By Anthony Diosdi
Form 5471 is used by certain U.S. persons who are officers, directors, or shareholders in respect of certain foreign entities that are classified as corporations for U.S. tax purposes. The Form 5471 and schedules are used to satisfy the reporting requirements of Internal Revenue Code Section 6038 and 6046 along with the applicable regulations.
Substantively, it backstops various international sections of the Internal Revenue Code including Sections 901/904 (Code Section 901 and 904 provide rules governing foreign tax credits), Section 951(a) (Section 951a provide rules governing Subpart F income and Section 956. Section 956 is an anomaly and operates differently than the rest of subpart F. Generally, a U.S. shareholder of a foreign corporation must include in income his or her pro rata share of the foreign corporation’s increase in its earnings and profits in U.S. property), Section 951A (Section 951A provides rules governing the Global Intangible Low-Taxed Income or “GILTI”), Section 965 (Section 965 imposes a one-time transition tax on a U.S. shareholder’s share of deferred foreign income of certain foreign corporations), and Section 482 (Section 482 governs transfer pricing. A “transfer price” must be computed for controlled transactions in order to satisfy various financial reporting, tax, and other regulatory requirements). Associated forms with a Form 5471 include Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation), Form 5713 (International Boycott Report), Form 8621 (PFIC), and Forms 1116/1118 (Foreign Tax Credit).
Within the Form 5471, there are 12 schedules. This article discusses Schedule G-1 of the Form 5471. This schedule is used to report cost sharing arrangements.
Defining Key Terms For Filing the Form 5471
There are five filing categories (or should I say 12 filing categories) for the Form 5471. The category of filer determines the schedule of the Form 5471 that must be filed. There are a number of key terms that must be defined before determining which category filer a taxpayer is for purposes of the Form 5471. Below are the key terms that should be understood before preparing the Form 5471:
U.S. Person
Only U.S. persons can have a Form 5471 filing obligation. A U.S. person is generally a citizen or resident of the United States, a domestic partnership, a domestic corporation, or a domestic trust or estate as defined by Section 7701(a)(30)(A) – (E). A tax-exempt U.S. entity may have a Form 5471 filing obligation. In addition, an individual who relies upon the residency provision of an income tax treaty to shed himself of U.S. income tax and files Form 8833 remains a U.S. person for purposes of the Form 5471. See Treas. Reg. Section 301.7701(b)-7(a)(3). There are some slight modifications to the definition of a U.S. person which will be discussed in more detail below. All categories of filers apply to U.S. persons for purposes of Form 5471 classification.
U.S. Shareholder
Internal Revenue Code Section 951(b) defines a “U.S. shareholder” as a U.S. citizen, resident alien, corporation, partnership, trust or estate, owning directly, indirectly or constructively under the ownership rules of Section 958, ten percent or more of the total combined voting power of all classes of stock of a foreign corporation or the value of all the outstanding shares of a foreign corporation. Categories 1a, 1c, 5a, and 5c apply to U.S. shareholders for purposes of Form 5471 classification.
Controlled Foreign Corporation (“CFC”)
A foreign corporation is a CFC if, on any day during the foreign corporation’s taxable year, U.S. shareholders own more than 50 percent of the combined voting power of all classes of stock, or more than 50 percent of the total value, of the foreign corporation. Only U.S. shareholders are considered in applying for the 50 percent test. All forms of ownership, including direct, indirect (ownership through intervening entities), and constructive (attribution of ownership from one related party to another), are considered in applying the 50 percent test. The term “foreign” means a corporation that is not domestic. In other words, the corporation was not incorporated in a U.S. state or District of Columbia. See IRC Section 7701(a)(5).
An individual preparing a Form 5471 should not interpret terms in an entity name such as “ltd,” or “S.A.” to classify a foreign entity as a corporation for U.S. tax purposes. Instead, Treasury Regulation should be consulted to determine if a foreign entity is a corporation for U.S. tax purposes. Treasury Regulation 301.7701-2(b)(8) provides a list of foreign entities that will be treated as corporations for U.S. tax purposes. If a foreign entity is not in that list. Treasury Regulation Section 301.7701-3(b)(2) should be consulted. This regulation provides a relatively comprehensive list of foreign entities that will be treated as per se corporations, and, unless an election to the contrary is timely filed, the foreign organization may be treated as a partnership or a disregarded entity that is separate from its owner. Categories 1a, 1c, 5a, and 5c to CFCs for purposes of Form 5471 classification. .
Section 965 Specified Foreign Corporation (“SFC”)
An SFC is a foreign corporation that is either a CFC or has at least one U.S. shareholder that is a corporation. The term SFC includes not only CFCs, but also entities commonly referred to as 10/50 companies. These foreign companies have at least one U.S. shareholder, but are not CFCs because U.S. shareholders do not own more than 50 percent of the entity by vote or value. Categories 1a through 1c apply to SFCs.
Category of Filers
The Form 5471 and appropriate accompanying schedules must be completed (to the extent required on the form) and filed by the following categories of persons:
Category 1 Filer
A Category 1 filer is a U.S. shareholder of a SFC at any time during any taxable year of the SFC who owned that stock on the last day in that year on which it was an SFC. A SFC is a CFC, or any foreign corporation with one or more 10 percent domestic corporation shareholders.
