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Exploitation of Intangible Property Abroad: The Use of Cost Sharing Arrangements to Avoid the Transfer Pricing Rules

Exploitation of Intangible Property Abroad: The Use of Cost Sharing Arrangements to Avoid the Transfer Pricing Rules

By Anthony Diosdi

In considering the U.S. and foreign tax aspects of exploiting abroad intangible property rights, such as rights to patents, copyrights, trademarks, confidential knowhow, and trade secrets, it is convenient to analyze transfers of intangible property between commonly controlled parties.

For example, Corp A, U.S. corporation owns the copyright in a computer program, Program X, and Corp A transfers a disk containing Program X to Corp B, wholly owned subsidiary, a Country Z corporation, and grants Corp B “an exclusive license for the remaining term of the copyright to copy and distribute an unlimited number of copies of Program X in the geographic area of Country X, prepare derivative works based upon Program X, make public performances of Program X and publicly display Program X. Corp B will pay Corp A royalty of $y a year for three years which is the expected period during which Program X will have commercially exploitable value. Since Corp A and Corp B are related parties, a “transfer price” must be computed for these controlled transactions in order to satisfy various provisions of the Internal Revenue Code. Although transfer prices do not affect the combined income of the controlled group of corporations, they do affect how that income is allocated among the group members. The term “transfer pricing” is often used to refer to the setting of prices on all types of transactions between related parties.

Internal Revenue Code Section 482 provides that, where one member of a group of controlled entities sells or otherwise disposes of intangible property to another member of such group at other than an arm’s length price, the Internal Revenue Service (“IRS”) may make appropriate allocations to reflect an arm’s length price for such sale or disposition. The purpose of Internal Revenue Code Section 482 is to ensure that multinational corporations report and pay tax on their actual share of income arising from controlled transactions. To arrive at an arm’s length result, the multinational corporation must select and apply the method that provides the most reliable estimate of an arm’s length price. This includes making a comparison between controlled and uncontrolled transactions, as well as analyzing data and certain assumptions.

Exploitation of Intangible Property

The application of the arm’s length stands of transactions between related parties can be a very complex task. This task is never more difficult than in transactions involving the exploitation of intangible properties such as patents, knowhow, trademarks, or trade secrets. There are several reasons for the high degree of complicity. Almost by definition, these types of assets tend to be peculiar or unique. In fact, their peculiarity or uniqueness often contributes substantially to their value. Further, the legal transfer of intangible property can be achieved relatively simply by the execution of documents of sale or license coupled with the provision of information. The ease of transferring ownership of or rights to use intangible property had led to the development of relatively simple means of effecting tax-avoidance arrangements.

Internal Revenue Code Section 482 gives the IRS the power to reallocate, redistribute, or reapportion gross income, deductions, and other tax items among taxpayers owned or controlled directly or indirectly by the same interests, to more properly reflect income or prevent the evasion of taxes. Control for this purpose is not established by a specific threshold, but rather by the reality of control, in any form, direct or indirect, however exercisable or exercised, and whether or not legally enforceable.

Concern with the possibility of avoiding taxes on the exploitation by foreign affiliates of technology developed in the United States resulted in the inclusion of the following amendments to Section 482: “In the case of any transfer (or license) of intangible property * * *, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” The purpose of this provision was to ensure that the consideration paid over time remains commensurate with the income produced by the intangible in the hands of the transferee. Any transfer of an intangible for more than one year between commonly controlled persons is subject, in principle, to a periodic review and adjustment by the IRS can not defeat transfer price challenges through the establishment of long term licensing arrangements. To avoid these results, the regulations provide a series of exceptions to these rules. One such exception is cost sharing arrangements.

Cost Sharing Arrangements

As indicated above, one way for controlled parties to avoid the transfer pricing rules for intangibles is to enter into a cost sharing arrangement. Under Treasury Regulation Section 1.482-7, an arrangement called cost sharing is provided as a basic alternative to arm’s length royalty arrangements between related parties with respect to intangibles. In general, 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. Because each participant receives rights to any intangibles developed under the arrangement, no royalties are payable by the participants for exploiting their rights to such intangibles.

Cost sharing arrangements obviate the uncertainties of attempting to fix arm’s length royalties for intangibles. 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). In other words, a bona fide cost sharing arrangement must allocate research and development costs in proportion to the profits earned by each controlled party from the intangible and each controlled party must bear a portion of the costs incurred at each stage of the development of both successful and unsuccessful intangibles.

