IRS Logo
Print - Click this link to Print this page

Checklist for Cost Sharing Arrangements

ALERT: Revised Checklist was completed on May 27, 2008

 


OVERVIEW

Introduction

 

In general, a cost sharing arrangement (CSA) is an arrangement by which the participants agree to share the cost of developing one or more intangibles (referred to as “covered intangibles” or “cost shared intangibles”) that will be separately exploited by each of the participants. A CSA is governed by Treas. Reg. §1.482-7. By participating in a CSA, each participant obtains a separate interest in such cost shared intangible. Treas. Reg. § 1.482-7(b)(4)(iv). Consequently, each participant may separately exploit the cost shared intangible in a manner consistent with that interest, without owing additional compensation to the other participants. 

At the inception of the CSA, however, a participant may make available existing intangibles which it already owns to the CSA. In this situation, a “buy-in” (an “initial buy-in”) is owed to that participant from the other participants in the CSA.  In addition, a participant may subsequently acquire or develop intangibles outside the CSA and make those intangibles available to the CSA.  This would also require a buy-in (“acquisition buy-in”) to be paid to the participant contributing such intangibles to the CSA.  The intangibles made available to the CSA for research are referred to as either the “buy-in intangible” or the “platform intangible.”  During the CSA, participants share the intangible development costs (referred to as “IDCs” or “cost sharing pool”) in proportion to their shares of the benefits they reasonably anticipate from their individual exploitation of the cost-shared intangibles (referred to as “reasonably anticipated benefits”, “RABs” or “RAB shares”).  Upon termination of the CSA, a “buy-out” may be owed to the participants who relinquish their interests in the cost shared intangibles.  A CSA is subject to various documentation and reporting requirements pursuant to Treas. Reg. § 1.482-7.  Buy-ins and buy-outs are also subject to the rules under Treas. Regs. §§ 1.482-1, and 1.482-4 through 1.482-6.  A qualified CSA produces arm’s length results if, and only if, the requirements of Treas. Reg. § 1.482-7 are satisfied.  The IRC 6662(e) penalty regulations also apply to a CSA pursuant to Treas. Reg. § 1.482-7(j)(2)(ii).  The following checklist is provided as a tool to help International Examiners and Field Specialists (economists, engineers and computer audit specialists) review and evaluate a CSA

 


Objective of Checklist

This checklist is written for International Examiners and Field Specialists to use in examining cost sharing issues on an income tax return: 

  • First, to assess the taxpayer’s treatment of the issue; and
  • Second, as a guide in determining whether cost sharing documentation submitted by the taxpayer complies with the contemporaneous documentation requirements of Treas. Reg. § 1.482-7(j)(2) and the IRC 6662(e) penalty regulations.

 

 

 


Checklist General Makeup

The checklist consists of eight sections, each corresponding to one of the requirements set forth by Treas. Reg. § 1.482-7(j).

  • Part “A” of each checklist section quotes the applicable requirement of the regulations. 
  • Part “B” of each checklist section lists the suggested documentation that pertains to the applicable requirement of the regulations.
  • Part “C” of each checklist section provides information that is designed to help the user determine whether there are cost sharing issues.

 


Assistance

Assess the type of assistance needed in examination of the CSA.  This may include assistance from an Economist, Engineer, Technical Advisor (TA), International Technical Advisor (ITA), National Office Counsel, International Field Counsel, Local Counsel, or Industry Expert, for example.  There are many resources available within the Service to assist with cost sharing cases.  In addition, consider whether an outside specialist may be necessary. Refer to the following web pages on the LMSB web sites for:

  • Field Specialists
  • International
  • High Technology Industry
  • Industry Issue Focus and Control of LMSB Compliance Issues 

 


Caution

The pertinent regulations on cost sharing arrangements do not precisely specify the documentation that the taxpayer is required to create and maintain and no inference should be drawn that taxpayers will create and maintain any and all of the documents listed in this checklist. 

Furthermore, the checklist does not suggest a mechanical test for compliance with the regulations.  For instance, the taxpayer could maintain only a portion of the documents specified on the checklist and still be in compliance with the documentation requirements established by the regulations.  On the other hand, the taxpayer could provide most of the documents specified on the checklist and still not be in compliance. 

 


Checklist for Evaluating Cost Sharing Arrangements

 

Complied:  

Document Set

 YES

 NO

 

   

1.  30-day time limit for providing documentation, CSA document requirements and CSA participant requirements.

