By Anthony Diosdi
In order to effectively audit the transfer prices used by a U.S. subsidiary of a foreign corporation, the Internal Revenue Service (“IRS”) often must examine the books and records of the foreign parent corporation. Historically, foreign parties have resisted making their records available to the IRS, or have not maintained records sufficient to determine arm’s length transfer prices. In response, Congress enacted the requirement that each year certain reporting corporations must file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, and maintain certain records. See IRC Sections 6038A and 6038C. A domestic corporation is a reporting corporation if, at any time during the taxable year, 25 percent or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. A foreign corporation is a reporting corporation if, at any time during the taxable year, it is engaged in a U.S. trade or business, and 25 percent or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. See Treas. Reg. Section 1.6038A-1(c). In filing a Form 5472, the reporting corporation must provide information regarding its foreign shareholder, certain other related parties, and the dollar amounts of the transactions that it entered into during the taxable year with foreign related parties. See Treas. Reg. Section 1.6038A-2(b). A separate Form 5472 must be filed for each foreign or domestic related party with which the reporting corporation engaged in reportable transactions during the year. See Treas. Reg. Section 1.6038A-2(a). Anyone completing a Form 5472 must understand the importance of this form and the fact that the IRS often uses the Form 5472 as a starting point for conducting a transfer pricing examination.
The information required to prepare a Form 5472 is as follows:
1. The name and address of the reporting corporation, and its employer identification number.
2. Identification of the foreign stockholder of the reporting corporation, including the country of organization, the countries where it conducts business, and countries where it files its income tax returns.
3. Identification of the related party with which the reporting corporation is conducting reportable transactions, including its name and address, principle business activity, the countries in which it conducts business, and the countries in which it files income tax returns.
4. Information about non-monetary transactions between the reporting corporation and the related party, describing the substance and the size of the transaction or group of transactions, with an estimate of the fair market value, or nature or importance of any non-monetary value transferred.
We will next review the Form 5472 line-by line.
Part 1 Reporting Corporation
Line 1a. Name of Reporting Corporation
For Line 1a, the preparer should state the name of the reporting corporation and its address.
Line 1c. Total Gross Assets
For Line 1c, the domestic reporting corporation should enter its total assets from item D, page 1, Form 1120. Foreign reporting corporations enter the amount from line 17, column (d), Schedule L, Form 1120-F.
Lines 1d and 1e. Principal Business Activity and Principal Business Activity Code
For Lines 1d and 1e, the preparer should enter a description of the principal business activity and enter the principal business activity code. A list of business activity codes can be found in the instructions for Form 1120 or Form 1120-F instructions.
Line 1f. Total Value
For Line 1f, the preparer must enter the total value in U.S. dollars of all foreign related party transactions reported in Parts IV and VI of this Form 5472. This is the total of the amounts entered on lines 13 and 26 of Part IV plus the fair market value of the nonmonetary transactions reported in Part VI. For purposes of Form 5472, related parties include the 25 percent foreign owner and any party related to the reporting corporation or the 25 percent foreign owner, using the affiliation rules of Internal Revenue Code Sections 318, 267(b), 707(b)(1), and 482.
Line 1g. Total Number of Form 5472 Filed for the Tax Year
For Line 1g, the preparer must state the number of Form 5472s being filed for the year on behalf of the reporting corporation.
Line 1h. Total Value of Gross Payments Made or Received
For Line 1h, the preparer must enter the total value in U.S. dollars of all foreign-related party transactions reported in Part IV and VI of all Form 5472 filed for the tax year.
Line 1j. Countries Under Whose Laws the Reporting Corporation Files an Income Tax Return as a Resident
For Line 1j, the preparer should check the box if this is the initial year for which the U.S. reporting corporation is filing a Form 5472.
Line 1k.
Like 1K asks the preparer for the total number of Parts VIII attached to the Form 5472. A preparer must complete Part VIII for each cost sharing arrangement.
By way of background, 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.
