**\[4830-01-P\]**

**DEPARTMENT OF THE TREASURY**

**Internal Revenue Service**

**26 CFR Parts 1 and 301**

**\[REG-144615-02\]**

**RIN 1545-BB26**

**Section 482: Methods to Determine Taxable Income in Connection With a
Cost Sharing Arrangement**

**AGENCY:** Internal Revenue Service (IRS), Treasury.

**ACTION:** Notice of proposed rulemaking and notice of public hearing.

**SUMMARY:** This document contains proposed regulations that provide
guidance regarding methods under section 482 to determine taxable income
in connection with a cost sharing arrangement. These proposed
regulations potentially affect controlled taxpayers within the meaning
of section 482 that enter into cost sharing arrangements as defined
herein. This document also provides a notice of public hearing on these
proposed regulations.

**DATES**: Written or electronic comments must be received on or before
November 28, 2005. Requests to speak and outlines of topics to be
discussed at the public hearing scheduled for November 16, 2005, at
10:00 a.m. must be received by October 26, 2005.

**ADDRESSES:** Send submissions to CC:PA:LPD:PR (REG-144615-02), room
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered **Monday through
Friday** between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR
(REG-144615-02), Courier's desk, Internal Revenue Service, 1111
Constitution Avenue, NW., Washington, DC 20044, or sent electronically,
via the IRS Internet site at [www.irs.gov/regs](http://www.irs.gov/regs)
or via the Federal eRulemaking Portal at
[www.regulations.gov](http://www.regulations.gov/) (IRS and
REG-144615-02). The public hearing will be held in the IRS Auditorium,
Internal Revenue Building, 1111 Constitution Avenue, NW., Washington,
DC.

**FOR FURTHER INFORMATION CONTACT:** Concerning the proposed
regulations, Jeffrey L. Parry or Christopher J. Bello, (202) 435-5265;
concerning submissions of comments, the hearing, and/or to be placed on
the building access list to attend the hearing, LaNita Van Dyke, (202)
622-7180 (not toll-free numbers).

**SUPPLEMENTARY INFORMATION**

**Paperwork Reduction Act**

The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction of 1995 (44 U.S.C.
3507(d)).

An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless the collection of
information displays a valid control number assigned by the Office of
Management and Budget.

The collection of information requirements are in proposed
§1.482-7(b)(1)(iv)-(vii) and (k). Responses to the collections of
information are required by the IRS to monitor compliance of controlled
taxpayers with the provisions applicable to cost sharing arrangements.

[Estimated total annual reporting and/or recordkeeping
burden:]{.underline} 1250 hours.

[Estimated average annual burden hours per respondent and/or
recordkeeper:]{.underline} 2.5 hours.

[Estimated number of respondents and/or recordkeepers:]{.underline} 500.

[Estimated frequency of responses:]{.underline} Annually.

Comments on the collection of information should be sent to the **Office
of Management and Budget**, Attn: Desk Officer for the Department of the
Treasury, Office of Information and Regulatory Affairs, Washington, DC
20503, with copies to the **Internal Revenue Service**, Attn: IRS
Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224.
Comments on the collection of information should be received by October
28, 2005.

Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the
proper performance of the functions of the IRS, including whether the
information will have practical utility;

The accuracy of the estimated burden associated with the proposed
collection of information (see below);

How the burden of complying with the proposed collection of information
may be minimized, including through the application of automated
collection techniques or other forms of information-technology; and

Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.

Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.

**Background**

Section 482 of the Internal Revenue Code generally provides that the
Secretary may allocate gross income, deductions, credits, and allowances
between or among two or more taxpayers that are owned or controlled by
the same interests in order to prevent evasion of taxes or clearly to
reflect income of a controlled taxpayer. The second sentence of section
482 added by the Tax Reform Act of 1986 enunciates the "commensurate
with income" standard that in the case of any transfer (or license) of
intangible property (within the meaning of section 936(h)(3)(B)), the
income with respect to such transfer or license shall be commensurate
with the income attributable to the intangible. Public Law 99-5143,
1231(e)(1), [reprinted in]{.underline} 1986-3 C.B. (Vol. 1) 1, 479-80.

Comprehensive regulations under section 482 were published in the
**Federal Register** (33 FR 5849) on April 16, 1968, and were revised
and updated by transfer pricing regulations in the **Federal Register**
(59 FR 34971, 60 FR 65553, 61 FR 21955, and 68 FR 51171) on July 8,
1994, December 20, 1995, May 13, 1996, and August 26, 2003,
respectively.

The 1968 regulations contained guidance regarding the sharing of costs
and risks. See §1.482-2A(d)(4). The 1968 regulations were replaced in
1996 by §1.482-7 regarding the sharing of costs and risks (the 1996
regulations were further modified in 2003 with respect to stock-based
compensation).

Experience in the administration of existing §1.482-7 has demonstrated
the need for additional regulatory guidance to improve compliance with,
and administration of, the cost sharing rules. In particular, there is a
need for additional guidance regarding the external contributions for
which arm's length consideration must be provided as a condition to
entering into a cost sharing arrangement. The consideration for this
type of external contributions is referred to in the existing
regulations as the [buy-in]{.underline}. Furthermore, additional
guidance is needed on methods for valuing these external contributions.
The proposed regulations also provide the opportunity to address other
technical and procedural issues that have arisen in the course of the
administration of the cost sharing rules.

**Explanation of Provisions**

[A. Overview]{.underline}

Under a cost sharing arrangement, related parties agree to share the
costs and risks of intangible development in proportion to their
reasonable expectations of the extent to which they will relatively
benefit from their separate exploitation of the developed intangibles.
The existing §1.482-7 regulations and these proposed regulations provide
rules governing cost sharing arrangements consistent with the
commensurate income standard under the statute and the general arm's
length standard under the section 482 regulations.

Comment letters and other information available to the Treasury
Department and IRS have provided limited information on third-party
arrangements that are asserted to be similar to cost sharing
arrangements. Typically, in the context of discussion concerning the
current §1.482-7 regulations, information has been provided on certain
arrangements involving cost plus research and development or government
contracts, which, while no doubt arm's length transactions, are not
viewed by the Treasury Department and IRS as analogous to cost sharing
arrangements.

Thus, in accordance with §1.482-1(b)(1), the task is to provide guidance
relative to cost sharing arrangements regarding "the results that [would
have been realized]{.underline} if uncontrolled taxpayers [had
engaged]{.underline} in the same transaction under the same
circumstances." (Emphasis added.) This guidance is necessary because of
the fundamental differences in cost sharing arrangements between related
parties as compared to any superficially similar arrangements that are
entered into between unrelated parties. Such other arrangements
typically involve a materially different division of costs, risks, and
benefits than in cost sharing arrangements under the regulations. For
example, other arrangements may contemplate joint, rather than separate,
exploitation of results, or may tie the division of actual results to
the magnitude of each party's contributions (for example, by way of
preferential returns). Those types of arrangements are not analogous to
a cost sharing arrangement in which the controlled participants divide
contributions in accordance with reasonably anticipated benefits from
separate exploitation of the resulting intangibles.

For purposes of determining the results that would have been realized
under an arm's length cost sharing arrangement, the proposed regulations
adopt as a fundamental concept an [investor model]{.underline} for
addressing the relationships and contributions of controlled
participants in a cost sharing arrangement. Under this model, each
controlled participant may be viewed as making an aggregate investment,
attributable to both cost contributions (ongoing share of intangible
development costs) and external contributions (the preexisting
advantages which the parties bring into the arrangement), for purposes
of achieving an anticipated return appropriate to the risks of the cost
sharing arrangement over the term of the development and exploitation of
the intangibles resulting from the arrangement. In particular, the
investor model frames the guidance in the proposed regulations for
valuing the external contributions that parties at arm's length would
not invest, along with their ongoing cost contributions, in the absence
of an appropriate reward. In this regard, valuations are not appropriate
if an investor would not undertake to invest in the arrangement because
its total anticipated return is less than the total anticipated return
that could have been achieved through an alternative investment that is
realistically available to it.

The investor model is grounded in the legislative history of the Tax
Reform Act of 1986 which provided in pertinent part as follows:

> In revising section 482, the conferees do not intend to preclude the
> use of certain bona fide cost-sharing arrangements as an appro­pri­ate
> method of allocating income attributable to intangibles among related
> parties, if and to the extent such agreements are consistent with the
> purposes of this provision that the income allocated among the parties
> reasonably reflect the actual economic activity undertaken by each.
> Under such a bona fide cost-sharing arrangement, the cost-sharer would
> be expected to bear its portion of all research and develop­ment costs,
> on successful as well as unsuccessful products within an appropriate
> product area, and the cost of research and development at all relevant
> develop­mental stages would be included. In order for cost-sharing
> arrangements to produce results consistent with the changes made by
> the Act to royalty arrangements, it is envisioned that the allocation
> of R&D cost-sharing arrangements generally should be proportionate to
> profit as determined before deduction for research and development.
> [In addition, to the extent, if any, that one party is actually
> contributing funds toward research and develop­ment at a significantly
> earlier point in time than the other, or is otherwise effectively
> putting its funds at risk to a greater extent than the other, it would
> be expected that an appropriate return would be provided to such party
> to reflect its investment]{.underline}.

H.R. Conf. Rep. No. 99-841 at II-638 (1986)(emphasis supplied).

There are special implications that are derived from determining the
arm's length compensation for external contributions in line with the
investor model. In evaluating that arm's length compensation, it is
appropriate, consistent with the investor model, to determine (1) what
an investor would pay at the outset of a cost sharing arrangement for an
opportunity to invest in that arrangement, and (2) what a participant
with external contributions would require as compensation at the outset
of a cost sharing arrangement to allow an investor to join in the
investment. The appropriate "price" of undertaking a risky investment is
typically determined at the time the investment is undertaken, based on
the ex ante expectations of the investors. Given the uncertainty about
whether and to what extent intangibles will be successfully developed
under a cost sharing arrangement, ex post interpretations of ex ante
expectations are inherently unreliable and susceptible to abuse.
Accordingly, an important implication of determining the arm's length
result under the investor model, reflected in the methods, is that
compensation for external contributions is analyzed and valued ex ante.
The ex ante perspective is fundamental to achieving arm's length
results.

Accordingly, the proposed regulations provide guidance under section 482
that would replace the existing regulations under §1.482-7 relating to
cost sharing arrangements. They revise §1.482-7 in light of the
experience of both the IRS and taxpayers with the existing regulations.
The proposed regulations also restructure the format of the existing
regulations to be more consistent with that of the 1994 regulations (for
example, §§1.482-3 and 1.482-4) and to add organizational clarity.

The proposed regulations begin by specifying the transactions relevant
to a cost sharing arrangement. Importantly, the proposed regulations
acknowledge that in a typical cost sharing arrangement, at least one
controlled participant provides resources or capabilities developed,
maintained, or acquired externally to the arrangement that are
reasonably anticipated to contribute to the development of intangibles
under the arrangement, namely what are referred to as external
contributions. Thus, the proposed regulations integrate into the
definition of a cost sharing arrangement both "cost sharing
transactions" regarding the ongoing sharing of intangible development
costs as well as "preliminary or contemporaneous transactions" by which
the controlled participants compensate each other for their external
contributions to the arrangement (that is, what the existing regulations
refer to as the "buy-in"). The proposed regulations provide that
§1.482-7 only governs arrangements that are within (or which the
controlled taxpayers reasonably concluded to be within) the definition
of a cost sharing arrangement. Arrangements outside that definition must
be analyzed under the other sections of the section 482 regulations to
determine whether they achieve arm's length results.

The proposed regulations provide supplemental guidance on the valuation
of the arm's length amount to be charged in a preliminary or
contemporaneous transaction. The proposed regulations clarify that the
valuation of the rights associated with the external contribution that
is compensated in a preliminary or contemporaneous transaction cannot be
artificially limited by purported conditions or restrictions. Rather,
the arm's length compensation, and the applicable method used to
determine that compensation, must reflect the type of transaction and
contractual terms of a "reference transaction" by which the benefit of
exclusive and perpetual rights in the relevant resources or capabilities
are provided. This compensation will be determined by a method that will
yield a value for the obligation of any given controlled participant
that is consistent with that participant's share of the combined value
of the external contribution to all controlled participants.

The proposed regulations set forth new specified methods and provide
rules for application of existing specified methods, for purposes of
determining the arm's length compensation due with respect to external
contributions in preliminary or contemporaneous transactions. The
proposed regulations also enunciate general principles governing all
methods, specified and unspecified, for these purposes.

The proposed regulations provide guidance on allocations that the
Commissioner may make to more clearly reflect arm's length results for
the controlled taxpayers' cost sharing transactions and preliminary or
contemporaneous transactions. In particular, building again on the
investor model, the proposed regulations provide guidance on the
periodic adjustments that the Commissioner may make in situations where
the actually experienced results of a controlled participant's
investment attributable to cost contributions and external contributions
is widely divergent from reasonable expectations at the time of the
investment. Exceptions are provided, including one under which the
taxpayer may establish that the differential is due to events beyond its
control that are extraordinary and not reasonably anticipated (including
business growth that was not reasonably anticipated). The proposed
regulations provide that periodic adjustments may only be made by the
Commissioner.

Finally, the proposed regulations include provisions to facilitate
administration of, and compliance with, the cost sharing rules. These
include contractual provisions required for cost sharing arrangements,
documentation that must be maintained (and produced upon request by the
IRS), accounting requirements, and reporting requirements. Transition
rules are provided for modified compliance in the case of qualified cost
sharing arrangements under existing §1.482-7, as well as rules for
terminating such grandfather status. The proposed regulations also make
conforming and other changes to provisions of the current regulations
under sections 482 and 6662 that are related to this guidance.

[B. Basic Rules Applicable to CSAs]{.underline}

[1. General rule \-- proposed §1.482-7(a)]{.underline}

Consistent with the rules governing other controlled transactions (for
example, transfers of tangibles and intangibles under existing §§1.482-3
and 1.482-4), proposed §1.482-7(a) provides that the arm's length amount
charged in a controlled transaction reasonably anticipated to contribute
to developing intangibles pursuant to a cost sharing arrangement must be
determined under a method described in the proposed regulations.

The controlled participants must share intangible development costs of
the intangibles developed or to be developed (the cost shared
intangibles) in cost sharing transactions in proportion to their shares
of reasonably anticipated benefits (RAB shares) from exploiting cost
shared intangibles.

The controlled participants must also compensate other controlled
participants for their external contributions in preliminary or
contemporaneous transactions. The arm's length amount charged in a
preliminary or contemporaneous transaction must be determined pursuant
to the method or methods under the other provision or provisions of the
section 482 regulations, as supplemented by proposed §1.482-7(g),
applicable to the reference transaction reflected by the preliminary or
contemporaneous transaction. Such method will yield a value for the
obligation of each obligor in the preliminary or contemporaneous
transaction that is consistent with the product of the combined value to
all controlled participants of the external contribution that is the
subject of the preliminary or contemporaneous transaction multiplied by
the obligor's RAB share.

Contributions to developing the cost shared intangibles made by a
controlled taxpayer that is not a controlled participant in the cost
sharing arrangement must be determined pursuant to §1.482-4(f)(3)(iii)
(Allocations with respect to assistance to the owner). Arm's length
consideration for the transfer by a controlled participant of an
interest in a cost shared intangible at any time (whether during the
term, or upon or after the termination of a cost sharing arrangement)
must be determined under the rules of §§1.482-1 and 1.482-5 through
1.482-6.

The proposed regulations provide that if an arrangement comes within the
definition of a cost sharing arrangement, it is subject to §1.482-7 (see
next section of this Preamble for discussion of the definition of a cost
sharing arrangement). Other arrangements that are not cost sharing
arrangements (or are not treated as such) must be analyzed under the
other provisions of the section 482 regulations to determine whether
they achieve arm's length results.

[2. Definition of a CSA \-- proposed §1.482-7(b)]{.underline}

a\. CSA Transactions in General

Under §1.482-1(b)(1), a "controlled transaction meets the arm's length
standard if the results of the transaction are consistent with the
results that [would have been realized]{.underline} if uncontrolled
taxpayers [had engaged]{.underline} in the same transaction under the
same circumstances." (Emphasis added.) Thus, it is important to define
with reasonable precision the category of arrangements treated as cost
sharing arrangements, their terms, and the functions and risks assumed
by the participants in such arrangements. The determination of what
"would have been" the arm's length results of such transactions is based
on those definitions.

Proposed §1.482-7(b) identifies two groups of transactions that are
integral to a cost sharing arrangement -- cost sharing transactions and
preliminary or contemporaneous transactions. A cost sharing transaction
or [CST]{.underline} is a transaction in which the controlled
participants share the intangible development costs of one or more cost
shared intangibles in proportion to their respective shares of
reasonably anticipated benefits from their individual exploitation of
their interests in the cost shared intangibles that they obtain under
the arrangement. CSTs reflect the results that would have been expected
in a cost sharing agreement between uncontrolled taxpayers that did not
bring any external contributions to the arrangement. In other words, if
uncontrolled taxpayers started in a true "green field," they would be
expected to agree to split ongoing costs of the research in proportion
to the relative value of their respective reasonably anticipated
benefits from the arrangement.

The proposed regulations are premised in part, however, on the fact that
at least one controlled participant typically provides external
contributions to a cost sharing arrangement. Thus, the proposed
regulations integrate into the definition of a cost sharing arrangement
not only the CSTs for the ongoing sharing of intangible development
costs, but also the preliminary or contemporaneous transactions or
[PCTs]{.underline} by which the controlled participants compensate one
another for their respective external contributions. The necessity of
PCTs in connection with cost sharing arrangements was anticipated in the
legislative history of the Tax Reform Act of 1986:

> In addition, to the extent, if any, that one party is actually
> contributing funds toward research and develop­ment at a significantly
> earlier point in time than the other, or is otherwise effectively
> putting its funds at risk to a greater extent than the other, it would
> be expected that an appropriate return would be provided to such party
> to reflect its investment.

H.R. Conf. Rep. No. 99-841 at II-638 (1986).

b\. Constituent Elements of a CSA \-- Proposed §1.482-7(b)(1)

The proposed regulations define a cost sharing arrangement or
[CSA]{.underline} as a contractual agreement to share the costs of one
or more intangibles that meet three substantive and four administrative
requirements. The term [CSA]{.underline}, as defined, would replace the
term [qualified cost sharing arrangement]{.underline} employed in the
existing regulations. The substantive requirements are that the
controlled participants (1) divide all interests in cost shared
intangibles on a territorial basis, (2) enter into and effect all CSTs
and all PCTs, and (3) as a result, individually own and exploit their
respective interests in the cost shared intangibles without any further
obligation to compensate one another for such interests. The
administrative requirements are that the controlled participants
substantially comply with (1) the CSA contractual requirements, (2) the
CSA documentation requirements, (3) the CSA accounting requirements, and
(4) the CSA reporting requirements.

The Treasury Department and the IRS recognize that a CSA, as defined,
represents one possible arrangement by which parties may choose to share
the costs, risks, and benefits of intangible development. Other
arrangements, however, may involve a materially different division of
costs, risks, and benefits in contrast to a CSA. For example, other
arrangements may contemplate joint, rather than separate, exploitation
of results, or may tie the division of actual results to the magnitude
of each party's contributions (for example, by way of preferential
returns), rather than divide contributions in accordance with reasonably
anticipated benefits from separate exploitation. Given such differences,
the guidance under §1.482-7, as applicable to CSAs, is not appropriate
to evaluate what would have been the arm's length results of these other
arrangements that do not constitute CSAs when they are undertaken among
controlled taxpayers. In such cases the proposed regulations direct
taxpayers to guidance under other provisions of the section 482
regulations to determine whether such arrangements achieve arm's length
results.

c\. External Contributions and PCTs \-- Proposed §1.482-7(b)(3)(i)
Through (iv)

PCTs are the transactions by which the controlled participants
compensate one another for their external contributions to the CSA.
External contributions are any resources or capabilities which one or
more controlled participants bring to a CSA that were developed,
maintained, or acquired externally to the CSA (whether prior to or
during the course of the CSA), and that are reasonably anticipated to
contribute to developing cost shared intangibles. For example, one
controlled participant may have promising in-process technology, or a
developed and successful first generation technology, that may
reasonably be anticipated to provide a platform for future generation
technology to be developed under the CSA. As another example, one
controlled participant may have an experienced research team that could
reasonably be anticipated to be particularly suited to carrying out the
development contemplated under the CSA. The proposed regulations exclude
land, depreciable tangible property, and other resources acquired by
intangible development costs, since they are compensated by CSTs. See
discussion of proposed §1.482-7(d).

The Treasury Department and the IRS believe that uncontrolled parties
entering into a long term commitment to share intangible development
costs would require an agreement upfront that all external contributions
be made available to the fullest extent for the full period over which
they are reasonably anticipated to be needed. Accordingly, the proposed
regulations introduce the concept of the reference transaction or
[RT]{.underline} in order to ensure that compensation for external
contributions to the CSA reflects the full economic value of resources
or capabilities that a participant brings to the CSA. The RT is a
transaction providing the benefit of all rights, exclusively and
perpetually, in a resource or capability described above, apart from the
rights to exploit an existing intangible without further development
(see section of Preamble below regarding §1.482-7(c) (Make-or-sell
rights excluded)). The arm's length compensation pursuant to the PCT,
and the applicable method used to determine such compensation, must
reflect the type of transaction and contractual terms of the RT. The
controlled participants must enter into a PCT as of the earliest date
(whether on or after the date the CSA is entered into) on which the
external contribution is reasonably anticipated to contribute to
developing cost shared intangibles (the date of a PCT). The controlled
participants are not required to actually enter into the RT and the
compensation due from any controlled participant will be limited to its
RAB share of the total value of the external contribution, the scope of
which is defined by the RT.

The concept of the RT was developed in response to arguments that have
been encountered in the examination experience of the IRS under the
existing regulations. In numerous situations taxpayers have purported to
convey only limited availability of resources or capabilities for
purposes of the intangible development activity (IDA) under a CSA. An
example is a short-term license of an existing technology. Under the
existing regulations, such cases may, of course, be examined to assess
whether the purported limitations conform to economic substance and the
parties' conduct. See §1.482-1(d)(3)(ii)(B) (Identifying contractual
terms). In addition, even if the short-term license were respected, the
continued availability of the contribution past the initial license term
would require new license terms to be negotiated taking into account
relevant factors, such as whether the likelihood of success of the IDA
had materially changed in the interim. The proposed regulations address
the problems in administering such approaches more directly by requiring
an upfront valuation of all external contributions which would be much
more difficult to calculate if it involved the valuation of a series of
short-term licenses with terms contingent on such interim changes.
Accordingly, the proposed regulations assume a reference transaction
that does not allow for contingencies based on the expiration of
short-term licenses that might require further renegotiation of the
compensation for the external contribution. No inference is intended
concerning the outcome of such limitations under the existing
regulations.

Thus, for example, consider a CSA for the development of future
generations of an existing technology owned by one controlled
participant. The PCT compensation obligation of the other controlled
participant or participants would be determined by reference to the RT
consisting of the transfer of all rights to the existing technology
apart from the rights to exploit the existing technology without further
development (see section of Preamble below regarding §1.482-7(c)
(Make-or-sell rights excluded)). The rights transferred in the RT would
include the exclusive right to use the technology for purposes of
research. They would also include the right to exploit any resulting
products that incorporated the technology and any resulting products the
development of which is otherwise assisted by the technology. Moreover,
the rights transferred in the RT would cover a term extending as long as
the exploitation of future generations of the technology continued. The
RT provides the basis for selection and application of the method used
to value the compensation owed under the PCT by each other controlled
participant. The compensation obligation is limited to each such other
controlled participant's RAB share of the total value of the rights in
the existing technology that would have been transferred in the RT.

Issues have arisen regarding whether an existing research team in place
constitutes intangible property for which compensation is due, in
addition to sharing the ongoing compensation and other costs of
maintaining such team, for purposes of the buy-in provisions under the
existing regulations. The Treasury Department and the IRS believe that
the proper arm's length treatment is to include the obligation to
compensate such external contributions of in-place research capabilities
in PCTs. At arm's length, an uncontrolled taxpayer seeking to invest in
a research project involving the experienced in-place researchers would
require a commitment of the experienced team in place for purposes of
the project, rather than assuming the risks presented by an
inexperienced team. The Treasury Department and the IRS believe that a
contribution of such an experienced team in place would result in the
contribution of intangible property within the meaning of §1.482-4(b)
and section 936(h)(3)(B).

The proposed regulations, however, do not restrict the type of
transaction that may be the subject of the RT. An RT may consist of the
provision of services as well as the transfer of intangible property.
For example, in the case of an experienced research team in place,
therefore, the RT could be the services agreement to commit the team to
the research project under the CSA.

Under the proposed regulations, the controlled participants may
designate the type of transaction involved in the RT, if different
economically equivalent types of RTs are possible with respect to the
relevant resource or capability. If the controlled participants fail to
make such a designation, the Commissioner may do so.

Exacting compensation for an external contribution pursuant to a PCT is
distinguishable from charging for another's business opportunity. Any
taxpayer, controlled or uncontrolled, is free to undertake the business
opportunity of trying to develop an intangible on its own. In that case,
the taxpayer is bearing all costs and risks, and has no obligation to
compensate anyone for taking free advantage of the opportunity. Where,
however, the benefit of existing resources or capabilities belonging to
another are desired that are reasonably anticipated to contribute to the
development effort, then, at arm's length, the supplier of such
resources or capabilities would not contribute them absent appropriate
compensation.

d\. Form of PCT Payment and Post Formation Acquisitions \-- Proposed
§1.482-7(b)(3)(v) and (vi)

Under the proposed regulations, the general rule is that the
consideration owing pursuant to a PCT for an external contribution,
referred to as the [PCT Payments]{.underline}, may take the form of
fixed payments, payments contingent on the exploitation of the cost
shared intangibles, or a combination of both. The selected payment form
must be specified no later than the date of the PCT. The payor of PCT
Payments is referred to as the [PCT Payor]{.underline}, and the payee is
referred to as the [PCT Payee]{.underline}.

In the case of resources or capabilities developed, maintained, or
acquired prior to the time they are reasonably concluded to contribute
to developing cost shared intangibles (for example, resources or
capabilities that predate the CSA), the controlled participants have the
flexibility to structure PCT Payments in any of the available forms,
subject to conforming to contractual terms, economic substance, and the
parties' conduct. See §1.482-1(d)(3)(ii)(B) (Identifying contractual
terms). A CSA generally contemplates that the participants undertake
costs and risks in parallel and in proportion to their RAB shares, but
this result cannot be achieved in the case of external contributions
that are the product of previously incurred costs and risks. So, for
such resources or capabilities, the proposed regulations allow the
controlled participants to provide for the applicable payment form by
the date of the PCT.

A post formation acquisition (PFA) is an external contribution
representing resources or capabilities acquired by a controlled
participant in an uncontrolled transaction that takes place after
formation of the CSA and that, as of the date of the acquisition, are
reasonably anticipated to contribute to developing cost shared
intangibles. Resources or capabilities may be acquired in a PFA either
directly or indirectly through the acquisition of an interest in an
entity or tier of entities.

The Treasury Department and the IRS believe that the form of PCT
Payments for PFAs must be consistent with the principle that allocations
of cost and risk among controlled participants after a CSA has commenced
should be in proportion to their respective RAB shares. Accordingly, the
proposed regulations provide that the consideration under a PCT for a
PFA must follow the form of payment in the uncontrolled transaction in
which the PFA was acquired. For example, if subsequent to the formation
of a CSA one controlled participant makes a stock acquisition of a
target the assets of which consist of resources and capabilities
reasonably anticipated as of the date of the acquisition to contribute
to developing cost shared intangibles, the PCT Payment by each other
controlled participant must be in a lump sum. To avoid the possibility
that any payments are inappropriately characterized by the participants,
neither PCT Payments, nor cost sharing payments, may be paid in shares
of stock in the payor.

e\. Territorial Division of Interests \-- Proposed §1.482-7(b)(4)

Controlled participants in a CSA own interests in the cost shared
intangibles and are able to exploit those intangibles without any
obligation to compensate other participants (other than pursuant to CSTs
or PCTs). Controlled participants must share intangible development
costs in proportion to their reasonably anticipated benefits from their
individual exploitation of such interests. Taxpayers have entered into
cost sharing arrangements in which the controlled participants receive
nonexclusive, indivisible worldwide interests in cost shared
intangibles. Taxpayers have taken the position under the existing
regulations that such interests are susceptible to being individually
exploited, and that the participants' respective shares of benefits from
such exploitation are susceptible to being reasonably estimated.

The proposed regulations require that controlled participants receive
non-overlapping territorial interests in the cost shared intangibles
that in the aggregate utilize all the available territories worldwide.
The proposed regulations also require that a controlled participant be
entitled to the perpetual and exclusive right to cost shared intangible
profits of any other controlled taxpayer in the same controlled group as
the participant from transactions with uncontrolled taxpayers regarding
property or services for use, consumption, or disposition within the
participant's territory or territories. For example, where one
controlled participant sells part of its output into a territory
belonging to another controlled participant, the former must pay the
latter participant arm's length compensation to ensure that the
intangible profit on the sale is realized by the latter participant.
These territoriality requirements facilitate the ability to individually
exploit, and estimate the reasonably anticipated benefits from
individual exploitation of, interests in cost shared intangibles. No
inference is intended as to the permissibility of nonexclusive interests
under the existing regulations.

Comments are requested concerning whether alternatives should be
provided to territorial division of interests in cost shared
intangibles. Proposed alternatives should further the goal of dividing
the universe of interests into exclusive, non-overlapping segments to
promote measurability of anticipated benefits and administrability both
by taxpayers and the IRS. Comments are also requested about how to
facilitate attribution of sales to territories, or other non-overlapping
divisions of interests, such as in the case of sales via electronic
commerce. Comments are also requested on the division, territorially or
otherwise, of interests in exploiting cost shared intangibles in space.

f\. CSAs in Substance or Form \-- Proposed §1.482-7(b)(5)

Pursuant to proposed §1.482-7(b)(5)(i), as under the existing
regulations, the Commissioner may, consistently with
§1.482-1(d)(3)(ii)(B) (Identifying contractual terms), apply the
§1.482-7 rules to any arrangement that in substance constitutes a CSA in
accordance with the three substantive requirements enumerated in
proposed §1.482-7(b)(1)(i) through (iii), notwithstanding a failure
otherwise to meet the §1.482-7 requirements.

Provided a taxpayer has followed the formal requirements enumerated in
proposed §1.482-7(b)(1)(iv) through (vii), the Commissioner must treat
the arrangement as a CSA if the taxpayer reasonably concluded the
arrangement to be a CSA. The Commissioner may also treat any other
arrangement as a CSA, if the taxpayer has followed such formal
requirements.

[3. Exclusion of make-or-sell rights \-- proposed
§1.482-7(c)]{.underline}

Disputes have arisen under the existing regulations regarding the buy-in
related to a CSA to develop future generations of an intangible that is
being exploited in its then current version by the PCT Payee. For
example, there may be licenses of the current generation intangible to
uncontrolled taxpayers, perhaps with certain rights to make adaptations
for their customers. Taxpayers have asserted that a make-and-sell
license of this type satisfies the requirement for a buy-in in the CSA
under the current regulations. Such a position misconstrues the existing
regulations, which focus the buy-in on the availability of the
pre-existing intangibles "for purposes of research in the intangible
development area" under the CSA. See §1.482-7(g)(2).

The proposed regulations expressly exclude from the scope of a CSA any
provision to the extent it relates to exploiting an existing intangible
without further development, such as the right to make or sell existing
products. The proposed regulations do, however, allow the aggregate
valuation of controlled transactions relating to make-or-sell rights
with PCT Payments, where such aggregate evaluation provides a more
reliable measure of an arm's length result than a separate valuation of
the transactions. See proposed §1.482-7(g)(2)(v).

[4. Intangible development costs \-- proposed §1.482-7(d)]{.underline}

The proposed regulations restate the provisions defining intangible
development costs or [IDCs]{.underline} that are shared pursuant to CSTs
under a CSA to coordinate with the conceptual framework of the proposed
regulations and with the stock-based compensation provisions added in
2003.

As discussed, CSTs and PCTs are the two major groupings of transactions
entered into pursuant to a CSA. In CSTs, the controlled participants
share [all]{.underline} ongoing costs of developing intangibles. In
contrast, in PCTs they compensate one another for resources or
capabilities developed, maintained, or acquired externally to the CSA
(whether prior to or during the course of the CSA). It is necessary to
define IDCs shared in CSTs in a comprehensive manner that does not
overlap with the definition of external contributions compensated in
PCTs.

The proposed regulations, accordingly, define IDCs as all costs, in cash
or in kind (including stock-based compensation), but excluding costs for
land and depreciable property, in the ordinary course of business after
the formation of a CSA that, based on analysis of the facts and
circumstances, are directly identified with, or are reasonably allocable
to, the IDA. The IDA replaces the concept of the [intangible development
area]{.underline} under the existing regulations. The self-contained IDC
definition eliminates the need for the cross-reference to operating
expenses as defined in §1.482-5(d)(3) of the existing regulations and
thus eliminates potential disputes over the interaction of these
sections.