   

2. The total amount of costs incurred pursuant to the arrangement.

   

3.  The costs borne by each controlled participant.

   

4.  Methodology to determine participant’s share of IDCs.

   

5.  The accounting method used to determine IDCs and RABs.

   

6.  Prior research and other properties used in the CSA (including buy-in).

   

7.  Accounting for stock-based compensation.

   

8.  Reporting requirements.

 


DOCUMENT SET ONE

A.  30-day time limit for providing documentation, CSA document requirements and CSA participant requirements

A controlled participant must maintain sufficient documentation to establish that the requirements of paragraphs (b)(4) and (c)(1) of this section have been met, as well as the additional documentation specified in Treas. Reg. § 1.482-7(j)(2)(i), and must provide any such documentation to the Internal Revenue Service within 30 days of a request (unless an extension is granted by the Director of Field Operations).   

Treas. Reg. § 1.482-7(j)(2)(i)     

Treas. Reg. § 1.482-7(b) describes the requirements for a qualified CSA, including that there be:

  • Two or more participants.
  • Method to determine participants’ shares of intangible development costs.  See Document Set Four.
  • Adjustment of such shares in light of changes in economic conditions, business operations and practices, and ongoing intangible development under the CSA.
  • CSA agreement recorded contemporaneously with the formation and any revision of CSA, which includes the information specified in Treas. Reg. § 1.482-7(b)(4)(i)-(vi).

Treas. Reg. § 1.482-7(c) describes the requirements to be a participant in a qualified CSA, including:

  • Reasonable anticipation of benefits from the use of covered intangibles.
  • Substantial compliance with CSA accounting requirements.  See Document Set Five.
  • Substantial compliance with CSA administrative requirements (documentation and reporting).
  • All members of group filing a U.S. consolidated return treated as one participant. 

B.  Suggested information and documentation

  1. Cost sharing agreement and all revisions to the cost sharing agreement.  The cost sharing agreement must contain the information noted above (as specified in Treas. Reg. § 1.482-7(b)(2)-(4)) and must be recorded contemporaneously with the formation and any revision of the CSA.  See sample transfer pricing IDRs contained on the LMSB High Technology Industry web page. 
  2. Refer to Rev. Proc. 2004-40, Section 4.04, on content of an Advance Pricing Agreement request for a CSA.
  3. Department and legal entity organization charts (including headcount), and organization manuals for periods before the cost sharing arrangement, as of the date of the cost sharing arrangement, and after entering into the cost sharing arrangement.  This information will help identify the flow of cost sharing and transfer pricing transactions among the controlled participants and other controlled parties and establish how things changed functionally (if at all) as the result of the cost sharing arrangement.
  4. Request a list of all inter-company agreements and revisions entered into between the U.S. taxpayer and its subsidiaries and/or affiliated entities (including the foreign participant) relating to intangibles that are the subject of the cost sharing arrangement.  Select a sample from the list.  Often there will be multiple agreements entered into in connection with establishing the cost sharing arrangement, some of which may have been entered into in periods before or after the date the CSA was entered into. 
  5. Request a list of all license agreements and revisions entered into between the U.S. taxpayer, its subsidiaries and/or its affiliated entities and unrelated parties relative to intangibles which are the subject of the cost sharing arrangement.  Select a sample from the list. The list should indicate the title, parties, subject matter, date signed, and effective date for each listed agreement.
  6. Request intercompany agreements, including license agreements and revisions, (including amendments, modifications, etc.) entered into between the taxpayer and foreign controlled participants as well as between foreign controlled participants.  Controlled participants are not required to actually use the intangibles themselves, so long as they benefit from such use by transferring or licensing the intangibles to others.  See the examples under Treas. Reg. § 1.482-7(c) and Treas. Reg. § 1.482-7(f)(3)(ii) on measuring benefits.
  7. See the January 22, 2003 LMSB Commissioner Memorandum on Transfer Pricing Compliance Directive (2003 TNT 28-20 on Lexis-Nexis) and the March 8, 2005 LMSB Commissioner Memorandum on Guidelines for Requesting Transfer Pricing Documentation (posted on Memorandum page of LMSB Commissioner’s Office web page). 
  8. LMSB risk analysis procedures in accordance with the applicable transfer pricing guidance, including Internal Revenue Manual – 4.46.3  Planning the Examination (Cont. 2), Exhibit 4.46.3-5 Transfer Pricing Compliance Process. 