Category 1a, 1b, and 1c Filers
Recently, the IRS expanded Category 1 filers to (1a, 1b, and 1c). Category 1a is a so-called catch all category and includes a U.S. shareholder of a Section 965 “specified foreign corporation” at any time during the tax year of the foreign corporation, and who owned that stock on the last day in that year. A Category 1a filer also does not fit into the definition of Categories 1b and 1c. Category 1b and 1c have been added as the result of Rev. Proc. 2019-40 and the repeal of the downward attribution rules.
A Category 1b filer is a U.S. shareholder that owns stock in a foreign corporation directly or indirectly, but the shareholder is unrelated to the foreign corporation within the meaning of Section 954(d)(3). Section 954(d)(3) defines control in a related party context. A Category 1b filer is typically a shareholder that owns a foreign corporation directly or through another entity. For purposes of Section 954(d)(3), control means,
With respect to a corporation, the ownership, directly or indirectly, of stock possessing more than 50 percent of stock entitled to vote or of the total value of the stock of such corporation.
A Category 1c filer is a U.S. shareholder of a foreign corporation only because of constructive stock ownership from a foreign corporation as per Internal Revenue Code Section 318(a)(3) and the shareholder is related to the foreign corporation under the definition of Section 954(d)(3).
Category 2 Filer
A Category 2 filer is a U.S. person who is an officer or director of a foreign corporation in which there has been a change in substantial U.S. ownership – even if the change relates to stock owned by a U.S. person who is not an officer or director. For Category 2 purposes, a U.S. person is defined as a U.S. citizen, resident alien, domestic partnership, domestic corporation, domestic estate, and domestic trust. See Treas. Reg. Section 1.6045-1(f)(3)(i). Category 2 modifies the definition of a U.S. person. Under Treasury Regulations 1.6046-1(f)(3)(ii)(A), 1.6046-1(f)(3)(ii)(B), and 1.6046-1(f)(3)(iii) for Category 2 purposes, a U.S. person is a Puerto Rico resident, possessions resident , and Section 6013(g), (h) election (situations where a non-resident alien spouse makes an election to be taxed as a U.S. person). In regards to the definition of an officer or director, there is no clear answer as to what defines an officer or director for purposes of a Category 2 filer. However, Treasury Regulation Section 1.6046-1(d) defines a director or officer as “persons who would qualify by the nature of their functions and ownership in such associations, etc, as officers, directors, or shareholders thereof will be treated as such for purposes of this section without regard to their designations under local law.”
The Category 2 filing requirements do apply to just foreign corporations that are CFCs. Category 2 filing requirements apply to all foreign corporations.
For purposes of Category 2, a substantial change in U.S. ownership is when any U.S. person (not necessarily the U.S. citizen or resident who is the officer or director) acquires stock that causes him or her to own a 10 percent block, or acquires an additional 10 percent block, of stock in that corporation by vote or value. More precisely, if any U.S. person acquires stock, which, when added to any stock previously owned, causes him or her to own stock meeting the 10 percent stock ownership requirement, the U.S. officers and directors of that foreign corporation must report. A disposition of shares in a foreign corporation by a U.S. person does not create filing obligations under Category 2 for U.S. officers and directors. Stock ownership is a vote or value test.
Stock ownership for purposes of Category 2 is direct or indirect. For indirect ownership, stock owned by members of a shareholders family shall be taken into account for purposes of substantial change in ownership rules. Under Section 6046(c), the family of an individual shall be considered as including his or her brothers and sisters (whether by whole or half blood), his or her spouse, ancestors, and lineal descendants. Attribution from nonresidents is allowed.
Indirect ownership- for purposes of Category 2 filing obligations, a shareholder can have an ownership interest in an entity, and the entity is a direct owner of stock of a foreign corporation. For Category 2 filer purposes, the attribution rules apply only to foreign corporations and partnerships. A filer owns their proportional share of a foreign corporate stock owned by a foreign corporation. A Category 2 filer owns its proportional share of foreign corporate stock owned by a foreign partnership. See Treas. Reg. Section 1.6046-1(i)(1).
The regulations provide no inference of attribution of ownership through a foreign nongrantor trust, U.S. corporation, U.S. partnership, or disregarded entities. See Treas. Reg. Section 1.6046-1(i)(1).
Category 3 Filer
A U.S. person is a Category 3 filer with respect to a foreign corporation for a year if the U.S. person does any of the following during the tax year:
1. Acquires stock in the corporation, which, when added to any stock owned on the acquisition date, meets the Category 2 filer 10 percent stock ownership requirement.
2. Acquires additional stock that meets the 10 percent stock ownership requirement.
3. Becomes a U.S. person while meeting the 10 percent stock ownership requirement.
4. Disposes of sufficient stock in the corporation to reduce his or her interest to less than 10 percent stock ownership requirement.
5. Meets the 10 percent stock ownership requirement with respect to the corporation at a time when the corporation is reorganized.
