A Deep Dive into IRS Form IRS Form 5471 Schedule G-1 Used to Disclose Multinational Corporate Cost Sharing Arrangements

Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations) 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. Form 5471 and its schedules are used to satisfy the reporting requirements of Internal Revenue Code Sections 6038 and 6046.

Substantively, Form 5471 backstops various international sections of the Internal Revenue Code, including Sections 901 and 904 (foreign tax credits), Section 951(a) (subpart F income), Section 951A (global intangible low-taxed income or “GILTI”), Section 965 (one-time transition tax on a U.S. shareholder’s deferred foreign income), and Section 482 (transfer pricing). Other forms associated with Form 5471 include Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation), Form 5713 (International Boycott Report), Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund), and Forms 1116 and 1118 (Foreign Tax Credit).

Form 5471 includes 12 schedules. This article discusses the Schedule G-1 of Form 5471. This schedule is used to report cost sharing arrangements.

Key Terms for Form 5471

Form 5471 provides for five general categories of filers, numbered 1 through 5. Two of these general categories are subdivided into three subtypes each, with each subtype being a separate filer category as well. The filer category that a taxpayer falls under dictates the schedule or schedules that the taxpayer must include with the form. In order to understand how these filer categories work, it is helpful to review some basic terms.

U.S. Person

Only U.S. persons who own stock in a foreign corporation 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, each as defined in Internal Revenue Code Section 7701(a)(30)(A) through (E). A tax-exempt U.S. entity may have a Form 5471 filing obligation. In addition, an individual who relies on the residency provision of an income tax treaty to reduce his or her U.S. income tax liability (and files Form 8833) remains a U.S. person for purposes of 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 of the Form 5471 filer categories apply to U.S. persons.

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 that owns 10 percent or more of the total combined voting power of all classes of voting stock of a foreign corporation, or 10 percent or more of the total value of all the outstanding stock of a foreign corporation. All forms of stock ownership, — i.e., direct, indirect (ownership through intervening entities), and constructive (attribution of ownership from one related party to another) — are considered in applying the 10 percent test.

Controlled Foreign Corporation (“CFC”)

A foreign corporation is a CFC if, on any day during its taxable year, all of its U.S. shareholders, taken together as a group, own more than 50 percent of the combined voting power of all classes of the foreign corporation’s voting stock, or more than 50 percent of the total value of all of the foreign corporation’s outstanding stock. See IRC Section 957(a). Only U.S. persons who constitute U.S. shareholders are considered in applying the 50 percent test. Just as in the case of the 10 percent test for determining whether a U.S. person is a U.S. shareholder, direct, indirect, and constructive ownership of stock are all considered in applying the 50 percent test for CFCs. The term “foreign,” when applied to a corporation, means a corporation that is not domestic — i.e., a corporation that is not incorporated in a U.S. state or the District of Columbia. See IRC Section 7701(a)(5).

Treasury Regulations 301.7701-2(b)(8) provides a list of foreign entities that are conclusively treated as “per se” corporations for U.S. tax purposes. An individual preparing a Form 5471 should be aware that abbreviations in an entity name such as “Ltd.” and “S.A.” do not always stand for “Limited” or “Sociedad Anonima” (or “Societe Anonyme”). The preparer should confirm what the unabbreviated terms are, preferably from a charter or other official document from the relevant jurisdiction. If a foreign entity is not in the list of per se corporations, Treasury Regulations Section 301.7701-3(b)(2) provides that, unless a contrary election is made, the foreign entity will be treated as (1) an association taxable as a corporation if all its members have limited liability, (2) a partnership it it has two or more members (at least one of which does not have limited liability), or (3) a disregarded entity if it has a single owner who does not have limited liability.

Section 965 Specified Foreign Corporation (“SFC”)

An SFC is a foreign corporation that either is a CFC or has at least one U.S. shareholder that is a domestic corporation. See IRC Section 965(e)(1). The term SFC includes not only CFCs, but also entities commonly referred to as “10/50 corporations.” These foreign corporations have at least one U.S. shareholder, but are not CFCs because U.S. shareholders do not collectively own more than 50 percent of the corporation’s stock either by vote or value.