C.  Compliance

  1. FSA 200225009 concludes that a qualified CSA may NOT be modified retroactively by a taxpayer.  See Document Set Six for further holding of FSA.
  2. Controlled participants in a CSA may participate through various forms of legal entities, such as check-the-box partnerships.  These entities will be subject to reporting requirements based on their structure of operation, in addition to the cost sharing requirements.  See Law, Accounting and Procedures page of LMSB Foreign Joint Ventures, Partnerships & Check-the-Box web site.
  3. A CSA will not be a qualified CSA if the requirements of Treas. Reg. § 1.482-7(b) and (c) are not met.  The Service may, however, apply the rules of Treas. Reg. § 1.482-7 to any arrangement that in substance constitutes a CSA.  See Treas. Reg. § 1.482-7(a).

 


DOCUMENT SET TWO

A.  The total amount of costs incurred pursuant to the arrangement  
Treas. Reg. § 1.482-7(j)(2)(i)(A)
  

Treas. Reg. § 1.482-7(d) describes the costs of developing intangibles that must be shared by the CSA controlled participants.  Stock-based compensation is discussed in Document Set Seven.  

Intangible development costs (IDCs – key term) mean all of the costs incurred by the controlled participants related to the development of intangibles under the CSA.  IDCs include costs related to research within the CSA even if the research is not ultimately successful.  Since IDCs include all costs related to the intangible development area, IDCs may include costs in addition to Section 174 research and experimental expenditures, for example certain marketing, maintenance, and accounting department costs related to research.  In the case of tangible property, the arm’s length charge for use of such tangible property under Treas. Reg. § 1.482-2(c) is substituted for cost (including depreciation).  IDCs do not include the consideration for the use of any intangible property made available to the CSA.  See Document Set Six, covering the buy-in.    

The IDCs shared by the controlled participants are generally referred to as the cost sharing pool (key term).

B.  Suggested information and documentation

  1. Calculation of the total amount of costs, and substantiation of the source of the numbers used in the calculation.
  2. ALL costs of developing intangibles are included in the cost sharing pool.  This includes indirect support costs, such as costs incurred by the finance, human resources and accounting departments.  Taxpayers maintain profit and loss statements or trial balances by department, which summarize the costs of these departments. 
  3. Costs of obtaining a patent, such as attorney’s fees expended in making and perfecting a patent application, are included in the cost sharing pool. 

C.  Compliance

  1. IDCs are NOT limited to the definition of research expenses in IRC § 41 and Treas. Reg. § 1.174-2.  IDCs include ALL of the costs incurred by the controlled participants related to the development of intangibles under the CSA.
  2. Both direct (research and development) and indirect (administrative, etc.) costs are included in the cost sharing pool. 
  3. The cost sharing pool includes marketing expenses if marketing intangibles are being developed under the CSA.  The cost sharing agreement must include the scope of the research and development to be undertaken, including the intangible or class of intangibles intended to be developed.
  4. Some taxpayers may attempt to limit cost sharing payments by considering only a portion of the operations relevant to developing the cost shared intangibles and thus minimize the cost sharing pool.
  5. Some taxpayers may attempt to limit cost sharing payments by allocating development costs for the cost shared intangibles to intangibles that are not the subject of the CSA even though such costs further the research of the intangible development area under the CSA.
  6. Consider consulting with an Engineer to assist in reviewing expenses in order to ensure that all IDCs are taken into account.

 


DOCUMENT SET THREE 

A.  The costs borne by each controlled participant 
Treas. Reg. § 1.482-7(j)(2)(i)(B)

Treas. Reg. § 1.482-7(e) and (f) describe the term reasonably anticipated benefits  (RABs – key term) and how each controlled participant’s share of RABs is used to determine its share of IDCs.  Each controlled participant’s RABs divided by the total RABs of all controlled participants is generally referred to as the cost sharing ratio (key term). 

The cost sharing ratio must be determined using the most reliable estimate of RABs. Two factors are particularly relevant to the reliability of an estimate of anticipated benefits:

  • Basis used for measuring benefits.
  • Projections used for estimating benefits. 

RABs are measured either on a direct basis, by reference to estimated additional income to be generated or costs to be saved by the use of covered intangibles  developed under the CSA, or on an indirect basis which includes units used, produced or sold, sales, operating profit or other bases for measuring RABs.  The basis selected for measuring RABs must be the most reliable.  The situation in which each of the indirect bases is more reliable is explained in the regulations.  See Document Set Four covering the determination of RABs. 