For Category 3 purposes, a U.S. person is defined as a U.S. citizen, resident alien, domestic partnership, domestic corporation, domestic estate, and domestic trust. See Treas. Reg. Section 1.6045-1(f)(3)(i). Category 3 modifies the definition of a U.S. person. Under Treasury Regulations 1.6046-1(f)(3)(ii)(A), 1.6046-1(f)(3)(ii)(B), and 1.6046-1(f)(3)(iii) for Category 3 purposes, a U.S. person is a Puerto Rico resident, possessions resident, and Section 6013(g), (h) election (situations where a non-resident alien spouse makes an election to be taxed as a U.S. person).
Stock ownership for purposes of Category 3 is a vote or value test. Section 958 applies direct, indirect, and constructive ownership rules to determine stock ownership in the foreign corporation. The direct, indirect, and constructive ownership rules for purposes of a Category 3 filer can be defined as follows:
Direct ownership- an example of direct ownership is when a corporate shareholder’s name is on the stock certificate.
Indirect ownership- for purposes of Category 3 filing obligations, a shareholder can have an ownership interest in an entity, and the entity is a direct owner of stock of a foreign corporation. For Category 3 filer purposes, the attribution rules apply only to foreign corporations and partnerships. A filer owns their proportional share of a foreign corporate stock owned by a foreign corporation. A Category 3 filer owns its proportional share of foreign corporate stock owned by a foreign partnership. See Treas. Reg. Section 1.6046-1(i)(1).
The regulations provide no inference of attribution of ownership through a foreign nongrantor trust, U.S. corporation, U.S. partnership, or disregarded entities. See Treas. Reg. Section 1.6046-1(i)(1).
Constructive ownership- An individual is considered as owning stock owned by his spouse, children, grandchild, and parents. An individual shall be considered as owning the stock owned directly or indirectly by or for his brothers and sisters (whether by the whole or half blood), his spouse, his ancestors, and his lineal descendants. Treas. Reg. Section 1.6046-1(i)(2). Attribution from nonresidents is permitted for both Category 2 and 3 filers. This can result in unexpected Form 5471 filing obligations for U.S. persons. For example, let’s assume a nonresident alien who is married to a U.S. person establishes a foreign corporation. Let’s also assume that the U.S. person does not own any shares of the newly established foreign corporation and the U.S. person is not a director or officer of the foreign corporation. Even though the U.S. person does not own any shares of the U.S. corporation or can be classified as an officer or director of the foreign corporation, under the Category 3 attribution rules, the U.S. person has a Category 3 filing obligation. See IRC Section 6046(c); Treas. Reg. Section 1.6046-1(i)(2). In other words, if a nonresident alien spouse acquires 100 percent shares of a newly formed foreign corporation, for purposes filing a Form 5471, the U.S. resident spouse has constructively acquired 100 percent of the shares in the foreign corporation.
Category 4 Filer
A U.S. person is a Category 4 filer with respect to a foreign corporation for a taxable year if the U.S. person controls the foreign corporation. For Category 4 purposes, a U.S. person is defined as a U.S. citizen, resident alien, domestic partnership, domestic corporation, domestic estate, and domestic trust. See Treas. Reg. Section 1.6045-1(f)(3)(i). Category 4 modifies the definition of a U.S. person. Under Treasury Regulations 1.6046-1(f)(3)(ii)(A), 1.6046-1(f)(3)(ii)(B), and 1.6046-1(f)(3)(iii) for Category 4 purposes, a U.S. person is a Puerto Rico resident, possessions resident, and Section 6013(g), (h) election (situations where a non-resident alien spouse makes an election to be taxed as a U.S. person).
A U.S. person is considered to control a foreign corporation if at any time during the person’s taxable year, such person owns: 1) stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote; or 2) more than 50 percent of the total value of shares of all stock of the foreign corporation. See Treas. Reg. Section 1.6038-2(b). For purposes of Category 4, a U.S. person need only have control over the foreign corporation at any time in the tax year of the corporation.
See IRC Section 6038(a). The definition of “control” for Category 4 purposes is different from Section 957(a) which defines a “controlled foreign corporation.” Section 957(a) defines a “controlled foreign corporation” as a foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned, directly, indirectly or constructively under the Section 958 ownership rules by “U.S. shareholders” on any day during the foreign corporation’s tax year or more than 50 percent of the total value of the shares of the corporation. Under this definition. a controlled foreign corporation may potentially have multiple U.S. shareholders who collectively own more than 50 percent of a foreign corporation.
On the other hand, for purposes of Category 4 filers, the Internal Revenue Code examines whether a U.S. person owns more than 50 percent of a foreign corporation. Under Internal Revenue Code Sections 6038(a)(1), (e)(2), a U.S. person shall be deemed to be in control of a foreign corporation if at any time during that person’s taxable year it owns more than 50 percent of the total combined voting power of the total combined voting power of all classes of stock entitled to, or more than 50 percent of the total value of shares of all classes of stock of the foreign corporation. Section 6038(e)(2) refers U.S. persons to Section 318(a) to determine if the U.S. person directly, indirectly, or constructively owns enough shares to have “control” of a foreign corporation.