The proposed regulations also avoid overlapping definitions of IDCs and
external contributions. IDCs are limited to costs in the ordinary course
of business incurred after the formation of a CSA and that are directly
identified with, or reasonably allocable to, the IDA. Thus, for example,
the expected value over and above ongoing compensation and other costs
of an experienced research team would be compensated by PCTs, but the
ongoing compensation and other costs of the team attributable to the IDA
would be IDCs shared in CSTs. Moreover, costs for depreciable property,
which under section 197(f)(7) would include amortization of any
amortizable section 197 intangible, are carved out from IDCs. Instead,
to the extent such intangibles are reasonably anticipated to contribute
to developing cost shared intangibles, they would be compensated in
PCTs.

Land and depreciable tangible property (for example, use of a laboratory
facility) would represent an external contribution. The proposed
regulations, however, continue the practical approach of the existing
regulations of treating the arm's length rental charge under §1.482-2(c)
(Use of tangible property) for such land and depreciable tangible
property as IDCs, since typically these items can be readily valued.

In line with the direction in the 1986 legislative history to reflect
"the actual economic activity" undertaken pursuant to a CSA, the
proposed regulations expressly provide that generally accepted
accounting principles or federal income tax accounting rules may provide
a useful starting point, but will not be conclusive regarding inclusion
of costs in IDCs. As under the existing regulations, IDCs exclude
interest expense, foreign income taxes, and domestic income taxes.

The balance of the proposed regulations restate the existing regulations
with conforming changes in light of the new terminology and framework.
Technical amendments were made to the special transition rule on time
and manner of making the election with respect to certain stock-based
compensation and the consistency rules for measurement and timing with
respect to such stock-based compensation.

Except for such technical amendments, these proposed regulations
incorporate the existing provisions relating to the elective method of
measurement and timing permitted with respect to certain options on
publicly traded stock. However, the Treasury Department and the IRS are
considering extending availability of the elective method to other forms
of publicly traded stock-based compensation. The Treasury Department and
the IRS request comments on which forms of publicly traded stock-based
compensation should be eligible for the elective method.

[5. Reasonably anticipated benefits share (RAB Share) \-- proposed
§1.482-7(e)]{.underline}

Proposed §1.482-7(e) restates existing §1.482-7(f)(3)(i) through (iv)(A)
with some technical clarifications and changes to conform to the new
terminology and framework. The proposed regulations provide, as is
implicit in existing §1.482-7(b)(3), (e)(2), and (f)(3), that for
purposes of determining RAB shares at any given time, reasonably
anticipated benefits must be estimated over the entire period, past and
future, of exploitation of the cost shared intangibles, and must reflect
appropriate updates to take into account the most current reliable data
regarding past and projected future results as is available at such
time.

[6. Changes in participation under a CSA \-- proposed
§1.482-7(f)]{.underline}

Proposed §1.482-7(f) replaces existing §1.482-7(g)(3) and (4), as well
as the third and fourth sentences of existing §1.482-7(g)(1). This
provision clarifies the application of the rules of §1.482-7 in the
event of a change in participation under a CSA. A change in
participation includes the transfer between controlled participants of
all or part of a participant's territorial rights coupled with the
assumption by the transferee of the associated obligations under the
CSA, the entry into a CSA of a new controlled participant that acquires
any territorial rights and associated obligations under the CSA, and the
withdrawal of a controlled participant or other relinquishment or
abandonment of territorial rights and associated obligations under the
CSA. In the event of a change in participation, the transferee of the
territorial rights and associated obligations under the CSA succeeds to
the transferor's prior history under the CSA, including IDCs borne,
benefits derived, and compensation expenditures pursuant to any PCTs.
The transferor must receive an arm's length amount of consideration from
the transferee under the rules of §§1.482-1 and 1.482-4 through 1.482-6.

Proposed §1.482-7(e)(2)(i) provides that in the case of transfers of
cost shared intangibles between controlled participants, other than by
way of a change in participation described in proposed §1.482-7(f), the
transferor's benefits for purposes of RAB share determination are
measured on a look-through basis with reference to the transferee's
benefits, disregarding any consideration paid by the transferee (such as
a royalty pursuant to a license agreement).

[C. Supplemental Guidance on Methods Applicable to PCTs]{.underline}

The Treasury Department and the IRS recognize that taxpayers and the IRS
need additional guidance on the appropriate methods for valuation of
external contributions to a CSA. A typical challenge to valuing
nonroutine intangibles is the uncertainty as to the profitability of
their exploitation. In the case of a CSA, however, there is also the
uncertainty whether and to what extent any intangible will be
successfully developed under the CSA. Accordingly, proposed §1.482-7(g)
provides supplemental guidance on evaluating external contributions
compensated by PCTs, including general principles for specified and
unspecified methods, guidance on the application of existing specified
methods, and new specified methods.

The investor model informs the guidance on valuation. The guidance
generally aims at valuation of the amount charged in a PCT such that a
controlled participant's aggregate net investment in a CSA attributable
to cost contributions and external contributions may be expected to earn
a return appropriate to the riskiness of the CSA.

[1. General rule \-- proposed §1.482-7(g)(1)]{.underline}

As discussed, PCTs are one of two major categories of transactions (the
other being CSTs) entered into pursuant to a CSA. In PCTs, the
controlled participants compensate one another for their respective
external contributions that they bring into a CSA, that is, the
resources or capabilities they have developed, maintained, or acquired
externally to (whether prior to or during the course of) the CSA that
are reasonably anticipated to contribute to developing cost shared
intangibles.

Pursuant to §1.482-1(b)(2), different sections of the section 482
regulations apply to different types of transactions, such as transfers
of tangible and intangible property, services, loans or advances, and
rentals. The method or methods most appropriate to the calculation of
arm's length results for controlled transactions in each category must
be selected. When interrelated controlled transactions are of different
types, the participants, depending on what produces the most reliable
means of measuring arm's length results, may either (1) apply different
methods to the different transactions or (2) aggregate the transactions
for valuation purposes. See also §1.482-1(f)(2)(i) and proposed
§1.482-7(g)(2)(v) regarding aggregation of transactions.

A key concept in valuing PCTs is the RT. The RT is a transaction
providing the benefit of all rights, exclusively and perpetually, in a
resource or capability that is the subject of the external contribution,
apart from the rights to exploit an existing intangible without further
development. If in fact, the resource or capability is reasonably
anticipated to contribute both to developing or exploiting cost shared
intangibles and to other business activities of a PCT Payee, the
proposed regulations provide that the otherwise applicable value of the
relevant PCT Payments may need to be prorated between the CSA and any
other business activities on a reasonable basis that reflects the
relative economic values of the different business activities.

For purposes of the selection of the category of method applicable to a
controlled transaction pursuant to §1.482-1(b)(2)(ii), proposed
§1.482-7(b)(3)(iii) provides that the applicable method used to
determine the compensation for a PCT shall reflect the type of
transaction of the RT. For example, in the case of an external
contribution consisting of an in-process intangible, the RT could be a
transfer of intangibles generally to be evaluated pursuant to §§1.482-1
and 1.482-4 through 1.482-6. As a further example, in the case of an
external contribution consisting of an experienced research team in
place, the RT could be the provision of services generally to be
evaluated pursuant to §1.482-2(b). If different economically equivalent
types of RTs are possible with respect to the relevant resource or
capability, the controlled participants may designate the type of
transaction involved in the RT.

Proposed §1.482-7(a)(2) provides that the arm's length amount charged in
a PCT must be determined pursuant to the method or methods applicable to
the RT under the relevant provision or provisions of the section 482
regulations (as those methods are supplemented by proposed §1.482-7(g)).
Such method will yield a value for the obligation of each obligor in the
PCT (PCT Payor) consistent with the product of the combined value to all
controlled participants of the external contribution that is the subject
of the PCT multiplied by the PCT Payor's RAB share. Although some
specified and unspecified methods may involve measuring PCT Payments
with reference to the value of exploiting cost shared intangibles in one
or more controlled participants' territories, the application of such
methods must still yield a value that is consistent with the foregoing
RAB share of the total value of the external contribution to all
controlled participants.

Proposed §1.482-7(g) sets forth new specified methods for purposes of
determining the arm's length compensation due under a PCT, namely, the
income method, the acquisition price method, and the market
capitalization method. The proposed regulations also provide rules for
application of existing specified methods, such as the comparable
uncontrolled transaction method and the residual profit method. The
proposed regulations also enunciate general principles governing all
methods, specified and unspecified, for these purposes. Proposed
§1.482-7(g)(1) provides that each method must be applied in accordance
with the provisions of §1.482-1, including the best method rule of
§1.482-1(c), the comparability analysis of §1.482-1(d), and the arm's
length range of §1.482-1(e), except as those provisions are modified in
§1.482-7(g).

[2. General principles \-- proposed §1.482-7(g)(2)]{.underline}

a\. In General \-- Proposed §1.482-7(g)(2)(i)

The proposed regulations provide general principles for valuing PCT
Payments, applicable for both specified and unspecified methods.

b\. Valuation Consistent With Upfront Contractual Terms and Risk
Allocations \-- Proposed §1.482-7(g)(2)(ii)

Existing §1.482-1(d)(3)(ii) and (iii) generally provide that contractual
terms and risk allocations are significant factors in evaluating the
most reliable measure of arm's length results. The proposed regulations
provide for particular contractual terms and allocations of risk with
regard to PCTs determined no later than the date of the PCT. See, for
example, proposed §1.482-7(b)(1)(ii), (b)(3), and (k)(1). Proposed
§1.482-7(g)(ii) accordingly reiterates the requirement that any method
applied at any time for purposes of valuing PCT Payments must be
consistent with the applicable contractual terms and allocation of risk
under the CSA and proposed §1.482-7 as of the date of a PCT, unless
there has been a change in such terms or allocation made in return for
arm's length consideration.

It may be particularly important to maintain consistency with upfront
contractual terms and allocation of risk for CSAs, since PCT Payments
may extend over a period of years. Thus, for example, PCT Payments may
become due in subsequent years when actual economic results may have
departed from those reasonably anticipated as of the date of the PCT.
Subject to the Commissioner's ability to make periodic adjustments (see
proposed §1.482-7(i)(6)), the method for determining the PCT Payments
due in the subsequent year must remain consistent with the contractual
terms and allocation of risks as of the date of the PCT. Cost sharing
participants, like unrelated investors, are held to the terms of their
deal at the outset of the investment. For example, under the proposed
income method, this upfront contractual-risk consistency principle is
illustrated by the use of the applicable rate on sales or profits
determined as of the date of the PCT. Thus, while actual sales or
profits may depart from projections, the upfront risk allocation
continues to be respected by use of the applicable rate determined as of
the date of the PCT. Note, while a taxpayer may defend the amount of its
PCT Payment in a subsequent year as arm's length based on a different
method than that applied in earlier years, it may only do so to the
extent the other method also satisfies the upfront contractual-risk
consistency principle.

Proposed §1.482-7(b)(3)(vi) provides that the form of payment for a PCT
must be specified no later than the date of the PCT. The form of payment
of a PCT, that is, fixed and/or contingent payments, involves an
allocation of risk among the controlled participants. In the case of PCT
Payments regarding a PFA, the form of payment in the uncontrolled
acquisition must be followed. However, in the case of other PCT
Payments, the taxpayer has flexibility in the choice of form, subject to
economic substance and the parties' conduct.

As the result of the upfront contractual-risk consistency principle, it
will be possible for the taxpayer to compute a present value, as of the
date of the PCT, of the total arm's length amount of all PCT Payments.
Under the CSA documentation requirements in proposed
§1.482-7(k)(2)(ii)(J)([6]{.underline}) and (k)(2)(iii)(B), the taxpayer
is required to maintain documentation of such upfront valuation and
produce it to the IRS within 30 days of a request.

c\. Projections \-- Proposed §1.482-7(g)(2)(iii)

Since PCT Payments often extend over a period of years and may be
contingent on items (for example, sales, costs, and operating profit) in
such future periods, the valuation method, specified or unspecified, may
rely on projections of such items. The reliability of the valuation
method will in such cases depend on the reliability of such projections.
The proposed regulations provide that, for these purposes, projections
that have been prepared for non-tax purposes are generally more reliable
than projections that have been prepared solely for purposes of PCT
Payment valuations.

d\. Realistic Alternatives \-- Proposed §1.482-7(g)(2)(iv)

Regardless of the method or methods used, evaluation of the arm's length
charge for a PCT should take into account the general principle that
uncontrolled taxpayers dealing at arm's length would evaluate the terms
of a transaction, and would enter into a particular transaction only if
none of the alternatives is preferable. See §1.482-1(d)(3)(iv)(H) (The
alternatives realistically available to the buyer and seller). Based on
that principle, PCT valuations would not meet the foregoing condition
where, for any controlled participant, the total anticipated value, as
of the date of the PCT, is less than the total anticipated value that
could have been achieved through a realistically available alternative
investment (whether it is an alternative arrangement for the development
of the cost shared intangibles or an alternative with a similar risk
profile to the CSA). In other words, a controlled participant, like any
rational investor, would not enter into an investment when a better
alternative investment is available. Examples are provided illustrating
the application of the realistic alternatives principle in the CSA
context.

e\. Aggregation of Transactions \-- Proposed §1.482-7(g)(2)(v)

The proposed regulations provide that multiple PCTs, or one or more PCTs
and one or more transactions not governed by proposed §1.482-7 (such as
a make-or-sell license excluded from CSA coverage by proposed
§1.482-7(c)), may be aggregated for purposes of valuation, subject to
consideration of whether such aggregate valuation yields a more reliable
measure of an arm's length result than would separate valuations. See
also §1.482-1(f)(2)(i) (Aggregation of transactions). For example,
assume the CSA involves a PCT for an external contribution of an
existing intangible for purposes of developing future generations of the
intangible. Also assume that there is a license to the other controlled
participants of make-and-sell rights with respect to the current
generation of the intangible. The reliability of an aggregate analysis
of the PCT and the license will be affected by the degree to which the
relative current exploitation benefits from the existing intangible of
the controlled participants may be expected to match up with the RAB
shares regarding exploitation of the future generations of the
intangible. Though it will not generally be necessary to allocate a
reliable aggregate arm's length charge as between the various
transactions, in certain cases such an allocation may be necessary, for
example, in applying the periodic adjustment rules in proposed
§1.482-7(i)(6).

f\. Discount Rate \-- Proposed §1.482-7(g)(2)(vi)

Specified and unspecified methods for valuing PCT Payments may involve
converting future or past monetary sums into a present value as of the
date of a PCT. The proposed regulations recognize that there may be
different risks and, hence, different discount rates associated with
different activities undertaken by a taxpayer. Consistent with the
investor model, for items relating to a CSA, the discount rate employed
should be that which most appropriately reflects, as of the date of the
PCT, the risks of development and exploitation of the intangibles
anticipated to result from the CSA. In other words, this follows the
approach that unrelated investors would take to making an ex ante
evaluation of a prospective investment. Namely, the expected value of
the investment would equal the projected future cash flows discounted
using a discount rate that appropriately reflects the anticipated level
of risk being undertaken.

The proposed regulations enumerate several possibilities for choosing an
appropriate discount rate. Where there are publicly traded entities that
would be comparables dedicated to similar development and exploitation
activities, their weighted average cost of capital (WACC) may provide a
reliable basis for derivation of an appropriate discount rate. Or, if
the taxpayer's group's activities are dedicated to development and
exploitation of the contemplated cost shared intangibles, then the
taxpayer's own WACC may provide a reliable basis for derivation of an
appropriate discount rate. In other cases, depending upon the facts and
circumstances, a taxpayer's internal hurdle rate for investments having
a comparable risk profile may provide a reliable basis for derivation of
an appropriate discount rate.

g\. Accounting Principles \-- Proposed §1.482-7(g)(2)(vii)

The proposed regulations provide that, while allocations and valuations
for accounting purposes may provide a useful starting point, they will
not be determinative of PCT Payments to the extent that the accounting
treatment is not consistent with economic value. For example, with
respect to an acquisition of a target business consisting of wanted
assets (that are reasonably anticipated to contribute to developing cost
shared intangibles) and of unwanted assets (that will be abandoned
immediately after the acquisition), an allocation of a portion of the
acquisition price to the abandoned assets done for accounting purposes,
under the proposed regulations, would not prevent the proper allocation
of the entire acquisition price, in line with economic reality, to the
wanted assets for purposes of PCT Payment valuation. Similarly, with
respect to an acquisition of a target business consisting only of an
in-process intangible and an experienced research team in place, an
allocation of a portion of the acquisition price to "goodwill" for
accounting purposes would not, under the proposed regulations, prevent
the proper allocation of the entire acquisition price, in line with the
economic reality, to the in-process intangible and experienced research
team in place for purposes of PCT Payment valuation. On the other hand,
if the target conducts an operating business with exploitation already
at an advanced stage of the current generation of the intangible to be
further developed under the CSA, then an accounting allocation to
goodwill may suggest the need for further consideration of the
reliability of an acquisition price method for valuing an external
contribution whose value excluded the value of such existing goodwill.

h\. Valuation Consistent With the Investor Model \-- Proposed
§1.482-7(g)(2)(viii)

As has been discussed, the proposed regulations require that PCT
valuations be consistent with an investor model for cost sharing. Under
the investor model, the amount charged in a PCT must be consistent with
the assumption that each controlled participant is making a net
aggregate investment, as of the date of a PCT, attributable to both
external contributions and cost contributions, for purposes of achieving
an anticipated return appropriate to the risks of the CSA over the
entire term of development and exploitation of the intangibles resulting
from the CSA.

The investor model is based on two key principles regarding PCT
valuations. The first principle is that, ex ante, the aggregate
investment in an IDA would be expected to yield a rate return equal to
the appropriate discount rate for the CSA. If the anticipated rate of
return exceeds the appropriate discount rate for the CSA, either
anticipated profits have been overstated or the amount of investment has
been understated. If the projections of IDCs and profits are reliable,
then the implication could be that the portion of the investment
attributable to external contributions has been undervalued. Thus, a
valuation method for PCTs is less likely to be reliable if it results in
a rate of return to any controlled participant's aggregate investment
that is not equal to the appropriate discount rate for the CSA.

The second principle is that, ex ante, the appropriate return to the
aggregate investment in an IDA is measured over the entire period of
development and exploitation of cost shared intangibles. Included in
this principle is the concept that no part of the investment should be
viewed as separately earning a return over a more limited period. As a
general matter, successful completion of each step in a research program
is a necessary condition for the completion of the program as a whole
and its contribution continues over the entire life of the project. As
an example, a project to develop a new commercial aircraft would not be
considered successfully completed if all parts of the aircraft had been
designed except the tail assembly. Neither does the fact that the tail
assembly is completed last imply that its usefulness in the manufacture
and sale of aircraft extends beyond the usefulness of any components
completed earlier in the design process. Each step of the project
continues to have value as long as the aircraft continues to be built
and used. For this reason, each aspect of the research program must be
viewed as contributing to the success of the program as a whole (and not
just its success for some limited period of time). Thus, a valuation
method for PCTs is likely to be less reliable if it assumes a useful
life for any contribution to the CSA that does not extend through the
entire anticipated period of development and exploitation.

The IRS has examined cases in which CSAs were entered into to utilize
current generation intangibles as the base or platform for future
generation intangibles, with buy-ins structured as declining royalties
over the limited useful life of the current generation intangible. The
structure of these buy-ins effectively diminish the value of the buy-in
payments, such that the return to a controlled participant making the
depressed buy-in payments has an expected return significantly in excess
of the appropriate discount rate for the CSA. Furthermore, a buy-in
based on declining royalties over a shortened useful life for the
contributed intangibles, on its face, is not consistent with the
principle that the return to the aggregate investment in an IDA should
be measured over the entire period of development and exploitation of
cost shared intangibles.

i\. Coordination of Best Method Rule and Form of Payment \-- Proposed
§1.482-7(g)(2)(ix)

Any method for valuing the amount charged in a PCT under the proposed
regulations, whether specified or unspecified, will assume a particular
form of payment (method payment form) for PCT Payments. For example, as
will be discussed, the proposed income method assumes contingent
payments in the form of an applicable rate on sales or profits, and the
market capitalization method assumes a lump sum method payment form.
Except for PCT Payments in respect of PFAs, the proposed regulations
allow taxpayers to convert the reasonably anticipated present value, as
of the date of the PCT, of the total arm's length amount of all PCT
Payments determined under the method payment form into another form of
payment (specified payment form). For purposes of the best method rule
of §1.482-1(c), the analysis among competing methods will be undertaken
without regard to whether their method payment forms corresponds to the
taxpayer's specified payment form for PCT Payments. A best method
analysis determines which valuation method is most reliable from the
perspective of comparability, completeness and accuracy of the data, and
reliability of the underlying assumptions. If the method payment form of
the best method determined under this analysis differs from the
taxpayer's specified payment form, then the Commissioner will effect a
conversion of the best method results into the specified payment form on
a reasonable basis, giving due regard to the taxpayer's conversion basis
if the taxpayer's method was determined to be the best method as to its
method payment form.

j\. Coordination of the Valuations of Prior and Subsequent PCTs \--
Proposed §1.482-7(g)(2)(x)

Cases may arise where, after the date of one PCT, another PCT is
required for other resources or capabilities of a controlled participant
which only as of a subsequent date are reasonably anticipated to
contribute to the development of cost shared intangibles and therefore
are external contributions only as of such subsequent date. In such
cases where there are PCTs with different dates, coordination of the
valuations of the prior and subsequent PCTs must be effected pursuant to
a method that provides the most reliable measure of an arm's length
result.

In some instances the coordination will be straightforward. As an
example, in the case of a subsequent PCT entered into with respect to a
PFA, the PCT Payments are determined based on the related acquisition,
independent of any prior PCT. For purposes of determining PCT Payments
under a prior PCT, the proposed regulations provide that the PCT
Payments with respect to the subsequent PCT in this case are treated the
same as unanticipated IDCs. A divergence between actual IDCs and IDCs
anticipated on the date of a PCT does not change the method for
determining PCT Payments with respect to that PCT. Accordingly,
unanticipated payments under a subsequent PCT entered into with respect
to a PFA will not affect the method for determining PCT Payments in
respect of a prior PCT.

The coordination in other cases will depend on the facts and
circumstances. If the external contributions that were the subjects of
the respective prior and subsequent PCTs were nonroutine contributions,
an approach which may be appropriate would be to determine PCT Payments
both for the prior and subsequent PCTs going forward from the date of
the subsequent PCT pursuant to a residual profit split method, as
described in proposed §1.482-7(g)(7). Such application of the residual
profit split method would include as nonroutine contributions all of the
following: the external contribution(s) that were the subject of the
prior PCT(s), the external contribution that is the subject of the
subsequent PCT, and the interests of the controlled participants in the
portion of cost shared intangibles in process of development under the
CSA that does not reflect any external contributions.

k\. Proration of PCT Payments to the Extent Allocable to Other Business
Activities \-- Proposed §1.482-7(g)(2)(xi)

The proposed regulations provide that the otherwise applicable value of
PCT Payments may need to be prorated between the CSA and any other
business activities (other than current make-or-sell activities) to
which the resource or capability that is the subject of the PCT is
reasonably anticipated to contribute as of the date of the PCT. A
proration will only be necessary if the method used for valuing the PCT
Payment includes the value of the contribution of the resource or
capability to the other business activities. For example, an application
of the acquisition price method is based on the full value of a resource
or capability and therefore includes the value of any contributions to
other business activities, whereas the CUT and CPM applications of the
income method are based only on the sales or profits of exploiting cost
shared intangibles, and therefore do not include any value of
contributions to other business activities. For purposes of the best
method rule under §1.482-1(c), the reliability of the analysis under a
method that requires proration is reduced relative to the reliability of
an analysis under a method that does not require proration. Any
proration must be done on a reasonable basis that reflects the relative
economic values of the different business activities.

[3. Comparable uncontrolled transaction (CUT) method \-- proposed
§1.482-7(g)(3)]{.underline}

The comparable uncontrolled transaction (CUT) method described in
§1.482-4(c), and the arm's length charge described in
§1.482-2(b)(3)(first sentence) based on a comparable uncontrolled
transaction, may be applied to evaluate whether the amount charged in a
PCT is arm's length by reference to the amount charged in a comparable
uncontrolled transaction. When applied in the manner described in
§1.482-4(c), or where a comparable uncontrolled transaction provides the
most reliable measure of the arm's length charge described in
§1.482-2(b)(3)(first sentence), the CUT method, or the arm's length
charge in the comparable uncontrolled transaction, will typically yield
an arm's length total value for the external contribution that is the
subject of the PCT. That value must then be multiplied by each PCT
Payor's respective RAB share in order to determine the arm's length PCT
Payment due from each PCT Payor. A territorial CUT may also be reliably
used to the extent the value of the PCT Payment under the territorial
CUT is consistent with the RAB share of the worldwide external
contribution value.

[4. Income method \-- proposed §1.482-7(g)(4)]{.underline}

The income method, a new specified method under the proposed
regulations, follows from the realistic alternatives principle. The
income method determines PCT Payments in amounts such that the present
value, as of the date of the PCT, to a controlled participant of
entering into a CSA equals the present value of the PCT Payee's best
realistic alternative.

The proposed regulations provide two specific (but nonexclusive)
applications of the income method, one based on the comparable
uncontrolled transaction (CUT) method of §1.482-4(c), and the other
based on the comparable profit method (CPM) of §1.482-5. These
applications may include certain simplifying assumptions and are meant
to provide examples of possible applications of the general income
method, not to exclude other possible applications of this method. Both
applications compute the arm's length PCT Payment for each year as the
product of an applicable rate on sales or profit. The [applicable
rate]{.underline} is equal to the [alternative rate]{.underline} less
the [cost contribution adjustment]{.underline}. The alternative rate
represents the rate on sales or profit which the PCT Payee could have
earned by exploiting cost shared intangibles in the PCT Payor's
territory if the PCT Payee alone had borne the risks and costs of
developing the cost share intangibles. The CUT application determines
the alternative rate from the perspective of a licensor as the royalty
rate it would have charged under a license to exploit the cost shared
intangibles in the territory, based on comparable third party license
arrangements. The CPM application determines the alternative rate from
the perspective of a licensee as the royalty rate it would have paid
such that it earned only a market return for its routine contributions
to the exploitation of the cost shared intangibles, based on comparable
returns earned by uncontrolled taxpayers engaged in similar routine
activities. The cost contribution adjustment is the reduction of the
alternative rate to reflect the anticipated costs and risks the PCT
Payor will take on by entering into the CSA.

The income method is typically used in cases where only one controlled
participant, namely the PCT Payee, brings nonroutine contributions into
the CSA. In such circumstances, the other controlled participant or
participants, that is, the PCT Payors, essentially only commit to
bearing their respective shares of anticipated IDCs and bring only
routine contributions for purposes of exploiting cost shared
intangibles. Under the investor model, what is essentially a routine
financing investment by the PCT Payors in the development of
intangibles, represented by bearing their share of anticipated IDCs,
would be expected to earn an ex ante rate of return appropriate to the
risks associated with the CSA and reflected in the discount rate. The
cost contribution adjustment effectively represents the appropriate
return to that routine financing investment, as of the date of the PCT,
expressed as a rate on sales or profit.

The use of the applicable rate on sales or profit, determined as of the
date of the PCT under the income method, also reflects the principle of
consistency with the original contractual allocation of risk. Thus,
while actual sales may depart from projections, the upfront risk
allocation continues to be respected by use of the applicable rate
determined as of the date of the PCT.

Under the CUT and CPM applications of the income method, any routine
contributions that are external contributions (routine external
contributions) are treated similarly to cost contributions.

The reliability of the income method may decrease if more than one
controlled participant brings nonroutine contributions into the CSA.

[5. Acquisition price method \-- proposed §1.482-7(g)(5)]{.underline}

The acquisition price method is an application of the CUT method
pursuant to §1.482-4(c) and the arm's length charge pursuant to
§1.482-2(b)(3). This method ordinarily applies only when substantially
all of the nonroutine resources and capabilities of a recently acquired
target's business constitute external contributions, that is, they are
reasonably anticipated to contribute to developing cost shared
intangibles. Thus, when these circumstances are present, this method may
be expected to be appropriate for valuing PCT Payments for PFAs.

Under the acquisition price method, the arm's length charge to each PCT
Payor is the product of the adjusted acquisition price, multiplied by
such PCT Payor's RAB share. The adjusted acquisition price seeks to
isolate that portion of the acquisition price of the target business
attributable to the external contributions. The adjusted acquisition
price is equal to the acquisition price of the target, increased by
relevant liabilities, and decreased by the value of tangible property
(separately accounted for under proposed §1.482-7(d)) and by the value
of any other resources and capabilities not covered by PCTs. The
reliability of this method is reduced to the extent the acquisition
price must be adjusted to take into account significant
difficult-to-value tangible property or resources or capabilities of the
target not covered by a PCT.

[6. Market capitalization method \-- proposed
§1.482-7(g)(6)]{.underline}

The market capitalization method is also an application of the CUT
method pursuant to §1.482-4(c) and the arm's length charge pursuant to
§1.482-2(b)(3). This method ordinarily applies only when substantially
all of the nonroutine resources and capabilities of the PCT Payee's
business constitute external contributions, that is, they are reasonably
anticipated to contribute to developing cost shared intangibles.

Under the market capitalization method, the arm's length charge to each
PCT Payor is the product of the adjusted average market capitalization,
multiplied by such PCT Payor's RAB share. The adjusted average market
capitalization seeks to determine that portion of the market
capitalization of the PCT Payee's business attributable to the external
contributions. The adjusted average market capitalization is equal to
the 60-day (ending on the date of the PCT) average of the daily market
capitalizations of the PCT Payee, increased by liabilities, and
decreased by the value of tangible property separately accounted for
under proposed §1.482-7(d) and by the value of any other resources and
capabilities not covered by PCTs. The daily market capitalization is
calculated on each day the PCT Payee's stock is actively traded as the
total number of shares outstanding multiplied by the stock's closing
price on that day (as adjusted, for example, for dividends, stock
splits, and restructurings to the extent such adjustment can be done
reliably). The reliability of this method is reduced to the extent the
market capitalization must be adjusted to take into account significant
difficult to value tangible property or resources or capabilities of the
target not covered by a PCT. The reliability of this method is also
reduced to the extent the facts and circumstances demonstrate the
likelihood of a material divergence between the average market
capitalization of the PCT Payee and the value of its resources and
capabilities for which reliable adjustments cannot be made.

[7. Residual profit split method \-- proposed
§1.482-7(g)(7)]{.underline}

The proposed regulations provide needed guidance on the proper
application of the residual profit split method (RPSM) of §1.482-6 in
the context of the development and exploitation of intangibles pursuant
to a CSA. The guidance is necessary in order to implement the general
principles of proposed §1.482-7(g)(2), such as consistency with the
upfront contractual terms and risk allocation under the CSA and with the
investor model. A purported application of RPSM not in accordance with
this guidance would constitute an unspecified method for purposes of the
sections 482 and 6662(e) and (h) regulations.

Under the proposed regulations, the RPSM may not be applied where only
one controlled participant makes significant nonroutine contributions to
the development and exploitation of cost shared intangibles. (An RPSM in
such a situation would be logically equivalent to the income method
using an applicable rate on profit, and is best considered under that
method.) The RPSM divides operating profit or loss before any expense or
amortization on account of IDCs, routine external contributions, and
nonroutine contributions, from developing and exploiting cost shared
intangibles in a controlled participant's territory (territorial
operating profit or loss) in three steps.

In the first step of the RPSM, each controlled participant is allocated
an amount of income that is subtracted from its territorial operating
profit or loss to provide a market return to its routine contributions,
other than cost contributions (that is, a controlled participant's IDCs
borne, gross of cost sharing payments made, and net of cost sharing
payments received).

In the second step of the RPSM, each controlled participant is allocated
a portion of the residual of its territorial profit or loss, after the
first step allocation, attributable to its cost contributions. The
second step cost contribution share is a fraction of such residual
operating profit or loss. The numerator is the present value, determined
as of the date of the PCTs, of the summation, over the entire period of
developing and exploiting cost shared intangibles, of the total value of
the territorial owner's total anticipated cost contributions. The
denominator of the territorial owner's cost contribution fraction is the
present value, determined as of the date of the PCTs, of the summation,
over the same period, of the territorial owner's total anticipated
territorial operating profits, reduced by a market return for routine
contributions (other than cost contributions) to the relevant business
activity in the territory.

The cost contribution share under the second step of the RPSM
corresponds to the cost contribution adjustment under the income method.
The cost contribution share under the RPSM, similar to the cost
contribution adjustment under the income method, is a reflection of the
investor model. What is essentially a routine financing investment in
the development of intangibles by the controlled participants,
represented by bearing their share of anticipated IDCs, would be
expected to earn a return appropriate to the risks associated with the
CSA. The cost contribution share effectively represents the appropriate
return to that financing investment, as of the date of the PCTs,
expressed as a share of territorial operating profit or loss.

In the third step of the RPSM, the residual territorial profit or loss
remaining after the first and second step allocations is divided among
all the controlled participants based on the relative value, as of the
date of the PCTs, of their nonroutine contributions. The relative value
of the nonroutine contributions may be measured with reference to
external benchmarks that reflect their fair market value, or with
reference to estimated capitalized development costs as appropriately
grown or discounted so that all contributions may be valued on a
comparable dollar base as of the date of the PCTs.

Any amount of a controlled participant's territorial operating profit
that is allocated to another controlled participant's nonroutine
external contributions under the third step of the RPSM represents the
amount of the PCT Payment due to that other controlled participant for
its external contributions.