Treasury Regulation 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 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. The IRS can only adjust the cost sharing payments to make each controlled participant’s share of the relevant intangibles development costs equal to its share of reasonably anticipated benefits from use of the intangibles developed. To be treated as a qualified cost sharing arrangement and thus insulated from risk of royalty allocations, the arrangement must satisfy the following four requirements:
1) Include two or more participants;
2) Provide a method to calculate each controlled participant’s share of intangible development costs, based on factors that can reasonably be expected to reflect the participant’s share of anticipated benefits;
3) Provide for adjustment to the controlled participant’s shares of intangible development costs to account for changes in economic conditions, the business operations and practices of the participants and the ongoing development of intangibles under the arrangements; and
4) Be recorded in a document that is contemporaneous that includes:
i) A list of the arrangement’s participants, and any other member of the controlled group that will benefit from the use of intangibles developed under the cost sharing arrangement;
ii) The information described in paragraphs (2) and (3) above;
iii) A description of the scope of the research and development to be undertaken, including the intangible or class of intangibles intended to be developed;
iv) A description of each participant’s interest in any covered intangibles;
v) The duration of the arrangement; and
vi) The conditions under which the arrangement may be modified or terminated and the consequences of such modification or termination, such as the interest that such participants will receive in any covered intangibles.
Line 1l. Country of Incorporation
For Line 1k, the preparer should state the country the reporting corporation is incorporated.
Line 1m.
For Line 1m, the preparer should state the date the corporation was incorporated.
Line 1n. Country Under Whose Laws the Reporting Corporation Files an Income Tax Return as a Resident
For Line 1l, the preparer must state the country or countries whose laws the reporting corporation files an income tax return as a resident.
Line 1o. Principal Countries Where Business is Conducted
For Line 1m, the preparer must provide the principal countries where business is conducted. The preparer should not list any countries in which business is conducted solely through a subsidiary.
Line 2.
For Line 2, the preparer should check the box if at any time during the tax year the reporting corporation if a “foreign person” had a 50 percent direct or indirect ownership (applying the constructive ownership rules of Section 318) in the reporting corporation.
Line 3.
For Line 3, the preparer should check the box if the reporting corporation is a disregarded entity for U.S. tax purposes.
Part II. 25 Percent Foreign Shareholder
For Part II, the preparer is required to provide basic information regarding direct (or ultimate indirect) 25% foreign shareholders. An indirect owner is an individual or entity that owns more than 50 percent of the corporation’s shares, either directly or indirectly through other entities in a group.
Part III. Related Party
All reporting corporations must complete Part III of Form 5472. The preparer must also check the boxes next to “Part III” to notify the IRS if the subsection of the form is being prepared for a “foreign person” or a “U.S. person.”
Line 8a. Name and Address of Related Party
For Line 8a, the related parties name and address must be stated.
Line 8b(1). U.S. Identifying Number
For line 8b(1), the preparer must enter the related party’s U.S. identifying number, if any.
Line 8b(2). Reference ID Number
For Line 8b(2), the preparer should enter the related party’s U.S. reference number, if required. A reference ID number is required only in cases where no U.S. identifying number was entered for the foreign related party on line 1b(1).
Line 8b(3). Foreign Taxpayer Identification Number
For Line 8b(3), the preparer should enter the Foreign Tax Identification Number (“FTIN”) of the reporting corporation.
Line 8c. Principal Business Activity
For Line 8c, the preparer should state the principal business activity of the reporting corporation.
Line 8d. Principal Business Activity Code
For Line 8d, the preparer should enter the principal business activity code of the reporting corporation.
Line 8e. Relationship
For Line 8e, the preparer should check the boxes that apply.
Line 8f. Principal Country(ies) Where Business is Conducted
For Line 1f, the preparer should enter the principal country(ies) where business is conducted.
Line 8g. Country (ies) Under Whose Laws the Related Party Files an Income Tax Return as a Resident
For Line 8g, the preparer should enter the country(ies) whose laws the related party files an income tax return as a resident.
Part IV Monetary Transactions Between the Reporting Corporations and Foreign Related Party
Part IV must be completed if the “foreign person” box is checked in the heading for Part III. If estimates are used, the preparer should check the box next to “Part IV” of the form.
Line 9.
For Line 1, the preparer must report the payments received and paid from the sale of stock in trade (inventory) between the reporting corporation and a foreign related party.
Line 10.