The attribution rules for Category 4 filers are different compared to Category 2 and 3 filers. This is because Section 6038(e)(2)(A) modifies Section 318(a)(3)(A), (B), (c) so that downward attribution from foreign persons to United States persons is prohibited. However, Section 6038(e)(2)(B) modifies Section 318(a)(2)(C) for upward attribution from a corporation, changing the default 50 percent ownership threshold to 10 percent.
For Category 4 purposes of the constructive ownership rules, no attribution from grandparent, there is no sibling attribution. There however is parent and child attribution under Section 318(a)(1)(A)(ii) and spousal attribution under Section 318(a)(1)(A)(ii).
For Category 4 purposes, there is upward attribution from entities other than corporations. For example, partners own a proportional share of partnership-owned stock, beneficiaries own a proportional share of estate-owned stock, beneficiaries own their actuarially computed share of non grantor trust owned stock. See IRC Sections 318(a)(2)(A), IRC Section 318(a)(2)(A), IRC Section 318(a)(2)(B)(i). There is also upward attribution from corporate structure for purposes of Category 4 filers. However there are limits. There is no attribution of stock of a subsidiary to a shareholder if the shareholder owns less than 10 percent of the outstanding shares of the entity. See IRC Section 318(a)(2)(C); IRC Section 6038(e)(2)(C). If the shareholder owns more than 10 percent of the stock in a subsidiary corporation, the shareholder will own a proportional share of the stock for purposes of determining control. See IRC Section 318(a)(2)(C), IRC Section 6038(e)(2)(C). If the shareholder owns subsidiary stock and owns more than 50 percent of the outstanding stock in the entity, there is automatic control for purposes of Category 4 filing. See IRC Section 318(a)(2)(C), IRC Section 6038(e)(2)(C).
Unlike other categories of filers, under Section 6038(e)(2)(A), there is no downward attribution from a foreign person to a Category 4 filer. Section 318(a)(3) shall not be applied so as to consider a U.S. person as owning stock which is owned by a person who is not a U.S. person.
Category 5 Filer
A person is a Category 5 filer if the person: 1) is a U.S. shareholder of a CFC at any time during the CFC’s taxable year; and 2) owns stock of the foreign corporation on the last day in the year in which that corporation is a CFC. Category 5 uses the standard definition of a U.S. person under Section 7701(a)(30).
For category 5 purposes, partners own a proportional share of partnership-owned stock, beneficiaries own a proportional share of estate-owned stock, beneficiaries own their actuarially computed share of non grantor trust owned stock. See IRC Sections 318(a)(2)(A), IRC Section 318(a)(2)(A), IRC Section 318(a)(2)(B)(i). There is also upward attribution from corporate structure for purposes of Category 5 filers. However there are limits. There is no attribution of stock of a subsidiary to a shareholder if the shareholder owns less than 10 percent of the outstanding shares of the entity. See IRC Section 318(a)(2)(C); IRC Section 6038(e)(2)(C). If the shareholder owns more than 10 percent of the stock in a subsidiary corporation, the shareholder will own a proportional share of the stock for purposes of determining control. See IRC Section 318(a)(2)(C), IRC Section 6038(e)(2)(C). If the shareholder owns subsidiary stock and owns more than 50 percent of the outstanding stock in the entity, there is automatic control for purposes of Category 5 filing. See IRC Section 318(a)(2)(C), IRC Section 6038(e)(2)(C). For purposes of Category 5 filers, consider the ownership value of the shares of the CFC in determining the value of the corporate subsidiary stock.
Category 5a, 5b, and 5c Filers
Recently, the IRS expanded Category 5 filers to (5a, 5b, and 5c). Category 5a is a so-called catch all category and includes a U.S. person who is a ten percent or greater shareholder in a corporation that was a controlled foreign corporation for an uninterrupted period of thirty days during its annual accounting period and who owned stock in the controlled foreign corporation on its last day of its accounting period.
A Category 5b filer is an unrelated Section 958(a) U.S. shareholder who would not control (more than 50 percent vote or value) the CFC or be controlled by the same person which controls the CFC.
Category 5c filer is a related constructive U.S. shareholder. A Category 5c filer is typically an entity controlled by (more than 50% vote or value) the same person which controls the CFC and files only due to this downward attribution.
Why Category of Filers Matter
The category of filer will determine the Form 5471 schedule that is required to be attached to the Form 5471. Category 1c, 3, 4, 5a, and 5c filers are required to file Schedule G-1.
Schedule G-1
Before discussing Schedule G-1, we will begin by providing a general discussion why multinational corporations utilize cost sharing arrangements.
Multinational corporations usually engage in a variety of cross-border intercompany transactions. A common arrangement is for a U.S. parent corporation to license its intangibles to a foreign subsidiary for exploitation abroad. When such a transfer takes place, a “transfer price” must be computed in order to satisfy various financial reporting, tax, and other regulatory requirements. Internal Revenue Code Section 482 governs the transfer pricing rules and provides that multinational corporations must allocate their worldwide profits among the various countries in which they operate. To this end, Section 482 and its regulations adopt an arm’s-length standard for evaluating the appropriateness of a transfer price. To arrive at an arm’s-length result, a multinational corporation must select and apply the method that provides the most reliable estimate of an arm’s-length price.