Under the RPSM, the determinations as of the date of the PCT of the
second step cost contribution share and the third step relative
nonroutine contribution values reflect the principle of consistency with
the original contractual allocation of risk. Thus, while actual
territorial operating profit or loss may depart from projections, the
upfront risk allocation continues to be respected through the use of the
cost contribution shares and relative nonroutine contribution values
determined as of the date of the PCTs.

In applying the RPSM, any routine contributions that are external
contributions (routine external contributions) are treated similarly to
cost contributions.

The proposed regulations set forth comparability and reliability
considerations appropriate for application of the RPSM in the CSA
context.

[8. Unspecified methods \-- proposed §1.482-7(g)(8)]{.underline}

The proposed regulations also provide general rules applicable for
methods not specified in proposed §1.482-7(g)(3) through (7).

[D. Coordination with the Arm's Length Standard \-- Proposed
§1.482-7(h)]{.underline}

Transactions in connection with a CSA must produce results consistent
with the arm's length standard. The proposed regulations, therefore,
dispel the misconception that cost sharing is a safe harbor.

In accordance with §1.482-1(b)(1), the proposed regulations provide
guidance appropriate in the context of a CSA regarding "the results that
[would have been realized]{.underline} if uncontrolled taxpayers [had
engaged]{.underline} in the same transaction under the same
circumstances." (Emphasis added.) In a CSA where the resulting
intangibles may only be exploited in a controlled participant's
territory, the arm's length result would require a participant to bear
IDCs only in proportion to the expected relative values of its
territory, that is, in proportion to its respective RAB shares. The same
is true for PCTs. Where a controlled participant brings external
contributions into the arrangement, at arm's length that participant
would only agree to make the external contributions if it received
compensation from the other participants for the anticipated benefits to
their respective territories attributable to the external contributions.

Therefore, the proposed regulations provide that a CSA, and the CSTs and
PCTs required in connection with a CSA, produce results that are
consistent with an arm's length result within the meaning of §1.482-1(b)
if, and only if, each controlled participant's IDC share equals its RAB
share, and all other requirements are satisfied, including those with
respect to PCT Payments.

The Treasury Department and IRS recognize that a CSA, as defined,
represents only one possible arrangement pursuant to which parties may
choose to share the costs, risks, and benefits of intangible
development. Other arrangements, however, may involve a different
division of costs, risks, and benefits than those arising pursuant to a
CSA. Given such differences, the guidance under §1.482-7 is not
appropriate to evaluate what would have been arm's length results of
those other arrangements when undertaken among controlled taxpayers. As
discussed, in such cases the proposed regulations instead would point
taxpayers to the guidance under the other provisions of the section 482
regulations to determine whether such arrangements achieve arm's length
results.

[E. Allocations by the Commissioner in Connection with CSAs \-- Proposed
§1.482-7(i)]{.underline}

[1. Consolidation of existing allocation provisions \-- proposed
§1.482-7(i)(1) through (4)]{.underline}

Proposed §1.482-7(i) assembles in one section, provisions regarding
allocations by the Commissioner that currently are spread throughout
existing §1.482-7, with conforming changes to reflect the terminology
and framework of the proposed regulations. Thus, under §1.482-7(i)(1),
the Commissioner is generally authorized to make allocations to adjust
the results of a controlled transaction in connection with a CSA so that
the results are consistent with an arm's length result.

Under proposed §1.482-7(i)(2), the Commissioner may make appropriate
adjustments to CSTs to bring IDC shares in line with RAB shares. Such
adjustments include adding or removing costs from IDCs, allocating costs
between the IDA and other business activities, improving the reliability
of the benefits measurement basis used or the projections used to
estimate RAB shares, and allocating among the controlled participants
any unallocated territorial interests in cost shared intangibles. CST
adjustments must be reflected in the year in which the IDCs are
incurred, along with any appropriate allocation of arm's length interest
to the date of payment.

Under proposed §1.482-7(i)(3), the Commissioner may make appropriate
allocations to adjust PCT Payments in accordance with the proposed
regulations. Thus, the Commissioner may examine the taxpayer's method
for determining the amount charged in a PCT in accordance with the
provisions of the section 482 regulations as supplemented by proposed
§1.482-7(g). The Commissioner may either propose adjustments to the
taxpayer's method or apply another method to adjust the results reported
by the taxpayer consistent with an arm's length result.

Under proposed §1.482-7(i)(4), the Commissioner may make appropriate
allocations regarding changes in participation in accordance with
proposed §1.482-7(f).

[2. Allocations when CSTs are consistently and materially
disproportionate to RAB shares \-- proposed §1.482-7(i)(5)]{.underline}

The fundamental requirement of a CSA with regard to CSTs is for the
controlled participants to share IDCs in proportion to their respective
RAB shares. Under proposed §1.482-7(e)(1), RAB shares must be updated to
account for changes in economic conditions, the business operations and
practices of the participants and the ongoing development of
intangibles. Such updates must reflect a comprehensive revision over the
entire past and projected future period of intangible exploitation in
light of the most current reliable data.

To the extent the controlled participants consistently and materially
fail to bear IDC shares equal to their respective RAB shares, the
Commissioner would be able to exercise its authority pursuant to
existing §1.482-1(d)(3)(ii)(B) (Identifying contractual terms) to impute
an agreement that is consistent with the controlled participants' course
of conduct. Thus, a participant that bears a disproportionately greater
IDC share may be allocated an undivided interest in another territory or
territories of exploitation of the cost shared intangibles, and would be
allocated arm's length consideration from any other controlled
participant whose IDC share is less than its RAB share over time.

Current §1.482-7(g)(5) provides that these allocations be "after any
cost allocations authorized by \[§1.482-7(a)(2)\]" is eliminated. Some
have interpreted this reference to mean that the Commissioner must make
cost allocations, and failure to do so would bar the Commissioner from
making an allocation pursuant to existing §1.482-7(g)(5). This
interpretation, if accepted, defeats the expectation that controlled
participants must themselves act consistently with their CST deal and
maintain their RAB shares current for that purpose. No inference is
intended regarding the outcome under the existing regulations.

[3. Periodic adjustments \-- proposed §1.482-7(i)(6)]{.underline}

In 1986, Congress indicated a significant degree of skepticism about
related-party transfers of high-profit potential intangibles for
relatively insignificant lump sum or royalty consideration that
effectively place all the intangible development downside risk in one
controlled taxpayer and all the upside profit potential in another. See
H.R. Rep. 99-426, at 424-25 (1985). See also Notice 88-123 (the White
Paper), 1988-2 C.B. 458, 472-74, 477-480. The legislative history also
notes that it is especially difficult to obtain realistic comparables
with respect to such intangibles because they seldom if ever are
transferred to unrelated parties. See id.

The Commissioner's ability to evaluate controlled participants' deals
with regard to high-profit potential intangibles is hampered, not only
by the absence of comparables, but by an asymmetry of information
vis-a-vis the taxpayer. The taxpayer is in the best position to know its
business and prospects. The Commissioner faces real challenges in
ascertaining the reliability of the ex ante expectations of taxpayer's
initial arrangements in light of significantly different ex post
outcomes. While risk and uncertain outcomes are typically the hallmarks
of high-profit potential intangibles, significantly different results
raise concerns whether the form of the initial arrangement matches its
substance. These concerns are particularly problematic given the
information asymmetry between taxpayers and the IRS. Periodic
adjustments effectively permit the IRS to impute an arm's length
arrangement that appropriately reflects the profit potential of
transferred intangibles where the IRS believes that the taxpayers'
arrangement does not appropriately reflect such profit potential.
Because the guidance on periodic adjustments is intended to address the
problem of information asymmetry, and because it is exceedingly unlikely
that a taxpayer would use information asymmetry for anything other than
a tax-advantaged result, periodic adjustments of this type can only be
exercised by the Commissioner.

Accordingly, taxpayers cannot exercise periodic adjustments of this
type. This prohibition is necessary for proper administration of these
rules. Moreover, taxpayers are not inappropriately disadvantaged by this
rule because they have the ability to structure their related-party
arrangements in line with the economic prospects of their business. A
taxpayer can always protect itself against periodic adjustments by
adopting an arrangement that appropriately reflects the profit potential
and risks associated with an intangible transfer, which it is in the
best position to evaluate in an economically realistic way. There are
various forms of consideration that taxpayers at arm's length might
adopt in the face of uncertainty and risk. In some cases, uncontrolled
taxpayers might find that projections of anticipated profits are
sufficiently reliable to fix the pricing for the transaction at the
outset on the basis of those projections. In other cases the uncertainty
in valuing intangible property might lead them to adopt from the outset
contingent terms of different varieties and degrees that allow for
adjustment in light of actual profit experience. This does not mean that
the taxpayer must adopt an arrangement that tilts the risks in a way
that necessarily always involves reporting income without regard to
later actual results. For example, contingent arrangements may
appropriately reflect profit potential and yet appropriately tie in with
later outcomes. In such arrangements, less income may properly result if
the outcomes are less successful than reasonably anticipated, or greater
income will result if the outcomes are more successful. Taxpayers simply
are in the best position to structure their arrangements upfront to
accommodate a range of potential outcomes.

Proposed §1.482-7(j)(6) provides guidance on how periodic adjustments
may be made in the context of a CSA. The goal is to conform the results
of CSTs and PCTs to the arm's length standard. In accordance with the
1986 legislative history, achieving that goal requires that the "income
allocated among the parties reasonably reflect the actual economic
activity undertaken by each" and that "to the extent, if any, that one
party is actually contributing funds toward research and develop­ment at
a significantly earlier point in time than the other, or is otherwise
effectively putting its funds at risk to a greater extent than the
other, [it would be expected that an appropriate return would be
provided to such party to reflect its investment]{.underline}." H.R.
Conf. Rep. No. 99-841 at II-638 (1986). (Emphasis supplied.)

The proposed regulations build the CSA periodic adjustment provisions
upon the previously discussed investor model. The taxpayer's arrangement
will be respected so long as a controlled participant's actually
experienced return ratio (AERR), equal to the present value of its
actually experienced operating profits from exploiting cost shared
intangibles divided by its investment in the CSA (consisting of the
present value sum of its cost contributions and PCT Payments), is within
a specified periodic return ratio range (PRRR). The PRRR provides a band
of comfort for actual return ratios of no more than 2 and no less than
1/2 (unless there is a failure to substantially comply with the
administrative requirements of proposed §1.482-7(k), in which case the
comfort band consists of actual return ratios of no more than 1.5 and no
less than .67). Results above or below these respective thresholds
typically warrant a more thorough and detailed examination of the arm's
length nature of the initial taxpayer arrangement, as well as a means to
impute an alternative arrangement that more reliably reflects an arm's
length result, as described below.

In determining a controlled participant's AERR, the present values of
its operating profits and CSA investments are measured from the period
beginning on the commencement of the CSA through the end of the year of
adjustment. For these purposes, present values are determined using an
applicable discount rate (ADR) appropriate to the risks associated with
the given CSA, as the Commissioner may determine under the guidance of
proposed §1.482-7(g)(2)(vi). Where the stock of the PCT Payor, or
another company that owns stock in the PCT Payor and is in a
consolidated group with the PCT Payor for financial accounting purposes
is publicly traded, the Commissioner may treat the ADR as equal to the
publicly traded company's weighted average cost of capital, as
determined pursuant to the capital asset pricing model, subject to the
taxpayer's ability to show another discount rate is more appropriate in
the facts and circumstances to the satisfaction of the Commissioner.
Where there is no publicly traded company in the PCT Payor group, the
ADR will be determined under the general principles applicable for
discount rates, subject to such adjustments as the Commissioner
determines is appropriate.

In determining the AERR and, thus, whether the AERR is within or without
the PRRR, it is intended that the items entering into the computation
(e.g., operating profits, cost contributions, and PCT Payments) are
those items as adjusted (including as the result of any prior IRS
adjustments).

The guidance on periodic adjustments is not intended, for example, to
systematically reallocate above-market returns after-the-fact, since
such returns may in whole or in part reward legitimate ex ante
risk-taking by CSA investors. Accordingly, an AERR outside the PRRR does
not necessarily mean that adjustments will ultimately be warranted.
Rather, the PRRR provides comfort to taxpayers that within the PRRR they
will not be subject to periodic adjustments. If the AERR is outside the
PRRR, the proposed regulations provide exceptions pursuant to which
periodic adjustments will not be made where a taxpayer can demonstrate
that its deal was nevertheless arm's length. These exceptions adapt the
exceptions in existing §1.482-4(f)(2)(ii), along with three additional
exceptions appropriate in the CSA context. One exception effectively
would avoid "start up" triggers from return ratios below the low end of
the PRRR by delaying low end trigger testing until after the first five
years of substantial exploitation of cost shared intangibles resulting
from the CSA. A similar exception would enable a taxpayer to avoid a low
end trigger that it can establish to the satisfaction of the
Commissioner results from the "cut off" from consideration of
anticipated profits, cost contributions, or PCT Payments beyond the end
of the year of adjustment. For purposes of the foregoing exception, the
taxpayer may assume that the yearly average of past operating profits
for the years up through the year of adjustment in which there has been
substantial exploitation of cost shared intangibles will continue into
the future. The third additional exception would enable a taxpayer to
avoid a high end trigger that it can establish to the satisfaction of
the Commissioner results from routine contributions to its
profitability, or from nonroutine contributions, including its own
external contributions.

In the event that the AERR is outside the PRRR, and no exception
applies, then the Commissioner may adjust the taxpayer's PCT Payments to
the level of an equivalent stream of contingent royalties as would be
determined under a modified RPSM. The modified RPSM would vary depending
on whether the periodic adjustment was triggered by an AERR above the
high end or below the low end of the PRRR.

In the event of a trigger above the high end of the PRRR, the
arrangement going forward beginning with the year of adjustment would
effectively treat the past cost contribution shares of all controlled
participants as bought out and would determine new fractions for cost
contribution shares as of the start of the year of adjustment (if
development activity is then continuing under the CSA). Prior cost
contributions and operating profits, therefore, would not be taken into
account in the second step of the modified RPSM. The relative valuation
of nonroutine contributions, including external contributions, in the
third step of the modified RPSM would still be determined as of the
original date of the PCTs, but taking into account any data relevant to
such relative valuation as may be available up through the date of the
periodic adjustment.

In the event of a trigger below the low end of the PRRR, the arrangement
going forward beginning with the year of adjustment would effectively
recompute the original cost contribution share fractions by substituting
projections as revised in light of actual experience up through the date
of the periodic adjustment.

For these purposes only, the residual profit split method may be used
even where only one controlled participant makes significant nonroutine
contributions to the CSA Activity. (As mentioned above in the discussion
of the residual profit split method, applying the residual profit split
method in such a situation is logically equivalent to applying the
income method using an applicable rate on profit. For convenience, the
proposed regulations apply the residual profit split method to all
periodic adjustments rather than separately describing an equivalent
modified income method for the situation in which only one controlled
participant makes significant nonroutine contributions to the CSA
Activity.) If only one controlled participant provides all the external
contributions and other nonroutine contributions, then the third step
residual profit or loss belongs entirely to such controlled participant.

It should be emphasized that the Commissioner's determination whether or
not to make periodic adjustments would be informed by whether the
outcome as adjusted more reliably reflects an arm's length result.

[F. Definitions and Special Rules \-- Proposed §1.482-7(j)]{.underline}

Proposed §1.482-7(j) provides definitions and special rules relevant to
CSAs.

[1. Controlled participant \-- proposed §1.482-7(j)(1)(i)]{.underline}

The proposed regulations incorporate the existing definitions and
examples with regard to a controlled participant with conforming changes
to reflect the new framework and terminology. Thus, a controlled
participant is a controlled taxpayer that is a party to the CSA
contractual agreement that reasonably anticipates that it will derive
benefits from exploiting one or more cost shared intangibles.

The proposed regulations dispense with the possibility of an
uncontrolled participant in a CSA. The Treasury Department and the IRS
are not aware of any uncontrolled participants in any CSAs. The
elimination of uncontrolled participants simplified various provisions
of the proposed regulations. The Treasury Department and the IRS request
comments in this regard.

[2. Cost shared intangible \-- proposed §1.482-7(j)(1)(ii)]{.underline}

The term [cost shared intangible]{.underline} replaces the term [covered
intangible]{.underline} from existing §1.482-7(b)(4)(iv). A cost shared
intangible means any intangible developed or to be developed as a result
of the IDA. Thus, cost shared intangibles include both the intangibles
that are contemplated to result from the IDA as well as any which
serendipitously may result from the IDA.

Cost shared intangibles include any portion thereof that may be
attributable to an external contribution and, therefore, do not simply
represent the incremental results of the IDA. For example, if a new
generation software resulting from the IDA incorporates elements of the
prior generation software, the cost shared intangible is the total
result of the prior and subsequent contributions. No inference is
intended as to the outcome under the existing regulations.

[3. Interest in an intangible \-- proposed
§1.482-7(j)(1)(iii)]{.underline}

The proposed regulations employ the same general definition of an
[interest in an intangible]{.underline} found in existing
§1.482-7(a)(2). It should be noted, however, that the proposed
regulations provide that the interests in cost shared intangibles must
be divided among the controlled participants on a territorial basis. See
proposed §1.482-7(b)(1)(i) and (b)(4).

[4. Benefits \-- proposed §1.482-7(j)(1)(iv)]{.underline}

The proposed regulations clarify the definition of
[benefits]{.underline} found in existing §1.482-7(e)(1). Benefits means
the sum of additional revenue generated, plus cost savings, minus any
cost increases from exploiting cost shared intangibles.

[5. Reasonably anticipated benefits \-- proposed
§1.482-7(j)(1)(v)]{.underline}

The proposed regulations effectively employ the same definition of
[reasonably anticipated benefits]{.underline} found in existing
§1.482-7(e)(2).

[6. Territorial operating profit or loss \-- proposed
§1.482-7(j)(1)(vi)]{.underline}

The proposed regulations define [territorial operating profit or
loss]{.underline} as the operating profit or loss as separately earned
by each controlled participant in its geographic territory from the CSA
Activity, determined before an expense (including amortization) on
account of IDCs, routine external contributions, and nonroutine
contributions.

[7. CSA Activity \-- proposed §1.482-7(j)(1)(vii)]{.underline}

The proposed regulations define [CSA Activity]{.underline} as the
activity of developing and exploiting cost shared intangibles.

[8. Consolidated group \-- proposed §1.482-7(j)(2)(i)]{.underline}

In line with existing §1.482-7(c)(3), the proposed regulations treat all
members of a U.S. group filing consolidated income tax returns as one
taxpayer for purposes of the CSA provisions. The proposed regulations
would also treat all members of a foreign fiscal unity as one taxpayer
for these purposes.

[9. No trade or business and partnership \-- proposed §1.482-7(j)(2)(ii)
and (iii)]{.underline}

In line with existing §§1.482-7(a)(1) and 301.7701-1(c), the proposed
regulations provide that participation in a CSA, of itself, does not
constitute a U.S. trade or business or result in the creation of a
partnership for federal income tax purposes.

[10. Character of payments \-- proposed §1.482-7(j)(3)]{.underline}

In line with existing §1.482-7(h), the proposed regulations provide
ordering rules for characterizing cost sharing payments with regard to
the items they reimburse. PCT Payments will be characterized
consistently with the designation of the type of transaction involved in
the RT. The proposed regulations continue to provide for the netting of
PCT Payments made to, and received by, a controlled participant.

[G. Administrative Provisions \-- Proposed §1.482-7(k)]{.underline}

The proposed regulations include provisions to facilitate administration
of, and compliance with, the cost sharing rules. Thus, under a CSA, the
controlled participants must substantially comply with certain
contractual, documentation, accounting, and reporting requirements.
Similar requirements are spread throughout the existing regulations in
§1.482-7(b), (c)(1), (i), and (j). In the proposed regulations, the
substantial compliance standard is included in proposed
§1.482-7(b)(1)(iv) through (vii), and the specific requirements are
assembled together in §1.482-7(k).

[1. CSA contractual requirements \-- proposed
§1.482-7(k)(1)]{.underline}

Under proposed §1.482-7(k)(1)(i), a CSA must be recorded in writing in a
contract that is contemporaneous with the formation (and any revision)
of the CSA. The written CSA must incorporate the contractual provisions
set forth in proposed §1.482-7(k)(1)(ii). Proposed §1.482-7(k)(1)(iii)
provides that a written contractual agreement is contemporaneous with
the formation (or revision) of a CSA if, and only if, the controlled
participants record the CSA, in its entirety, in a document that they
sign and date no later than 60 days after the first occurrence of any
IDC to which such agreement (or revision) is to apply. By requiring that
CSAs be memorialized contemporaneously with formation (or revision), the
CSA contractual provisions are more likely to reliably reflect (without
hindsight) the relative risks of the controlled participants.

[2. CSA documentation requirements \-- proposed
§1.482-7(k)(2)]{.underline}

Under proposed §1.482-7(k)(2)(i), the controlled participants must
timely update and maintain sufficient documentation to establish that
the participants have met the contractual requirements of proposed
§1.482-7(k)(1). In addition, the controlled participants must timely
update and maintain documentation sufficient to establish and support
the items listed in proposed §1.482-7(k)(2)(ii) regarding the ongoing
implementation of the CSA, CSTs, and PCTs. Thus, each controlled
participant must at timely intervals update and maintain the
documentation required by proposed §1.482-7(k)(2)(i) and (ii) on an
ongoing basis from the outset of the formation of the CSA. To the extent
that additional documentation is required by the new availability of
information or the occurrence of post-formation events, each controlled
participant must maintain such documentation in a manner such that the
controlled participant retains and supplements (but does not replace)
the documentation maintained from the outset.

Proposed §1.482-7(k)(2)(iii), which replaces existing
§1.482-7(j)(2)(ii), cross-references proposed §1.6662-6(d)(2)(iii)(D)
for the coordination of the CSA documentation rules with the specified
method documentation rules under the section 6662 transfer pricing
penalty regulations. Proposed §1.6662-6(d)(2)(iii)(D) provides that
satisfaction of the CSA documentation requirements satisfies the
specified method principal documentation requirements with respect to
the CSTs and PCTs, other than the requirements to provide a description
of the relevant organizational structure and an index of principal and
background documents, provided that such documentation is sufficient to
establish that the taxpayer reasonably concluded that its method and
application provided the most reliable measure of an arm's length
result. Each controlled participant must provide such documentation to
the IRS within 30 days of a request, subject to extension in the
Commissioner's discretion.

[3. CSA accounting requirements \-- proposed §1.482-7(k)(3)]{.underline}

Proposed §1.482-7(k)(3)(i) tracks the existing regulations in requiring
that the controlled participants establish a consistent method of
accounting, translate foreign currencies on a consistent basis, and
explain any material differences from U.S. generally accepted accounting
principles. Under proposed §1.482-7(k)(3)(ii), controlled participants
may not rely solely upon financial accounting rules to establish
satisfaction of the accounting requirements. Rather, the method of
accounting must clearly reflect income.

[4. CSA reporting requirements \-- proposed §1.482-7(k)(4)]{.underline}

Proposed §1.482-(7)(k)(4)(i) requires that each controlled participant
must file with the Ogden Campus a statement regarding its participation
in a CSA (CSA Statement). The CSA Statement must provide the information
enumerated in proposed §1.482-7(k)(4)(ii), including the earliest date
that any IDC occurred, the date on which the controlled participants
formed (or revised) the CSA, and (if different from the immediately
preceding date) the date on which the controlled participants recorded
the CSA (or revision) in accordance with the contemporaneous recordation
requirement.

Pursuant to proposed §1.482-7(k)(4)(iii)(A), each controlled participant
must file an original CSA Statement with the IRS no later than 90 days
after the first occurrence of an IDC to which the newly-formed CSA
applies or, in the case of a taxpayer that became a controlled
participant after the formation of the CSA, no later than 90 days after
such taxpayer became a controlled participant. The CSA Statement must be
dated and signed, under penalties of perjury, by an officer of the
controlled participant who is duly authorized (under local law) to sign
the statement on behalf of the controlled participant.

In addition to the 90-day rule described above, proposed
§1.482-7(k)(4)(iii)(B) contains an annual reporting requirement. Each
controlled participant must attach to its U.S. income tax return, for
each taxable year for the duration of the CSA, a copy of the original
CSA Statement that the controlled participant filed in accordance with
the 90-day rule. Further, the annual reporting by the controlled
participant must update the information reflected on the original CSA
Statement by attaching a schedule that documents changes in such
information over time. If a controlled participant does not file a U.S.
income tax return, then it must ensure that the foregoing CSA Statement
and updated schedule are attached to any Schedule M of Form 5471, to any
Form 5472, or to any Form 8865 with respect to that participant.

[H. Effective Date and Transition Rule \-- Proposed §§1.482-7(l) and
(m)]{.underline}

The proposed regulations are proposed to be applicable on the date of
publication of the proposed regulations as a final regulation in the
**Federal Register**. Thus, CSAs commencing on or after such date, and
CSTs and PCTs occurring after such date with respect to CSAs existing as
of the effective date, will be subject to §1.482-7, as then finally
revised. Conversely, other transactions not reasonably anticipated to
contribute to developing intangibles pursuant to an arrangement
constituting a CSA described in §1.482-7(b)(1) or (5) will be subject to
other applicable section 482 regulations. See proposed
§1.482-7(a)(3)(iii).

The proposed regulations provide transition rules under which an
existing arrangement that constituted a qualified cost sharing
arrangement under the regulations before the effective date will be
considered a CSA and will be allowed an additional period to conform to
the new rules with certain modifications. Although certain documentation
requirements are delayed and certain substantive requirements concerning
pre-effective date matters are relaxed for a grandfathered CSA described
in the previous sentence, the controlled participants\' CSTs and PCTs
that occur after the effective date would have to comply with the
substantive requirements of these regulations beginning immediately
after such date. CSTs and PCTs occurring prior to the effective date are
subject to these regulations only in the event that PCT Payments become
subject to periodic adjustment under paragraph (i)(6) as a result of a
subsequent PCT occurring on or after the effective date.

The proposed regulations specify circumstances under which the
grandfathered status of pre-effective date arrangements would terminate.
Accordingly, an otherwise grandfathered arrangement would cease to be so
grandfathered from the earliest of a failure of the controlled
participants to substantially comply with the regulations as
transitionally modified, a material change in the scope of the CSA as
contemplated in the underlying contractual arrangement (such as a
material expansion of the activities undertaken in the CSA beyond those
undertaken as of the effective date), or a 50 percent change in the
beneficial ownership of the interests in cost shared intangibles.

[I. Changes to Other Provisions]{.underline}

The proposed regulations make conforming changes to §1.367(a)-1T,
§1.861-17, and §§1.482-1 et seq. of the section 482 regulations to
reflect the new terminology and framework of the CSA provisions.

The proposed regulations redesignate current §1.482-7 as §1.482-7A which
would continue to apply for dates prior to the publication of this
document as a final regulation in the **Federal Register** and to the
extent applicable under the transition rule of proposed §1.482-7(m).

The proposed regulations add examples to §1.482-8 to illustrate the
application of the best method rule in connection with the new specified
methods under proposed §1.482-7(g).

As previously stated, proposed §1.6662-6(d)(2)(iii)(D) coordinates the
CSA documentation requirements of proposed §1.482-7(k)(2) with the
specified method documentation requirements of the section 6662 transfer
pricing penalty regulations.

In line with the penultimate sentence of existing §1.482-7(a)(1) and
proposed §1.482-7(j)(2)(iii), proposed §301.7701-1(c) provides that
participation in a CSA, of itself, does not give rise to a separate
entity.

# Special Analysis

It has been determined that this notice of proposed rulemaking is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has been
determined also that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations. It is hereby
certified that the collections of information in these regulations will
not have a significant economic impact on a substantial number of small
entities. This certification is based on the fact that few small
entities are expected to enter into cost sharing agreements, as defined
herein, and that for those that do, the burdens imposed under proposed
§1.482-7(b)(1)(iv) through (vii) and (k) would be minimal. Therefore, a
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5
U.S.C. chapter 6) is not required. Pursuant to section 7805(f), this
notice of proposed rulemaking will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact
on small business.

**Comments and Public Hearing**

Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic or written comments (a
signed original and eight (8) copies) that are submitted timely to the
IRS. The Treasury Department and the IRS specifically request comments
on the clarity of the proposed regulations and how they may be made
easier to understand. All comments will be available for public
inspection and copying.

A public hearing has been scheduled for November 16, 2005, at 10 a.m.,
in the auditorium, Internal Revenue Building, 1111 Constitution Avenue,
NW., Washington, DC. Due to building security procedures, visitors must
enter at the Constitution Avenue entrance. In addition, all visitors
must present photo identification to enter the building. Because of
access restrictions, visitors will not be admitted beyond the immediate
entrance more than 30 minutes before the hearing starts. For information
about having your name placed on the building access list to attend the
hearing, see the **FOR FURTHER INFORMATION CONTACT** section of this
preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish
to present oral comments at the hearing must submit electronic or
written comments and an outline of the topics to be discussed and the
time to be devoted to each topic (signed original and eight (8) copies)
by October 26, 2005. A period of 10 minutes will be allotted to each
person for making comments.

An agenda showing the scheduling of the speakers will be prepared after
the deadline for receiving outlines has passed. Copies of the agenda
will be available free of charge at the hearing.

**Drafting Information**

The principal author of these proposed regulations is Jeffrey L. Parry
of the Office of Chief Counsel (International). However, other personnel
from the Treasury Department and the IRS participated in their
development.

**List of Subjects**

[26 CFR Part 1]{.underline}

Income taxes, Reporting and recordkeeping requirements

[26 CFR Part 301]{.underline}

Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes,
Penalties, Reporting and recordkeeping requirements

**Proposed Amendments to the Regulations**

Accordingly, CFR parts 1 and 301 are proposed to be amended as follows:

PART 1 \-- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an
entry in numerical order to read, in part, as follows:

Authority: 26 U.S.C. 7805 \* \* \*

Section 1.482-7A also issued under 26 U.S.C. 482. \* \* \*

Par 2. Section 1.367(a)-1T is amended by revising the second sentence of
paragraph (d)(3) to read as follows:

[§1.367(a)-1T Transfers to foreign corporations subject to section
367(a): In general (temporary)]{.underline}.

\* \* \* \* \*

\(d\) \* \* \*

\(3\) [Transfer]{.underline}. \* \* \* A person's entering into a cost
sharing arrangement under §1.482-7 or acquiring rights to intangible
property under such an arrangement shall not be considered a transfer of
property described in section 367(a)(1). \* \* \*

\* \* \* \* \*

Par. 3. Section 1.482-7 is redesignated §1.482-7A and an undesignated
centerheading preceding §1.482-7A is added to read as follows:

Regulations applicable on or before the date of publication of this
document as a final regulation in the **Federal Register**.

Par. 4. Section 1.482-0 is amended by revising the entry for §1.482-7 to
read as follows:

[§1.482-0 Outline of regulations under section 482]{.underline}

\* \* \* \* \*

[§1.482-7 Methods to determine taxable income in connection with a cost
sharing arrangement]{.underline}.

(a) In general.

\(1\) RAB share method for cost sharing transactions (CSTs).

\(2\) Methods for preliminary or contemporaneous transactions (PCTs).

\(3\) Methods for other controlled transactions.

\(i\) Contribution to a CSA by a controlled taxpayer that is not a
controlled participant.

\(ii\) Transfer of interest in a cost shared intangible.

\(iii\) Controlled transactions not in connection with a CSA.

(b) Cost sharing arrangement (CSA).

\(1\) In general.

(2) CSTs.

    i.  In general.

    ii. Example.

(3) PCTs.

    i.  In general.

    ii. External contributions.

    iii. PCT Payments.

    iv. Reference transaction (RT).

    v.  PFAs.

    vi. Form of payment.

        A.  In general.

        B.  PFAs.

        C.  No PCT Payor stock.

    vii. Date of a PCT.

    viii. Examples.

(4) Territorial division of interests.

    i.  In general.

    ii. Examples.

(5) CSAs in substance or form .

    i.  CSAs in substance.

    ii. CSAs in form.

    iii. Example.

(6) Treatment of CSAs.

\(c\) Make-or-sell rights excluded.

\(1\) In general.

\(2\) Examples.

\(d\) Intangible development costs (IDCs).

\(1\) Costs included in IDCs.

\(2\) Allocation of costs.

\(3\) Stock-based compensation.

\(i\) In general.

\(ii\) Identification of stock-based compensation with the IDA.

\(iii\) Measurement and timing of stock-based compensation IDC.

\(A\) In general.

([1]{.underline}) Transfers to which section 421 applies.

\(2\) Deductions of foreign controlled participants.

([3]{.underline}) Modification of stock option.

([4]{.underline}) Expiration or termination of CSA.

\(B\) Election with respect to options on publicly traded stock.

([1]{.underline}) In general.

([2]{.underline}) Publicly traded stock.

([3]{.underline}) Generally accepted accounting principles.

([4]{.underline}) Time and manner of making the election.

\(C\) Consistency.

\(4\) IDC share.

\(5\) Examples.

\(e\) Reasonably anticipated benefit shares (RAB shares).

\(1\) In general.

\(2\) Measure of benefits.

\(i\) In general.

\(ii\) Indirect bases for measuring benefits.

\(A\) Units used, produced, or sold.

\(B\) Sales.

\(C\) Operating profit.

\(D\) Other bases for measuring anticipated benefits.