For Line 2, the preparer must report the payments received and paid from the sale of tangible property other than stock in trade between the reporting corporation and a foreign related party.
Lines 11 and 25.
For Lines 11 and 25, the preparer must report platform contribution transaction payments received and paid by the reporting corporation (without giving effect to any netting of payments due and owed. The questions for Lines 11 and 25 ask the preparer to report platform contribution payments received from a foreign related party and platform contribution payments made to a foreign related party.
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.
Lines 12 and 26.
For lines 12 and 26, the preparer is required to report cost-sharing transaction payments received and paid by the reporting corporation (without giving effect to any netting of payments due and owed). The corporation is required to complete line 12 only if the corporation itself incurred intangible development costs. If the corporation does not itself incur intangible development costs, then it should only report cost-sharing transaction payments made on line 26.
Line 17. Amounts Borrowed
For line 17, the preparer should report amounts borrowed using either the outstanding balance method or the monthly average method. If the outstanding balance method is used, the preparer should enter the beginning and ending outstanding balance for the tax year on lines 17a and 17b. If the monthly average method is used, skip line 17a and enter the monthly average for the tax year on line 17b.
Line 21. Other Amounts Received
For line 21, the preparer should enter amounts received that are not specifically reported on lines 9 through 20. The preparer should include amounts on line 21 to the extent that these amounts are taken into account in determining the taxable income of the reporting corporation.
Line 32. Interest Paid
For line 32, the preparer must report the amount of interest paid or accrued. If the amount of interest paid or accrued is subject to the limitation of Section 163(j), the preparer should report only the amount allowed as a deduction under that section.
The preparer should keep in mind that controlled entities generally must charge each other an arm’s length rate of interest on any intercompany loans or advances. See Treas. Reg. Section 1.482-2(a)(1)(i). There is an exception, however, for intercompany trade receivables, which are debts that arise in the ordinary course of business and are not evidenced by a written agreement requiring the payment of interest. See Treas. Reg. Section 1.482-2(a)(1)(iii)(A).If the controlled borrower is located outside the United States, it is not necessary to charge interest on an intercompany trade receivable until the first day of the fourth month following the month in which the receivable arises. See Treas. Reg. Section 1.482-2(a)(1)(iii)(C). If the controlled borrower is located within the United States, the interest free period extends to the first day of the third month following the month in which the receivable arises. See Treas. Reg. Section 1.482-2(a)(1)(iii)(B).
Longer inter free periods are possible if the controlled lender ordinarily allows unrelated parties a longer interest-free period or if a controlled borrower purchases the goods for resale in a foreign country and the average collection period for its sales is longer than the interest free period. See Treas. Reg. Section 1.482-2(a)(1)(iii)(D). Intercompany debt other than a trade receivable generally must bear an arm’s length interest charge. See Treas. Reg. Section 1.482-2(a)(1)(i). To determine the arm’s length rate, the reporting corporation must consider all relevant factors, including the amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender for comparable loans between the uncontrolled parties. See Treas. Reg. Section 1.482-2(a)(20(i). If an arm’s length rate is not readily determinable, the reporting corporation can still protect itself against an IRS adjustment by satisfying the requirement of a safe-harbor provision. Under this safe harbor, an interest rate is deemed to be an arm’s length if it is between 100 percent and 130 percent of the applicable federal rate. See Treas. Reg. Section 1.482-2(a)(2)(iii)(B). The applicable federal rate is the average interest rate (redetermined monthly) on obligations of the federal government with maturities similar to the term on the intercompany loan. See IRC Section 1274.
Line 33. Premiums for Insurance or Reinsurance
For Line 33, the preparer should enter the amounts paid between the reporting corporation and a foreign related party for insurance or reinsurance.
Line 35. Other Amounts Paid
For Line 35, the preparer should enter the amounts paid that are not specifically reported on lines 23 through 34. The preparer should include the amounts taken into account in determining taxable income of the reporting corporation.
Part V. Reportable Transactions of a Reporting Corporation
For Part V, the preparer must check the box if the reporting reporting corporation
Is a foreign-owned disregarded entity that had any other transactions as defined by Treasury Regulation Section 1.482-1(i)(7) not already entered on Part IV. These transactions include amounts paid or received in connection with the formation, dissolution, acquisition, and disposition of the entity, including contributions to and distributions from the entity. These transactions must be described on an attachment to the Form 5472.