Under Section 482 of the Internal Revenue Code, the Internal Revenue Service (“IRS”) is empowered to reallocate income, deductions, credits and allowances among business enterprises controlled directly or indirectly by the same interests as may be necessary clearly to reflect the income of each such enterprise. In effect, the IRS is empowered to shift income, deductions and credits in order to produce the tax results that would have been obtained if the related parties had been dealing as independent parties at arm’s length. The Section 482 arm’s length standard applies to all transfers of intangible property. For transfer pricing purposes, an “intangible” includes any of the following items:
1) patents, inventions, formulae, processes, designs, patterns, or know-how;
2) copyrights and literary, musical, or artistic compositions;
3) trademarks, trade names, or brand names;
4) franchises, licenses, or contracts;
5) workforce, goodwill, and customer relations;
6) methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data, and;
7) other similar items.
Transfers of Intangible Property
The starting point under the regulations of Section 482 is to identify the owner of the intangible property. The owner of intangible property is typically the entity that owns a legally protected right to exploit the intangible. The owner of intangible property that is not legally protected will generally be the entity that bore the greatest part of the development costs. Because in theory the owner and a related party may enjoy the rights of intangibles through consolidated groups (e.g., one by the other or both by a common owner), the regulations to Section 482 refer to the owner as the controlled owner and the party using rights to the intangible as the controlled person.
The general rule is that when a controlled corporation pays inadequate consideration for the right to exploit an intangible, and the transfer retains a substantial interest in the intangible, the arm’s length consideration should be in the form of a taxable royalty. That is, unless under the circumstances a different classification of the payment is more appropriate. There are a number of methods for estimating an arm’s-length charge for transfers of intangibles. A multinational must select and apply the method which provides the most reliable estimate of an arm’s length price.
Cost Sharing Arrangements
The Section 482 regulations contain an important exception to the general rule that an arm’s length royalty or other consideration must be paid by a related enterprise when intangibles are transferred to it by an enterprise controlled by the same interest. Intangles may be shared between two or more related enterprises under an arrangement that provides for the sharing of the costs and risks of developing intangible property in return for an interest in the intangible property that may be produced. Under a qualified cost sharing arrangement, the related person receiving an interest in intangible property is not required to pay an arm’s length royalty for its use; it need only bear or pay an appropriate share of the cost of the research and development concerned.
For example, a U.S. parent corporation and a foreign subsidiary may agree to equally share the costs of developing a new software program. Under such an agreement, the parent might own the rights to engineer and market an English language program in the United States, while the subsidiary may own the rights to develop and market the English language program abroad. The advantage of a cost-sharing arrangement is that the foreign subsidiary’s ownership of the foreign rights to the software program negates the need to have that subsidiary pay a royalty to the U.S. parent corporation.
Treas. Reg. Section 1.482-7(a)(1) defines a cost sharing arrangement as an agreement for sharing costs of development of one or more intangibles in proportion to the participants’ shares of reasonably anticipated benefits (or “RAB”) from their exploitation of interests in any intangibles that are developed. If a “qualified cost sharing arrangement” exists, no Section 482 allocation of arm’s length royalties or equivalent payments can be made by the IRS. In other words, a cost sharing arrangement is an arrangement by which controlled participants share the costs and risks of developing cost shared intangibles in proportion to their reasonably RAB shares. An arrangement is a cost sharing agreement if and only if the requirements of Treasury Regulation Section 1.482-7(b)(ii) are satisfied.
According to Treasury Regulation Section 1.482-7(ii), all controlled participants must commit to, and in fact, engage in platform contributions transactions to the extent that there are platform contributions (or “PCTs”). In a PCT, each other controlled participant (or “PCT Payor”) is obligated to, and must in fact, make arm’s length payments (or “PCT Payments”) to each controlled participant (or “PCT Payee”) that provides a platform contribution.
A platform contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible developed activity (whether prior to or during the course of the cost sharing agreement) that is reasonably anticipated to contribute to developing cost sharing intangibles. The determination whether a resource, capability, or right is reasonably anticipated to contribute to developing cost shared intangibles is ongoing and based on the best available information.
A platform contribution transaction payment is not the equivalent of a licensing fee. Treasury Regulation Section 1.482-7(c)(4) provides:
“Certain make-or-sell rights excluded- (i) In general. Any right to exploit an existing intangible without further development, such as the right to make, replicate, license or sell existing products, does not constitute a platform contribution to a cost sharing agreement, and the arm’s length compensation for such rights (make-or-sell rights) does not satisfy the compensation obligation under a PCT. By definition, a PCT payment is not the equivalent of a licensing fee for an existing intangible, because a platform contribution transaction requires “further development” of the intangible. If the payment were made solely for the use of the existing intangible, without any further modification, it would not qualify as a PCT.
Below, please see Illustration 1 through Illustration 3 which demonstrate examples of PCTs.
Illustration 1.