\(E\) Examples.

\(iii\) Projections used to estimate benefits.

\(A\) In general.

\(B\) Examples.

(f) Changes in participation under a CSA.

\(g\) Supplemental guidance on methods applicable to PCTs.

\(1\) In general.

\(2\) General principles.

\(i\) In general.

\(ii\) Valuation consistent with upfront contractual terms and risk
allocations.

\(iii\) Projections.

\(iv\) Realistic alternatives.

\(A\) In general.

\(B\) Examples.

\(v\) Aggregation of transactions.

\(vi\) Discount rate.

\(A\) In general.

\(B\) Examples.

\(vii\) Accounting principles.

\(A\) In general.

\(B\) Examples.

\(viii\) Valuation consistent with the investor model.

\(A\) In general.

\(B\) Example.

\(ix\) Coordination of best method rule and form of payment.

\(x\) Coordination of the valuations or prior and subsequent PCTs.

\(xi\) Proration of PCT Payments to the extent allocable to other
business activities.

\(3\) Comparable uncontrolled transaction method.

\(4\) Income method.

\(i\) In general.

\(ii\) Determination of arm's length charge.

\(A\) In general.

\(B\) Example.

\(iii\) Application of income method using a CUT.

\(A\) In general.

\(B\) Determination of arm's length charge.

([1]{.underline}) In general.

([2]{.underline}) Applicable rate.

([3]{.underline}) Alternative rate.

([4]{.underline}) Cost contribution adjustment.

\(C\) Example.

\(iv\) Application of income method using CPM.

\(A\) In general.

\(B\) Determination of arm's length charge based on sales.

([1]{.underline}) In general.

([2]{.underline}) Applicable rate.

([3]{.underline}) Alternative rate.

([4]{.underline}) Cost contribution adjustment.

\(C\) Determination of arm's length charge based on profit.

([1]{.underline}) In general.

([2]{.underline}) Alternative rate.

([3]{.underline}) Cost contribution adjustment.

\(D\) Example.

\(v\) Routine external contributions.

\(vi\) Comparability and reliability considerations.

\(A\) In general.

\(B\) Application of the income method using a CUT.

\(C\) Application of the income method using CPM.

\(5\) Acquisition price method.

\(i\) In general.

\(ii\) Determination of arm's length charge.

\(iii\) Adjusted acquisition price.

\(iv\) Reliability and comparability considerations.

\(v\) Example.

\(6\) Market capitalization method.

\(i\) In general.

\(ii\) Determination of arm's length charge.

\(iii\) Average market capitalization.

\(iv\) Adjusted average market capitalization.

\(v\) Reliability and comparability considerations.

\(vi\) Examples.

\(7\) Residual profit split.

\(i\) In general.

\(ii\) Appropriate share of profits and losses.

\(iii\) Profit split.

\(A\) In general.

\(B\) Allocate income to routine contributions other than cost
contributions.

\(C\) Allocate residual profit.

([1]{.underline}) In general.

([2]{.underline}) Cost contribution share of residual profit or loss.

([3]{.underline}) Nonroutine contribution share of residual profit or
loss.

([4]{.underline}) Determination of PCT Payments.

([5]{.underline}) Routine external contributions.

\(iv\) Comparability and reliability considerations.

\(A\) In general.

\(B\) Comparability.

\(C\) Data and assumptions.

\(D\) Other factors affecting reliability.

\(v\) Example.

\(8\) Unspecified methods.

\(h\) Coordination with the arm's length standard.

\(i\) Allocations by the Commissioner in connection with a CSA.

\(1\) In general.

\(2\) CST allocations.

\(i\) In general.

\(ii\) Adjustments to improve the reliability of projections used to RAB
shares.

A.  Unreliable projections.

B.  Foreign-to-foreign adjustments.

C.  Correlative adjustments to PCTs.

D.  Examples.

\(iii\) Timing of CST allocations.

\(3\) PCT allocations.

\(4\) Allocations regarding changes in participation under a CSA.

\(5\) Allocations when CSTs are consistently and materially
disproportionate to RAB shares.

\(6\) Periodic adjustments.

\(i\) In general.

\(ii\) PRRR.

\(iii\) AERR.

\(A\) In general.

\(B\) PVTP.

\(C\) PVI.

\(iv\) ADR.

\(A\) In general.

\(B\) Publicly traded companies.

\(C\) Publicly traded.

\(D\) PCT Payor WACC.

\(E\) Generally accepted accounting principles.

\(v\) Determination of periodic adjustments.

\(vi\) Exceptions to periodic adjustments.

\(A\) Transactions involving the same external contributions as in the
PCT.

\(B\) Results not reasonably anticipated.

\(C\) Reduced AERR does not cause Periodic Trigger.

\(D\) Increased AERR does not cause Periodic Trigger.

\(E\) 10-year period.

\(F\) 5-year period.

\(vii\) Examples.

\(viii\) Documentation.

\(j\) Definitions and special rules.

\(1\) Definitions.

\(2\) Special rules.

\(i\) Consolidated group.

\(ii\) Trade or business.

\(iii\) Partnership.

\(3\) Character.

\(i\) In general.

\(ii\) PCT Payments.

\(iii\) Examples.

\(k\) CSA contractual, documentation, accounting, and reporting
requirements.

\(1\) CSA contractual requirements.

\(i\) In general.

\(ii\) Contractual provisions.

\(iii\) Meaning of contemporaneous.

\(A\) In general.

\(B\) Example.

\(2\) CSA documentation requirements.

\(i\) In general.

\(ii\) Additional CSA documentation requirements.

\(iii\) Coordination rules and production of documents.

\(A\) Coordination with penalty regulations.

\(B\) Production of documentation.

\(3\) CSA accounting requirements.

\(i\) In general.

\(ii\) Reliance on financial accounting.

\(4\) CSA reporting requirements.

\(i\) CSA Statement.

\(ii\) Content of CSA Statement.

\(iii\) Time for filing CSA Statement.

\(A\) 90-day rule.

\(B\) Annual return requirement.

([1]{.underline}) In general.

([2]{.underline}) Special filing rule for annual return requirement.

\(iv\) Examples.

\(l\) Effective date.

\(m\) Transition rule.

\(1\) In general.

\(2\) Termination of grandfather status.

\(3\) Transitional modification of applicable provisions.

\* \* \* \* \*

Par. 5. Section 1.482-1 is amended by:

1\. Revising the second sentence of paragraph (b)(2)(i).

2\. Revising the last sentence of paragraph (c)(1).

The revisions read as follows:

[§1.482-1 Allocation of income and deductions among
taxpayers]{.underline}.

\* \* \* \* \*

\(b\) \* \* \*

\(2\) \* \* \*

\(i\) \* \* \* Section 1.482-7 provides the methods to be used to
evaluate whether a cost sharing arrangement produces results consistent
with an arm's length result.

\* \* \* \* \*

\(c\) \* \* \*

\(1\) \* \* \* See §1.482-7 for the applicable methods in the case of a
cost sharing arrangement.

\* \* \* \* \*

Par. 6. Section 1.482-4 is amended by

1\. Redesignating paragraph (f)(3)(iv) as paragraph (f)(3)(v).

2\. Adding a new paragraph (f)(3)(iv).

The addition reads as follows:

[§1.482-4 Methods to determine taxable income in connection with a
transfer of intangible property]{.underline}.

\* \* \* \* \*

\(f\) \* \* \*

\(3\) \* \* \*

\(iv\) [Cost sharing arrangements]{.underline}. The rules in this
paragraph (f)(3) regarding ownership and assistance with respect to cost
shared intangibles and cost sharing arrangements will apply only as
provided in §1.482-7.

\* \* \* \* \*

Par. 7. Section 1.482-5 is amended by revising the last sentence of
paragraph (c)(2)(iv) to read as follows:

[§1.482-5 Comparable profits method]{.underline}.

\* \* \* \* \*

\(c\) \* \* \*

\(2\) \* \* \*

\(iv\) \* \* \* As another example, it may be appropriate to adjust the
operating profit of a party to account for material differences in the
utilization of or accounting for stock-based compensation (as defined by
§1.482-7(d)(3)(i)) among the tested party and comparable parties.

\* \* \* \* \*

Par. 8. Section 1.482-7 is revised to read as follows:

[§1.482-7 Methods to determine taxable income in connection with a cost
sharing arrangement]{.underline}.

\(a\) [In general]{.underline}. The arm's length amount charged in a
controlled transaction reasonably anticipated to contribute to
developing intangibles pursuant to a cost sharing arrangement (CSA), as
described in paragraph (b) of this section, must be determined under a
method described in this section. Each method must be applied in
accordance with the provisions of §1.482-1, except as those provisions
are modified in this section.

\(1\) [RAB share method for cost sharing transactions
(CSTs)]{.underline}. The controlled participants that are parties to a
cost sharing transaction (CST), as described in paragraph (b)(2) of this
section, must share the intangible develop­ment costs (IDCs) of the cost
shared intangibles in proportion to their shares of reasonably
anticipated benefits (RAB shares). See paragraph (j)(1) of this section
for the definitions of con­trolled participant, cost shared intangible,
benefits, and reasonably antici­pated benefits, and paragraphs (d) and
(e) of this section regarding IDCs and RAB shares, respectively.

\(2\) [Methods for preliminary or contemporaneous transactions
(PCTs)]{.underline}. The arm's length amount charged in a preliminary or
con­temp­or­aneous transaction (PCT), as described in paragraph (b)(3) of
this section, must be determined under the method or methods under the
other section or sections of the section 482 regulations, as
supplemented by paragraph (g) of this section, applicable to the
reference transaction (RT) reflected by the PCT. See §1.482-1(b)(2)(ii)
(Selection of category of method applicable to transaction), paragraph
(b)(3)(iv) of this section (Reference transaction), and paragraph (g) of
this section (Supplemental guidance on methods applicable to PCTs).

\(3\) [Methods for other controlled transactions]{.underline} \-- (i)
[Contribution to a CSA by a controlled taxpayer that is not a controlled
participant]{.underline}. If a controlled taxpayer that is not a
controlled participant contributes to developing the cost shared
intangibles, it must receive consideration from the other controlled
participants under the rules of §1.482-4(f)(3)(iii) (Allocations with
respect to assistance provided to the owner). Such consideration will be
treated as an intangible development cost for purposes of paragraph (d)
of this section.

\(ii\) [Transfer of interest in a cost shared intangible]{.underline}.
If at any time (during the term, or upon or after the termination, of a
CSA) a controlled participant transfers an interest in a cost shared
intangible to another controlled taxpayer, the controlled participant
must receive an arm's length amount of consideration from the transferee
under the rules of §§1.482-1 and 1.482-4 through 1.482-6.

\(iii\) [Controlled transactions not in connection with a
CSA]{.underline}. This section does not apply to a controlled
transaction reasonably anticipated to contribute to developing
intangibles pursuant to an arrangement that is not a CSA des­cribed in
paragraph (b)(1) or paragraph (b)(5) of this section. Whether the
results of any such controlled transaction are consistent with an arm's
length result must be deter­mined under the applicable rules of the
section 482 regulations without regard to this section. For example, an
arrange­ment for developing intangibles in which one controlled
taxpayer's costs of developing the intangibles significantly exceeds its
share of reasonably anticipated bene­fits from exploiting the developed
intan­gibles would not in substance be a CSA, as described in paragraphs
(b)(1)(i) through (iii) or paragraph (b)(5)(i) of this section. In such
a case, unless the rules of this section are applicable by reason of
paragraph (b)(5)(ii) of this section, the arrange­ment must be analyzed
under other applicable sections of the section 482 regulations to
determine whether it achieves arm's length results, and if not, to
determine any allocations by the Commissioner that are consistent with
such other section 482 regulations.

\(b\) [Cost sharing arrangement (CSA)]{.underline} \-- (1)  [In
general]{.underline}. A CSA to which the provisions of this section
apply is a contractual agreement to share the costs of developing one or
more intangibles under which the controlled participants \--

\(i\) At the outset of the arrangement divide among themselves all
interests in cost shared intangibles on a territorial basis as described
in paragraph (b)(4) of this section;

\(ii\) Enter into and effect CSTs covering all IDCs and PCTs covering
all external contributions, as described in para­graphs (b)(2) and (b)(3)
of this section, for purposes of developing the cost shared intangibles
under the CSA;

\(iii\) As a result, individually own and exploit their respective
interests in the cost shared intangibles without any further obligation
to compensate one another for such interests;

\(iv\) Substantially comply with the CSA contractual requirements that
are described in paragraph (k)(1) of this section;

\(v\) Substantially comply with the CSA documentation requirements that
are described in paragraph (k)(2) of this section;

\(vi\) Substantially comply with the CSA accounting requirements that
are described in paragraph (k)(3) of this sections; and

\(vii\) Substantially comply with the CSA reporting requirements that
are described in paragraph (k)(4) of this section.

\(2\) [CSTs]{.underline} \-- (i) [In general]{.underline}. CSTs are
controlled transactions between or among controlled participants in
which such participants share the IDCs of one or more cost shared
intangibles in pro­portion to their respective RAB shares from their
individual exploitation of their interests in the cost shared
intangibles that they obtain under the CSA. Cost sharing payments may
not be paid in shares of stock in the payor. See paragraphs (b)(4), (d),
and (e) of this section for the rules regarding interests in cost shared
intangibles, IDCs, and RAB shares, respectively.

\(ii\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (b)(2):

[Example]{.underline}. Companies C and D, who are members of the same
controlled group, enter into a CSA that is described in paragraph (b)(1)
of this section. In the first year of the CSA, C and D conduct the IDA,
as described in paragraph (d)(1) of this section. The total IDCs in
regard to such activity are \$3,000,000 of which C and D pay \$2,000,000
and \$1,000,000, respectively, directly to third parties. As between C
and D, however, their CSA specifies that they will share all IDCs in
accordance with their RAB shares (as described in paragraph (e)(1) of
this section), which are 60% for C and 40% for D. It follows that C
should bear \$1,800,000 of the total IDCs (60% of total IDCs of
\$3,000,000) and D should bear \$1,200,000 of the total IDCs (40% of
total IDCs of \$3,000,000). D makes a CST payment to C of \$200,000,
that is, the amount by which D's share of IDCs in accordance with its
RAB share exceeds the amount of IDCs initially borne by D (\$1,200,000
-- \$1,000,000), and which also equals the amount by which the total
IDCs initially borne by C exceeds its share of IDCS in accordance with
its RAB share (\$2,000,000 - \$1,800,000). As a result of D's CST
payment to C, C and D will bear amounts of total IDCs in accordance with
their respective RAB shares.

\(3\) [PCTs]{.underline} \-- (i) [In general]{.underline}. A PCT is a
controlled transaction in which each other controlled participant (PCT
Payor) is obligated to compensate a controlled participant (PCT Payee)
for an external contribution of the PCT Payee.

\(ii\) [External contributions]{.underline}. An external contribution
consists of the rights set forth under the reference transaction (RT) in
any resource or capability that is reasonably anticipated to contribute
to developing cost shared intangibles and that a PCT Payee has
developed, maintained, or acquired externally to (whether prior to or
during the course of) the CSA. For purposes of this section, external
contributions do not include rights in depreciable tangible property or
land, and do not include rights in other resources acquired by IDCs. See
paragraphs (b)(2) and (d)(1) of this section.

\(iii\) [PCT Payments]{.underline}. The arm's length amount of the
compensation due under a PCT (PCT Payment) will be determined under a
method pursuant to paragraphs (a)(2) and (g) of this section applicable
to the RT, as described in paragraph (b)(3)(iv) of this section. The
applicable method will yield a value for the compensation obligation of
each PCT Payor consistent with the product of the combined value to all
controlled participants of the external contribution that is the subject
of the PCT multiplied by the PCT Payor's RAB share.

\(iv\) [Reference transaction (RT)]{.underline}. An RT is a transaction
providing the benefits of all rights (RT Rights), exclusively and
perpetually, in a resource or capability described in paragraph
(b)(3)(ii) of this section, excluding any rights to exploit an existing
intangible without further development. See paragraph (c) of this
section (Make-or-sell rights excluded). If a resource or capability is
reasonably anticipated to contribute both to developing or exploiting
cost shared intangibles and to other business activities of the PCT
Payee, other than exploiting an existing intangible without further
development, then the PCT Payment that would otherwise be determined
with reference to the RT (which generally presumes a provision of
exclusive and perpetual rights) may need to be prorated as described in
paragraph (g)(2)(xi) of this section. For purposes of §1.482-1(b)(2)(ii)
and paragraph (a)(2) of this section, the controlled participants must
include the type of transaction involved in the RT as part of the
documentation of the RT required under paragraph (k)(2)(ii)(H) of this
section. If different economically equivalent types of RTs are possible
with respect to the relevant resource or capability, the controlled
participants may designate the type of transaction involved in the RT.
If the controlled participants fail to make this designation in their
documentation, the Commissioner may make a designation consistent with
the RT and other facts and circumstances. While the PCT Payee and PCT
Payors must enter into the PCT providing for the relevant compensation
obligation, they are not required to actually enter into the RT that is
referenced for purposes of determining the magnitude of the compensation
obligation under the PCT.

\(v\) [PFAs]{.underline}. A post formation acquisition (PFA) is an
external contribution that is acquired by a controlled participant in an
uncontrolled transaction that takes place after the formation of the CSA
and that as of the date of acquisition is reasonably anticipated to
contribute to developing cost shared intangibles. Resources or
capabilities may be acquired in a PFA either directly, or indirectly
through the acquisition of an interest in an entity or tier of entities.

\(vi\) [Form of payment]{.underline} \-- (A) [In general]{.underline}.
The consideration under a PCT for an external contribution other than a
PFA may take one or a combination of both of the following forms - -

([1]{.underline}) Payments of a fixed amount, either paid in a lump sum
payment or in installment payments spread over a specified period, with
interest calculated in accordance with §1.482-2(a) (Loans or advances);
or

([2]{.underline}) Payments contingent on the exploitation of cost shared
intangibles by the PCT Payor. The form of payment selected for any PCT,
including the basis and structure of the payments, must be specified no
later than the date of that PCT.

\(B\) [PFAs]{.underline}. The consideration under a PCT for a PFA must
be paid in the same form as the uncontrolled transaction in which the
PFA was acquired.

\(C\) [No PCT Payor Stock]{.underline}. PCT Payments may not be paid in
shares of stock in the PCT Payor.

\(vii\) [Date of a PCT]{.underline}. The controlled participants must
enter into a PCT as of the earliest date on or after the CSA is entered
into on which the external contribution is reasonably anticipated to
contribute to developing cost shared intangibles.

\(viii\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (b)(3). In each example, Companies P and S
are members of the same controlled group, and execute a CSA that is
described in paragraph (b)(1) of this section. The examples are as
follows:

[Example 1]{.underline}. Company P has developed and currently markets
version 1.0 of a new software application XYZ. Company P and Company S
execute a CSA under which they will share the IDCs for developing future
versions of XYZ. Version 1.0 is reasonably anticipated to contribute to
the development of future versions of XYZ and therefore the RT rights in
version 1.0 constitute an external contribution of Company P for which
compensation is due from Company S pursuant to a PCT. The applicable
method and determination of the arm's length compensation due pursuant
to the PCT will be based on the RT. The controlled participants
designate the RT as a transfer of intangibles that would otherwise be
governed by §1.482-4, if entered into by controlled parties.
Accordingly, pursuant to paragraph (a)(2) of this section, the
applicable method for determining the arm's length value of the
compensation obligation under the PCT between Company P and Company S
will be governed by §1.482-4 as supplemented by paragraph (g) of this
section. The RT in this case is the perpetual and exclusive provision of
the benefit of all rights in version 1.0, other than the rights
described in paragraph (c) of this section (Make-or-sell rights
excluded). This includes the exclusive right to use version 1.0 for
purposes of research and the right to exploit any products that
incorporated the platform technology of version 1.0, and would cover a
term extending as long as the uncontrolled taxpayer were to continue to
exploit future versions of XYZ or any other product based on the version
1.0 platform. Though Company P and Company S are not required to
actually enter into the transaction described by the RT, the value of
the compensation obligation of Company S for the PCT will reflect the
full value of the external contribution defined by the RT, as limited by
Company S's RAB share.

[Example 2]{.underline}. Company P and Company S execute a CSA under
which they will share the IDCs for developing Vaccine Z. Company P will
commit its research team that has successfully developed a number of
other vaccines to the project. The expertise and existing integration of
the research team is a unique resource or capability of Company P which
is reasonably anticipated to contribute to the development of Vaccine Z
and therefore the RT Rights in the research team constitute an external
contribution for which compensation is due from Company S as part of a
PCT. The applicable method and determination of the arm's length
compensation due pursuant to the PCT will be based on the RT. The
controlled parties designate the RT as a provision of services that
would otherwise be governed by §1.482-2(b)(3)(first sentence) if entered
into by controlled parties. Accordingly, pursuant to paragraph (a)(2) of
this section, the applicable method for determining the arm's length
value of the compensation obligation under the PCT between Company P and
Company S will be governed by §1.482-2(b)(3)(first sentence) as
supplemented by paragraph (g) of this section. The RT in this case is
the perpetual and exclusive provision of the benefits by Company P of
its research team to the development of Vaccine Z by the uncontrolled
party. Because the IDCs include the ongoing compensation of the
researchers, the compensation obligation under the PCT is only for the
value of the commitment of the research team by Company P to the CSA's
development efforts net of such researcher compensation. Though Company
P and Company S are not required to actually enter into the transaction
described by the RT, the value of the compensation obligation of Company
S for the PCT will reflect the full value of provision of services
described in the RT, as limited by Company S's RAB share.

[Example 3]{.underline}. In Year 1, Company P and Company S execute a
CSA under which they will share the IDCs for developing Product X. In
Year 3, Company P acquires technology intangibles that it anticipates
will contribute to the development of Product X from an uncontrolled
party for a lump sum consideration. Because the technology intangibles
are reasonably anticipated to contribute to the development on the date
of the acquisition and the acquisition is an uncontrolled transaction
that takes place after the formation of the CSA, the RT Rights in the
technology intangibles are an external contribution acquired as part of
a PFA. Accordingly, Company P and Company S must enter into a PCT in
which Company S compensates Company P for the RT Rights in the
technology intangibles and pursuant to paragraph (b)(3)(vi)(B) of this
section, the form of payment of the PCT must mirror the lump sum form of
payment of the PFA.

[Example 4]{.underline}. Assume the same facts as in [Example
3]{.underline}. In Year 4 Company P acquires Company X in a tax-free
stock-for-stock acquisition. Company X is a start-up technology company
with negligible amounts of tangible property and liabilities. Company X
joins in the filing of a U.S. consolidated income tax return with USP
and is treated as one taxpayer with Company P under paragraph (j)(2)(i)
of this section. Accordingly, under paragraph (b)(3)(v) of this section,
Company P's acquisition of the stock of Company X will be treated as an
indirect acquisition of the resources and capabilities of Company X. The
in-process technology and workforce of Company X acquired by Company P
are reasonably anticipated to contribute to the development of product Z
and therefore the RT Rights in the in-process technology and workforce
of Company X are external contributions for which compensation is due to
Company P from Company S under a PCT. Furthermore, because these
external contributions were acquired by Company P in an uncontrolled
transaction that took place after the formation of the CSA, they are
also PFAs. Accordingly, the consideration due from S under the PCT must
be paid in the same form of payment as Company's P acquisition of
Company X, which was done in a lump sum payment. Therefore,
consideration for the PCT must be paid in a lump sum.

\(4\) [Territorial division of interests]{.underline} \-- (i) [In
general]{.underline}. Pursuant to paragraph (b)(1)(i) of this section,
at the outset of the CSA the controlled participants must divide among
themselves all interests in cost shared intangibles on a territorial
basis as follows. The entire world must be divided into two or more
non-overlapping geographic territories. Each controlled participant must
receive at least one such territory, and in the aggregate all the
participants must receive all such territories. Each controlled
participant must be entitled to the perpetual and exclusive right to the
profits from transactions of any member of the controlled group that
includes the controlled participant with uncontrolled taxpayers
regarding property or services for use, consumption, or disposition in
such controlled participant's territory or territories, to the extent
that such profits are attributable to cost shared intangibles. Absent
the controlled participant\'s or other member of its controlled group\'s
actual knowledge or reason to know otherwise, for purposes of the
preceding sentence such use, consumption, or disposition of property or
services will be considered to occur at the location(s) to which notices
and other communications to the uncontrolled taxpayer(s) are to be
provided in accordance with the contractual provisions of the relevant
transactions.

\(ii\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (b)(4):

[Example]{.underline}. Companies P and S, both members of the same
controlled group, enter into a CSA to develop product Z. Under the CSA,
P receives the interest in product Z in the United States and S receives
the interest in product Z in the rest of the world, as described in
paragraph (b)(4)(i) of this section. Both P and S have plants for
manufacturing product Z located in their respective geographic
territories. However, for commercial reasons product Z is nevertheless
manufactured by P in the United States for sale to customers in certain
locations just outside the United States in close proximity to P's U.S.
manufacturing plant. Because S owns the territorial rights outside the
United States, intercompany compensation must be provided for between P
and S to ensure that S realizes all the cost shared intangible profits
from sales of product Z to customers in such proximate areas, even
though the manufacturing is done by P in the United States. The pricing
of such intercompany compensation must also ensure that P realizes an
appropriate manufacturing return for its efforts. Benefits projected
with respect to such sales will be included for purposes of estimating
S's, but not P's, RAB share.

\(5\) [CSAs in substance or form]{.underline} \-- (i) [CSAs in
substance]{.underline}. The Commissioner may apply, consistently with
the rules of §1.482-1(d)(3)(ii)(B) (Identifying contractual terms), the
rules of this section to any arrangement that in substance constitutes a
CSA described in paragraphs (b)(1)(i) through (iii) of this section,
not­withstanding a failure to comply with any requirement of this
section.

\(ii\) [CSAs in form]{.underline}. Provided the requirements of
paragraphs (b)(1)(iv) through (vii) are met with respect to an
arrangement among controlled taxpayers,

\(A\) The Commissioner must apply the rules of this section to any such
arrangement that the controlled taxpayers reasonably concluded to be a
CSA, as described in paragraph (b)(1) of this section; and

\(B\) Otherwise, the Commissioner may apply the rules of this section to
any other such arrangement.

\(iii\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (b)(5). In the examples, assume that
Companies P and S are both members of the same controlled group. The
examples are as follows:

[Example 1]{.underline}.  (i) P owns the patent on a formula for a
capsulated pain reliever, P-Cap. P reasonably anticipates, pending
further research and experimentation, that the P-Cap formula could form
the platform for a formula for P-Ves, an effervescent version of P-Cap.
P also owns proprietary software that it reasonably anticipates to be
critical to the research efforts. P and S execute a CSA by which they
agree to proportionally share the costs and risks of developing a
formula for P-Ves. The agreement reflects the various contractual
requirements described in paragraph (k)(1) of this section and P and S
comply with the documentation, accounting and reporting requirements of
paragraphs (k)(2) through (4) of this section. Both the patent for P-Cap
and the software are reasonably anticipated to contribute to the
development of P-Ves and therefore are external contributions for which
compensation is due from S as part of PCTs. Though P and S enter into a
PCT for the P-Cap patent, they fail to enter into a PCT for the
software.

\(ii\) In this case, P and S have substantially complied with the
contractual requirements of paragraph (k)(1) of this section and the
documentation, accounting and reporting requirements of paragraphs
(k)(2) through (4) of this section and therefore have met the formal
requirements of paragraphs (b)(1)(iv) through (vii) of this section.
However, because they did not enter into a PCT, as required under
paragraph (b)(1)(i) of this section, for the software that was
reasonably anticipated to be critical to the development of P-Ves, they
cannot reasonably conclude that their arrangement was a CSA.
Accordingly, the Commissioner is not required under paragraph
(b)(5)(ii)(A) of this section to apply the rules of this section to
their arrangement. Nevertheless, pursuant to paragraph (b)(5)(ii)(B),
the Commissioner may apply the rules of this section and treat P and S
as entering into a PCT for the software in accordance with the
requirements of paragraph (b)(1)(i) of this section, and make any
appropriate allocations under paragraph (i) of this section.
Alternatively, the Commissioner may decide that the arrangement is not a
CSA described in paragraph (b)(1) of this section and therefore that
this section's provisions do not apply in determining whether the
arrange­ment reaches arm's length results. In this case, the arrangement
would be analyzed under the methods under the section 482 regulations,
without regard to this section, to determine whether the arrangement
reaches such results.

[Example 2]{.underline}. The facts are the same as [Example
1]{.underline} except that P and S do enter into a PCT for the software.
Although the Commissioner determines that the PCT Payments for the
software were not arm's length, nevertheless, under the facts and
circumstances at the time they entered into the CSA and PCTs, P and S
reasonably concluded their arrangement to be a CSA. Because P and S have
met the requirements of paragraphs (b)(1)(iv) through (vii) and
reasonably concluded their arrangement is a CSA, pursuant to paragraph
(b)(5)(ii)(A) of this section, the Commissioner must apply the rules of
this section to their arrangement. Accordingly, the Commissioner treats
the arrangement as a CSA and makes adjustments to the PCT Payments as
appropriate under this section to achieve an arm's length result for the
PCT for the software.

\(6\) [Treatment of CSAs]{.underline}. See §301.7701-1(c) of this
chapter for the treatment of CSAs for purposes of the Internal Revenue
Code.

\(c\) [Make-or-sell rights excluded]{.underline} \-- (1) In
[general]{.underline}. Any right to exploit an existing intangible
without further development, such as the right to make or sell existing
products, does not constitute an external contribution to a CSA, as
described in paragraph (b)(3) of this section. Thus, the arm's length
compensation for such rights does not satisfy the compensation
obligation under a PCT.

\(2\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (c):

[Example 1]{.underline}*.* P and S, who are members of the same
controlled group, execute a CSA that is described in paragraph (b)(1) of
this section. Under the CSA, P and S will bear their proportional shares
of 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. Concurrently 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-and-sell rights
do not constitute an external contribution to the CSA. The rules of
§§1.482-1 and 1.482-4 through 1.482-6, without regard to the rules of
this section, must be applied to determine the arm's length
consideration in connection with the make-and-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 PCTs entered into by
P and S in connection with the CSA. See paragraph (g)(2)(v) of this
section.

[Example 2]{.underline}. (i) P, a software company, has developed and
currently exploits software program ABC. P and S enter into a CSA 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 an
external contribution of P for which compensation is due from S pursuant
to a PCT. Concurrently with entering into the CSA, P licenses to S the
make-and-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 for P's
external contribution and for the make-and-sell license. Based on the
uncontrolled make-and-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.

\(ii\) The make-and-sell rights for the current version of ABC are not
external contributions, though paragraph (g)(2)(v) of this section
provides for the possibility that the most reliable determination of an
arm's length charge for the PCT and the make-and-sell license may be one
that values the two transactions in the aggregate. A contingent payment
schedule based on the uncontrolled make-and-sell licenses may provide an
arm's length charge for the separate make-and-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 license payments it
does not account for the arm's length value of P's external
contributions which include the RT Rights in the source code and future
development rights in ABC.

\(d\) [Intangible development costs (IDCs)]{.underline} \-- (1)  [Costs
included in IDCs]{.underline}. For purposes of this section, IDCs mean
all costs, in cash or in kind (including stock-based compensation, as
described in paragraph (d)(3) of this section), but excluding costs for
land or depreciable property, in the ordinary course of business after
the formation of a CSA that, based on analysis of the facts and
circumstances, are directly identified with, or are reasonably allocable
to, the activity under the CSA of developing or attempting to develop
intangibles (IDA). IDCs shall also include the arm's length rental
charge for the use of any land or depreciable tangible property (as
determined under §1.482-2(c) (Use of tangible property)) directly
identified with, or reasonably allocable to, the IDA. Reference to
generally accepted accounting principles or federal income tax
accounting rules may provide a useful starting point but will not be
conclusive regarding inclusion of costs in IDCs. IDCs do not include
interest expense, foreign income taxes (as defined in §1.901-2(a)), or
domestic income taxes.

\(2\) [Allocation of costs]{.underline}. If a particu­lar cost is
reasonably allocable both to the IDA and to other business activities,
the cost must be allocated on a reasonable basis between the IDA and
such other business activities in proportion to the relative economic
value that the IDA and such other business activities are anticipated to
derive over time as a result of such cost.

\(3\) [Stock-based compensation]{.underline} \-- (i) [In
general]{.underline}. As used in this section, the term [stock-based
compensation]{.underline} means any compensation provided by a
controlled participant to an employee or independent contractor in the
form of equity instruments, options to acquire stock (stock options), or
rights with respect to (or determined by reference to) equity
instruments or stock options, including but not limited to property to
which section 83 applies and stock options to which section 421 applies,
regardless of whether ultimately settled in the form of cash, stock, or
other property.

\(ii\) [Identification of stock-based compensation with the
IDA]{.underline}. The determination of whether stock-based compensation
is directly identified with, or reasonably allocable to, the IDA is made
as of the date that the stock-based compensation is granted.
Accordingly, all stock-based compen­sation that is granted during the
term of the CSA and, at date of grant, is directly identified with, or
reasonably allocable to, the IDA is included as an IDC under para­graph
(d)(1) of this section. In the case of a repricing or other modification
of a stock option, the determination of whether the repricing or other
modification constitutes the grant of a new stock option for purposes of
this paragraph (d)(3)(ii) will be made in accordance with the rules of
section 424(h) and related regulations.