B.  Suggested information and documentation  

  1. Calculation of the numerator and denominator of the cost sharing ratio including the substantiation of the source for the numbers used. 
  2. Calculation of the cost sharing payments reported on the U.S. tax return.  The cost sharing payments may reflect a netting or reduction for IDCs incurred by the foreign cost sharing participants.
  3. Identification by the taxpayer of where the cost sharing payments are reported on the U.S. tax return, including on Forms 1118 and 5471.

C.  Compliance

  1. RABs are not product specific, but are broadly related to all intangibles developed under the CSA (cost sharing payment) or made available to the CSA (buy-in payment).

 


DOCUMENT SET FOUR 

A.  Methodology to determine participant’s share of IDCs
  Treas. Reg. § 1.482-7(j)(2)(i)(C)
  

The taxpayer must describe the method used to determine each participant’s share of the intangible development costs, including the projections used to estimate benefits, and an explanation of why that method was selected.
  
Treas. Reg. § 1.482-7(f)(3)(iv) describes how any projections used to estimate RABs are tested.

 

B.  Suggested information and documentation  

  1. Written description of the reasons for selecting the RABs basis used in the numerator and denominator of the cost sharing ratio.  The response should address the reliability requirements of Treas. Reg. § 1.482-7(f)(3)(ii) and (iii).
  2. Request actual data relating to the method the taxpayer used to compute RABs (e.g. actual sales data) for each of the cost sharing participants for all periods for which such information is available to date, including before entering into the cost sharing arrangement.
  3. Projections used to estimate shares of RABs should be tested against actual numbers, as described in Treas. Reg. § 1.482-7(f)(3)(iv).  A significant divergence may indicate that the projections were not reliable, in which case actual benefits may be used.  Projections are not considered unreliable if the divergence for every participant (treating all foreign participants as one for this purpose) is less than or equal to 20% of the participant’s projected share of RABs.  See Examples 10 and 11 of Treas. Reg. § 1.482-7(f)(3)(iv).  No adjustment will be made on account of a divergence that is due to an extraordinary event beyond the control of the participants that could not have been reasonably anticipated.  The divergence rule does not prevent adjustments on account of a failure to use the most reliable basis for measuring RABs.

C.  Compliance

  1. Sales are often used as the basis for measuring RABs.  While sales may be the easiest basis to measure benefits, it may not be the most reliable. 
  2. The cost sharing ratio is used to calculate both cost sharing payments and buy-in payments.  Therefore, it is important that the RABs basis be reliable and that the cost sharing ratio be correctly computed.  

 


DOCUMENT SET FIVE

A.  The accounting method used to determine IDCs and RABs 
Treas. Reg. § 1.482-7(j)(2)(i)(D)

The taxpayer must establish the accounting method used to determine the costs and benefits of the intangible development (including the method used to translate foreign currencies), and, to the extent that the method materially differs from U.S. generally accepted accounting principles, must provide an explanation of such material differences.
 
Treas. Reg. § 1.482-7(i) requires that a consistent method of accounting be used to measure IDCs and RABs.  

B.  Suggested information and documentation  

See A. above.  

C.  Compliance

Compare R&D expense on the financial statements to the costs included in the cost sharing pool.  Stock-based compensation will be included in a footnote disclosure to the financial statements for years prior to 2006.  Thereafter, stock-based compensation must be deducted on the income statement.  See FAS No. 123 (revised 2004) at FASB   

 


DOCUMENT SET SIX

A.  Prior research and other properties used in the CSA (including buy-in)

Prior research, if any, undertaken in the intangible development area, any tangible or intangible property made available for use in the arrangement, by each controlled participant, and any information used to establish the value of pre-existing and covered intangibles. 
Treas. Reg. § 1.482-7(j)(2)(i)(E)  

Treas. Reg. § 1.482-7(g) describes buy-in and buy-out payments (key terms).  If a controlled participant makes intangible property in which it owns an interest available to other controlled participants for purposes of research in the intangible development area under a CSA, then the other controlled participants must make buy-in payments to the owner.  If a controlled participant relinquishes its interests under the CSA to the other controlled participants, then the other controlled participants must make buy-out payments to that participant.    