P and S, which are members of the same controlled group, execute a cost sharing agreement. Under the cost sharing agreement, P and S will bear their RAB shares of intangible development cost (“IDCs”) for developing the second generation of ABC, a computer software program. Prior to that arrangement, P had incurred substantial costs and risks to develop ABC. Concurrent with entering into the arrangement, P (as the licensor) executes a license with S (as the licensee) by which S may make and sell copies of the existing ABC. Such make-or-sell rights do not constitute a platform contribution to the cost sharing agreement.
The rules of Treasury Regulations Sections 1.482-1 and 1.482-4 through 1.482-6 must be applied to determine the arm’s length consideration in connection with the make-or-sell licensing arrangement. In certain circumstances, this determination of the arm’s length consideration may be done on an aggregate basis with the evaluation of compensation obligations pursuant to the PCTs entered into by P and S in connection with the cost sharing agreement.
Illustration 2.
P, a software company, has developed and currently exploits software program ABC. P and S enter into a cost sharing agreement to develop future generations of ABC. The ABC source code is the platform on which future generations of ABC will be built and is therefore a platform contribution of P for which compensation is due from S pursuant to a PCT. Concurrent with entering into the cost sharing agreement, P licenses to S the make-or-sell rights for the current version of ABC. P has entered into similar licenses with uncontrolled parties calling for sales-based royalty payments at a rate of 20%. The current version of ABC has an expected product life of three years. P and S enter into a contingent payment agreement to cover both the PCT Payments due from S to P’s platform contribution and payments due from S for the make-or-sell license. Based on the uncontrolled make-or-sell licenses, P and S agree on a sales-based royalty rate of 20% in Year 1 that declines on a straight line basis to 0% over the 3 year product life of ABC.
The make-or sell rights for the current version of ABC are not platform contributions, though paragraph Section 1.482-1(g)(2)(iv) of the regulations provides for the possibility that the most reliable determination of an arm’s length charge for the platform contribution and the make-or-sell license may be one that values the two transactions in the aggregate. A contingent payment schedule based on the uncontrolled make-or-sell licenses may provide an arm’s length charge for the separate make-or-sell license between P and S, provided the royalty rates in the uncontrolled licenses similarly decline, but as a measure of the aggregate PCT and licensing payments it does not account for the arm’s length value of P’s platform contributions which includes the rights in the source code and future development rights in ABC.
Illustration 3.
S is a controlled participant that owns Patent Q, which protects S’s use of a research tool that is helpful in developing and testing new pharmaceutical compounds. The research tool, which is not itself such a compound, is used in the cost sharing agreement activity to develop such compounds. However, the cost sharing activity is not anticipated to result in the further development of the research tool or in patents based on Patent Q. Although the right to use Patent Q is not anticipated to result in the further development of Patent Q or the technology that it protects, that right constitutes a platform contribution (as opposed to make-or-sell rights) because it is anticipated to contribute to the research activity to develop cost shared intangibles relating to pharmaceutical compounds covered by the cost sharing agreement.
Development Costs and Reasonably Anticipated Benefits
Whenever parties enter into a cost sharing arrangement, the development costs should be carefully considered by the participants to a cost sharing arrangement. Treasury Regulation Section 1.482-7(d)(1) defines intangible development costs of a controlled participant as all of its costs related to the intangible development area, including operating expenses other than depreciation and amortization expenses, plus an arm’s length charge for intangible property made available to the cost sharing arrangement. Costs that may be shared include all costs associated with any research actually undertaken under the cost sharing arrangement. If a participant makes less payments in proportion to other participants, the IRS may adjust the pool of costs shared to properly reflect costs that relate to the intangible development area.
The participants must also consider the reasonable anticipated benefits or (“RAB”) of the cost sharing arrangement. Reasonably anticipated benefits are defined as additional income generated or cost saved by the use of covered intangibles. However, if the benefits received by a participant in a cost sharing arrangement is not in proportion to its contribution to the development costs, the IRS may make an adjustment to the taxable benefits derived from the cost sharing arrangement. Cost allocations that may be made by the IRS to make a controlled participant’s share of costs equal to its share of reasonably anticipated benefits are governed by Treasury Regulations Section 1.482-7. Anticipated benefits of uncontrolled participants will be excluded from anticipated benefits in calculating the benefits shares of controlled participants. A share of reasonably anticipated benefits will be determined using the most reliable estimate of benefits. The reliability of an estimate of RABs depends principally on two factors: the reliability of the basis for measuring benefits used and the reliability of the projections used. An allocation of costs or income may be made by the IRS if the participant did not use the most reliable estimate of benefits, which depends on the facts and circumstances of each case.
The measurement basis used for estimating a participant’s contribution and share of reasonably anticipated benefits must be consistent for all controlled participants. Benefits may be measured directly or indirectly, whichever produces the most reliable estimate, and it may be necessary to make adjustments to account for material differences in the activities that controlled participants perform in connection with exploitation of covered intangibles. Below are some of the methods that may be utilized to calculate the anticipated benefits and contributions to a cost sharing arrangement.
Arm’s-Length Calculation Using the Reasonable Anticipated Benefit Method
When determining RAB share, reasonable anticipated benefits must be estimated over the entire period, past and future, of exploitation of the cost sharing intangibles. A controlled participant’s RAB share is equal to its RAB divided by the sum of the RABs of all the controlled participants.