\(iii\) [Measurement and timing of stock-based compensation
IDC]{.underline} \-- (A) [In general]{.underline}. Except as otherwise
provided in this paragraph (d)(3)(iii), the cost attributable to
stock-based compensation is equal to the amount allowable to the
controlled participant as a deduction for federal income tax purposes
with respect to that stock-based compensation (for example, under
section 83(h)) and is taken into account as an IDC under this section
for the taxable year for which the deduction is allowable.

([1]{.underline}) [Transfers to which section 421 applies]{.underline}.
Solely for purposes of this paragraph (d)(3)(iii)(A), section 421 does
not apply to the transfer of stock pursuant to the exercise of an option
that meets the requirements of section 422(a) or 423(a).

([2]{.underline}) [Deductions of foreign controlled
participants]{.underline}. Solely for purposes of this paragraph
(d)(3)(iii)(A), an amount is treated as an allowable deduction of a
controlled participant to the extent that a deduction would be allowable
to a United States taxpayer.

([3]{.underline}) [Modification of stock option]{.underline}. Solely for
purposes of this paragraph (d)(3)(iii)(A), if the repricing or other
modification of a stock option is determined, under paragraph (d)(3)(ii)
of this section, to constitute the grant of a new stock option not
identified with, or reasonably allocable to, the IDA, the stock option
that is repriced or otherwise modified will be treated as being
exercised immediately before the modification, provided that the stock
option is then exercisable and the fair market value of the underlying
stock then exceeds the price at which the stock option is exercisable.
Accordingly, the amount of the deduction that would be allowable (or
treated as allowable under this paragraph (d)(3)(iii)(A)) to the
controlled participant upon exercise of the stock option immediately
before the modification must be taken into account as an IDC as of the
date of the modification.

([4]{.underline}) [Expiration or termination of CSA]{.underline}. Solely
for purposes of this paragraph (d)(3)(iii)(A), if an item of stock-based
compensation identified with, or reasonably allocable to, the IDA is not
exercised during the term of a CSA, that item of stock-based
compensation will be treated as being exercised immediately before the
expiration or termination of the CSA, provided that the stock-based
compensation is then exercisable and the fair market value of the
underlying stock then exceeds the price at which the stock-based
compensation is exercisable. Accordingly, the amount of the deduction
that would be allowable (or treated as allowable under this paragraph
(d)(3)(iii)(A)) to the controlled participant upon exercise of the
stock-based compensation must be taken into account as an IDC as of the
date of the expiration or termination of the CSA.

\(B\) [Election with respect to options on publicly traded
stock]{.underline} \-- ([1]{.underline}) [In general]{.underline}. With
respect to stock-based compensation in the form of options on publicly
traded stock, the controlled participants in a CSA may elect to take
into account all IDCs attributable to those stock options in the same
amount, and as of the same time, as the fair value of the stock options
reflected as a charge against income in audited financial statements or
disclosed in footnotes to such financial statements, provided that such
statements are prepared in accordance with United States generally
accepted accounting principles by or on behalf of the company issuing
the publicly traded stock.

([2]{.underline}) [Publicly traded stock]{.underline}. As used in this
paragraph (d)(3)(iii)(B), the term [publicly traded stock]{.underline}
means stock that is regularly traded on an established United States
securities market and is issued by a company whose financial statements
are prepared in accordance with United States generally accepted
accounting principles for the taxable year.

([3]{.underline}) [Generally accepted accounting
principles]{.underline}. For purposes of this paragraph (d)(3)(iii)(B),
a financial statement prepared in accordance with a comprehensive body
of generally accepted accounting principles other than United States
generally accepted accounting principles is considered to be prepared in
accordance with United States generally accepted accounting principles
provided that either \--

([i]{.underline}) The fair value of the stock options under
consideration is reflected in the reconciliation between such other
accounting principles and United States generally accepted accounting
principles required to be incorporated into the financial statement by
the securities laws governing companies whose stock is regularly traded
on United States securities markets; or

([ii]{.underline}) In the absence of a reconciliation between such other
accounting principles and United States generally accepted accounting
principles that reflects the fair value of the stock options under
consideration, such other accounting principles require that the fair
value of the stock options under consideration be reflected as a charge
against income in audited financial statements or disclosed in footnotes
to such statements.

([4]{.underline}) [Time and manner of making the election]{.underline}.
The election described in this paragraph (d)(3)(iii)(B) is made by an
explicit reference to the election in the written CSA required by
paragraph (k)(1) of this section or in a written amendment to the CSA
entered into with the consent of the Commissioner pursuant to paragraph
(d)(3)(iii)(C) of this section. In the case of a CSA in existence on
August 26, 2003, the election by written amendment to the CSA may be
made without the consent of the Commissioner if such amendment is
entered into not later than the latest due date (with regard to
extensions) of a federal income tax return of any controlled participant
for the first taxable year beginning after August 26, 2003.

\(C\) [Consistency]{.underline}. Generally, all controlled participants
in a CSA taking options on publicly traded stock into account under
paragraph (d)(3)(iii)(A) or (d)(3)(iii)(B) of this section must use that
same method of measurement and timing for all options on publicly traded
stock with respect to that CSA. Controlled participants may change their
method only with the consent of the Commissioner and only with respect
to stock options granted during taxable years subsequent to the taxable
year in which the Commissioner=s consent is obtained. All controlled
participants in the CSA must join in requests for the Commissioner's
consent under this paragraph. Thus, for example, if the controlled
participants make the election described in paragraph (d)(3)(iii)(B) of
this section upon the formation of the CSA, the election may be revoked
only with the consent of the Commissioner, and the consent will apply
only to stock options granted in taxable years subsequent to the taxable
year in which consent is obtained. Similarly, if controlled participants
already have granted stock options that have been or will be taken into
account under the general rule of paragraph (d)(3)(iii)(A) of this
section, then except in cases specified in the last sentence of
paragraph (d)(3)(iii)(B)([4]{.underline}) of this section, the
controlled participants may make the election described in paragraph
(d)(3)(iii)(B) of this section only with the consent of the
Commissioner, and the consent will apply only to stock options granted
in taxable years subsequent to the taxable year in which consent is
obtained.

\(4\) [IDC share]{.underline}. A controlled participant's IDC share for
a taxable year is equal to the controlled participant's cost
contribution for the taxable year, divided by the sum of all IDCs for
the taxable year. A controlled participant's cost contribution for a
taxable year means all of the IDCs initially borne by the controlled
participant, plus all of the cost sharing payments that the participant
makes to other controlled participants, minus all of the cost sharing
payments that the participant receives from other controlled
participants.

\(5\) [Examples]{.underline}. The following examples illustrate this
paragraph (d):

[Example 1]{.underline}. Foreign parent (FP) and its U.S. subsidiary
(USS) enter into a CSA to develop a better mousetrap. USS and FP share
the costs of FP\'s R&D facility that will be exclusively dedicated to
this research, the salaries of the researchers, and reasonable overhead
costs attributable to the project. They also share the cost of a
conference facility that is at the disposal of the senior executive
management of each company. Based on the facts and circumstances, the
cost of the conference facility cannot be directly identified with, and
is not reasonably allocable to, the IDA. In this case, the cost of the
conference facility must be excluded from the amount of IDCs.

[Example 2]{.underline}. U.S. parent (USP) and its foreign subsidiary
(FS) enter into a CSA to develop intangibles for producing a new device.
USP and FS share the costs of an R&D facility, the salaries of the
facility's researchers, and reasonable overhead costs attributable to
the project. Although USP also incurs costs related to field testing of
the device, USP does not include those costs in the IDCs that USP and FS
will share under the CSA. The Commissioner may determine, based on the
facts and circumstances, that the costs of field testing are IDCs that
the participants must share.

[Example 3]{.underline}. U.S. parent (USP) and its foreign subsidiary
(FS) enter into a CSA to develop a new process patent. USP employs
researchers who perform R&D functions in connection both with the
development of the new process patent and with the development of a new
design patent the development of which is outside the scope of the CSA.
During years covered by the CSA, USP compensates such employees with
cash salaries, stock-based compensation, or a combination of both. USP
and FS anticipate that the economic value attributable to such employees
will be derived from the process patent and the design patent at a
relative proportion of 75% and 25%, respectively. Applying the
principles of paragraph (d)(2) of this section, 75% of the compensation
of such employees must be allocated to the development of the new
process patent and, thus, treated as IDCs. With respect to the cash
salary compensation, the IDC is 75% of the face value of the cash. With
respect to the stock-based compensation, the IDC is 75% of the value of
the stock-based compensation as determined under paragraph (d)(3)(iii)
of this section.

[Example 4]{.underline}. Foreign parent (FP) and its U.S. subsidiary
(USS) enter into a CSA to develop a new computer source code. FP's
executive officers who oversee a research facility and employees
dedicated solely to the IDA have additional responsibilities, including
oversight of other research facilities and employees not in any way
relevant to the development of the new computer source code. The full
amount of the costs of the research facility and employees dedicated
solely to the IDA can be directly identified with the IDA and,
therefore, are IDCs. In addition, the participants determine that, of
the economic value attributable to the executive officers, the new
computer source code's share is 50%. Applying the principles of
paragraph (d)(2) of this section, 50% of the compensation of such
executives must be allocated to the development of the new computer
source code and, thus, treated as IDCs.

\(e\) [Reasonably anticipated benefits share (RAB share)]{.underline}
\-- (1) [In general]{.underline}. A controlled participant's share of
reasonably anticipated benefits (RAB share) is equal to its reasonably
anticipated benefits divided by the sum of the reasonably anticipated
benefits of all the controlled participants. See paragraph (j)(1)(v) of
this section (defining reasonably anticipated benefits). RAB shares must
be updated to account for changes in economic conditions, the business
operations and practices of the participants, and the ongoing
development of intangibles under the CSA. For purposes of determining
RAB shares at any given time, reasonably anticipated benefits must be
estimated over the entire period, past and future, of exploitation of
the cost shared intangibles, and must reflect appropriate updates to
take into account the most current reliable data regarding past and
projected future results as is available at such time. A con­trolled
participant's RAB share must be determined by using the most reliable
estimate. In determining which of two or more available estimates is
most reliable, the quality of the data and assumptions used in the
analysis must be taken into account, consistent with §1.482-1(c)(2)(ii)
(Data and assumptions). Thus, the reliability of an estimate will depend
largely on the complete­ness and accuracy of the data, the sound­ness of
the assumptions, and the relative effects of particular deficiencies in
data or assumptions on different estimates. If two estimates are equally
reliable, no adjustment should be made based on differences in the
results. The following factors will be particularly relevant in
determining the reliability of an estimate of RAB shares - -

\(A\) The basis used for measuring benefits, as described in paragraph
(e)(2)(i) of this section; and

\(B\) The projections used to estimate benefits, as described in
paragraph (e)(2)(iii) of this section.

\(2\) [Measure of benefits]{.underline} \-- (i) [In
general]{.underline}. In order to estimate a controlled participant\'s
RAB share, the amount of each controlled participant's reasonably
anticipated benefits must be measured on a basis that is consistent for
all such participants. See paragraph (e)(2)(ii)(E) [Example
8]{.underline} of this section. If a controlled participant transfers a
cost shared intangible to another controlled taxpayer, other than by way
of a transfer described in paragraph (f) of this section, that
participant\'s benefits from the transferred intangible must be measured
by reference to the transferee\'s benefits, disregarding any
con­sidera­tion paid by the transferee to the controlled participant (such
as a royalty pursuant to a license agreement). Reasonably anticipated
benefits are measured either on a direct basis, by reference to
estimated benefits to be generated by the use of cost shared
intangibles, or on an indirect basis, by reference to certain
measurements that reasonably can be assumed to be related to benefits to
be generated. Such indirect bases of measurement of anticipated benefits
are described in paragraph (e)(2)(ii) of this section. A controlled
participant\'s reasonably anticipated benefits must be measured on the
basis, whether direct or indirect, that most reliably determines RAB
shares. In determining which of two bases of measure­ment is most
reliable, the factors set forth in §1.482-1(c)(2)(ii) (Data and
assumptions) must be taken into account. It normally will be expected
that the basis that provided the most reliable estimate for a particular
year will continue to provide the most reliable estimate in subsequent
years, absent a material change in the factors that affect the
reliability of the estimate. Regardless of whether a direct or indirect
basis of measurement is used, adjustments may be required to account for
material differences in the activities that controlled participants
undertake to exploit their interests in cost shared intangibles. See
[Example 6]{.underline} of paragraph (e)(2)(ii)(E) of this section.

\(ii\) [Indirect bases for measuring anticipated benefits]{.underline}.
Indirect bases for measuring anticipated benefits from participation in
a CSA include the follow­ing:

\(A\) [Units used, produced, or sold]{.underline}. Units of items used,
produced, or sold by each controlled participant in the business
activities in which cost shared intangibles are exploited may be used as
an indirect basis for measur­­ing its anticipated benefits. This basis of
measurement will more reliably determine RAB shares to the extent that
each controlled participant is expected to have a similar increase in
net profit or decrease in net loss attributable to the cost shared
intangibles per unit of the item or items used, produced, or sold. This
circumstance is most likely to arise when the cost shared intangibles
are exploited by the controlled participants in the use, production, or
sale of substantially uniform items under similar economic conditions.

\(B\) [Sales]{.underline}. Sales by each controlled participant in the
business activities in which cost shared intangibles are exploited may
be used as an indirect basis for measuring its anticipated benefits.
This basis of measurement will more reliably determine RAB shares to the
extent that each controlled participant is expected to have a similar
increase in net profit or decrease in net loss attributable to cost
shared intangibles per dollar of sales. This circumstance is most likely
to arise if the costs of exploiting cost shared intangibles are not
sub­stantial relative to the revenues generated, or if the principal
effect of using cost shared intangibles is to increase the controlled
participants\' revenues (for example, through a price premium on the
products they sell) without affecting their costs substantially. Sales
by each controlled participant are unlikely to provide a reliable basis
for measuring RAB shares unless each controlled participant operates at
the same market level (for example, manufacturing, distribution, etc.).

\(C\) [Operating profit]{.underline}. Operating profit of each
controlled participant from the activities in which cost shared
intangibles are exploited, as determined before any expense (including
amortization) on account of IDCS, may be used as an indirect basis for
measuring anticipated benefits. This basis of measurement will more
reliably determine RAB shares to the extent that such profit is largely
attributable to the use of cost shared intangibles, or if the share of
profits attributable to the use of cost shared intangibles is expected
to be similar for each controlled participant. This circumstance is most
likely to arise when cost shared intangibles are closely associated with
the activity that generates the profit and the activity could not be
carried on or would generate little profit without use of those
intangibles.

\(D\) [Other bases for measuring anticipated benefits]{.underline}.
Other bases for measuring anticipated benefits may, in some
circumstances, be appropriate, but only to the extent that there is
expected to be a reasonably identifiable relationship between the basis
of measurement used and additional income generated or costs saved by
the use of cost shared intangibles. For example, a division of costs
based on employee compensa­tion would be considered unreliable unless
there were a relationship between the amount of compensation and the
expected income of the controlled participants from using the cost
shared intangibles.

\(E\) [Examples]{.underline}. The following examples illustrate this
paragraph (e)(2)(ii):

[Example 1]{.underline}. Foreign Parent (FP) and U.S. Subsidiary (USS)
both produce a feedstock for the manufacture of various high-performance
plastic products. Producing the feedstock requires large amounts of
electricity, which accounts for a significant portion of its production
cost. FP and USS enter into a CSA to develop a new process that will
reduce the amount of electricity required to produce a unit of the
feedstock. FP and USS currently both incur an electricity cost of \$2
per unit of feedstock produced and rates for each are expected to remain
similar in the future. The new process, if it is successful, will reduce
the amount of electricity required by each company to produce a unit of
the feedstock by 50%. Therefore, the cost savings each company is
expected to achieve after implementing the new process are \$1 per unit
of feedstock produced. Under the CSA, FP and USS divide the costs of
developing the new process based on the units of the feedstock each is
anticipated to produce in the future. In this case, units produced is
the most reliable basis for measuring RAB shares and dividing the IDCs
because each controlled participant is expected to have a similar \$1
(50% of current charge of \$2) decrease in costs per unit of the
feedstock produced.

[Example 2]{.underline}. The facts are the same as in [Example
1]{.underline}, except that currently USS pays \$3 per unit of feedstock
produced for electricity while FP pays \$6 per unit of feedstock
produced. In this case, units produced is not the most reliable basis
for measuring RAB shares and dividing the IDCs because the participants
do not expect to have a similar decrease in costs per unit of the
feedstock produced. The Commissioner determines that the most reliable
measure of RAB shares may be based on units of the feedstock produced if
FP\'s units are weighted relative to USS\' units by a factor of 2. This
reflects the fact that FP pays twice as much as USS as a percentage of
its other production costs for electricity and, therefore, FP\'s savings
of \$3 per unit of the feedstock (50% reduction of current charge of
\$6) would be twice USS\'s savings of \$1.50 per unit of feedstock (50%
reduction of current charge of \$3) from any new process eventually
developed.

[Example 3]{.underline}. The facts are the same as in [Example
2]{.underline}, except that to supply the particular needs of the U.S.
market USS manufactures the feedstock with somewhat different properties
than FP\'s feedstock. This requires USS to employ a somewhat different
production process than does FP. Because of this difference, it will be
more costly for USS to adopt any new process that may be developed under
the cost sharing agreement. In this case, units produced is not the most
reliable basis for measuring RAB shares. In order to reliably determine
RAB shares, the Commissioner offsets the reasonably anticipated costs of
adopting the new process against the reasonably anticipated total
savings in electricity costs.

[Example 4]{.underline}. U.S. Parent (USP) and Foreign Subsidiary (FS)
enter into a CSA to develop new anesthetic drugs. USP obtains the right
to use any resulting patent in the U.S. market, and FS obtains the right
to use the patent in the rest of the world. USP and FS divide costs on
the basis of anticipated operating profit from each patent under
development. USP anticipates that it will receive a much higher profit
than FS per unit sold because drug prices are uncontrolled in the United
States, whereas drug prices are regulated in many non-U.S.
jurisdictions. In both controlled participants' territories, the
operating profits are almost entirely attributable to the use of the
cost shared intangible. In this case, the controlled participants\'
basis for measuring RAB shares is the most reliable.

[Example 5]{.underline}. (i) Foreign Parent (FP) and U.S. Subsidiary
(USS) both manufacture and sell fertilizers. They enter into a CSA to
develop a new pellet form of a common agricultural fertilizer that is
currently available only in powder form. Under the CSA, USS obtains the
rights to produce and sell the new form of fertilizer for the U.S.
market while FP obtains the rights to produce and sell the fertilizer
for the rest of the world. The costs of developing the new form of
fertilizer are divided on the basis of the anticipated sales of
fertilizer in the controlled participants\' respective markets.

\(ii\) If the research and development is successful, the pellet form
will deliver the fertilizer more efficiently to crops and less
fertilizer will be required to achieve the same effect on crop growth.
The pellet form of fertilizer can be expected to sell at a price premium
over the powder form of fertilizer based on the savings in the amount of
fertilizer that needs to be used. This price premium will be a similar
premium per dollar of sales in each territory. If the research and
development is successful, the costs of producing pellet fertilizer are
expected to be approximately the same as the costs of producing powder
fertilizer and the same for both FP and USS. Both FP and USS operate at
approximately the same market levels, selling their fertilizers largely
to independent distributors.

\(iii\) In this case, the controlled participants\' basis for measuring
RAB shares is the most reliable.

[Example 6]{.underline}. The facts are the same as in [Example
5]{.underline}, except that FP distributes its fertilizers directly
while USS sells to independent distributors. In this case, sales of USS
and FP are not the most reliable basis for measuring RAB shares unless
adjustments are made to account for the difference in market levels at
which the sales occur.

[Example 7]{.underline}. Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a CSA to develop materials that will be used to train all new
entry-level employees. FP and USS determine that the new materials will
save approximately ten hours of training time per employee. Because
their entry-level employees are paid on differing wage scales, FP and
USS decide that they should not measure benefits based on the number of
entry-level employees hired by each. Rather, they measure benefits based
on compensation paid to the entry-level employees hired by each. In this
case, the basis used for measuring RAB shares is the most reliable
because there is a direct relationship between compensation paid to new
entry-level employees and costs saved by FP and USS from the use of the
new training materials.

[Example 8]{.underline}. U.S. Parent (USP), Foreign Subsidiary 1 (FS1)
and Foreign Subsidiary 2 (FS2) enter into a CSA to develop computer
software that each will market and install on customers\' computer
systems. The controlled participants measure benefits on the basis of
projected sales by USP, FS1, and FS2 of the software in their respective
geographic areas. However, FS1 plans not only to sell but also to
license the software to unrelated customers, and FS1\'s licensing income
(which is a percentage of the licensees\' sales) is not counted in the
projected benefits. In this case, the basis used for measuring the
benefits of each controlled participant is not the most reliable because
all of the benefits received by controlled participants are not taken
into account. In order to reliably determine RAB shares, FS1\'s
projected benefits from licensing must be included in the measurement on
a basis that is the same as that used to measure its own and the other
controlled participants\' projected benefits from sales (for example,
all controlled participants might measure their benefits on the basis of
operating profit).

\(iii\) [Projections used to estimate benefits]{.underline} \-- (A) [In
general]{.underline}. The reliability of an estimate of RAB shares also
depends upon the reliability of projections used in making the estimate.
Projections required for this purpose generally include a determination
of the time period between the incep­tion of the research and development
activities under the CSA and the receipt of benefits, a projection of
the time over which benefits will be received, and a pro­jection of the
benefits anticipated for each year in which it is anticipated that the
cost shared intangible will generate benefits. A projection of the
relevant basis for measuring anticipated benefits may require a
projection of the factors that underlie it. For example, a projection of
operating profits may require a projection of sales, cost of sales,
operating expenses, and other factors that affect operating profits. If
it is anticipated that there will be significant variation among
controlled participants in the timing of their receipt of benefits, and
con­sequently benefit shares are expected to vary significantly over the
years in which benefits will be received, it normally will be neces­sary
to use the present dis­counted value of the projected benefits to
reliably determine RAB shares. See paragraph (g)(2)(vi) of this section
for guidance on discount rates used for this purpose. If it is not
antici­pated that benefit shares will significantly change over time,
current annual bene­fit shares may provide a reliable projection of RAB
shares. This circumstance is most likely to occur when the CSA is a
long-term arrangement, the arrangement covers a wide variety of
intangibles, the composition of the cost shared intangibles is unlikely
to change, the cost shared intangibles are unlikely to generate unusual
profits, and each controlled participant\'s share of the market is
stable.

\(B\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (e)(2)(iii):

[Example 1]{.underline}. (i) Foreign Parent (FP) and U.S. Subsidiary
(USS) enter into a CSA to develop a new car model. The controlled
participants plan to spend four years developing the new model and four
years producing and selling the new model. USS and FP project total
sales of \$4 billion and \$2 billion, respectively, over the planned
four years of exploitation of the new model. Cost shares are divided for
each year based on projected total sales. Therefore, USS bears 66 2/3%
of each year\'s IDCs and FP bears 33 1/3% of such costs.

\(ii\) USS typically begins producing and selling new car models a year
after FP begins producing and selling new car models. In order to
reflect USS\' one-year lag in introducing new car models, a more
reliable projection of each participant\'s RAB share would be based on a
projection of all four years of sales for each participant, discounted
to present value.

[Example 2]{.underline}. U.S. Parent (USP) and Foreign Subsidiary (FS)
enter into a CSA to develop new and improved household cleaning
products. Both controlled participants have sold household cleaning
products for many years and have stable market shares. The products
under development are unlikely to produce unusual profits for either
controlled participant. The controlled participants divide costs on the
basis of each controlled participant\'s current sales of household
cleaning products. In this case, the controlled participants\' RAB
shares are reliably projected by current sales of cleaning products.

[Example 3]{.underline}. The facts are the same as in [Example
2]{.underline}, except that FS\'s market share is rapidly expanding
because of the business failure of a competitor in its geographic area.
The controlled participants\' RAB shares are not reliably projected by
current sales of cleaning products. FS\'s benefit projections should
take into account its growth in sales.

[Example 4]{.underline}. Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a CSA to develop synthetic fertilizers and insecticides. FP
and USS share costs on the basis of each controlled participant\'s
current sales of fertilizers and insecticides. The market shares of the
controlled participants have been stable for fertilizers, but FP\'s
market share for insecticides has been expanding. The controlled
participants\' projections of RAB shares are reliable with regard to
fertilizers, but not reliable with regard to insecticides; a more
reliable projection of RAB shares would take into account the expanding
market share for insecticides.

\(f\) [Changes in participation under a CSA]{.underline} \-- In the case
of any change in participation under a CSA as the result of a controlled
transfer of all or part of a controlled participant's territorial rights
under the CSA, as described in paragraph (b)(4) of this section, along
with the assumption by the transferee of the associated obligations
under the CSA, the transferee will be treated as succeeding to the
transferor's prior history under the CSA, including the transferor's
cost contributions, benefits derived, and PCT Payments attributable to
such rights or obligations. The transferor must receive an arm's length
amount of considera­tion from the transferee under the rules of §§1.482-1
and 1.482-4 through 1.482-6, as described in paragraph (a)(3)(ii) of
this section. For purposes of this section, such a change in
participation under a CSA includes, for example, any transaction in
which \--

\(1\) A controlled participant transfers all or part of its territorial
rights to another controlled participant that assumes the associated
obligations under a CSA;

\(2\) A new controlled participant enters an ongoing CSA and acquires
any territorial rights and assumes associated obligations under the CSA;
or

\(3\) A controlled participant withdraws from an ongoing CSA, or
otherwise abandons or relinquishes territorial rights and associated
obligations under the CSA.

\(g\) [Supplemental guidance on methods applicable to PCTs]{.underline}
\-- (1) [In general]{.underline}. This subsection provides supplemental
guidance on applying the methods listed below for purposes of evaluating
the arm\'s length amount charged in a PCT. Each method must be applied
in accordance with the provisions of §1.482-1, including best method
rule of §1.482-1(c), the comparability analysis of §1.482-1(d), and the
arm's length range of §1.482-1(e), except as those provisions are
modified in this subsection. The methods are \--

\(i\) The comparable uncontrolled transaction method described in
§1.482-4(c), or the arm's length charge described in
§1.482-2(b)(3)(first sentence) based on a comparable uncontrolled
transaction, further described in paragraph (g)(3) of this section;

\(ii\) The income method, described in paragraph (g)(4) of this section;

\(iii\) The acquisition price method, described in paragraph (g)(5) of
this section;

\(iv\) The market capitalization method, described in paragraph (g)(6)
of this section;

\(v\) The residual profit split method, described in paragraph (g)(7) of
this section; and

\(vi\) Unspecified methods, described in paragraph (g)(8) of this
section.

\(2\) [General principles]{.underline} \-- (i) [In general]{.underline}.
The principles set forth in this paragraph (g)(2) apply, as appropriate,
to the use of any of the methods set forth in this section to determine
the arm's length charge for a PCT.

\(ii\) [Valuations consistent with upfront contractual terms and risk
allocations]{.underline}. The application of any method as of any time
must be consistent with the applicable contractual terms and allocation
of risk under the CSA and this section among the controlled participants
as of the date of the PCT, unless there has been a change in such terms
or allocation made in return for arm's length consideration.

\(iii\) [Projections]{.underline}. The reliability of an estimate of the
value of an external contribution in connection with a PCT will often
depend upon the reliability of projections used in making the estimate.
Projections necessary for this purpose may include a projection of
sales, IDCs, routine operating expenses, and costs of sales. For these
purposes, projections that have been prepared for non-tax purposes are
generally more reliable than projections that have been prepared solely
for purposes of meeting the requirements in this paragraph (g).

\(iv\) [Realistic alternatives]{.underline} \-- (A) [In
general]{.underline}. Regardless of the method or methods used,
evaluation of the arm's length charge for the PCT in question should
take into account the general principle that uncontrolled taxpayers
dealing at arm's length would have evaluated the terms of a transaction,
and only entered into a particular transaction, if no alternative is
preferable. This condition is not met, for example, where for any
controlled participant the total anticipated present value from entering
into the CSA to that controlled participant, as of the date of the PCT,
is less than the total anticipated present value that could be achieved
through an alternative arrangement realistically available to that
controlled participant. When applying the realistic alternatives
principle, the reliability of the respective net present value
calculations may need to be considered.

\(B\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (g)(2)(iv):

[Example 1]{.underline}. (i) P, a corporation, and S, a wholly-owned
subsidiary of P, enter into a CSA to develop a gyroscopic personal
transportation device (the product). Under the arrangement, P will
undertake all of the R&D, and manufacture and market the product in
Country X. S will make CST payments to P for its appropriate share of
P's R&D costs, and manufacture and market the product in the rest of the
world. P owns existing patents and trade secrets associated with
gyroscopic applications. These patents and trade secrets are reasonably
anticipated to contribute to the development of the product and are
therefore the RT Rights in the patents and trade secrets are external
contributions for which compensation is due from S as part of a PCT.

\(ii\) S's manufacturing and distribution activities under the CSA will
be routine in nature, and identical to the activities it would undertake
if it alternatively licensed the product from P.

\(iii\) Reasonably reliable estimates indicate that P could self-develop
and license the product outside of the Country X for a royalty of 20% of
sales. Based on reliable financial projections that include all future
development costs and licensing revenue, the net present value of this
licensing alternative to P for the non-Country X market (measured as of
the date of the PCT) would be \$500 million of operating income. Thus,
based on this realistic alternative, the anticipated net present value
under the CSA to P in the non-Country X market (measured as of the date
of the PCT), including R&D reimbursement and PCT Payments from S, should
not be less than \$500 million.

[Example 2]{.underline}. (i) The facts are the same as [Example
1]{.underline}, except that there are no reliable estimates of the value
to P from the licensing alternative to the CSA. However, reasonably
reliable estimates indicate that S can earn a 10% mark-up on total
accounting costs related to its routine manufacturing and distribution
activities.

\(ii\) P undertakes an economic analysis that derives S's cost
contributions under the CSA, based on reliable financial projections.
Based on this and further economic analysis, P determines S\'s PCT
Payment as a certain lump sum amount to be paid as of the date of the
PCT.

\(iii\) Based on reliable financial projections that include S's cost
contributions and that incorporate S\'s PCT Payment, and using a
discount rate of D%, appropriate for the riskiness of the CSA (see
paragraph (g)(2)(vi) of this section), the anticipated net present value
to S under the CSA (measured at the time of the PCT) is \$800 million.
Of this amount, \$100 million is the portion associated with the 10%
markup on S's total accounting costs from its manufacturing and
distribution activities, utilizing its existing investment in plant and
equipment.

\(iv\) In evaluating the PCT under the CSA, the Commissioner concludes
that the respective activities undertaken by P and S would be identical
regardless of whether the arrangement was undertaken as a CSA or as a
licensing arrangement. That is, under either alternative, P would
undertake all research activities and S would undertake routine
manufacturing and distribution activities associated with its territory.
Consequently, in every year the total anticipated combined nominal
profits of P and S would be identical regardless of whether the
arrangement was undertaken as a CSA or as a licensing arrangement. In
addition, the Commissioner considers the fact that S's economic role in
the CSA (beyond its routine activities) is merely that of an investor. A
similarly situated investor would be willing to invest an amount in a
similar R&D project such that it earns an anticipated return on that
investment of D% and therefore has a net present value of \$0 on the
project (not taking into account any returns to routine activities). If
S were to realize a D% return on its lump sum PCT Payment, then the
anticipated net present value to S of the CSA would be \$100 million,
equal to the \$100 million anticipated net present value related to S\'s
manufacturing and distribution activities, utilizing its existing
investment in plant and equipment, plus the \$0 anticipated net present
value from the investment in the form of the lump sum PCT Payment in the
IDA of the CSA at a D% discount rate.

\(v\) The lump sum PCT Payment computed by P results in S having
significantly higher anticipated discounted profitability, and
therefore, in this case, higher anticipated nominal profitability, than
it could achieve under the licensing alternative. By implication, P must
correspondingly earn lower nominal profits under the CSA than it would
under the licensing alternative (that is, S's enhanced profitability
under the CSA is matched dollar-for-dollar by P's reduced profitability
under the CSA). Consequently, the Commissioner concludes that P is
earning a lower anticipated return through the CSA than it could achieve
under its realistic alternative to the CSA, and that consequently S's
lump sum PCT Payment under-compensates P for its external contribution.

[Example 3]{.underline}. (i) The facts are the same as [Example
2]{.underline} except as follows. Based on reliable financial
projections that include S's cost contributions and S\'s PCT Payment,
discounted at a rate of D% to reflect the riskiness of the CSA, the
anticipated net present value to S under the CSA (measured as of the
date of the PCT) is \$50 million. Instead of entering the CSA, S has the
realistic alternative of investing in an R&D project with similar risk,
at an anticipated return of D%, and manufacturing and distributing
products unrelated to the gyroscopic personal transportation device to
the same extent as its manufacturing and distribution under the CSA,
with the same anticipated 10% mark-up on total costs.

\(ii\) Under its realistic alternative, at a discount rate of D%, S
anticipates a present value of \$100 million from the routine
manufacturing and distribution and \$0 from the R&D investment, for a
total of \$100 million.