Cost sharing buy-in payments are a Tier 1 issue and are the subject of a Coordinated Issue Paper – Sec. 482 CSA Buy-in Adjustments issued on September 27, 2007 (CIP) and Industry Directors Directives (IDDs).  The valuation of the buy-in is determined as the arm’s length charge for the use of the intangibles calculated under Treas. Reg. § 1.482-1 and 1.482-4 through 1.482-6, multiplied by the controlled participant’s cost sharing ratio.  The best method rule in Treas. Reg. § 1.482-1(c) requires application of the transfer pricing method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.  The best method rule thus requires that the most reliable method be used to measure the buy-in, whether it is a specified or unspecified method. In determining whether a § 482 allocation is appropriate, IRS personnel should evaluate the result achieved, rather than the specific “method or procedure” that the taxpayer used to reach that result.  Treas. Reg. § 1.482-1(f)(2)(v)(A).  The CIP applies the best method rule in the context of certain fact patterns that are characteristic of many CSAs and concludes that the income (foregone profits) method will typically be the best method for valuing intangibles made available on inception of cost sharing (initial buy-in) and the acquisition price method will typically be the best method where intangibles are acquired by one participant and made available during the cost sharing arrangement.

The form of payment of the buy-in or buy-out so valued may be lump sum payments, installment payments with interest, or royalties or other payments contingent on the use of the intangibles by the transferee. Treas. Reg. § 1.482-7(g)(7).  A taxpayer’s chosen form of payment clearly stated at the time of or prior to the buy-in in the applicable agreements should generally be respected unless the form of payment lacks economic substance (e.g. the taxpayer does not follow its agreements).  Sometimes, it may be necessary to convert a buy-in valuation that yields one form of payment into another form that was appropriately selected by the taxpayer (e.g. from a lump sum into a royalty form of payment.) 

The buy-in and buy-out valuations may be substantiated in documentation prepared pursuant to Treas. Reg. § 1.6662-6(d)(2)(iii)(B) (principal documents) and (C) (background documents).  Documents described in this Document Set Six may constitute principal documents.  See Treas. Reg. § 1.482-7(j)(2)(ii).

B.  Suggested information and documentation  

B-1 General (all cases)

  1. Request all agreements entered into between the cost sharing participants and revisions (including amendments, modifications, etc.) including the cost sharing agreement (CSA), the license agreement, sometimes referred to as technology license agreement (TLA), and any other agreements.  Buy-in payments frequently take the form of a royalty paid pursuant to a non-exclusive license of intangibles.  
  2. Request the calculation of the buy-in payment reported on the U.S. tax return.  This amount is most often reported as royalty income.  A complete economic analysis should support the arm’s length buy-in calculation, and should identify the intangible property made available, the method used for valuation of the intangible property, and the method used to determine the arm’s length amount of the buy-in and the form of the payment chosen.  This documentation is typically provided pursuant to the request for transfer pricing documentation under Treas. Reg. § 1.6662-6(d)(2)(iii)(B).  Sample IDRs for requesting transfer pricing documentation are located on the High Technology web site. 
  3. Request identification by the taxpayer of where the buy-in and buy-out payments are reported on the U.S. tax return, including on Forms 1118 and 5471.
  4. Request a list of departments, individuals, and committees responsible for the development of intangibles which are the subject of the cost sharing arrangement.
  5. Request minutes, papers, memos and notes of product development committees, audit committees (especially relevant after Sarbanes-Oxley), finance committees, executive committees, management committees, information technology committees/groups, operating and/or policy committees, pricing committees, and board of directors.
  6. Request marketing plans/studies for all stages of product cycle, business development plans, advertising studies, sales studies, training materials and product prospectuses.  These types of documents and the types of documents in item 8 were requested in the GlaxoSmithKline case (see 2004 TNT 193-19 on Lexis-Nexis).
  7. Request documents submitted by the taxpayer in connection with a third-party loan.
  8. Request the taxpayer’s internal newsletters.
  9. Request taxpayer’s notes on interviews of its engineers and others on intangibles made available to the CSA including notes on the life of the intangibles.
  10. Review the taxpayer’s web site and the web sites of its competitors.
  11. Review the SEC web site for any filings by the taxpayer.
  12. Use the internet (e.g. Google) or other services to search for taxpayer and industry information.
  13. Request information pertaining to the functions performed by and risks born by the cost sharing participants relating to the intangibles which are the subject of the cost sharing arrangement.  In connection with such, consider performing location visitations and interviews.