RAB’s are measured either on a direct basis, by reference to estimated benefits to be generated by the use of cost-shared intangibles (generally based on additional revenues plus cost savings less any additional costs incurred), or on an indirect basis, by reference to certain measurements that reasonably can be assured to relate to benefits to be generated. Indirect basis for measuring anticipated benefits from participation in a cost sharing agreement include units used, produced, or sold; sales; or operating profits. See The Tax Advisor, Transfer Pricing: The New Temporary Cost-Sharing Regs, Jeffrey B. Kaufman (2009).
Question 1.
Question 1 asks the filer to provide a brief description of the cost sharing arrangement to Which this Schedule G-1 is being completed. A separate Schedule G-1 should be completed for each cost sharing arrangement. The filer should attach a detailed description of the cost sharing arrangement.
Question 2.
Question 2 asks if the foreign corporation was a participant of a cost sharing arrangement during the course of the year in which the Schedule G-1 is being completed.
Question 3.
Question 3 asks if the cost sharing arrangement was in effect before January 5, 2009.
Question 4.
For Question 4, the filer should enter the foreign corporation’s RAB for the cost sharing arrangement during the tax year for which the Schedule G-1 is being completed.
Question 5a.
For Question 5a, the filer should check “Yes” if the corporation made any platform contributions during the tax year for which the Schedule G-1 is being completed. A platform contribution is any resource, capability, or right that a participant has developed, maintained, or acquired externally to the intangible developed activity (whether prior to or during the course of the cost sharing arrangement) that is reasonably anticipated to contribute to developing cost sharing.
Question 5b.
For Question 5b, the filer needs to enter the value of the present value of the platform contribution.
Question 5c.
Question 5c asks the filer to determine the method under Treasury Regulation 1.482-7(g) used to determine the price of the platform contribution. In order to answer this question, the filer should understand a little about the regulations promulgated for Section 482 of the Internal Revenue Code. The starting point under the regulations of Section 482 is to identify the owner of the intangible property. The owner of intangible property is typically the entity that owns a legally protected right to exploit the intangible. The owner of intangible property that is not legally protected will generally be the entity that bore the greatest part of the development costs. Because in theory the owner and a related party may enjoy the rights of intangibles through consolidated groups (e.g., one by the other or both by a common owner), the regulations to Section 482 refer to the owner as the controlled owner and the party using rights to the intangible as the controlled person.
The general rule is that when a controlled corporation pays inadequate consideration for the right to exploit an intangible, and the transfer retains a substantial interest in the intangible, the arm’s length consideration should be in the form of a taxable royalty. That is, unless under the circumstances a different classification of the payment is more appropriate. As indicated by Question 5c to Schedule G-1, there are a number of different methods available to estimate an arm’s length charge for a transfer. three primary methods for estimating an arm’s length charge for transfers of intangibles:
1) The comparable uncontrolled transaction method or “CUT;”
2) The comparable profits method (residual profit split method) or CPM; and
3) The profit split method or PSM.
The parties involved in the transfer of intangible property must select and apply the method which provides the most reliable estimate of an arm’s length price.
Comparable Uncontrolled Transaction Method
The CUT method generally provides the most direct and reliable measure of an arm’s length royalty. It may be used if the same intangible is transferred in both the controlled and uncontrolled transactions and only minor differences exist between the uncontrolled and the controlled transactions, provided that these differences have a definite and reasonably ascertainable effect on pricing and that appropriate adjustments are made for them.
Although all the general factors for determining comparability of the controlled and uncontrolled transactions described in the regulations must be considered. To be considered comparable both intangibles must be used in connection with similar products or processes within the same general industry or market and must have similar profit potential. Basically, controlled and uncontrolled transfers of intangibles used for the same product type in the same industry will be comparable if they are anticipated to generate substantially the same tax benefits for the transferees. The profit potential of an intangible involves calculating the net present value of the benefits to be derived from the use of the intangibles by the transferee. Profit potential is most reliably measured by direct calculations, based on reliable projections of the net present value of the benefits to be realized through use of the intangible.
The Comparable Profits Method
The CPM may be used to determine the arm’s length consideration for intangible property where the CUT method cannot be employed because a comparable uncontrolled transaction has not been identified. The CPM relies on the general principles that similarly situated taxpayers will tend to earn similar returns over a reasonable period of time. In essence, it involves imputing to the related transferee a level of operating profit that would be earned by an unrelated similarly situated transferee.
The CPM determines the arm’s length consideration for a controlled transaction by referring to objective measures of operating profit or profit level indicators derived from uncontrolled persons that engage in similar activities with other uncontrolled persons under similar circumstances. The profit level indicators that are used to evaluate operating profit include two types of measure: the rate of return and financial ratios. In the alternative, any measure of profit based on objective measures of profitability derived from uncontrolled parties that engage in similar business activities under similar circumstances may be utilized.