\(iii\) Because the lump sum PCT Payment made by S results in S having a
considerably lower anticipated net present value than S could achieve
through an alternative arrangement realistically available to it, the
Commissioner may conclude that the lump sum PCT Payment overcompensates
P for its external contribution.

\(v\) [Aggregation of transactions]{.underline}. In some cases,
controlled participants are required to determine arm's length payments
for multiple PCTs covering various external contributions or, in
addition to one or more PCTs, for transactions covering resources or
capabilities that are not governed by this section, such as the transfer
of make-or-sell rights as described in paragraph (c) of this section.
Following the principles of aggregation described in §1.482-1(f)(2)(i),
a best method analysis under §1.482-1(c) may determine that the method
that provides the most reliable measure of an arm's length charge for
the multiple PCTs and other transactions not governed by this section,
if any, is a method that determines the arm's length charge for the
multiple transactions on an aggregate basis under this section. A
section 482 adjustment may be made by comparing the aggregate arm's
length charge so determined to the aggregate payments actually made for
the multiple transactions. In such a case, it generally will not be
necessary to allocate separately the aggregate arm's length charge as
between various PCTs or as between PCTs and transactions governed by
other regulations under section 482. However, such an allocation may be
necessary for other purposes, such as applying paragraph (i)(6)
(Periodic adjustments) of this section. An aggregate determination of
the arm's length charge for multiple transactions will generally yield a
payment for a controlled participant that is equal to the aggregate
value of the external contributions and other resources and capabilities
covered by the multiple transactions multiplied by that controlled
participant's RAB share. Because RAB shares only include benefits from
cost shared intangibles, the reliability of an aggregate determination
of payments for multiple transactions may be reduced to the extent that
it includes transactions not governed by this section covering resources
and capabilities for which the controlled participants' expected benefit
shares differ substantially from their RAB shares.

\(vi\) [Discount rate]{.underline} \-- (A) [In general]{.underline}.
Some calculations set forth in this paragraph (g) and elsewhere in this
section require determining a rate of return which is used to convert a
future or past monetary sum associated with a particular set of
activities or transactions into a present value. For this purpose, a
discount rate should be used that most reliably reflects the risk of the
activities and the transactions based on all the information potentially
available at the time for which the present value calculation is to be
performed. Depending on the particular facts and circumstances, the risk
involved and thus, the discount rate, may differ among a company\'s
various activities or transactions. Normally, discount rates are most
reliably determined by reference to market information. For example, the
weighted average cost of capital (WACC) of the relevant activities and
transactions derived using the capital asset pricing model might provide
the most reliable discount rate. In such cases, this WACC might most
reliably be based on information from uncontrolled companies whose
business activities as a whole constitute comparable uncontrolled
transactions. Where a company is publicly traded and its CSA involves
substantially the same risk as projects undertaken by the company as a
whole, then the WACC of the relevant activities and transactions might
most reliably be based on the company's own WACC. Depending on
comparability and reliability considerations, including the extent to
which the company's hurdle rate reflects market information and is used
in a similar manner in the controlled and uncontrolled transactions, in
some circumstances discount rates might be most reliably determined by
reference to other data such as a company\'s internal hurdle rate for
projects of comparable risk.

\(B\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (g)(2)(vi):

[Example 1]{.underline}. USPharm, a publicly traded U.S. pharmaceutical
company, enters into a CSA with FPharm, its wholly-owned foreign
subsidiary. Under the agreement both controlled participants agree to
share the research costs of developing a specific drug compound called
T. USPharm is also engaged in another development project for compounds
U and V, which involves different risks than the T development project
and which is not part of the CSA. However, there are a large number of
uncontrolled publicly traded U.S. companies, for which information can
be reliably derived, that are highly comparable to USPharm but that
conduct research only on compounds similar to T involving risks similar
to those of the T development project. At the commencement of the CSA
(Year 1), USPharm and FPharm enter into a PCT with respect to external
contributions owned by USPharm in the form of the RT Rights in its
pre-existing drug research. As part of the method that USPharm
determines will most reliably calculate PCT Payments, a discount rate is
needed to convert future monetary sums into a present value. After
analysis, USPharm concludes that the discount rate is most reliably
determined by calculating a WACC based on the information relating to
the comparable uncontrolled companies, with suitable adjustments for
factors such as differences in capital structure between USPharm and the
comparables, and for the stability and other statistical properties of
the beta measurement of the comparables.

[Example 2]{.underline}. The facts are the same as in [Example
1]{.underline} except that the T development project is the only
business activity of USPharm and FPharm and no reliable data exists on
uncontrolled companies undertaking similar activities and risk as those
associated with the CSA. After analysis, USPharm concludes that the
discount rate is most reliably determined by reference to its own WACC.
USPharm funds its operations with debt and common stock. Debt comprises
40% of its financing and USPharm's cost of debt is 6%. Equity comprises
the remaining 60% of financing. USPharm is publicly traded and its
equity beta is 1.25. Using third party information, USPharm concluded
that the appropriate risk-free rate and equity risk premium are X% and
Y%, respectively, implying a return on USPharm's equity of Z% \[ X% + (
1.25 × Y% )\]. The weighted average cost of capital is calculated by
blending and weighting the after-tax cost of debt and the cost of equity
according to percentage of total financing. USPharm's weighted average
cost of capital is W% \[( 6% × 0.4 ) + ( Z% × 0.6 )\].

[Example 3]{.underline}. [Use of a documented discount
rate]{.underline}. The facts are the same as [Example 1]{.underline}
except that no data exists on uncontrolled companies undertaking similar
activities and risks as those associated with the CSA. USPharm has
documented a hurdle rate of 12% that it uses as the minimum anticipated
return for its business investments having a comparable risk profile.
The Commissioner examines USPharm's documentation and concludes that the
hurdle rate provides a reliable discount rate in this case.

\(vii\) [Accounting principles]{.underline} \-- (A) [In
general]{.underline}. Allocations or other valuations done for
accounting purposes may provide a useful starting point but will not be
conclusive for purposes of assessing or applying methods to evaluate the
arm's length charge in a PCT, particularly where the accounting
treatment of an asset is inconsistent with its economic value.

\(B\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (g)(2)(vii):

[Example 1]{.underline}. (i) USP, a U.S. corporation and FSub, a
wholly-owned foreign subsidiary of USP, enter into a CSA in Year 1 to
develop software programs with application in the medical field. Company
X is an uncontrolled software company located in the United States that
is engaged in developing software programs that could significantly
enhance the programs being developed by USP and FSub. Company X is still
in a startup phase, so it has no currently exploitable products or
marketing intangibles and its workforce consists of a team of software
developers. Company X has negligible liabilities and tangible property.
In Year 2, USP purchases Company X as part of an uncontrolled
transaction in order to acquire its in-process technology and workforce
for purposes of the development activities of the CSA. USP files a
consolidated return that includes Company X. For accounting purposes,
\$50 million of the \$100 million acquisition price is allocated to the
in-process technology and workforce, and the residual \$50 million is
allocated to goodwill.

\(ii\) The in-process technology and workforce of Company X acquired by
USP are reasonably anticipated to contribute to developing cost shared
intangibles and therefore the RT Rights in the in-process technology and
workforce of Company X external contributions for which FSub must
compensate USP as part of a PCT. In determining whether to apply the
acquisition price or another method for purposes of evaluating the arm's
length charge in the PCT, relevant comparability and reliability
considerations must be weighed in light of the general principles of
paragraph (g)(2) of this section. The allocation for accounting purposes
raises an issue as to the reliability of using the acquisition price
method in this case because it indicates that a significant portion of
the value of Company X's assets is allocable to goodwill, which is often
difficult to value reliably and which, depending on the facts and
circumstances, might not be attributable to external contributions that
are to be compensated by PCTs. See paragraph (g)(5)(iv(A) of this
section.

\(iii\) Paragraph (g)(2)(vii) of this section provides that accounting
treatment may be a starting point, but is not determinative for purposes
of assessing or applying methods to evaluate the arm's length charge in
a PCT. The facts here reveal that Company X has nothing of economic
value aside from its in-process technology and assembled workforce. The
\$50 million of the acquisition price allocated to goodwill for
accounting purposes, therefore, is economically attributable to either
or both the in-process technology and the workforce. That moots the
potential issue under the acquisition price method of the reliability of
valuation of assets not to be compensated by PCTs, since there are no
such assets. Assuming the acquisition price method is otherwise the most
reliable method, the aggregate value of Company X's in-process
technology and workforce is the full acquisition price of \$100 million.
Accordingly, the aggregate value of the arm's length PCT Payments due
from FSub to USP for the external contributions consisting of the RT
Rights in Company X's in-process technology and workforce will equal
\$100 million multiplied by FSub's RAB share.

[Example 2]{.underline}. (i) The facts are the same as in [Example
1]{.underline}, except that Company X is a mature software business in
the United States with a successful current generation of software that
it markets under a recognized trademark, in addition to having the
research team and new generation software in process that could
significantly enhance the programs being developed under USP's and
FSub's CSA. USP continues Company X's existing business and integrates
the research team and the in-process technology into the efforts under
its CSA with FSub. For accounting purposes, the \$100 million
acquisition price for acquiring Company X is allocated \$50 million to
existing software and trademark, \$25 million to in-process technology
and research workforce, and the residual \$25 million to goodwill and
going concern value.

\(ii\) In this case an analysis of the facts indicates a likelihood,
consistent with the allocation under the accounting treatment (although
not necessarily in the same amount), of goodwill and going concern value
economically attributable to the existing U.S. software business rather
than to the external contributions consisting of the RT Rights in the
in-process technology and research workforce. Accordingly, further
consideration must be given to the extent to which these circumstances
reduce the relative reliability of the acquisition price method in
comparison to other potentially applicable methods for evaluating the
PCT Payment.

[Example 3]{.underline}. (i) USP, a U.S. corporation and FSub, a
wholly-owned foreign subsidiary of USP, enter into a CSA in Year 1 to
develop Product A. Company Y is an uncontrolled corporation that owns
Technology X that is critical to the development of Product A. Company Y
currently markets Product B, which is dependent on Technology X. USP is
solely interested in acquiring Technology X, but is only able to do so
through the acquisition of Company Y in its entirety for \$200 million
in an uncontrolled transaction in Year 2. For accounting purposes, the
acquisition price is allocated as follows: \$120 million to Product B
and the underlying Technology X, \$30 million to trademark and other
marketing intangibles, and the residual \$50 million to goodwill and
going concern. After the acquisition of Company Y, Technology X is used
to develop Product A. No other part of Company Y is utilized in any
manner. Product B is discontinued and accordingly, the accompanying
marketing intangibles become worthless. None of the previous employees
of Company Y are retained.

\(ii\) The Technology X of Company Y acquired by USP is reasonably
anticipated to contribute to developing cost shared intangibles and is
therefore an external contribution for which FSub must compensate USP as
part of a PCT. Although for accounting purposes a significant portion of
the acquisition price of Company Y was allocated to items other than
Technology X, the facts demonstrate that USP had no intention of using
and therefore placed no economic value on any part of Company Y other
than Technology X. If USP was willing to pay \$200 million for Company Y
solely for purposes of acquiring Technology X, then assuming the
acquisition price method is otherwise the most reliable method, the
value of Technology X is the full \$200 million acquisition price.
Accordingly, the value of the arm's length PCT Payment due from FSub to
USP for the external contribution consisting of the RT Rights in
Technology X will equal \$200 million multiplied by FSub's RAB share.

\(viii\) [Valuation consistent with the investor model]{.underline} \--
(A) [In general]{.underline}. The valuation of the amount charged in a
PCT must be consistent with the assumption that, as of the date of the
PCT, each controlled participant's aggregate net investment in
developing cost shared intangibles pursuant to the CSA, attributable to
both external contributions and cost contributions, is reasonably
anticipated to earn a rate of return equal to the appropriate discount
rate, determined following the principles set forth in paragraph
(g)(2)(vi) of this section, over the entire period of developing and
exploiting the cost shared intangibles. If the cost shared intangibles
themselves are reasonably anticipated to contribute to developing other
intangibles, then the period in the preceding sentence includes the
period of developing and exploiting such indirectly benefited
intangibles.

\(B\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (g)(2)(viii):

[Example]{.underline}. (i) P, a U.S. corporation, has developed a
software program, DEF, which applies certain algorithms to reconstruct
complete DNA sequences from partially-observed DNA sequences. S is a
wholly-owned foreign subsidiary of P. P and S enter into a CSA to
develop a new generation of genetic tests, GHI, based in part on the use
of DEF which is therefore an external contribution of P for which
compensation is due from S pursuant to a PCT. S makes no external
contributions to the CSA. GHI sales are projected to commence two years
after the inception of the CSA, which is on the first day of Year 1, and
then to continue for eight more years. P and S project that GHI will be
replaced by a new generation of genetic testing based on technology
unrelated to DEF or GHI at the end of Year 10.

\(ii\) For purposes of valuing the PCT for P's external contribution of
DEF to the CSA, P and S apply a type of residual profit split method
that is not described in paragraph (g)(7) of this section and which,
accordingly, constitutes an unspecified method. See paragraph
(g)(7)(i)(last sentence) of this section. The principles of this
paragraph (g)(2) apply to any method for valuing a PCT, including the
unspecified method used by P and S.

\(iii\) Under the method employed by P and S, in each Year, a portion of
the income from sales of GHI in S's territory is allocated to certain
routine contributions made by S. The residual of the profit or loss from
GHI sales in S's territory after the routine allocation step is divided
between the controlled participants pro rata to their capital stocks
allocable to S's territory. Each controlled participant's capital stock
is computed by growing and amortizing (in the case of P) its historical
expenditures regarding DEF allocable to S's territory and (in the case
of S) its ongoing cost contributions towards developing GHI. The
amortization of the capital stocks is effected on a straight-line basis
over an assumed four-year life for the relevant expenditures. The
capital stocks are grown using an assumed growth factor which P and S
consider to be appropriate. Thus, the residual profit or loss from sales
of GHI in S's territory is divided between P and S pro rata to P's
capital stock in DEF attributable to S's territory and to S's capital
stock from its cost contributions.

\(iv\) The assumption that all expenditures amortize on a straight-line
basis over four years does not appropriately reflect the principle that
as of the date of the PCT regarding DEF, every contribution to the
development of GHI, including DEF is reasonably anticipate to have value
throughout the entire period of exploitation of GHI as projected to
continue through Year 10. Under this method as applied by P and S, P's
capital stock in DEF, and therefore the amount of profit in S's
territory allocated to P as a PCT Payment from S, will decrease every
year. After Year 4, P's capital stock in DEF will necessarily be \$0.
Thus, under this method, P will receive none of the residual profit or
loss from GHI sales in S's territory after Year 4 as a PCT Payment. As a
result of this limitation of the PCT Payments to be made by S, the
return to S's aggregate investment in the CSA is anticipated to be
significantly higher than the appropriate discount rate for the CSA.
This is not consistent with the investor model principle that S should
anticipate a return to its aggregate investment in the CSA equal to the
appropriate discount rate over the entire period of developing and
exploiting GHI. The inconsistency of the method with the investor model
materially lessens its reliability for purposes of a best method
analysis. See §1.482-1(c)(2)(ii)(B).

\(ix\) [Coordination of best method rule and form of
payment]{.underline}. A method described in paragraph (g)(1) of this
section evaluates the arm's length amount charged in a PCT in terms of a
form of payment (method payment form). For example, the method payment
form for the income method described in paragraph (g)(4)(iii) or (iv) of
this section is payment contingent on the exploitation of cost shared
intangibles by the PCT Payor, and the method payment form for the market
capitalization method is lump sum payment. The method payment form may
not necessarily correspond to the form of payment specified pursuant to
paragraphs (b)(3)(vi)(A) and (k)(2)(ii)(l) of this section (specified
payment form). The determination under §1.482-1(c) of the method that
provides the most reliable measure of an arm's length result is to be
made without regard to whether the respective method payment forms under
the competing methods correspond to the specified payment form. If the
method payment form of the method determined under §1.482-1(c) to
provide the most reliable measure of an arm's length result differs from
the specified payment form, then the conversion from such method payment
form to such specified payment form will be made on a reasonable basis
to the satisfaction of the Commissioner. For purposes of the preceding
sentence, if the method described in the documentation by the controlled
participants pursuant to paragraph (k)(2)(ii)(J) of this section is
determined under §1.482-1(c) to provide the most reliable measure of an
arm's length result, then the Commissioner will give due consideration
whether the conversion from the method payment form to the specified
payment form was made by the controlled participants on a reasonable
basis.

\(x\) [Coordination of the valuations of prior and subsequent
PCTs]{.underline} \-- (A) [In general]{.underline}. In cases where PCTs
are required on different dates, coordination of the valuations of the
prior and subsequent PCTs must be effected pursuant to a method that
provides the most reliable measure of an arm's length result. Depending
on the facts and circumstances, such as whether the external
contributions that were the subject of the prior and subsequent PCTs
were nonroutine contributions, an approach which may be appropriate
would be to determine PCT Payments both for the prior and subsequent
PCTs going forward from the date of the subsequent PCT pursuant to a
residual profit split method, as described in paragraph (g)(7) of this
section. Such application of the residual profit split method would
include as nonroutine contributions all of the following: the external
contribution(s) that were the subject of the prior PCT(s), the external
contribution that is the subject of the subsequent PCT, and the
interests of the controlled participants in the incremental cost shared
intangible development resulting from the development activities under
the CSA. Paragraph (g)(2)(x)(B) of this section specifies the
appropriate coordination with a prior PCT in the case of a subsequent
PCT the subject of which is a PFA.

\(B\) [Coordination with regard to PFAs]{.underline}. PCT Payments for a
subsequent PCT that is derived from a PFA are determined independently
of any prior PCTs. Such PCT Payments will be treated, for purposes of
the application of the method used for evaluating a prior PCT, the same
as IDCs the actual amounts of which may not correspond to those
projected on the date of the prior PCT. A divergence between actual and
anticipated IDCs does not require alteration in the application of the
method used to value PCT Payments. Similarly, a subsequent PCT derived
from a PFA will not require alteration in the application of the method
used to value PCT Payments for a prior PCT.

\(xi\) [Proration of PCT Payments to the extent allocable to other
business activities]{.underline}. If a resource or capability that is
the subject of a PCT is reasonably anticipated to contribute both to
developing or exploiting cost shared intangibles and to other business
activities of the PCT Payee (other than exploiting an existing
intangible without further development), then to the extent it can be
demonstrated that a portion of the value of the relevant PCT Payments
otherwise determined under this section is attributable to such other
business activities, the PCT Payments must be prorated. Such proration
will be done on a reasonable basis in proportion to the relative
economic value, as of the date of the PCT, reasonably anticipated to be
derived from the resource or capability by the CSA Activity as compared
to such other business activities of the PCT Payee. In the case of an
aggregate valuation done under the principles of paragraph (g)(2)(v) of
this section that includes payment for rights to exploit an existing
intangible without further development, the prorated aggregate payments
must take into account the economic value attributable to such
exploitation rights as well. For purposes of the best method rule under
§1.482-1(c), the reliability of the analysis under a method that
requires proration pursuant to this paragraph is reduced relative to the
reliability of an analysis under a method that does not require
proration.

\(3\) [Comparable uncontrolled transaction method]{.underline}. The
comparable uncontrolled transaction (CUT) method described in
§1.482-4(c), and the arm's length charge described in
§1.482-2(b)(3)(first sentence) based on a comparable uncontrolled
transaction, may be applied to evaluate whether the amount charged in a
PCT is arm's length by reference to the amount charged in a comparable
uncontrolled transaction. When applied in the manner described in
§1.482-4(c), or where a comparable uncontrolled transaction provides the
most reliable measure of the arm's length charge described in
§1.482-2(b)(3)(first sentence), the CUT method, or the arm's length
charge in the comparable uncontrolled transaction, will typically yield
an arm's length total value for the external contribution that is the
subject of the PCT. That value must then be multiplied by each PCT
Payor's respective RAB share in order to determine the arm's length PCT
Payment due from each PCT Payor. The reliability of a CUT that yields a
value for the external contribution only in the PCT Payor's territory
will be reduced to the extent that value is not consistent with the
total worldwide value of the external contribution multiplied by the PCT
Payor's RAB share.

\(4\) [Income method]{.underline} \-- (i) [In general]{.underline}. The
income method evaluates whether the amount charged in a PCT is arm's
length by reference to the controlled participants' realistic
alternatives to entering into a CSA.

\(ii\) [Determination of arm's length charge]{.underline} \-- (A) [In
general]{.underline}. Under this method, the arm's length charge for a
PCT Payment will be an amount such that a controlled participant's
present value, as of the date of the PCT, of entering into a CSA equals
the present value of its best realistic alternative. Paragraphs
(g)(4)(iii) and (iv) of this section describe two specific applications
of the income method, but do not exclude other possible applications of
this method.

\(B\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (g)(4)(ii):

[Example]{.underline}. (i) USP, a U.S. manufacturer, has developed a
new, light weight fabric for sleeping bags. In Year 1 USP enters into a
CSA with its wholly-owned foreign subsidiary, FSub, to develop an
improved version of this fabric. Under the CSA, USP will own the rights
to exploit improved versions of the fabric in the United States and FSub
will own the rights to exploit improvements in the rest of the world
(ROW). The rights to further develop the fabric are reasonably
anticipated to contribute to the development of future improved versions
and therefore the RT Rights in the fabric are external contributions for
which compensation is due pursuant to a PCT. USP does not transfer the
right to exploit its current fabric to FSub. FSub does not furnish any
external contributions. If USP did not participate in the CSA, its next
best realistic alternative would be to develop future versions of the
fabric on its own, exploit those versions in the United States and
license such versions for exploitation outside the United States to
FSub. In Year 1, USP estimates that its present value of this
alternative (including arm's length royalties on sales in the ROW) is
\$100 million. Under the CSA, USP projects U.S. sleeping bag sales with
improved versions of the fabric to amount to \$80 million (present value
in Year 1). The costs (other than IDCs) plus the routine return to such
costs associated with the U.S. sales are anticipated to be \$10 million.
USP's anticipated cost contributions under the CSA are \$10 million
(present value in Year 1). FSub projects that in the ROW future sales
should amount to \$100 million (present value in Year 1).

\(ii\) An arm's length contingent PCT Payment under the income method is
a sales-based royalty at a rate, p, such that the present value to USP
of the next best realistic alternative is equal to the present value to
USP of participating in the CSA. In other words, the rate is such that
\$100 million (value of licensing alternative) = \$80 million
(anticipated U.S. sales) - \$10 million (anticipated costs, other than
IDCs, plus routine return) - \$10 million (anticipated cost
contribution) + (p \* \$100 million (anticipated ROW sales)), or 40%.
Accordingly, FSub should pay USP a royalty of 40% of actual ROW sales
annually when the two begin to exploit future generations of the fabric.

\(iii\) [Application of income method using a CUT]{.underline} \-- (A)
[In general]{.underline}. This application of the income method is
typically used in cases where only one controlled participant furnishes
nonroutine contributions, as described in paragraph
(g)(7)(iii)(C)([1]{.underline}) of this section. This application
assumes that the best reasonable alternative of the PCT Payee to
entering into the CSA would be to develop the cost shared intangibles on
its own, bearing all the IDCs itself, and then to license the cost
shared intangibles to the other controlled participants.

\(B\) [Determination of arm's length charge]{.underline} \--
([1]{.underline}) [In general]{.underline}. An arm's length PCT Payment
under this application of the income method is represented as an
applicable rate on sales from exploiting the cost shared intangibles,
determined as of the date of the PCT.

([2]{.underline}) [Applicable rate]{.underline}. The applicable rate is
equal to the alternative rate less the cost contribution adjustment.

([3]{.underline}) [Alternative rate]{.underline}. The alternative rate
is the constant rate the PCT Payee would charge an uncontrolled licensee
over the period the cost shared intangibles are anticipated to be
exploited if the PCT Payee had developed the cost shared intangibles on
its own and licensed them to the uncontrolled licensee. The alternative
rate is determined using the comparable uncontrolled transaction method,
as described in §1.482-4(c)(1) and (2).

([4]{.underline}) [Cost contribution adjustment]{.underline}. The cost
contribution adjustment is equal to a fraction, the numerator of which
is the present value of the PCT Payor's total anticipated cost
contributions and the denominator of which is the present value of the
PCT Payor's total anticipated sales from exploiting the cost shared
intangibles.

\(C\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (g)(4)(iii):

[Example]{.underline}. (i) USP, a software company, has developed
version 1.0 of a new software application which it is currently
marketing. In Year 1 USP enters into a CSA with its wholly-owned foreign
subsidiary, FS, to develop future versions of the software application.
Under the CSA, USP will have the rights to exploit the future versions
in the United States, and FS will have the rights to exploit them in the
rest of the world (ROW). The future rights in version 1.0, and USP's
development team, are reasonably anticipated to contribute to the
development of future versions and therefore the RT Rights in version
1.0 are external contributions for which compensation is due from FS as
part of a PCT. USP does not transfer the current exploitation rights in
version 1.0 to FS. FS does not furnish any external contributions. FS
anticipates sales of \$100 million (present value in Year 1) in its
territory and anticipates cost contributions of \$40 million (present
value in Year 1). The arm's length rate USP would have charged an
uncontrolled licensee for a license of future versions of the software
had USP further developed version 1.0 on its own is 60%, as determined
under the comparable uncontrolled transaction method in §1.482-4(c).

\(ii\) An arm's length contingent PCT Payment under the income method is
an applicable rate equal to the alternative rate less the cost
contribution adjustment. In this case the alternative rate is 60%, the
arm's length rate determined under §1.482-4(c). The cost contribution
adjustment is 40%, the present value to FS of its anticipated cost
contribution over the present value of its anticipated sales of future
versions of the software, that is, \$40 million / \$100 million. The
applicable rate, which represents an arm's length contingent PCT
Payment, payable by the FS to USP on all actual ROW sales of the future
versions of the software therefore is 20%, which is equal to the
alternative rate of 60% less the cost contribution adjustment of 40%.

\(iv\) [Application of income method using CPM]{.underline} \-- (A) [In
general]{.underline}. This application of the income method is typically
used in cases where only one controlled participant furnishes nonroutine
contributions. Under this application, the present value of the
anticipated PCT Payments is equal to the present value, as of the date
of the PCT, of the PCT Payor's anticipated profit from developing and
exploiting cost shared intangibles. This PCT Payment ensures that PCT
Payors who do not furnish any external contributions subject to a PCT
receive an appropriate ex ante risk adjusted return on their investment
in the CSA.

\(B\) [Determination of arm's length charge based on sales]{.underline}
\-- ([1]{.underline}) [In general]{.underline}. An arm's length PCT
Payment under this application of the income method is represented as an
applicable rate on sales from exploiting the cost shared intangibles,
determined as of the date of the PCT.

([2]{.underline}) [Applicable rate]{.underline}. The applicable rate is
equal to the alternative rate less the cost contribution adjustment.

([3]{.underline}) [Alternative rate]{.underline}. The alternative rate
is determined using the comparable profits method described in §1.482-5
and is estimated as a fraction. The numerator of the fraction is the
present value of the PCT Payor's total anticipated territorial operating
profit, as defined in paragraph (j)(1)(vi) of this section, reduced by a
market return for the routine contributions (other than cost
contributions) to the relevant business activity in the relevant
territory. The denominator of the fraction is the discounted present
value of the PCT Payor's total anticipated sales from exploiting the
cost shared intangibles.

([4]{.underline}) [Cost contribution adjustment]{.underline}. The cost
contribution adjustment is equal to a fraction the numerator of which is
the present value of the PCT Payor's total anticipated cost
contributions and the denominator of which is the present value of the
PCT Payor's total anticipated sales from exploiting the cost shared
intangibles.

\(C\) [Determination of arm's length charge based on profit]{.underline}
\-- ([1]{.underline}) [In general]{.underline}. An arm's length PCT
Payment under this application of the income method may also be
represented as an applicable rate on territorial operating profit, as
defined in paragraph (j)(1)(vi) of this section, reduced by a market
return for the routine contributions (other than cost contributions) to
the relevant business activity in the relevant territory. This is done
following the calculations described in paragraph (g)(4)(iv)(B) of this
section, substituting anticipated territorial operating profit, reduced
by a market return for the routine contributions (other than cost
contributions) to the relevant business activity in the relevant
territory, wherever anticipated sales appear in the calculations.

([2]{.underline}) [Alternative rate]{.underline}. Substituting
territorial operating profits, reduced by a market return for the
routine contributions (other than cost contributions) to the relevant
business activity in the relevant territory, for sales in the
calculation of the alternative rate results in a fraction with both a
numerator and denominator equal to the present value of the PCT Payor's
total anticipated territorial operating profit, as defined in paragraph
(j)(1)(vi) of this section, reduced by a market return for the routine
contributions (other than cost contributions) to the relevant business
activity in the relevant territory. Therefore the alternative rate under
this application is 1, or 100%.

([3]{.underline}) [Cost contribution adjustment]{.underline}.
Substituting territorial operating profit, reduced by a market return
for the routine contributions (other than cost contributions) to the
relevant business activity in the relevant territory, for sales results
in a cost contribution adjustment equal to a fraction the numerator of
which is the present value of the PCT Payor's total anticipated cost
contributions and the denominator of which is the present value of the
PCT Payor's total anticipated territorial operating profit, as defined
in paragraph (j)(1)(vi) of this section, reduced by a market return for
the routine contributions (other than cost contributions) to the
relevant business activity in the relevant territory.

\(D\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (g)(4)(iv):

[Example]{.underline}. (i) USP, a U.S. pharmaceutical company, invests
in research and development to begin developing a vaccine for disease K.
In Year 1, USP enters into a CSA with its wholly-owned foreign
subsidiary, FS, to complete the development of the vaccine. Under the
CSA, USP will have the rights to exploit the vaccine in the United
States, and FS will have the rights to exploit it in the rest of the
world. The partially developed vaccine owned by USP, and USP's
development team, are reasonably anticipated to contribute to the
development of the final vaccine and therefore the RT Rights in the
vaccine and the development team are external contributions for which
compensation is due from FS as part of a PCT. FS does not furnish any
external contributions. The total anticipated IDCs under the CSA are
\$100 million (in Year 1 dollars). USP and FS each have total projected
sales of \$100 million (in Year 1 dollars) of the vaccine, which they
use as the basis for determining RAB shares. Accordingly, they divide
the development costs based on 50/50 RAB shares, \$50 million (in Year 1
dollars) paid by each participant. Based on an analysis under the
comparable profits method under §1.482-5, FS's anticipated territorial
operating profit, as reduced by a market return for the its routine
contributions to exploiting the vaccine in its territory, is \$80
million (in Year 1 dollars).

\(ii\) An arm's length contingent PCT Payment under the income method is
an applicable rate equal to the alternative rate less the cost
contribution adjustment. In this case the alternative rate is 80% ((\$80
million territorial operating profit/\$100 million sales). The cost
contribution adjustment is 50%, the present value to FS of its
anticipated cost contributions over the present value of its anticipated
sales of the vaccine, that is, \$50 million/\$100 million. The
applicable rate, which represents an arm's length contingent PCT
Payment, payable by the FS to the USP over the period the vaccine is
exploited therefore is 30%, which is equal to the alternative rate of
80% less the cost contribution adjustment of 50%.

\(iii\) An arm's length contingent PCT Payment based on territorial
operating profits under the income method is an applicable rate equal to
the alternative rate less the cost contribution adjustment. In this case
the alternative rate is 100% ((\$80 million territorial operating profit
/\$80 million territorial operating profit). The cost contribution
adjustment is 62.5%, the present value to FS of its anticipated cost
contributions over the present value of its anticipated territorial
profits from sales of the vaccine, that is, \$50 million/\$80 million.
The applicable rate on territorial operating profit, which represents an
arm's length contingent PCT Payment, payable by the FS to the USP over
the period the vaccine is exploited therefore is 37.5%, which is equal
to the alternative rate of 100% less the cost contribution adjustment of
62.5%.

\(v\) [Routine external contributions]{.underline}. For purposes of this
paragraph (g)(4), any routine contributions that are external
contributions (routine external contributions), the valuation and PCT
Payments for which are determined and made independently of the income
method, are treated similarly to cost contributions. Accordingly,
wherever the term cost contributions appears in this paragraph (g)(4) it
shall be read to include net routine external contributions. Net routine
external contributions are defined as a controlled participant's total
anticipated routine external contributions, plus its anticipated PCT
Payments to other controlled participants in respect of their routine
external contributions, minus the anticipated PCT Payments it is to
receive from other controlled participants in respect of its routine
external contributions.

\(vi\) [Comparability and reliability considerations]{.underline} \--
(A) [In general]{.underline}. Whether results derived from this method
are the most reliable measure of the arm\'s length result is determined
using the factors described under the best method rule in §1.482-1(c).
Thus, comparability and the quality of data and assumptions must be
considered in determining whether this method provides the most reliable
measure of an arm\'s length result. Consistent with those
considerations, the reliability of applying the income method as a
measure of the arm's length charge for a PCT Payment is typically less
reliable to the extent that more than one controlled participant
furnishes nonroutine contributions.

\(B\) [Application of the income method using a CUT]{.underline}. If the
income method is applied using a CUT, as described in paragraph
(g)(4)(iii) of this section, any additional comparability and
reliability considerations stated in §1.482-4(c)(2) may apply.