Part VI. Nonmonetary and Less-Than Full Consideration Transactions Between the Reporting Corporation and the Foreign Related Party
The preparer must check the box for Part VI and attach a description to Form 5472 if the related party is a foreign person or foreign corporation. If there are transaction(s) between the reporting corporation and a foreign related party that is non monetary or less-than full consideration, the attachment must include the following description:
1. A description of all property (including monetary consideration), rights, or obligations transferred to the foreign-related party and from the foreign-related party to the reporting corporation.
2. A description of all services performed by the reporting corporation for the foreign-related party and by the foreign-related party for the reporting corporation; and
3. A reasonable estimate of the fair market value of all properties and services exchanged, if possible, or some other reasonable indicator or value.
Part VII. Additional Information
Line 37. Does the reporting corporation import goods from a foreign related party?
Line 37 calls for a “Yes” or “No” answer. In order to answer this question, the term “foreign related party” must be defined. A related party is any party that is related to the reporting corporation or the 25 percent foreign owner, using the affiliation rules of Internal Revenue Code Sections 318, 267(b), 707(b)(1), and 482.
Line 38a.
If the preparer answered “Yes” to Line 38a of Part VII, the preparer must state “Yes” or “No” if the basis or inventory cost of the goods are valued greater than the customs value of the imported goods.
Line 38b.
If the preparer answered “Yes” to Line 38b, the preparer must attach a statement to the Form 5472 explaining the difference. When preparing this attachment, the preparer must keep in mind Section 1059A of the Internal Revenue Code. Section 1059A provides that property imported into the United States in a transaction that is, directly or indirectly, between related persons will have a cost or inventory basis not greater than the “custom value” of the property. The customs value is the amount used to determine customs and other duties imposed on the import of the property. Section 1059A effectively establishes the maximum cost that the related party may use for tax purposes. Note that the reporting corporation may use a tax cost that is less than the customs value if it satisfies the requirements of Section 482. See Treas. Reg. Section 1.1059A-1(c)(1).
Line 38c.
If the preparer answered “Yes” to questions 37 and 38a, the preparer must answer “Yes” or “No” if documents were used to support the treatment of the imported goods and if the documents are available for inspection by the IRS.
Line 39.
Line 39 asks if during the tax year was the foreign parent corporation a participant in any cost-sharing arrangement? The question calls for a “Yes” or “No” answer. The question calls for a “Yes” or “No” answer.
In order to answer Line 39, the preparer must know the definition of a “cost sharing arrangement” for U.S. tax purposes. As discussed above, a cost sharing arrangement is an agreement between two or more persons to share the costs and risks of research and development as they are incurred in exchange for a specified interest in any intangible property that is developed. The preparer should keep in mind that that although the IRS permits cost sharing arrangements, it expects them to produce results consistent with the purpose of the commensurate-with-income standards in Section 482- i.e., that the “income allocated among the parties reasonably reflect the actual economic activity undertaken by each.” See H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-638 (1986).
The regulations provide that no reallocation under Section 482 will generally be made with respect to a “qualified cost sharing arrangement” except for assuring that the parties to the arrangement bear shares of the costs of developing the intangible property equal to their shares of reasonably anticipated benefits. See Treas. Reg. Section 1.482-7(a)(2). Certain requirements must be met if the cost sharing agreement is to be treated as “qualified.” The agreement must be in writing and must reflect a sharing of the costs of developing intangibles based upon the participants’ respective shares of anticipated benefits from exploiting them. It must provide for adjustments to account for changes in economic conditions, business operations and practices and the ongoing developments of intangibles.
Line 40a.
Line 40a asks if during the tax year, did the reporting corporation pay or accrue any interest or royalty, to the related party, for which the deduction is not allowed under Section 267A? This question calls for a “Yes” or “No” answer. In order to answer this question, Internal Revenue Code Section 267A must be defined. Section 267A disallows deductions for “disregarded payment” of interest or royalties to a related person. Under the proposed regulations, “disregarded payments” are interest and royalty payments that are not taxable income to the recipient. Specifically, Section 267A includes payments that: 1) are not considered received by the recipient under the tax law of the recipient’s home country; and 2) that would be deductible to the recipient.