In determining an arm’s length royalty under the CPM, a company’s average reported operating profit for the year under review and the preceding two tax years ordinarily will be compared to the average profit of the uncontrolled comparable persons for the same period. However, a multiple year profit average tends to provide a more accurate reflection for purposes of a transfer pricing analysis. Adjustments must also be made for all material differences to the extent that such adjustments improve the reliability of the analysis. The CPM looks to the operating profit of the entire enterprise, rather than operating profit attributable to a particular intangible. It also focuses on the total operating profit based on all functions performed, capital invested and risks assumed. Finally, the CPM takes into account the profitability of uncontrolled parties that engage in similar business activities under similar circumstances.
Profit Split Methods
If members of a controlled group are engaged in a functionally integrated business and each member uses valuable intangibles, it will normally be difficult to identify comparable uncontrolled transactions and comparable uncontrolled transferees of comparable intangibles that can be used to determine arm’s length pricing for particular intangible transfers. Without comparable transactions or comparable uncontrolled holders of similar intangible rights, neither the CUT method nor the CPM can be used. In such a situation, a profit split method could be utilized for transfer pricing purposes.
The basic approach of the profit split method is to estimate an arm’s length return by 1) comparing the relative economic contributions that the parties make to the success of a business venture and 2) dividing the returns from that venture between them on the basis of the relative value of such contributions. The relative value of each controlled party’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed and resources employed by each participant in the relevant business activity. Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled parties, each performing functions similar to those of the various controlled parties engaged in the relevant business activity.
Two profit split methods are provided: the comparable profit split and the residual profit split. A comparable profit split is derived from the combined operating profit of uncontrolled parties, the transactions and activities of which are similar to those of the controlled parties in the relevant business activity. Each uncontrolled party’s percentage of the combined operating profit or loss to allocate the combined operating profit or loss of each controlled party involved in the relevant business activity.
The residual profit split method determines an arm’s length consideration in a two-step process. First, using other methods such as the CPM, market returns for routine functions are estimated and allocated to the parties that performed them. The remaining, residual amount is then allocated between the parties on the assumption that this residual is attributable to intangible property contributed to the activity by the controlled parties. Using this assumption, the residual is divided based on the estimate of the relative value of the parties’ contributions of such property. Since the fair market value of the intangible property usually will not be readily ascertainable, other measures of the relative values of intangible property may be used, including capitalized intangible development expenses.
The filer needs to check the appropriate box describing the method and state the acceptable method of determining the plattform contribution. If the corporation engaged in multiple platform contributions during the tax year with a foreign corporation, the filer should check the appropriate box or boxes.
Question 6a through 6c.
Question 6a through 6c asks the filer to enter the total amount of stock-based deductions claimed for the year the Form G-1 is filed. When preparing the Form G-1, the preparer should understand that costs that may be shared to develop intangible property include all costs of any research actually undertaken under the cost sharing arrangement. These costs include cost sharing payments a participant makes to the other participant or participants less such payments it receives from other participants. Over the years, issues have surfaced concerning whether operating expenses include stock-based compensation provided by a controlled participant, often in the form of stock options. Treasury Regulation Section 1.482-7(d)(2) was issued by the Department of Treasury which takes the position that operating expenses include any stock-based compensation provided to an employee or independent contractor, including for example, restricted stock, stock options, and stock appreciation rights. Under Treasury Regulation Section 1.482-7(d)(2)(ii), the determination of whether stock-based compensation is related to the development of an intangible is to be made as of the date the stock-based compensation is granted. The regulation deals in detail with permissible methods for measuring the cost associated with stock-based compensation. A word of warning to any multinational corporation having cost-sharing arrangements with foreign affiliates which involves stock-based compensation arrangements to develop intangible assets, this area is full of minefields. This is particularly the case after the United States Supreme Court announced that it was denying the petition for certiorari for Altera Corporation & Subsidiaries v. Commissioner, 926 F.3d. 1061 (2019). By way of background, in Altera Corp. v. Commissioner, Altera prevailed in a suit before the United States Tax Court. The Tax Court invalidated a requirement that related parties allocate stock-based compensation costs when entering into cost-sharing arrangements to develop intangible assets. On appeal, the Ninth Circuit Court of Appeals reversed the Tax Court and upheld the regulation. The Supreme Court’s denial of Altera’s petition for certiorari basically affirmed the Ninth Circuit Court of Appeal’s decision.
The filer must disclose the total value of stock-based compensation deductions must be listed on Question 6a through 6c. The filer should carefully review Altera Corporation before answering questions 6a through 6c..
Questions 7a and 7b.
Questions 7a and 7b ask the preparer to enter the amount of intangible development costs allocable to the foreign corporation based on the foreign corporation’s reasonable anticipated benefit share. For Question 7a, the filer should enter the total amount of intangible development costs. On Line 7b, the filer should enter the amount of intangible development allocated to the foreign corporation for the tax year based on the foreign corporation’s RAB share.
Conclusion
Schedule G-1 is a new form added to Form 5471. The form is designed to measure the value of cross-border intercompany transfers. The Form G-1 is an incredibly new return added to an already very difficult Form 5471. Any company corporation that has a Schedule G-1 filing requirement should consult with an international tax attorney well versed in transfer pricing and the Form 5471.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted large law firms and accounting firms and high net-worth individuals with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.