\(C\) [Application of the income method using CPM]{.underline}. If the
income method is applied using CPM, as described in paragraph (g)(4)(iv)
of this section, any additional comparability and reliability
considerations stated in §1.482-5(c) apply.

\(5\) [Acquisition price method]{.underline} \-- (i) [In
general]{.underline}. The acquisition price method applies the
comparable uncontrolled transaction method of §1.482-4(c), or the arm's
length charge described in §1.482-2(b)(3)(first sentence) based on a
comparable uncontrolled transaction, to evaluate whether the amount
charged in a PCT, or group of PCTs, is arm's length by reference to the
amount charged (the acquisition price) for the stock or asset purchase
of an entire organization or portion thereof (the target) in an
uncontrolled transaction. The acquisition price method is ordinarily
used only where substantially all the target's nonroutine contributions
(as described in paragraph (g)(7)(iii)(C)([1]{.underline}) of this
section) to the PCT Payee's business activities are covered by a PCT or
group of PCTs.

\(ii\) [Determination of arm's length charge]{.underline}. Under this
method, the arm's length charge for a PCT or group of PCTs covering
resources and capabilities of the target is equal to the adjusted
acquisition price, as divided among the controlled participants
according to their respective RAB shares.

\(iii\) [Adjusted acquisition price]{.underline}. The adjusted
acquisition price is the acquisition price of the target increased by
the value of the target's liabilities on the date of the acquisition,
other than liabilities not assumed in the case of an asset purchase, and
decreased by the value of the target's tangible property on that date
and by the value on that date of any other resources and capabilities
not covered by a PCT or group of PCTs.

\(iv\) [Reliability and comparability considerations]{.underline}. The
comparability and reliability considerations stated in §1.482-4(c)(2)
apply. Consistent with those considerations, the reliability of applying
the acquisition price method as a measure of the arm's length charge for
the PCT Payment normally is reduced if \--

\(A\) A substantial portion of the target's nonroutine contributions to
the PCT Payee's business activities is not required to be covered by a
PCT or group of PCTs, and that portion of the nonroutine contributions
cannot reliably be valued; or

\(B\) A substantial portion of the target's assets consists of tangible
property that cannot reliably be valued.

\(v\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (g)(5):

[Example]{.underline}*.* USP, a U.S. corporation, and its newly
incorporated, wholly-owned foreign subsidiary (FS) enter into a CSA in
Year 1 to develop Group Z products. Under the CSA, USP and FS will have
the exclusive rights to exploit the Group Z products in the U.S. and the
rest of the world, respectively. Based on RAB shares, USP will bear 60%
and FS will bear 40% of the costs incurred during the term of the
agreement. USP acquires Company X in Year 2 for cash consideration worth
\$110 million. Company X joins in the filing of a U.S. consolidated
income tax return with USP. Under paragraph (j)(2)(i) of this section,
Company X and USP are treated as one taxpayer. Accordingly, the RT
Rights in any of Company X's resources and capabilities that are
reasonably anticipated to contribute to the development activities of
the CSA will be considered external contributions furnished by USP.
Company X's resources and capabilities consist of its workforce, certain
technology intangibles, \$15 million of tangible property and other
assets and \$5 million in liabilities. The technology intangibles, as
well as Company X's workforce, are reasonably anticipated to contribute
to the development of the Group Z products under the CSA and therefore
the RT Rights in the technology intangibles and the workforce are
external contributions by way of a PFA for which FS must make a PCT
Payment to USP. None of Company X's existing intangible assets or any of
its workforce are anticipated to contribute to activities outside the
CSA. Applying the acquisition price method, the value of USP's external
contributions is the adjusted acquisition price \$100 million (\$110
million acquisition price plus \$5 million liabilities less \$15 million
tangible property and other assets). FS must make a PCT Payment to USP
for these external contributions in an amount of \$40 million, which is
the product of \$100 million (the value of the external contributions)
and 40% (FS's RAB share).

\(6\) [Market capitalization method]{.underline} \-- (i) [In
general]{.underline}. The market capitalization method applies the
comparable uncontrolled transaction method of §1.482-4(c), or the arm's
length charge described in §1.482-2(b)(3)(first sentence) based on a
comparable uncontrolled transaction, to evaluate whether the amount
charged in a PCT, or group of PCTs, is arm's length by reference to the
average market capitalization of a controlled participant (PCT Payee)
whose stock is regularly traded on an established securities market. The
market capitalization method is ordinarily used only where substantially
all of the PCT Payee's nonroutine contributions (as described in
paragraph (g)(7)(iii)(C)([1]{.underline}) of this section) to the PCT
Payee's business are covered by a PCT or group of PCTs.

\(ii\) [Determination of arm's length charge]{.underline}. Under the
market capitalization method, the arm's length charge for a PCT or group
of PCTs covering resources and capabilities of the PCT Payee is equal to
the adjusted average market capitalization, as divided among the
controlled participants according to their respective RAB shares.

\(iii\) [Average market capitalization]{.underline}. The average market
capitalization is the average of the daily market capitalizations of the
PCT Payee over a period of time beginning 60 days before the date of the
PCT and ending on the date of the PCT. The daily market capitalization
of the PCT Payee is calculated on each day its stock is actively traded
as the total number of shares outstanding multiplied by the adjusted
closing price of the stock on that day. The adjusted closing price is
the daily closing price of the stock, after adjustments for stock-based
transactions (dividends and stock splits) and other pending corporate
(combination and spin-off) restructuring transactions for which reliable
arm's length adjustments can be made.

\(iv\) [Adjusted average market capitalization]{.underline}. The
adjusted average market capitalization is the average market
capitalization of the PCT Payee increased by the value of the PCT
Payee's liabilities on the date of the PCT and decreased by the value on
such date of the PCT Payee's tangible property and of any other
resources and capabilities of the PCT Payee not covered by a PCT or
group of PCTs.

\(v\) [Reliability and comparability considerations]{.underline}. The
comparability and reliability considerations stated in §1.482-4(c)(2)
apply. Consistent with those considerations, the reliability of applying
the comparable uncontrolled transaction method using the adjusted market
capitalization of a company as a measure of the arm's length charge for
the PCT Payment normally is reduced if \--

\(A\) A substantial portion of the PCT Payee's nonroutine contributions
to its business activities is not required to be covered by a PCT or
group of PCTs, and that portion of the nonroutine contributions cannot
reliably be valued;

\(B\) A substantial portion of the PCT Payee's assets consists of
tangible property that cannot reliably be valued; or

\(C\) Facts and circumstances demonstrate the likelihood of a material
divergence between the average market capitalization of the PCT Payee
and the value of its resources and capabilities for which reliable
adjustments cannot be made.

\(vi\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (g)(6):

[Example 1]{.underline}. (i) USP, a publicly traded U.S. company, and
its newly incorporated wholly-owned foreign subsidiary (FS) enter into a
CSA on Date 1 to develop software. Under the CSA, USP and FS will have
the exclusive rights to exploit all future generations of the software
in the United States and the rest of the world, respectively. Based on
RAB shares, USP will bear 70% and FS will bear 30% of the costs incurred
during the term of the CSA. USP's assembled team of researchers and its
entire existing and in-process software are reasonably anticipated to
contribute to the development of the software under the CSA and the RT
Rights in the research team and existing and in-process software are
therefore external contributions for which compensation is due from FS.
USP separately enters into a license agreement with FS for make-and-sell
rights for all existing software in the rest of the world. This license
of current make-and-sell rights is a transaction that is governed by
§1.482-4. However, after analysis, it is determined that the PCT
Payments and the arm's length payments for the make-and-sell license may
be most reliably determined in the aggregate using the market
capitalization method, under principles described in paragraph (g)(2)(v)
of this section.

\(ii\) On Date 1, USP had an average market capitalization of \$205
million, tangible property and other assets that can be reliably valued
worth \$5 million and no liabilities. Applying the market capitalization
method, the aggregate value of USP's external contributions and the
make-and-sell rights in its existing software is \$200 million (\$205
million average market capitalization of USP less \$5 million of
tangible property and other assets). The total arm's length value of the
PCT Payments and license payments FS must make to USP for the external
contributions and current make-and-sell rights is \$60 million, which is
the product of \$200 million (the value of the external contributions
and the make-and-sell rights) and 30% (FS's share of anticipated
benefits of 30%).

[Example 2]{.underline}. The facts are the same as [Example
1]{.underline} except that USP also makes significant nonroutine
contributions that are difficult to value to several other mature
business divisions it operates that are not reasonably anticipated to
contribute software development that is the subject of the CSA and are
therefore not external contributions and accordingly not required to be
covered by a PCT. The reliability of using the market capitalization
method to determine the value of USP's external contributions to the CSA
is significantly reduced in this case because it would require adjusting
USP's average market capitalization to account for the significant
nonroutine contributions that are not required to be covered by a PCT.

\(7\) [Residual profit split method]{.underline} \-- (i) [In
general]{.underline}. The residual profit split method evaluates whether
the allocation of combined operating profit or loss attributable to one
or more external contributions subject to a PCT is arm's length by
reference to the relative value of each controlled participant's
contribution to that combined operating profit or loss. The combined
operating profit or loss must be derived from the most narrowly
identifiable business activity of the controlled participants for which
data are available that include the developing and exploiting of cost
shared intangibles (relevant business activity). The residual profit
split method may not be used where only one controlled participant makes
significant nonroutine contributions to the development and exploitation
of the cost shared intangibles. The provisions of §1.482-6 shall apply
to CSAs only to the extent provided and as modified in this paragraph
(g)(7). Any other application to a CSA of a residual profit method not
described below will constitute an unspecified method for purposes of
sections 482 and 6662(e) and the regulations thereunder.

\(ii\) [Appropriate share of profits and losses]{.underline}. The
relative value of each controlled participant'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,
consistent with the comparability provisions of §1.482-1(d)(3). Such an
allocation is intended to correspond to the division of profit or loss
that would result from an arrangement between uncontrolled taxpayers,
each performing functions similar to those of the various controlled
participants engaged in the relevant business activity. The profit
allocated to any particular controlled participant is not necessarily
limited to the total operating profit of the group from the relevant
business activity. For example, in a given year, one controlled
participant may earn a profit while another controlled participant
incurs a loss. In addition, it may not be assumed that the combined
operating profit or loss from the relevant business activity should be
shared equally, or in any other arbitrary proportion.

\(iii\) [Profit split]{.underline} \-- (A) [In general]{.underline}.
Under the residual profit split method, each controlled participant's
territorial operating profit or loss, as defined in paragraph (j)(1)(vi)
of this section, is allocated between the controlled participants that
each furnish significant nonroutine contributions to the relevant
business activity in that territory following the three step process set
forth in paragraphs (g)(7)(iii)(B) and (C) of this section.

\(B\) [Allocate income to routine contributions other than cost
contributions]{.underline}. The first step allocates an amount of income
to each controlled participant that is subtracted from its territorial
operating profit or loss to provide a market return for the controlled
participant's routine contributions (other than cost contributions) to
the relevant business activity in its territory. Routine contributions
are contributions of the same or a similar kind to those made by
uncontrolled taxpayers involved in similar business activities for which
it is possible to identify market returns. Routine contributions
ordinarily include contributions of tangible property, services and
intangibles that are generally owned or provided by uncontrolled
taxpayers engaged in similar activities. A functional analysis is
required to identify these contributions according to the functions
performed, risks assumed, and resources employed by each of the
controlled participants. Market returns for the routine contributions
should be determined by reference to the returns achieved by
uncontrolled taxpayers engaged in similar activities, consistent with
the methods described in §§1.482-3, 1.482-4, and1.482-5, or with the
arm's length charge described in §1.482-2(b)(3)(first sentence) based on
a comparable uncontrolled transaction.

\(C\) [Allocate residual profit]{.underline} \-- ([1]{.underline}) [In
general]{.underline}. The allocation of income to each controlled
participant's routine contributions in the first step will not reflect
profit or loss attributable to that controlled participant's cost
contributions, nor reflect the profit or loss attributable to any
controlled participant's nonroutine contributions to the relevant
business activity. Nonroutine contributions include nonroutine external
contributions, and other nonroutine contributions, to the relevant
business activity in the relevant territory. The residual territorial
profit or loss after the allocation of income in the first step in
paragraph (g)(7)(iii)(B) of this section is further allocated under the
second and third steps in paragraphs (g)(7)(iii)(C)([2]{.underline}) and
([3]{.underline}) of this section.

([2]{.underline}) [Cost contribution share of residual profit or
loss]{.underline}. Under the second step, a portion of each controlled
participant's residual territorial profit or loss after the first step
allocation is allocated to that controlled participant's cost
contributions (cost contribution share). A controlled participant's cost
contribution share is equal to the following fraction of such residual
territorial profit or loss. The numerator is the present value,
determined as of the relevant date, of the summation, over the entire
period of developing and exploiting cost shared intangibles, of the
total value of such controlled participant's total anticipated cost
contributions. The denominator is the present value, determined as of
the relevant date, of the summation, over the same period, of such
controlled participant's total anticipated territorial operating
profits, as defined in paragraph (j)(1)(vi) of this section, reduced by
a market return for the routine contributions (other than cost
contributions) to the relevant business activity in the relevant
territory. For these purposes, the relevant date is the date of the
PCTs.

([3]{.underline}) [Nonroutine contribution share of residual profit or
loss]{.underline}. Under the third step, the remaining share of each
controlled participant's residual territorial profit or loss after the
first and second step allocations generally should be divided among all
of the controlled participants based upon the relative value, determined
as of the date of the PCTs, of their nonroutine contributions to the
relevant business activity in the relevant territory. The relative value
of the nonroutine contributions of each controlled participant may be
measured by external market benchmarks that reflect the fair market
value of such nonroutine contributions. Alternatively, the relative
value of nonroutine contributions may be estimated by the capitalized
cost of developing the nonroutine contributions and updates, as
appropriately grown or discounted so that all contributions may be
valued on a comparable dollar basis as of the same date. If the
nonroutine contributions by a controlled participant are also used in
other business activities (such as the exploitation of make-or-sell
rights described in paragraph (c) of this section), an allocation of the
value of the nonroutine contributions must be made on a reasonable basis
among all the business activities in which they are used in proportion
to the relative economic value that the relevant business activity and
such other business activities are anticipated to derive over time as
the result of such nonroutine contributions.

([4]{.underline}) [Determination of PCT Payments]{.underline}. Any
amount of a controlled participant's territorial operating profit or
loss that is allocated to another controlled participant's external
contributions to the relevant business activity in the relevant
territory under the third step represents the amount of the PCT Payment
due to that other controlled participant for its such external
contributions.

([5]{.underline}) [Routine external contributions]{.underline}. For
purposes of this paragraph (g)(7), routine external contributions, the
valuation and PCT Payments for which are determined and made
independently of the residual profit split method, are treated similarly
to cost contributions. Accordingly, wherever used in this paragraph
(g)(7), the term routine contribution shall not be read to include
routine external contributions and the term cost contribution shall be
read to include net routine external contributions, as defined in
paragraph (g)(4)(v) of this section.

\(iv\) [Comparability and reliability considerations]{.underline} \--
(A) [In general]{.underline}. Whether results derived from this method
are the most reliable measure of the arm\'s length result is determined
using the factors described under the best method rule in §1.482-1(c).
Thus, comparability and the quality of data and assumptions must be
considered in determining whether this method provides the most reliable
measure of an arm\'s length result. The application of these factors to
the residual profit split in the context of the relevant business
activity of developing and exploiting cost shared intangibles is
discussed in paragraphs (g)(7)(iv)(B), (C), and (D) of this section.

\(B\) [Comparability]{.underline}. The first step of the residual profit
split relies on market benchmarks of profitability. Thus, the
comparability considerations that are relevant for the first step of the
residual profit split are those that are relevant for the methods that
are used to determine market returns for the routine contributions.

\(C\) [Data and assumptions]{.underline}. The reliability of the results
derived from the residual profit split is affected by the quality of the
data and assumptions used to apply this method. In particular, the
following factors must be considered \--

([1]{.underline}) The reliability of the allocation of costs, income,
and assets between the relevant business activity and the controlled
participants' other activities will affect the reliability of the
determination of the territorial operating profit and its allocation
among the controlled participants. See
§1.482-6(c)(2)(ii)(C)([1]{.underline});

([2]{.underline}) The degree of consistency between the controlled
participants and uncontrolled taxpayers in accounting practices that
materially affect the items that determine the amount and allocation of
operating profit affects the reliability of the result. See
§1.482-6(c)(2)(ii)(C)([2]{.underline}); and

([3]{.underline}) The reliability of the data used and the assumptions
made in valuing the nonroutine contributions by the controlled
participants. In particular, if capitalized costs of development are
used to estimate the value of intangible property, the reliability of
the results is reduced relative to the reliability of other methods that
do not require such an estimate, for the following reasons. In any given
case, the costs of developing the intangible may not be related to its
market value. In addition, the calculation of the capitalized costs of
development may require the allocation of indirect costs between the
relevant business activity and the controlled participant's other
activities, which may affect the reliability of the analysis.

\(D\) [Other factors affecting reliability]{.underline}. Like the
methods described in §§1.482-3, 1.482-4, and 1.482-5, or with the arm's
length charge described in §1.482-2(b)(3) (first sentence) based on a
comparable uncontrolled transaction, the first step of the residual
profit split relies exclusively on external market benchmarks. As
indicated in §1.482-1(c)(2)(i), as the degree of comparability between
the controlled participants and uncontrolled trans­actions increases, the
relative weight accorded the analysis under this method will increase.
In addition, to the extent the allocation of profits in the third step
is not based on external market benchmarks, the reliability of the
analysis will be decreased in relation to an analysis under a method
that relies on market benchmarks. Finally, the reliability of the
analysis under this method may be enhanced by the fact that all the
controlled participants are evaluated under the residual profit split.
However, the reliability of the results of an analysis based on
information from all the controlled participants is affected by the
reliability of the data and the assumptions pertaining to each
controlled participant. Thus, if the data and assumptions are
significantly more reliable with respect to one of the controlled
participants than with respect to the others, a different method,
focusing solely on the results of that party, may yield more reliable
results.

\(v\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (g)(7):

[Example]{.underline}*.* (i) USP, a U.S. nanotech company, has partially
developed technology for nanomotors which are used to provide mobility
for nanodevices. At the same time, USP's wholly-owned subsidiary, FS, a
foreign nanotech company, has partially developed technology for
nanosensors which provide sensing capabilities for nanodevices. At the
beginning of Year 1, USP enters into a CSA with FS to develop NanoBuild,
a technology which will be used to build a wide range of fully
functioning nanodevices. The partially developed nanomotor and
nanosensor technologies owned by USP and FS, respectively, are
reasonably anticipated to contribute to the development of NanoBuild and
therefore the RT Rights in the nanomotor and nanosensor technologies
constitute external contributions of USP and FS for which compensation
is due under PCTs. Under the CSA, USP will have the right to exploit
NanoBuild in the United States, while FS will have the right to exploit
NanoBuild in the rest of the world. USP's and FS's RAB shares are 40%
and 60% respectively.

\(ii\) The present value of the total projected IDCs for the CSA is \$10
billion (as of the date of the PCTs). Based on RAB shares, USP expects
to bear 40%, or \$4 billion, of these IDCS and FS expects to bear 60%,
or \$6 billion. For accounting purposes, USP and FS project a combined
operating profit from exploitation of the NanoBuild of \$11 billion (in
Year 1 dollars), taking into account the \$10 billion of projected IDCs.
However, for purposes of applying the residual profit split method,
combined operating profit is determined without taking into account
IDCs. Therefore, USP and FS redetermine their combined operating profits
for purposes of the residual profit split method to equal \$21 billion
(adding \$10 billion of IDCs back to the accounting profit of \$11
billion). Of this amount, 40% or \$8.4 billion is expected to be
generated by USP in the U.S. and 60% or \$12.6 billion is expected to be
generated by FS in the rest of the world.

\(iii\) USP and FS each undertake routine distribution activities in
their respective markets that constitute routine contributions to the
relevant business activity of exploiting NanoBuild. They estimate that
the total market return (costs plus a market return on those costs) on
these routine contributions will amount to \$1 billion, (in Year 1
dollars). Of this amount, USP's anticipated routine return is \$400
million and FS's anticipated routine return is \$600 million. After
deducting the routine return, USP's total anticipated residual operating
profit is \$8 billion (\$8.4 billion - \$0.4 billion) and FS's total
anticipated residual operating profit equals \$12 billion (\$12.6
billion - \$0.6 billion).

\(iv\) After analysis, USP and FS determine that the relative values of
the nanomotor and nanosensor technologies are most reliably measured by
their respective capitalized costs of development. Some of the factors
considered in this analysis include the similar nature and success, and
the relatively contemporaneous timing, of the nanoengineering research
done to develop both the nanomoter and nanosensor technologies and the
lack of external market benchmarks. The capitalized costs of the
nanomotor and nonsensor technologies are \$3 billion and \$5 billion,
respectively.

\(v\) Under the residual profit split method, in each taxable year USP
and FS will allocate the operating income they each separately report in
their territory (territorial operating income) between their routine
contributions, their cost contribution share and their nonroutine
contributions, in this case the nanomotor and nanosensor technologies.

\(vi\) In step one of the residual profit split, USP and FS each
allocate an amount of income that is subtracted from their actual
territorial operating income for the taxable year to provide a market
return for their actual routine contributions in that year.

\(vii\) In step two, a portion of residual territorial operating profit
or loss after accounting for the allocation of income to routine
contributions in step one, will be allocated by USP and FS to their cost
contribution shares. The percentage allocable to the cost contribution
share in this case is equal to the each participant's share of total
anticipated IDCs divided by the difference between its total anticipated
operating profits in its territory and the total anticipated routine
return in its territory. It follows that the cost contribution shares of
USP and FS are as follows: USP = 50% (\$4 billion / \$8 billion) and FS
= 50% (\$6 billion / \$12 billion).

\(viii\) In step three, USP and FS each allocate a portion of their
residual territorial operating income remaining after application of
steps one and two between their respective nonroutine contributions. USP
and FS have estimated relative values for USP's nanomotor technology at
\$3 billion and FS's nanosensor technology at \$5 billion. The
percentage of each participant's residual territorial operating income
that is allocated to the nanomotor technology is therefore 37.5% (\$3
billion/(\$3 billion + \$5 billion)) and the percentage allocated to the
nanosensor technology is 62.5% (\$5 billion/(\$3 billion + \$5
billion)).

\(ix\) USP will owe a PCT Payment to FS equal to the amount of its
territorial operating profit or loss that is allocated in step three to
FS's nanosensor technology and FS will owe a PCT Payment to USP equal to
the amount of its territorial operating iprofit or loss that is
allocated in step three to USP's nanomotor technology. The PCT Payments
owed each year by USP and FS, respectively, will be netted against each
other, so that only one participant will make a net PCT Payment.

\(8\) [Unspecified methods]{.underline}. Methods not specified in
paragraphs (g)(3) through (7) of this section may be used to evaluate
whether the amount charged for a PCT is arm's length. Any method used
under this paragraph (g)(8) must be applied in accordance with the
provisions of §1.482-1 and of paragraph (g)(2) of this section.
Consistent with the specified methods, an unspecified method should take
into account the general principle that uncontrolled taxpayers evaluate
the terms of a transaction by considering the realistic alternatives to
that transaction, and only enter into a particular transaction if none
of the alternatives is preferable to it. Therefore, in establishing
whether a PCT achieved an arm's length result, an unspecified method
should provide information on the prices or profits that the controlled
participant could have realized by choosing a realistic alternative to
the CSA. As with any method, an unspecified method will not be applied
unless it provides the most reliable measure of an arm's length result
under the principles of the best method rule. See §1.482-1(c). In
accordance with §1.482-1(d) (Comparability), to the extent that an
unspecified method relies on internal data rather than uncontrolled
comparables, its reliability will be reduced. Similarly, the reliability
of a method will be affected by the reliability of the data and
assumptions used to apply the method, including any projections used.

\(h\) [Coordination with the arm's length standard]{.underline}. A CSA
produces results that are consistent with an arm's length result within
the meaning of §1.482-1(b)(1) if, and only if, each controlled
participant's IDC share (as determined under paragraph (d)(4) of this
section) equals its RAB share (as required by paragraph (a)(1) of this
section), and all other requirements of this section are satisfied.

\(i\) [Allocations by the Commissioner in connection with a
CSA]{.underline} \-- (1) [In general]{.underline}. The Commissioner may
make allocations to adjust the results of a controlled transaction in
connection with a CSA so that the results are consistent with an arm's
length result, in accordance with the provisions of this paragraph (i).

\(2\) [CST allocations]{.underline} \-- (i) [In general]{.underline}.
The Commissioner may make allocations to adjust the results of a CST so
that the results are consistent with an arm's length result, including
any allocations to make each controlled participant's IDC share, as
determined under paragraph (d)(4) of this section, equal to that
participant's RAB share, as determined under paragraph (e)(1) of this
section. Such allocations may result from, for purposes of CST
determinations, adjustments to \--

\(A\) Redetermine IDCs by adding any costs (or cost categories) that are
directly identified with, or are reasonably allocable to, the IDA, or by
removing any costs (or cost categories) that are not IDCs;

\(B\) Reallocate costs between the IDA and other business activities;

\(C\) Improve the reliability of the selection or application of the
basis used for measuring benefits for purposes of estimating a
controlled participant's RAB share;

\(D\) Improve the reliability of the projections used to estimate RAB
shares, including adjustments described in paragraph (i)(2)(ii) of this
section; and

\(E\) Allocate among the controlled participants any unallocated
interests in cost shared intangibles.

\(ii\) [Adjustments to improve the reliability of projections used to
estimate RAB shares]{.underline} \-- (A) [Unreliable
projections]{.underline}. A significant divergence between projected
benefit shares and benefit shares adjusted to take into account any
available actual benefits to date (adjusted benefit shares) may indicate
that the projections were not reliable for purposes of estimating RAB
shares. In such a case, the Commissioner may use adjusted benefit shares
as the most reliable measure of RAB shares and adjust IDC shares
accordingly. The projected benefit shares will not be considered
unreliable, as applied in a given taxable year, based on a divergence
from adjusted benefit shares for every controlled participant that is
less than or equal to 20% of the participant's projected benefits share.
Further, the Commissioner will not make an allocation based on such
divergence if the difference is due to an extra­ordinary event, beyond
the control of the controlled participants, which could not reasonably
have been anticipated at the time that costs were shared. The
Commissioner generally may adjust projections of benefits used to
calculate benefit shares in accordance with the provisions of §1.482-1.
In particular, if benefits are projected over a period of years, and the
projections for initial years of the period prove to be unreliable, this
may indicate that the projections for the remaining years of the period
are also unreliable and thus should be adjusted. For purposes of this
paragraph, all controlled partici­pants that are not U.S. persons are
treated as a single controlled participant. Therefore, an adjustment
based on an unreliable projection of RAB shares will be made to the IDC
shares of foreign controlled participants only if there is a matching
adjustment to the IDC shares of controlled participants that are U.S.
persons. Nothing in this paragraph (i)(2)(ii)(A) prevents the
Commissioner from making an allocation if taxpayer did not use the most
reliable basis for measuring anticipated benefits. For example, if the
taxpayer measures its anticipated benefits based on units sold, and the
Commissioner determines that another basis is more reliable for
measuring anticipated benefits, then the fact that actual units sold
were within 20% of the projected unit sales will not preclude an
allocation under this section.

\(B\) [Foreign-to-foreign adjustments]{.underline}. Adjustments to IDC
shares based on an unreliable projection also may be made solely among
foreign controlled participants if the variation between actual and
projected benefits has the effect of substantially reducing U.S. tax.

\(C\) [Correlative adjustments to PCTs]{.underline}. Correlative
adjustments will be made to any PCT Payments of a fixed amount that were
determined based on RAB shares which are subsequently adjusted on a
finding that they were based on unreliable projections. No correlative
adjustments will be made to contingent PCT Payments regardless of
whether RAB shares were used as a parameter in the valuation of those
payments.

\(D\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (i)(2)(ii):

[Example 1]{.underline}. U.S. Parent (USP) and Foreign Subsidiary (FS)
enter into a CSA to develop new food products, dividing costs on the
basis of projected sales two years in the future. In Year 1, USP and FS
project that their sales in Year 3 will be equal, and they divide costs
accordingly. In Year 3, the Commissioner examines the controlled
participants\' method for dividing costs. USP and FS actually accounted
for 42% and 58% of total sales, respectively. The Commissioner agrees
that sales two years in the future provide a reliable basis for
estimating benefit shares. Because the differences between USP\'s and
FS\'s adjusted and projected benefit shares are less than 20% of their
projected benefit shares, the projection of future benefits for Year 3
is reliable.

[Example 2]{.underline}. The facts are the same as in [Example
1]{.underline}, except that in Year 3 USP and FS actually accounted for
35% and 65% of total sales, respectively. The divergence between USP\'s
projected and adjusted benefit shares is greater than 20% of USP\'s
projected benefit share and is not due to an extraordinary event beyond
the control of the controlled participants. The Commissioner concludes
that the projected benefit shares were unreliable, and uses adjusted
benefit shares as the basis for an adjustment to the cost shares borne
by USP and FS.

[Example 3]{.underline}. U.S. Parent (USP), a U.S. corporation, and its
foreign subsidiary (FS) enter a CSA in Year 1. They project that they
will begin to receive benefits from covered intangibles in Years 4
through 6, and that USP will receive 60% of total benefits and FS 40% of
total benefits. In Years 4 through 6, USP and FS actually receive 50%
each of the total benefits. In evaluating the reliability of the
controlled participants\' projections, the Commissioner compares the
adjusted benefit shares to the projected benefit shares. Although USP\'s
adjusted benefit share (50%) is within 20% of its projected benefit
share (60%), FS\'s adjusted benefit share (50%) is not within 20% of its
projected benefit share (40%). Based on this discrepancy, the
Commissioner may conclude that the controlled participants\' projections
were not reliable and may use adjusted benefit shares as the basis for
an adjustment to the cost shares borne by USP and FS.

[Example 4]{.underline}. Three controlled taxpayers, USP, FS1 and FS2
enter into a CSA. FS1 and FS2 are foreign. USP is a United States
corporation that controls all the stock of FS1 and FS2. The controlled
participants project that they will share the total benefits of the
covered intangibles in the following percentages: USP 50%; FS1 30%; and
FS2 20%. Adjusted benefit shares are as follows: USP 45%; FS1 25%; and
FS2 30%. In evaluating the reliability of the controlled participants\'
projections, the Commissioner compares these adjusted benefit shares to
the projected benefit shares. For this purpose, FS1 and FS2 are treated
as a single controlled participant. The adjusted benefit share received
by USP (45%) is within 20% of its projected benefit share (50%). In
addition, the non-US controlled participants\' adjusted benefit share
(55%) is also within 20% of their projected benefit share (50%).
Therefore, the Commissioner concludes that the controlled participants\'
projections of future benefits were reliable, despite the fact that
FS2\'s adjusted benefit share (30%) is not within 20% of its projected
benefit share (20%).

[Example 5]{.underline}. The facts are the same as in [Example
4]{.underline}. In addition, the Commissioner determines that FS2 has
significant operating losses and has no earnings and profits, and that
FS1 is profitable and has earnings and profits. Based on all the
evidence, the Commissioner concludes that the controlled participants
arranged that FS1 would bear a larger cost share than appropriate in
order to reduce FS1\'s earnings and profits and thereby reduce
inclusions USP otherwise would be deemed to have on account of FS1 under
subpart F. Pursuant to paragraph (i)(2)(ii)(B) of this section, the
Commissioner may make an adjustment solely to the cost shares borne by
FS1 and FS2 because FS2\'s projection of future benefits was unreliable
and the variation between adjusted and projected benefits had the effect
of substantially reducing USP\'s U.S. income tax liability (on account
of FS1 subpart F income).

[Example 6]{.underline}. (i)(A) Foreign Parent (FP) and U.S. Subsidiary
(USS) enter into a CSA in 1996 to develop a new treatment for baldness.
USS\'s interest in any treatment developed is the right to produce and
sell the treatment in the U.S. market while FP retains rights to produce
and sell the treatment in the rest of the world. USS and FP measure
their anticipated benefits from the cost sharing arrangement based on
their respective projected future sales of the baldness treatment. The
following sales projections are used:

> Sales

\[In millions of dollars\]

Year USS FP

1 5 10

2 20 20

3 30 30

4 40 40

5 40 40

6 40 40

7 40 40

8 20 20

9 10 10

10 5 5

\(B\) In Year 1, the first year of sales, USS is projected to have lower
sales than FP due to lags in U.S. regulatory approval for the baldness
treatment. In each subsequent year USS and FP are projected to have
equal sales. Sales are projected to build over the first three years of
the period, level off for several years, and then decline over the final
years of the period as new and improved baldness treatments reach the
market.

\(ii\) To account for USS\'s lag in sales in the Year 1, the present
discounted value of sales over the period is used as the basis for
measuring benefits. Based on the risk associated with this venture, a
discount rate of 10 percent is selected. The present discounted value of
projected sales is determined to be approximately \$154.4 million for
USS and \$158.9 million for FP. On this basis USS and FP are projected
to obtain approximately 49.3% and 50.7% of the benefit, respectively,
and the costs of developing the baldness treatment are shared
accordingly.