B-2 Initial Buy-in Specific

An initial buy-in is due upon inception of cost sharing to the extent that one party has made an investment in research intangibles which it make available to the cost sharing arrangement and its participants.   Often, in addition to rights to further develop intangibles in cost sharing (research rights), the foreign participant is transferred rights to make and sell current generation products (make-sell rights). The CIP analyzes the factual scenarios in which an unspecified method known as the income or forgone profits method will generally constitute the most reliable method for determining the arm’s length initial buy-in in the aggregate with the tandem arm’s length compensation for the transfer of make-sell rights.  

  • Taxpayers often claim that the TLA satisfies the requirements for an initial buy-in payment.  It is important to identify all intangibles made available to the CSA and otherwise to the foreign participant from which the foreign participant will benefit. Many of these intangibles may be outside the TLA.  Further, it is important to identify intangible transfers that may be technically outside of the Section 1.482-7(g) buy-in payment and are rather -4 transfers of intangibles (e.g. customer base, marketing, and other intangibles) not developed further in research in the CSA but by which the foreign participants benefits as a result.
  • If the taxpayer has an all encompassing cost sharing arrangement (for further development of all intangibles), request that the taxpayer identify and value any intangibles which should not be a part of the buy-in payment and/or are not otherwise transferred to the foreign participant in connection with the CSA.
  • Request all financial projections for the cost sharing participants (individually and/or in the aggregate) prepared as close to the inception date of the cost sharing arrangement as possible.  Projections may be of profits by product line or/business segment, on a territory and/or worldwide basis.  The financial projections should include the year of inception of the CSA and for future years after commencement of the CSA.  Such projections may include but are not limited to the following projections:
    • Income and income statement
      1. Sales
      2. Operating profits
      3. Operating expenses
      4. R&D costs, including intangible development costs (IDCs) attributable to the CSA
    • b. Balance sheet
      1. Capital expenditures
      2. Cash flows
  • Request taxpayer projections for internal growth rates.
  • Request actual financial results pertaining to 3. (above) for the cost sharing participants (individually and/or in the aggregate) for the year the cost sharing arrangement was entered into and all future years for which actual data exists.
  • Request information and documents relating to any pre-existing (before cost sharing) non-routine operating intangibles (e.g. manufacturing, marketing, or other intangibles) owned and/or developed by or associated with the foreign participant’s operations that will affect the income attributable to exploiting the intangibles resulting from co-development in cost sharing (or from making and selling current generation products).  If the CFC participant is determined to own pre-existing non-routine intangibles (mature foreign operations) additional information will be needed to allocate these profits under an approach similar to the residual profit method under Treas. Reg. 1.482-6(c)(i)(B) (see footnote #44 of the CIP for additional information).
  • Request that the taxpayer identify and value any intangibles made available to the CSA by the foreign participant.
  • An IRS Economist should assist in requesting the following and determining necessary inputs:
    • Request information relevant to calculating the company’s cost of equity capital (e.g. risk-free interest rate, taxpayer’s historical equity prices and market fluctuations, etc.).
    • Request information relevant to calculating the taxpayer’s Weighted Average Cost of Capital (WAAC) (e.g. debt levels). 
    • Request information relating to calculating the routine return for the foreign participant.
    • Request information related to the projected return to investment required by the taxpayer before it will undertake a new project (“hurdle” rates) particularly as they pertain to the CSA or other similar research and development projects.
    • Request information related to how the taxpayer assesses the relative risk of various R&D projects, including the CSA, and projects that do not involve R&D (such as manufacture of currently available product). 

B-3 Acquisition Buy-in Specific

A subsequent acquisition buy-in involves an intangible acquired by one cost sharing participant from an unrelated third party, that is made available  to the cost sharing arrangement and its participants.   The CIP analyzes this scenario and concludes that an unspecified method known as the acquisition price method will generally be the most reliable method for measuring the value of the intangible property.  Pre-mergers are reported to the Federal Trade Commission under the Hart-Scott-Rodino Act.  Reports filed by the taxpayer under this Act should be requested.  See information on the Act and filings at the Federal Trade Commission.