When Section 267A applies, the deduction generally is disallowed to the extent the related party does not include the amount in income or is allowed a deduction with respect to the amount. However, the deduction is not disallowed to the extent the amount is included in the gross income of a U.S. shareholder under Section 951(a).
Line 40b.
If question 5a was answered “Yes,” the preparer must state the amount of the disallowed deduction.
Line 41a.
Line 41a asks the preparer to state whether or not the reporting corporation claimed a foreign-derived intangible income (“FDII”) deduction (under Section 250) with respect to the amounts listed in Part IV?
FDII is determined as follows: First, a corporation’s gross income is determined and then reduced by certain items of income, including subpart F income, dividends received from controlled foreign corporations, and income earned from foreign branches. This amount is reduced by deductions allocable to such income. After applicable deductions are utilized, the deduction eligible income (FDDEI”) is determined. Second, the foreign portion of such income is determined. This amount includes any income derived from the sale of property to any foreign person for foreign use. Third, the corporation’s deemed intangible income is determined. This is the excess of the corporation’s deduction eligible income over 10 percent of its qualified business asset investment (“QBAI”). A corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases are determined using straight line depreciation.
The FDII calculation is expressed by the following formula:
FDII = Deemed Intangible Income x Foreign-Derived Deduction Eligible Income
Deduction Eligible Income
Domestic corporations are allowed to deduct 37.5 percent of its FDII under Internal Revenue Code Section 250. The preparer is required to state in Line 6a, the Section 250 deduction of FDII income.
Line 41b.
Line 41b asks the preparer to enter the FDDI gross income derived from sales, leases, exchanges, or other dispositions (but not licenses) of property to the foreign related party that the reporting corporation included in its computation of FDDEI is discussed in the explanation for Line 41a.
Line 41c.
Line 41c asks the preparer to list any FDDEI income derived from a license of property to a related foreign party.
Line 41d.
Line 41d asks the preparer to list any FDDEI income derived from services provided to a foreign related party.
Line 42.
For Line 42, the preparer should check the “Yes” box if, during the tax year, the reporting corporation had loans to or from a related party, to which the safe-haven rate rules of Treasury Regulation Section 1.482-2(a)(2)(iii)(B) are applicable, and for which the reporting corporation used a rate of interest within the safe-haven range of Section 1.482-2(a)(2)(iii)(B)(1) which is 100 to 130 percent of the Applicable Federal Rate for the relevant term.
Line 43a.
Lines 43a through 43b(2) are completed only if the reporting corporation is a domestic corporation. For Line 43a, the preparer should check “yes” in the box if the reporting corporation engaged in at least one of the transactions described in Treasury Regulation Section 1.385-3(b)(2). Treasury Regulation Section 1.385-3(b)(2) provides rules for the characterization of related-party debt.
Line 43b(1).
For Line 43b(1), the preparer must provide the total amount of the transaction described in Treasury Regulation Section 1.385-3(b)(2). This is the measure of the fair market values of the distributions of the debt instrument or the fair market value of the debt instrument exchanged for property.
Line 43b(2).
For Line 43b(2), the preparer must provide the total amount (as measured by issue price in the case of an instrument treated as stock upon issue, or adjusted issue price in the case of an instrument deemed exchanged for stock) of the debt instrument issuances addressed by Line 43a. The adjusted issue price of a debt instrument is the issue price increased by the amount of original issue discount previously includible in gross income of any holder and decreased by payment of original issue discount previously includible in gross income of any holder and decreased by payment other than payment of qualified stated interest. See IRC Section 1272(a)(4); Treas. Reg. Section 1.1275-1(b)(1).
Part VIII- Cost Sharing Arrangement (CSA)
A separate Part VIII must be filed for each cost sharing arrangement.
Line 44.
For Line 44, the preparer should provide a brief description of the cost sharing agreement, including the industry, tangibles, or intangibles involved.
Line 45.
For Line 45, the preparer should state if the reporting corporation became a member of a cost sharing arrangement.