Stock Ownership

For purposes of Form 5471, a U.S. person can own stock in a corporation in three possible ways. First, the person can own the stock “directly.” For example, owning stock in a brokerage account constitutes direct ownership of the stock. Second, the U.S. person can own the stock “indirectly” through an intervening entity, such as a corporation, partnership, estate, or trust, in which the U.S. person owns an interest. In these cases, the stock owned by the intervening entity is typically considered to be owned proportionately by its shareholders, partners, or beneficiaries, as the case may be. For example, if a U.S. person directly owns 40 percent of the stock of a corporation and that corporation, in turn, directly owns 50 percent of the stock of a second corporation, then the U.S. person is considered to own indirectly 20 percent (i.e., 40% × 50%) of the stock of the second corporation. Indirect stock ownership can extend through several layers of intervening entities, where each intervening entity directly owns an interest in the one immediately below it. The third way that a U.S. person can own stock is by “constructively” owning the stock due to a relationship with another person. This relationship most commonly involves family members. For example, if a U.S. citizen mother directly owns 6 percent of a corporation’s stock and her U.S. citizen daughter directly owns 5 percent of the same corporation’s stock, then each of them is considered to own constructively the shares of the other. As a result, the mother and daughter are each considered to own 11 percent of the corporation’s stock. Another less common relationship involves sister entities. This form of constructive ownership (referred to as downward attribution) arises when an individual or entity parent directly or indirectly owns stock in a corporation and, at the same time, owns an interest in another entity. Under downward attribution, the corporation’s stock that the parent owns is attributed downward from the parent to the second entity. As a result, the second entity is considered to own constructively the same stock owned by the parent. Generally, the stock that is owned constructively by one person due to family or downward attribution cannot be further owned constructively by another.

All three kinds of stock ownership apply when determining which Form 5471 filer category or categories a taxpayer falls under, but there are variations among the categories. For example, in Categories 2 and 3, constructive family ownership includes attribution of stock from siblings, grandparents, and nonresident aliens, whereas the other three categories do not allow for these attributions. Categories 1, 4, and 5 define indirect ownership to mean only indirect ownership through foreign intervening entities, and include indirect ownership through intervening U.S. entities as constructive upward attribution. Categories 2 and 3 specifically provide for indirect ownership, but only through entities that are foreign corporations or partnerships, and refer to this type of non-direct ownership as both indirect and constructive ownership. Constructive ownership in the form of downward attribution does not exist in Categories 2 and 3, but exists in Categories 1, 4, and 5. Category 4’s version of downward attribution prohibits attribution of stock from a foreign entity to a U.S. person. Category 1 and 5’s version, however, contains no such prohibition due to the Tax Cuts and Jobs Act of 2017 (the “TCJA”). All these variations, as well as others not described above, will need to be taken into account when preparing a Form 5471.

Filer Categories

Form 5471, together with its applicable schedules, must be completed (to the extent required on the form) and filed by the taxpayer according to the taxpayer’s filer category. What follows is a description of each filer category.

Category 1 Filer

A Category 1 filer is a U.S. shareholder of a foreign corporation that is an SFC at any time during the corporation’s taxable year. However, to be classified as a Category 1 filer, the U.S. shareholder of the SFC must also own the SFC’s stock on the last day of the SFC’s taxable year.

The stock ownership rules applicable to Category 1 (including Categories 1a, 1b, and 1c) are contained in Internal Revenue Code Section 958, which incorporates and modifies the constructive stock ownership rules of Section 318(a). For Category 1 purposes, if a person does not directly own stock, the person can own stock as follows:

• Indirect stock ownership through an intervening entity. The intervening entity (i.e., a corporation, partnership, estate, or trust) can only be a foreign entity. The person, who is to become the indirect owner of stock through the intervening entity, is not required to hold a minimum ownership interest (i.e., stock, partnership interest, or beneficial interest) in the intervening foreign entity.
• Constructive stock ownership from another person.
  • Attribution from family members. A person can only be attributed stock owned by his or her parent, spouse, child, or grandchild. However, no attribution is permitted from a nonresident alien to a U.S. citizen or resident.
  • Upward attribution from entities. The attributing entity can be either a U.S. or foreign entity. However, if the attributing entity is a corporation, the person to whom the stock is to be attributed must own at least 10 percent (by value) of the attributing entity’s stock. Furthermore, if the stock to be attributed upward constitutes more than 50 percent of a corporation’s voting stock, then the stock is deemed to constitute 100% of the corporation’s voting stock when it gets proportionately allocated among the attributing entity’s owners.
  • Downward attribution from persons. The attributing person can be either an individual or entity. However, if the stock is to be attributed downward to a corporation, the attributing person must own at least 50 percent (by value) of that corporation’s stock.