  1. Purchase agreements, valuation appraisals, letters of intent, and due diligence reports for (major) acquisitions should be reviewed to determine if the intangibles acquired were made available to or could be used by the foreign cost sharing participants.
  2. Determine the type of acquisition –merger, stock purchase, asset purchase, etc.; form of payment --cash, stock, debt, etc. and the parties to the acquisition.
  3. Copies of contemporaneous strategic business plans associated with the acquired products related to strategic planning, product development, and marketing, etc.
  4. Copies of any agreements to which the acquired company has been a party regarding the acquisition or divestiture of corporate shares, companies, business, significant assets, mergers, consolidations, reorganizations or similar corporate transactions, other than purchase of goods in the ordinary course of business.
  5. Copies of all market research or marketing studies concerning the acquired company’s business conducted.
  6. List of foreign countries where the acquired company does or contemplates doing business and related good standings.
  7. Copies of any studies or reports relating to the validity or value of the acquired company’s patents, technology, trade secrets, trademarks (service marks), trade dress, and copyrights and the licensing or merchandising thereof.
  8. Schedule of patent registrations and/or applications of acquired intangibles identifying each patent by title, registration (application) number, date of registration (application), and country. (Preliminary Due Diligence Request List).
  9. Schedule of copyright registrations and applications of acquired intangibles identifying each copyright by title, registration number, and date of registration.
  10. Distribution, marketing, advertising, sale, agency and supplier agreements of acquired company.
  11. Customer agreements and a list of top 10 customers of acquired company showing total sales and products sold to each during the last three fiscal years.
  12. Audited financial statements of the acquired company.
  13. Financial projections (income statement, balance sheets, and cash flow projections) of the acquired company approximately contemporaneous with the acquisition.
  14. Request that the taxpayer identify and value any acquired intangibles which the taxpayer asserts are not made available to the cost sharing arrangement or for which the foreign participant will not benefit.
  15. If the acquired company is already in cost sharing, request all relevant documents and information pertaining to the acquired company’s CSA.

C.  Compliance

  1. There may be intercompany agreements outside the CSA which relate to the transfer of other intangibles and reimbursement of expenses.  Compare these to the license agreement and cost sharing agreement between the cost sharing participants.
  2. Compare the taxpayer’s license agreements with unrelated parties to the license agreement between the cost sharing participants.  Check for similarities and differences.  Licenses to unrelated third parties of limited rights to make and sell products incorporating current generation intangibles generally will not provide a comparable basis for valuing the buy-in for intangibles made available to the CSA as a platform for further research and development.
  3. License agreements should be analyzed in conjunction with the cost sharing agreement and the facts surrounding the entire CSA.  Consideration should also be given to the estimated life and value of core technology that may extend well beyond the current product life and over the lives of the future generation products to be developed.
  4. Request the assistance of Field Specialists for the identification, estimation of the useful life and valuation of intangibles.  In particular, Field Specialists may be consulted to evaluate projections and discount rates employed in valuing intangibles.  Refer to the LMSB Field Specialists and High Technology web sites for information on outside expert assistance.
  5. The buy-in payment should reflect the valuation of all preexisting or acquired intangibles made available to the CSA.  FSA 200225009, discussed above in Document Set One, further concludes that the buy-in valuation must reflect the value of all preexisting intangible property (whether internally developed or acquired) made available to a CSA, and is not limited to the value of only those preexisting intangibles that ultimately are embedded in a manufactured product.
  6.  Previous administrative guidance on issues related to buy-in payments also includes FSA 200023014, FSA 200001018.  In addition, TAM 200444022 addresses both buy-in and Foreign Sales Corporation issues.
  7. Buy-in payments in the form of royalties are often structured by taxpayers with declining percentage royalty rates over a short period of time that corresponds to the current generation’s product life.  Analysis may reveal that such royalties only capture the value of current make and sell rights, and do not capture the value of the contribution of the existing intangible for purposes of research under the CSA. See TAM 200444022.
  8. Treas. Reg. § 1.482-4(a) enumerates specified and unspecified methods that, subject to applicable comparability and reliability considerations, may be used for the buy-in valuation. Unspecified methods include cost based approaches (return on total cost, replacement cost), income based approaches (discounted cash flow, foregone profits) or market based approaches (market capitalization and acquisition price method), and hybrids of these methods.  Each of these methods must be applied in accordance with all of the provisions of the “Best Method rule” of Treas. Reg. § 1.482-1(c)(1).  For further discussion of the specified and unspecified methods, see CIP dated September 27, 2007.
  9. Historical cost may not reliably correlate to value, particularly that of high profit potential intangibles.  A RPSM split with respect to relative values of contributed intangibles will similarly be less reliable to the extent it uses relative costs for purposes of the split by a comparison based on historical intangible costs to ongoing IDCs.
  10. Buy-in valuations, like other intangible valuations, are subject to periodic adjustments over time.  See Treas. Reg. § 1.482-4(f)(2).  Periodic adjustments are the prerogative of the Service, although taxpayers may achieve somewhat similar results through an appropriately valued contingent royalty extending over the entire life of the intangible.