Line 46.
For Line 46, the preparer should state if the cost sharing arrangement was in existence before January 5, 2009.
Line 47.
For Line 47, the preparer should state the reporting corporation’s share of reasonably anticipated benefits of the cost sharing arrangement.
Reasonably anticipated benefits or (“RABs”) are defined as additional income generated or cost saved by the use of covered intangibles. 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).
Income Method
Participants of a cost sharing arrangement may also use the income method to determine the reasonable anticipated benefits. Under income method, a cost sharing agreement between a platform contribution transaction payor and platform contribution payee, where the platform contribution transaction payor makes payments for its shares of the platform intangible contributed by the platform contribution transaction payee, the parties to the cost sharing agreement agree to share in the costs of the intellectual property development.
A platform contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the cost sharing arrangement) that is reasonably anticipated to contribute to developing cost shared intangibles. The value of the platform contribution transaction is the present value of the stream of the reasonably anticipated residuals, over the duration of the cost sharing agreement activity, of divisional profits or losses, minus operating cost contributions, minus intangible cost contributions, minus platform contribution payments.
Market Capitalization Method
Under the market capitalization method, the arm’s length charge for a platform contribution covering resources, capabilities, and rights of the platform contribution payee is equal to the adjusted average market capitalization, as divided among the controlled participants according to their respective shares of the anticipated benefits. See The Tax Advisor, Transfer Pricing: The New Temporary Cost-Sharing Regs, Jeffrey B. Kaufman (2009).
Acquisition Price Method
The acquisition price method applies the comparable uncontrolled transaction or “CUT” method defined in Treasury Regulation Section 1.482-4 to evaluate reasonable anticipated benefits from a cost sharing arrangement. Under the CUT method, the arm’s length price is the price charged for comparable transactions between uncontrolled parties, adjusted for any material differences that exist between the controlled and uncontrolled transactions. The acquisition price method is ordinarily used where substantially all the target’s nonroutine contributions made to the platform contribution payee’s business activities are covered by a platform contribution transaction. Under this method, the arm’s length change for a platform contribution transaction is equal to the adjusted acquisition price, as divided among the controlled participants according to their respective reasonably anticipated benefits. Because information regarding comparable uncontrolled transactions is usually not available regarding intangible assets, this method usually is difficult to apply in practice.
Residual Profit Split Method
The residual profit split method evaluates whether the allocation of combined operating profit or loss attributable to one or more platform contributions subject to a platform contribution transaction is determined at arm’s length by reference to the relative value of each controlled participant’s contribution to that combined operating profit or loss. In other words, the division of profits must reflect the actual profit or loss between uncontrolled parties. To meet this requirement, the division or profit or loss must be adjusted annually to reflect any unanticipated changes in the income actually generated by the intangible.
Under the residual profit split method, the comparable profits method is used to estimate and allocate an arm’s length profit for contributions made by each controlled entity. Routine contributions ordinarily include contributions of tangible property, intangible property, and services. The residual profit not allocated on the basis of routine function is then allocated between the controlled entities on the basis of the relative value of the intangible property contributed by each controlled party. The difficulty in obtaining financial data may render this method difficult to apply in practice.
Comparable Uncontrolled Transaction Method
The comparable uncontrolled transaction method is the arm’s length total value for the platform contribution comparable to intangibles in transactions between uncontrolled parties, adjusted for any material differences that exist between the controlled and uncontrolled transactions. In order for the intangibles involved in the uncontrolled transaction to be considered comparable to the intangibles involved in the controlled transaction, both intangibles should be used in connection with similar products or processes within the same or similar industries.
“Best Method” for Determining the Arm’s Length Price
Treasury Regulation Section 1.482-7(g)(2) provides guidance on selecting the best method for purposes of evaluating a PCT, explaining that each method must be applied within the provisions of Treasury Regulation 1.482-1(c) (the best method rule), 1.482-1(d) (comparability analysis) and Section 1.482-1(e) (arm’s length range), unless modified in Treasury Regulation Section 1.482-7(g).