Category 1a, 1b, and 1c Filers

Category 1 is subdivided into Categories 1a, 1b, and 1c. Category 1a is a catchall category and applies to Category 1 filers who do not otherwise fall under either Category 1b or 1c. Categories 1b and 1c were added to Form 5471 as the result of Revenue Procedure 2019-40, which the IRS issued in response to the repeal of provisions in Section 958(b) that previously disapplied the constructive downward attribution rules of Section 318(a)(3) to the extent that they attributed stock owned by a foreign person to a U.S. person.

Categories 1b and 1c specifically apply to those SFCs that are considered to be foreign-controlled for purposes of Form 5471. Such an SFC, referred to herein as a “Foreign-Controlled SFC,” is a foreign corporation that, although classified as an SFC, would not be so classified if the determination were made without applying Section 318(a)(3)’s downward attribution rules so as to consider a U.S. person as owning the stock owned by a foreign person.

A Category 1b filer is a U.S. shareholder who owns, directly or indirectly under Section 958(a) (but not constructively under Section 958(b)), the stock of a Foreign-Controlled SFC and is not related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled SFC. Section 954(d)(3) defines two persons as being “related” to each other in terms of “control,” where one person controls or is controlled by the other, or is controlled by the same person or persons who control the other. Here, control over a corporation means directly or indirectly owning more than 50 percent of the corporation’s stock by either vote or value. A Category 1b filer is typically a shareholder who owns, directly or indirectly, stock in a foreign corporation but is not related to the foreign corporation because the common parent of both the shareholder and the foreign corporation does not control the foreign corporation.

A Category 1c filer is a U.S. shareholder who does not own, either directly or indirectly, the stock of a Foreign-Controlled SFC but is related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled SFC. A Category 1c filer is typically a shareholder that owns the stock of a foreign corporation only because of constructive stock ownership under Section 318(a)(3) and the shareholder is related to the foreign corporation because each of them is under the control of a common parent.

A U.S. shareholder who does not own, either directly or indirectly, the stock of a Foreign-Controlled SFC and is not related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled SFC, is neither a Category 1b nor 1c filer. Such U.S. shareholder is deemed not to fall under the Category 1a catchall and is exempt from the obligation to file Form 5471.

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 substantial change in its U.S. ownership. A U.S. person can be a Category 2 filer even if the change relates to stock owned by another U.S. person and regardless of whether or not that other U.S. person is an officer or director of the foreign corporation. For Category 2 purposes, a U.S. person is defined as a U.S. citizen, resident alien, corporation, partnership, estate, or trust. However, Category 2 also expands the definition of a U.S. person to include a bona fide Puerto Rico resident, a bona fide possessions resident, and a nonresident alien as to whom a Section 6013(g) or (h) election is in effect (i.e., where a nonresident alien spouse has made an election to be taxed as a U.S. person). In regard to the definition of an officer or director, there is no clear answer as to what constitutes an officer or director for purposes of a Category 2 filer. Treasury Regulations Section 1.6046-1(d) provides that “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.”

For purposes of Category 2, a substantial change in U.S. ownership in a foreign corporation occurs when any U.S. person (not necessarily the U.S. citizen or resident who is the officer or director) either (1) acquires stock that causes that U.S. person to own a 10 percent block of stock in that foreign corporation (by vote or value) or (2) acquires an additional 10 percent block of stock in that corporation (by vote or value). More precisely, if any U.S. person acquires stock that, when added to any stock previously owned by that U.S. person, causes the U.S. person 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, however, does not create filing obligations under Category 2 for U.S. officers and directors of that foreign corporation.

