(g)(2)(vii)
g (g)( )( )

22. Key Changes in the 2009
Temporary Regulations
• Intangible Development Costs (“IDC”) and Reasonably
Anticipated Benefit (“RAB”). Temporary regulations increase
the amount of documentation required with respect to IDC &
RAB.
RAB
• Commensurate-with-Income provisions (“CWI”). The
Temporary Regulations reduce the safe harbors in the Proposed
Regulations b fift
R l ti by fifty-percent, increasing th lik lih d of
t i i the likelihood f
Taxpayers’ having a “Periodic Trigger” under the Temporary
Regulations. In the event the Periodic Trigger is tripped, Foreign
Sub would be limited to a return on its routine functions and
PCT payments. See Treas. Reg. §§ 1.482-7T(i)(6) and 1.482-
7T(i)(6)(v)

23. Key Changes in the 2009
Temporary Regulations
• CWI Trigger: A Mechanical Test. Initially tripped when (1) PV of
Foreign Sub actual operating income from all its activities
associated with the development and exploitation of the cost-
shared i t
h d intangibles over (2) PV of it PCT and cost-sharing
ibl f its d t h i
payments is less that 0.667 or greater than 1.5. For public
companies, PV is determined using the weighted-average cost
of capital (“WACC”) as of the “Periodic Trigger” date; unless the
( WACC ) Periodic Trigger
Taxpayer establishes an alternative discount rate better reflects
the degree of risk as of the Trigger date. [Note: If adequate
documentation is not maintained the “Periodic Trigger”
Periodic Trigger
thresholds are reduced to 0.8 and 1.25, respectively.] There are
some exceptions that may apply in certain circumstances to
mitigate the impact of the Periodic Trigger. See Treas. Reg. §
g p gg g
1.482-7T(i)(6)(iv)(B) and (vi)

24. Key Changes in the 2009
Temporary Regulations
• Other Arrangements. The Temporary Regulations’ make
coordinating amendments to other regulations under Section
482; this effectively exports the Investor Model to other
provisions of the regulations to address non-CSA based
transfers of intangibles under either the services regulations in
Treas. Reg. § 1.482-9T(m)(3) or the general intangibles
provisions of Treas. Reg. § 1.482-4T(g)(3), for example. This is
a departure from the predecessor regulations’ that contained a
binary construct for being a “QCSA.” It will be interesting to see
how the Investor Model is applied in other non CSA contexts
non-CSA
over time and how this impacts the Arm’s Length standard vis-à-
vis Article 9 of US Income Tax Treaties.

25. Key Changes in the 2009
Temporary Regulations
• Compulsory contract requirements. Temporary Regulations
impose fairly extensive documentation requirements upon CSA
participants including detailed contractual provisions that must
g
be substantively complied with in order for the arrangement to
be treated as a CSA under the Temporary Regulations. Under
the Temporary regulations, participants must include the nature
of the activities, risks, and benefits to be borne by and inure to
the respective participants’ in the CSA as part of the initial
contract. Moreover, there’s a 60-day grace period from the
effective date to the existence of a “contemporaneous contract.”
contemporaneous contract
See Treas. Reg. § 1.482-7T(k)(1)
Trust-me-its-in-there days are over.

26. Key Changes in the 2009
Temporary Regulations
• Compulsory Documentation, Accounting and Reporting
requirements. Documentation requirements under the
Temporary Regulations are considerably more extensive than
those under the 1995 regulations. Under the Temporary
Regulations, specific documentation with respect to PCTs must
be maintained—at all times—not just when the tax-return is
filed. Detailed transition rules exist for CSA’s in effect prior to
January 5, 2009. See Treas. Reg. § 1.482-7T(k)(2)-(4)

27. Key Changes in the 2009
Temporary Regulations
• Effective Date. Temporary Regulations are effective on January
5, 2009, except where a transition rule modifies the effective
date, e.g., pre-January 5th CSAs, which will be subject to
g y j
specific transition rules. See Treas. Reg. § 1.482-7T(m)
For tax years beginning after January 5, 2009, taxpayers
must satisfy the new documentation requirements under
Treas. Reg. § 1.482-7T(k) for purposes of satisfying the
Section 6662 documentation requirements.

28. Potential Opportunities for
U.S. Multinationals
• While requirements under the Temporary cost-sharing
Regulations are strict, opportunities remain for multinational
enterprises to use CSAs to achieve:
Cost-savings through operational and tax-efficiencies from
alignment of IP ownership with regional business operations
Reduction of audit risk from multilateral APA and thorough
analysis of facts and circumstances.

29. Potential Challenges for U.S.
Multinationals
• Under OECD Guidelines a Cost Contribution Arrangement
(“CCA”) is broader by definition than a CSA (OECD 8.7).
Posits that CCA payment should be remunerated with a
“routine return” only, conflicting with US’ CWI-construct.
Under the Temporary Regulations rights must be
exclusive,
exclusive perpetual and have non-overlapping territory
while under OECD there is no obligation for the CCA to
be exclusive, perpetual or have non-overlapping
territorial interests.
• Investor model appears to attract more profit into the U.S; may
conflict with Arm’s Length result in Article 9 of U.S. treaties.
• Expanded U S documentation requirements could lead other
U.S.
taxing authorities to request U.S. documentation.

30. Contact us
Verse Consulting LLC
1200 Smith Street, Suite 1600
Houston, T
H t Texas 77002
713-353-3964 (main)
713-353-4601 (fax)
( )
info [at] verseconsulting [dot] com

31. The Fine Print
• Not to be repurposed or sold.
• This presentation is provided for information purposes only and
is not intended to constitute tax advice which may be relied
upon to avoid penalties under any federal, state, local or other
tax statutes or regulations, and do not resolve any tax issues in
your favor.
Upon request, we can provide you with express written tax advice
after necessary factual development and subject to such conditions
and qualifications as we may deem appropriate under the
circumstances.
i t