Under the best method, a method must be applied that provides the most reliable measure of an arm’s length result. The two primary factors are 1) degree of comparability and 2) the quality of the data and assumptions used in the analysis. Treasury Regulation Section 1.482-7(g)(2) provides other best method factors specific to PCTs including: 1) consistency with upfront contractual terms and risk allocation- the “investor model;” 2) consistency of evaluation with realistic alternatives; 3) aggregation; 4) discount rates; 5) financial projections; 6) accounting principles; and 7) valuation of subsequent PCTs. Based on these rules, it is extremely important to complete a detailed functional analysis to develop the relevant facts for purposes of determining the best method for the initial PCT transaction and show why other non-chosen methods are less reliable.
Lines 48b and 48c.
For Lines 48b through 48c, the preparer must enter the amount of stock-based deductions that was granted during the term of the cost sharing arrangement.
The 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.
Lines 49a and 43b.
For Lines 49a and 49b, the preparer should enter the total amount of the total amount of the intangible development costs for the cost sharing agreement for Line 49a and the intangible development costs allocable to the reporting corporation on the reporting corporation’s reasonable anticipated benefits share for Line 43b.
Part IX. Base Erosion Payments and Base Erosion Tax Benefits Under Section 59A
Line 50. Amounts defined as base erosion payments under Section 59A(d).
Line 50 asks the preparer to enter the amount of base erosion payments made by the reporting corporation (if any). The 2017 Tax Cuts and Jobs Act introduced Internal Revenue Code Section 59A otherwise known as base erosion and anti-abuse tax (“BEAT”). This code section was designed to prevent base erosion in the crossborder context by imposing a type of alternative minimum tax, which is applied by adding back to taxable income certain deductible payments, such as interest and royalties, made to related foreign persons. Section 59A applies to C corporations with gross receipts of at least $500 million over a three-year testing period and a “base erosion percentage” of at least 3 percent. See IRC Section 59A(C)(4)(A). (A 2 percent threshold applies to banks and registered securities dealers). The base erosion minimum tax is the excess of 10 percent of the corporation’s modified taxable income over its regular tax liability. (The percentage is one percent higher for banks and registered securities dealers).
For purposes of completing Line 1, the term base erosion payment generally means any amount paid or accrued by the reporting corporation or a foreign person, which is related party and with respect to which a U.S. deduction is allowed. Base erosion payments also include amounts paid or accrued by the reporting corporation to the foreign related party in connection with the acquisition of depreciable or amortizable property, certain reinsurance payments, and certain payments to expatriated entities. If applicable, for Line 1, The preparer should enter any base erosion payments.
Line 51. Amount of base erosion tax benefits under Section 59A(c)(2).
For Line 51, the preparer must enter the amount of the base erosion tax benefits under Section 59A(c)(2). The term base erosion tax benefit generally means any permissible U.S. deduction. The term base erosion tax benefit also includes certain reductions in gross premiums with respect to certain reinsurance payments. If applicable, the preparer should enter on Line 50 any base erosion tax benefits.
Line 52. Amount of total qualified derivative payments as described in Section 59A(h) made by the reporting corporation.
For Line 52, the preparer must enter the total qualified derivative payments. The term qualified derivative payment generally means any payment made by a taxpayer according to a derivative with respect to which the taxpayer: 1) recognizes gain or loss as such derivative were sold for its fair market value on the last business day of the taxable year; 2) treats any gain or loss so recognized as ordinary; and 3) treats the character of all items of income, deduction, gain, or loss with respect to a payment according to the derivative as ordinary. If applicable, on Line 52, the preparer should enter the total qualified derivative payments discussed above.
Conclusion
Completing Form 5472 is extraordinarily complex. In addition, the Internal Revenue Code requires a reporting corporation to keep extensive records of the related parties and all transactions (including those with unrelated parties). The type of records that must be maintained include not only all the usual accounting records, but also records concerning pricing of transactions with related parties. The failure to file a Form 5472 or to maintain records is $25,000. If such failure continues for more than 90 days after notification by the IRS, an additional $25,000 penalty may be assessed for each 30-day period or fraction thereof.
If your company is required to file a Form 5472 or the Form 5472 that you filed is being audited by the IRS, you should consult with an international tax attorney well versed in international tax planning and compliance. We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi 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.