For example, let’s assume that Jetflix, a U.S. corporation develops software that employers can use to spy on their employees. Jetflix believes that there is a market for this software and anticipates spending $10 million this year on research and development. Jetflix believes that 60 percent of the market for its software will be in Europe, which is served by its U.K subsidiary (“U.K. Spy”). Jetflix has two alternatives for the U.S. taxation of its new software. First, Jetflix may deduct all the research and development expenses for the new software on its U.S. tax return and license the intangible to U.K Spy in exchange for a royalty. Second, U.K. Spy could enter into a cost sharing arrangement with Jetflix and pay $6,000,000 (the 60% anticipated share of the market x the $10 million of the research and development expenses incurred). By entering into the cost sharing arrangement, U.K. Spy would own the European rights to the new software and not have to pay a royalty in the future for the use of the intangible.

In order for a cost sharing agreement to be recognized by the IRS it must be “qualified.”
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 also provide for adjustments to account for changes in economic conditions, business operations and practices and the ongoing developments of intangibles. In addition, a cost sharing arrangement must satisfy the following four requirements:

1) The cost sharing arrangement must include two or more participants;

2) The cost sharing arrangement must provide a method to calculate each 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) The cost sharing arrangement must provide for adjustment to the 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 arrangement; and

4) The cost sharing arrangement be recorded in a document contemporaneously with the formation (and any revision) of the cost sharing arrangement 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) A description of the scope of the research and development to be undertaken, including the intangible or class of intangibles intended to be developed;

iii) A description of the scope of the research and development to be undertaken, including the intangibles 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, such as the interest that each participant will receive in any covered intangibles.

Covered Intangibles and Participants

In order for an intangible to receive favorable tax treatment through cost sharing arrangement, the intangible must be classified as “covered intangibles.” A covered intangible is defined broadly as “any intangible property that is developed as a result of the research and development undertaken under cost sharing arrangement.” Examples are given for cost sharing arrangements covering the development of vaccines and of computer software, which imply wide flexibility in what may be brought within the concept of a “covered intangible.” See Treas. Reg. Section 1.482-7. An “intangible” is defined broadly for the purposes of Internal Revenue Code Section 482 to include:

1) Patents, inventions, formulae, designs, patterns, or knowhow;

2) Copyrights and literary, musical, or artistic composition;

3) Trademarks, trade names, or brand names;

4) Franchises, licenses, or contracts;

5) Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and

6) Other similar items if it derives its value not from its physical attribution but from its intellectual content or other intangible properties. See Treas. Reg. Section 1.482-4.

As indicated above, commonly controlled participants may participate in a cost sharing arrangement to produce intangible property. To qualify as a controlled participant, a controlled entity must reasonably anticipate that it will derive benefits from the use of the covered intangible. This requirement will presumably be met if the controlled participant uses the intangible itself, licenses or otherwise transfers the intangible to others so long as the controlled participant’s benefits can be reliably measured. In certain cases, an entity that is not classified a controlled participant may furnish assistance in the development of an intangible and still participate in a cost sharing arrangement.

Development Costs and Reasonable 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 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 anticipated benefits 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 taxpayer 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 reasonable anticipated benefit “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.

Reasonable anticipated benefits 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.

Other Considerations

Finally, it should be understood that cost sharing arrangements are not treated as partnerships for U.S. tax purposes. This means that a foreign controlled participant is not involved in a U.S. trade or business. This means that cost sharing payments technically do involve income that is subject to U.S. withholding taxes. In certain cases, cost sharing payments may also be exempt from withholding taxes in foreign countries.


One way for multinational corporations to avoid the administrative burden and uncertainties associated with transfer pricing for intangibles is to enter into a cost sharing arrangement. Under such an agreement, a parent corporation may own the rights to software in the United States, while a foreign subsidiary might own the rights to the same software abroad. The advantage of a cost sharing agreement is that the foreign subsidiary’s ownership of the foreign rights to the software negates the need to have the foreign subsidiary pay a royalty to its U.S. parent. However, a cost sharing arrangement should allocate all research and development costs in proportion to the profits received by each party. This requires each party to bear a portion of the costs incurred at each stage of the development of both successful and unsuccessful intangibles.

We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also  provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted 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.