 


DOCUMENT SET SEVEN 

A.  Accounting for stock-based compensation (for purposes of this Checklist, the term stock-based compensation also includes other forms of equity-based compensation) Treas. Reg. § 1.482-7(j)(2)(i)(F) effective for stock-based compensation granted in taxable years beginning on or after 8/26/03

 The taxpayer must establish the amount taken into account as operating expenses attributable to stock-based compensation and equity-based compensation, including the method of measurement and timing used with respect to that amount as well as the data, as of date of grant, used to identify stock-based compensation related to the development of covered intangibles.

See CTM Industry Director’s Directive dated January 12, 2004 (2004 TNT 10-25 on Lexis-Nexis) and Notice 2005-99, 2005-2 C.B. 1214 dated December 27, 2005, and Coordinated Issue Paper dated March 20, 2008 for treatment of stock-based compensation in taxable years beginning before August 26, 2003, and/or after August 26, 2003.  Only stock options that are related to the intangible development area and that are granted after the formation of the CSA are considered.

B.  Suggested information and documentation  

  1. Refer to the rules under Treas. Reg. § 1.482-7(d)(2), Stock-based compensation, effective for taxable years beginning on or after 8/26/03. Refer to the LMSB High Technology Industry website for technical resources.
  2. Workpapers for the stock-based compensation (nonqualified stock options, incentive stock options, stock purchase) for tax deduction purposes.
  3. Workpapers for the valuation of stock options for financial statement purposes.
  4. Intercompany agreements regarding the reimbursement and the treatment of stock-based compensation.
  5. Research credit workpapers containing stock-based compensation for research employees.  Some of these employees may be in non-R&D departments (such as product marketing) which the taxpayer claims qualify for the research credit.  If so, consider including the wages, stock-based compensation and other department expenses in the cost sharing pool in the same percentage claimed for the research credit.

C.  Compliance

  1. The stock-based compensation issue is the subject of litigation in the Xilinx case. Contact Counsel for information regarding this case.
  2. Prior FSAs on this issue include FSA 200103024, FSA 200003010, 1997 FSA LEXIS 311 and 1997 FSA LEXIS 533.
  3. The stock-based compensation for employees in the R&D function and employees in those functions which indirectly support (human resources, finance, etc.) the R&D function should be included in the cost sharing pool.
  4. Termination or expiration of the CSA will cause vested stock-based compensation to be treated as being exercised immediately before the termination or expiration of the CSA and includible in the pool of costs under the CSA.

 

 


DOCUMENT SET EIGHT

 A.  Reporting requirements

A controlled participant must attach to its U.S. income tax return (including to Forms 5471 or 5472 with regard to a participant not filing its own return) a statement indicating that it is a participant in a qualified CSA, and listing the other controlled participants in the arrangement.
Treas. Reg. § 1.482-7(j)(3)  

Treas. Reg. § 1.482-7(h) describes how payments made pursuant to a qualified CSA are reported for tax purposes.  Payments of IDCs received by the U.S. participant from the foreign participant are treated as a reimbursement of the U.S. participant’s costs.  See Example (1) under Treas. Reg. § 1.482-7(h).  However, a U.S. participant’s costs are not reduced by the reimbursement for purposes of the research credit.  Notice 2005-10 states that R&D expenditures which are reimbursed by another party pursuant to a CSA are not permitted investments for purposes of IRC 965 added by the American Jobs Creation Act.

B.  Suggested information and documentation  

  1. Check the U.S. tax return to see if the required statement is attached to the return.  If not attached, request that the taxpayer provide a written explanation of why the statement was not attached.
  2. Request that the taxpayer explain where the cost sharing payments, and buy-in and buy-out payments, were reported on the U.S. tax return (including their treatment on Forms 1118 and 5471).  See Document Set Three and Document Set Six

C.  Compliance  

If the taxpayer fails to attach the required statement, the Service may not accept the taxpayer’s CSA as a qualified CSA.  See FSAs 200011021 and 200009022.

Page Last Reviewed or Updated: 19-Nov-2014