The stock ownership rules applicable to Category 2 are contained in Internal Revenue Code Section 6046(c) and Treasury Regulations Section 1.6046-1(i). For Category 2 purposes, if a person does not directly own stock, the person can own stock as follows:

• Constructive stock ownership from another person.
  • Attribution from family members. A person can only be attributed stock owned by his or her brother, sister, spouse, ancestors, and lineal descendants. Attribution from nonresident aliens is permitted.
  • Upward attribution from entities. The attributing entity can be either a foreign corporation or a foreign partnership. The person, who is to become the constructive/indirect owner of stock through the attributing foreign corporation or partnership, is not required to hold a minimum ownership interest (i.e., stock or partnership interest) in the attributing foreign corporation or partnership. By negative implication, there is no attribution of stock from U.S. entities, or from foreign estates or trusts. Nevertheless, stock owned by U.S. entities that are not treated as entities separate from their owners for U.S. income tax purposes (i.e., grantor trusts and disregarded entities) should be attributable to their owners.

Category 3 Filer

A U.S. person who owns stock in a foreign corporation is a Category 3 filer if any one of the following events occurs during the taxable year:

1. The U.S. person acquires stock in the corporation that, when added to any stock already owned by the person, causes the person to own at least 10 percent (by vote or value) of the corporation’s stock.
2. The U.S. person acquires stock that, without regard to any stock already owned by the person, constitutes at least 10 percent (by vote or value) of the corporation’s stock.
3. The U.S. person becomes a U.S. person while owning at least 10 percent (by vote or value) of the corporation’s stock.
4. The U.S. person disposes of sufficient stock in the corporation to reduce the person’s interest to less than 10 percent (by vote or value) of the corporation’s stock.
5. The U.S. person owns at least 10 percent (by vote or value) of the corporation’s stock when the corporation is reorganized.

For Category 3 purposes, a U.S. person is defined as a U.S. citizen, resident alien, corporation, partnership, estate, or trust. However, Category 3 also expands the definition of a U.S. person to include a bona fide Puerto Rico resident, a bona fide possessions resident, and a nonresident alien as to whom a Section 6013(g) or (h) election is in effect (i.e., where a nonresident alien spouse has made an election to be taxed as a U.S. person).

The stock ownership rules applicable to Category 3 are the same as the ones applicable to Category 2, as described above under “Filer Categories–Category 2 Filer.” These rules are contained in Internal Revenue Code Section 6046(c) and Treasury Regulations Section 1.6046-1(i).

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, corporation, partnership, estate, or trust. However, Category 4 also expands the definition of a U.S. person to include a bona fide Puerto Rico resident, a bona fide possessions resident, and a nonresident alien as to whom a Section 6013(g) or (h) election is in effect (i.e., where a nonresident alien spouse has made an election to be taxed as a U.S. person). See Treas. Reg. Section 1.6038-2(d).

A U.S. person is considered to “control” a foreign corporation for purposes of Category 4 if at any time during the person’s taxable year, such person owns more than 50 percent of the combined voting power of all classes of the foreign corporation’s voting stock, or more than 50 percent of the total value of all of the foreign corporation’s outstanding stock. See IRC Section 6038(e)(2). It is important to note that the concept of control here for Category 4 filers is distinct from the one in the definition of CFC, a term used for Category 1 and Category 5 filers. There, control over a foreign corporation exists when more than 50 percent (by vote or value) of the corporation’s stock is owned by one or more U.S. shareholders, each of whom individually owns at least 10 percent of the corporation’s stock. By contrast, a Category 4 filer is a single U.S. person who individually owns more than 50 percent (by vote or value) of the foreign corporation’s stock.

The stock ownership rules applicable to Category 4 are contained in Internal Revenue Code Section 6038(e)(2), which incorporates and modifies the constructive stock ownership rules of Section 318(a). For Category 4 purposes, if a person does not directly own stock, the person can own stock as follows:

• Constructive stock ownership from another person.
  • Attribution from family members. A person can only be attributed stock owned by his or her parent, spouse, child, or grandchild. Attribution from nonresident aliens is permitted.
  • Upward attribution from entities. The attributing entity can be either a U.S. or foreign entity. However, if the attributing entity is a corporation, the person to whom the stock is to be attributed must own at least 10 percent (by value) of the attributing entity’s stock. Furthermore, because Section 6038(e)(2) defines control for purposes of Category 5 as owning more than 50% (by vote or value) of a corporation’s stock, if a person controls a corporation that, in turn, owns more than 50% (by vote or value) of the stock of a second corporation, then such person will be treated as in control of the second corporation as well.
  • Downward attribution from persons. The attributing person can be either an individual or entity. However, if the stock is to be attributed downward to a corporation, the attributing person must own at least 50 percent (by value) of that corporation’s stock. Furthermore, no downward attribution is allowed if it results in a U.S. person constructively owning stock that is owned by a foreign person (as the attributing person).

Category 5 Filer

A Category 5 filer is a U.S. shareholder of a foreign corporation that is a CFC at any time during the corporation’s taxable year. However, to be classified as a Category 5 filer, the U.S. shareholder of the CFC must also own the CFC’s stock on the last day of the CFC’s taxable year.

The stock ownership rules applicable to Category 5 (including Categories 5a, 5b, and 5c) are the same as the ones applicable to Category 1 (including Categories 1a, 1b, and 1c), as described above under “Filer Categories–Category 1 Filer.” These rules are contained in Internal Revenue Code Section 958, which incorporates and modifies the constructive stock ownership rules of Section 318(a).

Category 5a, 5b, and 5c Filers

Category 5 is subdivided into Categories 5a, 5b, and 5c. Category 5a is a catchall category and applies to Category 5 filers who do not otherwise fall under either Category 5b or 5c. Categories 5b and 5c were added to Form 5471 as the result of Revenue Procedure 2019-40, which the IRS issued in response to the repeal of provisions in Section 958(b) that previously disapplied the constructive downward attribution rules of Section 318(a)(3) to the extent that they attributed stock owned by a foreign person to a U.S. person.

Categories 5b and 5c specifically apply to those CFCs that are considered to be foreign-controlled for purposes of Form 5471. Such a CFC, referred to herein as a “Foreign-Controlled CFC,” is a foreign corporation that, although classified as a CFC, would not be so classified if the determination were made without applying Section 318(a)(3)’s downward attribution rules so as to consider a U.S. person as owning the stock owned by a foreign person.

A Category 5b filer is a U.S. shareholder who owns, directly or indirectly under Section 958(a) (but not constructively under Section 958(b)), the stock of a Foreign-Controlled CFC and is not related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled CFC. Section 954(d)(3) defines two persons as being “related” to each other in terms of “control,” where one person controls or is controlled by the other, or is controlled by the same person or persons who control the other. Here, control over a corporation means directly or indirectly owning more than 50 percent of the corporation’s stock by either vote or value. A Category 5b filer is typically a shareholder who owns, directly or indirectly, stock in a foreign corporation but is not related to the foreign corporation because the common parent of both the shareholder and the foreign corporation does not control the foreign corporation.

A Category 5c filer is a U.S. shareholder who does not own, either directly or indirectly, the stock of a Foreign-Controlled CFC but is related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled CFC. A Category 5c filer is typically a shareholder that owns the stock of a foreign corporation only because of constructive stock ownership under Section 318(a)(3) and the shareholder is related to the foreign corporation because each of them is under the control of a common parent.

A U.S. shareholder who does not own, either directly or indirectly, the stock of a Foreign-Controlled CFC and is not related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled CFC, is neither a Category 5b nor 5c filer. Such U.S. shareholder is deemed not to fall under the Category 5a catchall and is exempt from the obligation to file Form 5471.

Schedule G-1

Schedule G-1 must be completed by Category 1c, 3, 4, 5a, and 5c filers.

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 platform 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

The IRS Form 5471 is an incredibly complicated return. Each year an international tax attorney should review direct, indirect, and constructive ownership of the reporting CFC to determine the impact of any changes in percentages, filer categories, and CFC status. Workpapers should also be prepared and maintained for each U.S. GAAP adjustment and foreign exchange. In addition, an accounting should be made for adjustments to prior and current year previously taxed E&P that become PTEPs on Schedule J, E-1, and P.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & 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 tax professionals.

Anthony has assisted companies 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.