\(iii\) (A) In Year 6 the Commissioner examines the cost sharing
arrangement. USS and FP have obtained the following sales results
through the Year 5:

Sales

\[In millions of dollars\]

Year USS FP

1 0 17

2 17 35

3 25 41

4 38 41

5 39 41

\(B\) USS\'s sales initially grew more slowly than projected while FP\'s
sales grew more quickly. In each of the first three years of the period
the share of total sales of at least one of the parties diverged by over
20% from its projected share of sales. However, by Year 5 both parties\'
sales had leveled off at approximately their projected values. Taking
into account this leveling off of sales and all the facts and
circumstances, the Commissioner determines that it is appropriate to use
the original projections for the remaining years of sales. Combining the
actual results through Year 5 with the projections for subsequent years,
and using a discount rate of 10%, the present discounted value of sales
is approximately \$141.6 million for USS and \$187.3 million for FP.
This result implies that USS and FP obtain approximately 43.1% and
56.9%, respectively, of the anticipated benefits from the baldness
treatment. Because these adjusted benefit shares are within 20% of the
benefit shares calculated based on the original sales projections, the
Commissioner determines that, based on the difference between adjusted
and projected benefit shares, the original projections were not
unreliable. No adjustment is made based on the difference between
adjusted and projected benefit shares.

[Example 7]{.underline}. (i) The facts are the same as in [Example
6]{.underline}, except that the actual sales results through Year 5 are
as follows:

Sales

\[In millions of dollars\]

Year USS FP

1 0 17

2 17 35

3 25 44

4 34 54

5 36 55

\(ii\) Based on the discrepancy between the projections and the actual
results and on consideration of all the facts, the Commissioner
determines that for the remaining years the following sales projections
are more reliable than the original projections:

Sales

\[In millions of dollars\]

Year USS FP

6 36 55

7 36 55

8 18 28

9 9 14

10 4.5 7

\(iii\) Combining the actual results through Year 5 with the projections
for subsequent years, and using a discount rate of 10%, the present
discounted value of sales is approximately \$131.2 million for USS and
\$229.4 million for FP. This result implies that USS and FP obtain
approximately 35.4% and 63.6%, respectively, of the anticipated benefits
from the baldness treatment. These adjusted benefit shares diverge by
greater than 20% from the benefit shares calculated based on the
original sales projections, and the Commissioner determines that, based
on the difference between adjusted and projected benefit shares, the
original projections were unreliable. The Commissioner adjusts costs
shares for each of the taxable years under examination to conform them
to the recalculated shares of anticipated benefits.

\(iii\) [Timing of CST allocations]{.underline}. If the Commissioner
makes an allocation to adjust the results of a CST, the allocation must
be reflected for tax purposes in the year in which the IDCs were
incurred. When a cost sharing payment is owed by one controlled
participant to another controlled participant, the Commissioner may make
appropriate allocations to reflect an arm's length rate of interest for
the time value of money, consistent with the provisions of §1.482-2(a)
(Loans or advances).

\(3\) [PCT allocations]{.underline}. The Commissioner may make
allocations to adjust the results of a PCT so that the results are
consistent with an arm's length result in accordance with the provisions
of the applicable sections of the section 482 regulations, as deter­mined
pursuant to paragraph (a)(2) of this section.

\(4\) [Allocations regarding changes in participation under a
CSA]{.underline}. The Commissioner may make allocations to adjust the
results of any controlled transaction described in paragraph (f) of this
section, if the controlled participants do not reflect arm's length
results in relation to any such transaction.

\(5\) [Allocations when CSTs are consistently and materially
disproportionate to RAB shares]{.underline}. If a controlled participant
bears IDC shares that are consistently and materially greater or lesser
than its RAB share, then the Commissioner may conclude that the economic
substance of the arrangement between the controlled participants is
inconsistent with the terms of the CSA. In such a case, the Commissioner
may disregard such terms and impute an agreement that is consistent with
the controlled participants' course of conduct, under which a controlled
participant that bore a disproportionately greater IDC share received
additional interests in the cost shared intangibles. See
§1.482-1(d)(3)(ii)(B) (Identifying contractual terms) and
§1.482-4(f)(3)(ii) (Identification of owner). Such additional interests
will consist of partial undivided interests in another controlled
participant's territory. Accordingly, that controlled participant must
receive arm's length consideration from any controlled participant whose
IDC share is less than its RAB share over time, under the provisions of
§§1.482-1 and 1.482-4 through 1.482-6.

\(6\) [Periodic adjustments]{.underline} \-- (i) [In
general]{.underline}. Subject to the exceptions in paragraph (i)(6)(vi)
of this section, the Commissioner may make periodic adjustments with
respect to all PCT Payments for an open taxable year (the Adjustment
Year), and for all subsequent taxable years for the duration of the CSA
Activity, if the Commissioner determines that, for a particular PCT (the
Trigger PCT), a particular controlled participant that owes or owed a
PCT Payment relating to that PCT (the PCT Payor) has realized an
Actually Experienced Return Ratio (AERR) that is outside the Periodic
Return Ratio Range (PRRR). The satisfaction of the condition stated in
the preceding sentence is referred to as a Periodic Trigger. See
paragraph (i)(6)(ii) through (vi) of this section regarding the PRRR,
the AERR, and periodic adjustments. In determining whether to make such
adjustments, the Commissioner may consider whether the outcome as
adjusted more reliably reflects an arm's length result under all the
relevant facts and circumstances, including any information known as of
the Determination Date. The Determination Date is the date of the
relevant determination by the Commissioner. The failure of the
Commissioner to determine for an earlier taxable year that a PCT Payment
was not arm's length will not preclude the Commissioner from making a
periodic adjustment for a subsequent year. A periodic adjustment under
this paragraph may be made without regard to whether the taxable year of
the Trigger PCT or any other PCT remains open for statute of limitations
purposes.

\(ii\) [PRRR]{.underline}. Except as provided in the next sentence, the
PRRR will consist of return ratios that are not less than 1/2 nor more
than 2. Alternatively, if the controlled participants have not
substantially complied with the documentation requirements referenced in
paragraph (k) of this section, as modified, if applicable, by paragraph
(m)(3) of this section, the PRRR will consist of the return ratios that
are not less than .67 nor more than 1.5.

\(iii\) [AERR]{.underline}. (A) [In general]{.underline}. The AERR is
the Present Value of Total Profits (PVTP) divided by the Present Value
of Investment (PVI). In computing PVTP and PVI, present values are
computed using the Applicable Discount Rate (ADR), and all information
available as of the Determination Date is taken into account.

\(B\) [PVTP]{.underline}. The PVTP is the present value, as of the
earliest date that any IDC described in paragraph (d)(1) of this section
occurred (the CSA Start Date), of the PCT Payor's actually experienced
territorial operating profits, as defined in paragraph (j)(1)(vi) of
this section, from the CSA Start Date through the end of the Adjustment
Year.

\(C\) [PVI]{.underline}. The PVI is the present value, as of the CSA
Start Date, of the PCT Payor's investment associated with the CSA
Activity, defined as the sum of its cost contributions and its PCT
Payments, from the CSA Start Date through the end of the Adjustment
Year. For purposes of computing the PVI, PCT Payments means all PCT
Payments due from a PCT Payor before netting against PCT Payments due
from other controlled participants.

\(iv\) [ADR]{.underline} \-- (A) [In general]{.underline}. Except as
provided in paragraph (i)(6)(iv)(B) of this section, the ADR is the
discount rate pursuant to paragraph (g)(2)(vi) of this section, subject
to such adjustments as the Commissioner determines appropriate.

\(B\) [Publicly traded companies]{.underline}. If the PCT Payor meets
the conditions of paragraph (i)(6)(iv)(C) of this section, the ADR is
the PCT Payor WACC as of the date of the trigger PCT. However, if the
Commissioner determines, or the controlled participants establish to the
Commissioner\'s satisfaction, that a discount rate other than the PCT
Payor WACC better reflects the degree of risk of the CSA Activity as of
such date, the ADR is such other discount rate.

\(C\) [Publicly traded]{.underline}. A PCT Payor meets the conditions of
this paragraph (i)(6)(iv)(C) if \--

([1]{.underline}) Stock of the PCT Payor is publicly traded; or

([2]{.underline}) Stock of the PCT Payor is not publicly traded,
provided \--

([i]{.underline}) The PCT Payor is included in a group of companies for
which consolidated financial statements are prepared; and

([ii]{.underline}) A publicly traded company in such group owns,
directly or indirectly, stock in PCT Payor. Stock of a company is
publicly traded within the meaning of this paragraph (i)(6)(iv)(C) if
such stock is regularly traded on an established United States
securities market and the company issues financial statements prepared
in accordance with United States generally accepted accounting
principles for the taxable year.

\(D\) [PCT Payor WACC]{.underline}. The PCT Payor WACC is the WACC of
the PCT Payor or the publicly traded company described in paragraph
(i)(6)(iv)(C)([2]{.underline}) of this section, as the case may be.

\(E\) [Generally accepted accounting principles]{.underline}. For
purposes of paragraph (i)(6)(iv)(C) of this section, a financial
statement prepared in accordance with a comprehensive body of generally
accepted accounting principles other than United States generally
accepted accounting principles is considered to be prepared in
accordance with United States generally accepted accounting principles
provided that the amounts of debt, equity and interest expense are
reflected in the reconciliation between such other accounting principles
and United States generally accepted accounting principles required to
be incorporated into the financial statement by the securities laws
governing companies whose stock is regularly traded on United States
securities markets.

\(v\) [Determination of periodic adjustments]{.underline}. In the event
of a Periodic Trigger, subject to paragraph (i)(6)(vi) of this section,
the Commissioner may make periodic adjustments with respect to all PCT
Payments between all PCT Payors and PCT Payees for the Adjustment Year
and all subsequent years for the duration of the CSA Activity pursuant
to the residual profit split method as provided in paragraph (g)(7) of
this section, subject to the further modifications in this paragraph
(i)(6)(v).

\(A\) If the AERR is less than the PRRR, then the cost contribution
share of residual profit or loss under paragraph
(g)(7)(iii)(C)([2]{.underline}) of this section is determined as
follows:

([1]{.underline}) The relevant date specified in that paragraph is the
CSA Start Date. However, the effect of using such relevant date is
modified as specified in paragraphs (i)(6)(vi)(A)([2]{.underline}) and
(i)(6)(vi)(A)([3]{.underline}) of this section.

([2]{.underline}) The discount rate to be used in paragraph
(g)(7)(iii)(C)([2]{.underline}) of this section is determined as of the
relevant date, but taking into account any data relevant to such
determination that may become available up through the Determination
Date.

([3]{.underline}) The present values of the summations described in
paragraph (g)(7)(iii)(C)([2]{.underline}) of this section are determined
by substituting actual results up through the Determination Date, and
future results anticipated on that date, for the results anticipated on
the relevant date. It is possible that, because of these substitutions,
the resulting fraction determined in that paragraph will be greater than
one.

\(B\) If the AERR is greater than the PRRR, then the cost contribution
share of residual profit or loss under paragraph
(g)(7)(iii)(C)([2]{.underline}) of this section is determined as
follows:

([1]{.underline}) The relevant date specified in that paragraph is the
first day of the Adjustment Year. However, the effect of using such
relevant date is modified as specified in paragraphs
(i)(6)(vi)(B)([2]{.underline}) and (i)(6)(vi)(B)([3]{.underline}) of
this section.

([2]{.underline}) The discount rate to be used in paragraph
(g)(7)(iii)(C)([2]{.underline}) of this section is determined as of the
relevant date, but taking into account any data relevant to such
determination that may become available up through the Determination
Date.

([3]{.underline}) In computing the fraction described in paragraph
(g)(7)(iii)(C)([2]{.underline}) of this section, the summation period
described in that paragraph is modified to start on the first day of the
Adjustment Year; thus, the summations described in that paragraph that
are used to determine that fraction will not include any items relating
to periods before the first day of the Adjustment Year.

\(C\) The relative value of nonroutine contributions in paragraph
(g)(7)(iii)(C)([3]{.underline}) of this section are determined as
described in that paragraph, but taking into account any data relevant
to such determination that may become available up through the
Determination Date.

\(D\) For these purposes, the residual profit split method may be used
even where only one controlled participant makes significant nonroutine
contributions to the CSA Activity. If only one controlled participant
provides all the external contributions and other nonroutine
contributions, then the third step residual profit or loss belongs
entirely to such controlled participant.

\(vi\) [Exceptions to periodic adjustments]{.underline} \-- (A)
[Transactions involving the same external contribution as in the
PCT]{.underline}. If \--

([1]{.underline}) The same external contribution is furnished to an
uncontrolled taxpayer under substantially the same circumstances as
those of the relevant RT (as defined in paragraph (b)(3)(iii) of this
section) and with a similar form of payment as the PCT;

([2]{.underline}) This transaction serves as the basis for the
application of the comparable uncontrolled transaction method described
in §1.482-4(c), or the arm's length charge described in
§1.482-2(b)(3)(first sentence) based on a comparable uncontrolled
transaction, in the first year in which substantial PCT Payments
relating to this PCT were required to be paid; and

([3]{.underline}) The amount of those PCT Payments in that year was
arm's length; then no periodic adjustment that uses that PCT as the
Trigger PCT will be made under paragraphs (i)(6)(i) and (i)(6)(v) of
this section.

\(B\) [Results not reasonably anticipated]{.underline}. If the
controlled participants establish to the satisfaction of the
Commissioner that the differential between the AERR and the nearest
bound of the PRRR is due to extraordinary events beyond its control and
that could not reasonably have been anticipated at the time of the
Trigger PCT, then no periodic adjustment will be made under paragraphs
(i)(6)(i) and (i)(6)(v) of this section.

\(C\) [Reduced AERR does not cause Periodic Trigger]{.underline}. If the
controlled participants establish to the satisfaction of the
Commissioner that the Periodic Trigger would not have occurred had the
PCT Payor's operating profits used to calculate its PVTP excluded those
operating profits attributable to the PCT Payor's routine contributions
to its exploitation of cost shared intangibles, and nonroutine
contributions to the CSA Activity, then no periodic adjustment will be
made under paragraphs (i)(6)(i) and (i)(6)(v) of this section.

\(D\) [Increased AERR does not cause Periodic Trigger]{.underline} \--
([1]{.underline}) If the controlled participants establish to the
satisfaction of the Commissioner that the Periodic Trigger would not
have occurred had the operating profits of the PCT Payor used to
calculate its PVTP included its reasonably anticipated operating profits
after the Adjustment Year from the CSA Activity, including from routine
contributions to that activity, and had the cost contributions and PCT
Payments of the PCT Payor used to calculate its PVI included its
reasonably anticipated cost contributions and PCT Payments after the
Adjustment Year, then no periodic adjustment will be made under
paragraphs (i)(6)(i) and (i)(6)(v) of this section. The reasonably
anticipated amounts in the previous sentence are determined based on all
information available as of the Determination Date.

([2]{.underline}) For purposes of this paragraph (i)(6)(vii)(D) of this
section, the controlled participants may, if they wish, assume that the
average yearly operating profits for all taxable years prior to and
including the Adjustment Year, in which there has been substantial
exploitation of cost shared intangibles resulting from the CSA
(exploitation years), will continue to be earned in each year over a
period of years equal to 15 minus the number of exploitation years prior
to and including the Determination Date.

\(E\) [10-year period]{.underline}. If the AERR determined is within the
PRRR for each year of the 10-year period beginning with the first
taxable year in which there is substantial exploitation of cost shared
intangibles resulting from the CSA is, then no periodic adjustment in a
subsequent year will be made under paragraphs (i)(6)(i) and (i)(6)(v) of
this section.

\(F\) [5-year period]{.underline}. For any year of the 5-year period
beginning with the first taxable year in which there is substantial
exploitation of cost shared intangibles resulting from the CSA, no
Periodic Trigger will be considered to occur as a result of a
determination that the AERR falls below the lower bound of the PRRR.

\(vii\) [Examples]{.underline}. The following examples illustrates the
principles of this paragraph (i)(6):

[Example 1]{.underline}. (i) At the beginning of Year 1, USP, a publicly
traded U.S. company, and FS, its wholly-owned foreign subsidiary, enter
into a CSA to develop new technology for wireless cell phones. As part
of a PCT, USP furnishes an external contribution, the RT Rights for an
in-process technology that when developed will improve the clarity of
cell to cell calls, for which compensation is due from FS. FS furnishes
no external contributions to the CSA. The weighted average cost of
capital of the controlled group that includes USP and FS in Year 1 is
15%. In Year 10, the Commissioner audits Years 1 through 8 of the CSA to
determine whether or not any periodic adjustments should be made. USP
and FS have substantially complied with the documentation requirements
of this section.

\(ii\) FS derives the following actual cash flow from its participation
in the CSA. The cash flows include the lump sum PCT of \$100 million
made by FS to USP. The derivation of such PCT Payment was based on
financial projections undertaken in Year 1 (not shown). (All amounts in
this table and the tables that follow are in millions.)

+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| Year  | Sa  | N   | I   | PCT | To  | Operating | Expl     | A   |
|       | les | on- | DCs |     | tal | profits   | oitation | ERR |
|       |     | IDC |     | Pay | i   | (Ac       | Profits  |     |
|       |     | Co  |     |     | nv. | counting) |          |     |
|       |     | sts |     | me  | co  |           |          |     |
|       |     |     |     | nts | sts |           |          |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| 1     | 0   | 0   | 15  | 100 | 115 | -115      | 0        |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| 2     | 0   | 0   | 17  | 0   | 17  | -17       | 0        |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| 3     | 0   | 0   | 18  | 0   | 18  | -18       | 0        |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| 4     | 780 | 562 | 20  | 0   | 20  | 198       | 218      |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| 5     | 936 | 618 | 22  | 0   | 22  | 296       | 318      |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| 6     | 1,  | 680 | 24  | 0   | 24  | 420       | 444      |     |
|       | 123 |     |     |     |     |           |          |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| 7     | 1,  | 747 | 27  | 0   | 27  | 405       | 432      |     |
|       | 179 |     |     |     |     |           |          |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| 8     | 1,  | 822 | 29  | 0   | 29  | 387       | 416      |     |
|       | 238 |     |     |     |     |           |          |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| NPV   | 1   | 722 | 69  | 100 | 169 | 157       | 326      | 1.9 |
| th    | 048 |     |     |     |     |           |          |     |
| rough |     |     |     |     |     |           |          |     |
| Year  |     |     |     |     |     |           |          |     |
| 5     |     |     |     |     |     |           |          |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| NPV   | 1   | 1,  | 81  | 100 | 181 | 365       | 546      | 3.0 |
| th    | 606 | 060 |     |     |     |           |          |     |
| rough |     |     |     |     |     |           |          |     |
| Year  |     |     |     |     |     |           |          |     |
| 6     |     |     |     |     |     |           |          |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+
| NPV   | 2   | 1,  | 92  | 100 | 192 | 541       | 733      | 3.8 |
| th    | 116 | 383 |     |     |     |           |          |     |
| rough |     |     |     |     |     |           |          |     |
| Year  |     |     |     |     |     |           |          |     |
| 7     |     |     |     |     |     |           |          |     |
+-------+-----+-----+-----+-----+-----+-----------+----------+-----+

\(iii\) Because USP is publicly traded in the United States and is a
member of the controlled group to which the PCT Payor, FS, belongs, for
purposes of calculating the AERR for FS, the present values of its PVTP
and PVI are determined using an ADR of 15%, the weighted average cost of
capital of the controlled group. At a 15% discount rate, the PVTP,
calculated in Year 8 as of Year 1, and based on actual profits realized
by FS through Year 7 from exploiting the new wireless cell phone
technology developed by the CSA, is \$733 million. The PVI, based on
FS's IDCs and its compensation expenditures pursuant to the PCT, is
\$192 million. The AERR for FS is equal to its PVTP divided by its PVI,
\$733 million/\$192 million, or 3.8. There is a Periodic Trigger because
FS's AERR of 3.8 falls outside the PRRR of 1/2 to 2, the applicable PRRR
for controlled participants complying with the documentation
requirements of this section.

\(iv\) At the time of the Determination Date, it is determined that the
first Adjustment Year in which a Periodic Trigger occurred was Year 6,
when the AERR of FS was determined to be 3.0. It is also determined that
none of the exceptions to periodic adjustments described in paragraph
(i)(6)(vi) of this section applies. It follows that the arm's length PCT
Payments made by FS from Year 6 forward shall be determined each taxable
year using the residual profit split method described in paragraph
(g)(7) of this section as modified by paragraph (i)(6)(v) of this
section. Periodic adjustments will be made to the extent the PCT
Payments actually made by FS differ from the PCT Payment calculation
under the residual profit split.

\(v\) Actual and projected IDCs, territorial operating profits and
returns to routine contributions for the remainder of the exploitation
of the cost shared intangibles, determined as of the beginning of Year 6
are as follows:

+---------------+--------+-----------+--------------+-----------------+
| Year          | IDCs   | Te        | Return to    | Profits less    |
|               |        | rritorial | routine      | routine return  |
|               |        | operating | c            |                 |
|               |        |           | ontributions |                 |
|               |        | profits   |              |                 |
+---------------+--------+-----------+--------------+-----------------+
| 6             | 24     | 444       | 68           | 376             |
+---------------+--------+-----------+--------------+-----------------+
| 7             | 27     | 432       | 75           | 357             |
+---------------+--------+-----------+--------------+-----------------+
| 8             | 29     | 416       | 82           | 334             |
+---------------+--------+-----------+--------------+-----------------+
| 9 (Projected) | 32     | 396       | 90           | 305             |
+---------------+--------+-----------+--------------+-----------------+
| 10            | 35     | 370       | 99           | 271             |
| (Projected)   |        |           |              |                 |
+---------------+--------+-----------+--------------+-----------------+
| Total PV as   | 116    | 1666      | 326          | 1340            |
| of Year 6     |        |           |              |                 |
+---------------+--------+-----------+--------------+-----------------+

\(vi\) Under step one of the residual profit split method, for each
taxable year, FS will be allocated a portion of its actual territorial
operating income for the taxable year to provide a market return for its
actual routine contributions in that year. As a result of a transfer
pricing analysis, the Commissioner determines that the return to FS's
routine activities, based on the return for comparable routine functions
undertaken by comparable unrelated companies, is 10% of non-IDC costs.
The allocations of actual territorial profits in Years 6 through 8 are
as follows:

+----------------+------------------+-----------------+---------------+
| Year           | Territorial      | Return to       | Residual      |
|                | operating        | routine         | profits after |
|                |                  | contributions   | step 1        |
|                | profits          |                 |               |
+----------------+------------------+-----------------+---------------+
| 6              | 444              | 68              | 376           |
+----------------+------------------+-----------------+---------------+
| 7              | 432              | 75              | 357           |
+----------------+------------------+-----------------+---------------+
| 8              | 416              | 82              | 334           |
+----------------+------------------+-----------------+---------------+

\(vii\) Under step two, a portion of the residual territorial operating
profit or loss after the allocation of profit to routine contributions
in step one will be allocated by FS to its cost contribution share. The
percentage allocable to the cost contribution share is equal to FS's
share of the total anticipated IDCs divided by its total anticipated
territorial operating profits reduced by total expected return to its
routine contributions to the exploitation of the cost shared technology
in its territory. All amounts are determined as present values as of the
first day of Year 6, using an appropriate discount rate on that date,
and do not include any amounts relating to periods before the first day
of Year 6. Following these rules, it is determined that the present
value of FS's share of the total anticipated IDCs after the first day of
Year 6 is \$116 million and its total anticipated territorial operating
profits reduced by the return to its routine contributions is \$1,340
million. It follows that the percentage of residual territorial
operating profit or loss allocated to FS's cost contribution share is
8.6% (\$116/\$1,340). The allocation of actual residual profits after
Step 1 in Years 6 through 8 is as follows:

  ----------------- ------------------ ------------------ ----------------
  Year              Residual profits   Step 2 profits     Residual profits
                    after step 1       allocated to FS    after step 2

  6                 376                32                 344

  7                 357                31                 327

  8                 334                29                 305
  ----------------- ------------------ ------------------ ----------------

\(viii\) In step three, because USP provided the only nonroutine
contributions to the CSA Activity, 100% of FS's residual operating
income after steps one and two is allocated to USP's external
contributions and therefore represents the amount of the PCT Payment due
from FS to USP for the particular taxable year. Also because USP
provided the only nonroutine contributions to the CSA Activity, none of
its residual territorial operating profit or loss is attributable to FS,
therefore no offsetting PCT Payment is due from USP to FS. The PCT
Payments due and adjustments made in Years 6 through 8 are as follows:

  ------------- ----------------- ------------- ------------ --------------
  Year          Residual profits  PCT Payment   Actual PCT   Adjustment
                after step 2      due from FS   Payment made 
                                  to USP                     

  6             344               344           0            344

  7             327               327           0            327

  8             305               305           0            305
  ------------- ----------------- ------------- ------------ --------------

[Example 2]{.underline}. The facts are the same as [Example
1]{.underline} paragraphs (i) through (iii). At the time of the
Determination Date, it is determined that the first Adjustment Year in
which a Periodic Trigger occurred was Year 6, when the AERR of FS was
determined to be 3.0. Upon further investigation as to what may have
caused the high return in FS's market, the Commissioner learns that, in
Year 4, significant health risks were linked to the use of wireless cell
phones of USP's leading competitors. No such health risk was linked to
the cell phones developed by USP and FS under the CSA. This resulted in
a significant increase in USP's and FS's market share for cellular
phones. Further analysis determines that it was this unforeseen
occurrence that was primarily responsible for the AERR trigger. Based on
paragraph (i)(6)(vi)(B) of this section, the Commissioner concludes that
no adjustments are warranted, as FS simply has earned the premium return
that any such investor would earn under the circumstances.

\(j\) [Definitions and special rules]{.underline} \-- (1)
[Definitions]{.underline}. For purposes of this section:

\(i\) [Controlled participant]{.underline} means a controlled taxpayer,
as defined under §1.482-1(i)(5), that is a party to the contractual
agreement that underlies the CSA, and that reasonably anticipates that
it will derive benefits, as defined in paragraph (j)(1)(iv) of this
section, from exploiting one or more cost shared intangibles.

\(ii\) [Cost shared intangible]{.underline} means any intangible, within
the meaning of §1.482-4(b), developed or to be developed as a result of
the IDA, as described in paragraph (d)(1) of this section, including any
portion of such intangible that reflects an external contribution, as
described in paragraph (b)(3)(ii) of this section.

\(iii\) An [interest in an intangible]{.underline} includes any
commercially transferable interest, the benefits of which are
susceptible of valuation.

\(iv\) [Benefits]{.underline} mean the sum of additional revenue
generated, plus cost savings, minus any cost increases from exploiting
cost shared intangibles.

\(v\) A controlled participant's [reasonably anticipated
benefits]{.underline} mean the aggregate benefits that reasonably may be
anticipated to be derived from exploiting cost shared intangibles.

\(vi\) [Territorial operating profit or loss]{.underline} means the
operating profit or loss as separately earned by each controlled
participant in its geographic territory, described in paragraph (b)(4)
of this section, from the CSA activity, determined before any expense
(including amortization) on account of IDCs, routine external
contributions, and nonroutine contributions.

\(vii\) The [CSA Activity]{.underline} is the activity of developing and
exploiting cost shared intangibles.

\(viii\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (j)(1):

[Example 1]{.underline}. [Controlled participant]{.underline}. Foreign
Parent (FP) is a foreign corporation engaged in the extraction of a
natural resource. FP has a U.S. subsidiary (USS) to which FP sells
supplies of this resource for sale in the United States. FP enters into
a CSA with USS to develop a new machine to extract the natural resource.
The machine uses a new extraction process that will be patented in the
United States and in other countries. The CSA provides that USS will
receive the rights to exploit the machine in the extraction of the
natural resource in the United States, and FP will receive the rights in
the rest of the world. This resource does not, however, exist in the
United States. Despite the fact that USS has received the right to
exploit this process in the United States, USS is not a controlled
participant because it will not derive a benefit from the exploiting the
intangible developed under the CSA.

[Example 2]{.underline}.  [Controlled participants]{.underline}.  (i)
U.S. Parent (USP), one foreign subsidiary (FS), and a second foreign
subsidiary constituting the group\'s research arm (R+D) enter into a CSA
to develop manufacturing intangibles for a new product line A. USP and
FS are assigned the exclusive rights to exploit the intangibles
respectively in the United States and the rest of the world, where each
presently manufactures and sells various existing product lines. R+D is
not assigned any rights to exploit the intangibles. R+D\'s activity
consists solely in carrying out research for the group. It is reliably
projected that the RAB shares of USP and FS will be 66 2/3% and 33 1/3%,
respectively, and the parties\' agreement provides that USP and FS will
reimburse 66 2/3% and 33 1/3%, respectively, of the IDCs incurred by R+D
with respect to the new intangible.

\(ii\) R+D does not qualify as a controlled participant within the
meaning of paragraph (j)(1)(i) of this section, because it will not
derive any benefits from exploiting cost shared intangibles. Therefore,
R+D is treated as a service provider for purposes of this section and
must receive arm\'s length consideration for the assistance it is deemed
to provide to USP and FS, under the rules of paragraph (a)(3) of this
section and §1.482-4(f)(3)(iii). Such consideration must be treated as
IDCs incurred by USP and FS in proportion to their RAB shares (i.e., 66
2/3% and 33 1/3%, respectively). R+D will not be considered to bear any
share of the IDCs under the arrangement.

[Example 3]{.underline}. [Cost shared intangible]{.underline}. U.S.
Parent (USP) has developed and currently exploits an antihistamine, XY,
which is manufactured in tablet form. USP enters into a CSA with its
wholly-owned foreign subsidiary (FS) to develop XYZ, a new improved
version of XY that will be manufactured as a nasal spray. XYZ is a cost
shared intangible under the CSA.

[Example 4]{.underline}. [Cost shared intangible]{.underline}. The facts
are the same as in [Example 3]{.underline}, except that instead of
developing XYZ, the controlled participants develop ABC, a cure for the
common cold. ABC is a cost shared intangible under the CSA.

[Example 5]{.underline}. [Reasonably anticipated benefits]{.underline}.
Controlled parties A and B enter into a cost sharing arrangement to
develop product and process intangibles for an already existing Product
P. Without such intangibles, A and B would each reasonably anticipate
revenue, in present value terms, of \$100M from sales of Product P until
it became obsolete. With the intangibles, A and B each reasonably
anticipate selling the same number of units each year, but reasonably
anticipate that the price will be higher. Because the particular product
intangible is more highly regarded in A\'s market, A reasonably
anticipates an increase of \$20M in present value revenue from the
product intangible, while B reasonably anticipates only an increase of
\$10M. Further, A and B each reasonably anticipate spending an extra
\$5M present value in production costs to include the feature embodying
the product intangible. Finally, A and B each reasonably anticipate
saving \$2M present value in production costs by using the process
intangible. A and B reasonably anticipate no other economic effects from
exploiting the cost shared intangibles. A\'s reasonably anticipated
benefits from exploiting the cost shared intangibles equal its
reasonably anticipated increase in revenue (\$20M) plus its reasonably
anticipated cost savings (\$2M) minus its reasonably anticipated
increased costs (\$5M), which equals \$17M. Similarly, B\'s reasonably
anticipated benefits from exploiting the cost shared intangibles equal
its reasonably anticipated increase in revenue (\$10M) plus its
reasonably anticipated cost savings (\$2M) minus its reasonably
anticipated increased costs (\$5M), which equals \$7M. Thus A\'s
reasonably anticipated benefits are \$17M and B\'s reasonably
anticipated benefits are \$7M.

\(2\) [Special rules]{.underline} \-- (i) [Consolidated
group]{.underline}. For purposes of this section, all members of the
same consolidated group shall be treated as one taxpayer. For purposes
of this paragraph (j)(2)(i), the term [consolidated group]{.underline}
means all members of a group of controlled entities created or organized
within a single country and subjected to an income tax by such country
on the basis of their combined income.

\(ii\) [Trade or business]{.underline}.  A participant that is a foreign
corporation or nonresident alien individual will not be treated as
engaged in a trade or business within the United States solely by reason
of its participation in a CSA described in paragraph (b)(1) of this
section. See generally §1.864-2(a).

\(iii\) [Partnership]{.underline}. A CSA, or an arrangement to which the
Commissioner applies the rules of this section, will not be treated as a
partnership to which the rules of subchapter K of the Internal Revenue
Code apply. See §301.7701-1(c) of this chapter.

\(3\) [Character]{.underline} \-- (i) [In general]{.underline}. CST
payments generally will be considered costs of developing intangibles of
the payor and reimbursements of the same kind of costs of developing
intangibles of the payee. For purposes of this paragraph (j)(3), a
controlled participant's payment required under a CSA is deemed to be
reduced to the extent of any payments owed to it under the CSA from
other controlled participants. Each payment received by a payee will be
treated as coming pro rata from payments made by all payors. Such
payments will be applied pro rata against deductions for the taxable
year that the payee is allowed in connection with the CSA. Payments
received in excess of such deductions will be treated as in
consideration for use of the land and tangible property furnished for
purposes of the CSA by the payee. For purposes of the research credit
determined under section 41, cost sharing payments among controlled
participants will be treated as provided for intra-group transactions in
§1.41-6(e). Any payment made or received by a taxpayer pursuant to an
arrangement that the Commissioner determines not to be a CSA will be
subject to the provisions of §§1.482-1 and 1.482-4 through 1.482-6. Any
payment that in substance constitutes a cost sharing payment will be
treated as such for purposes of this section, regardless of its
characterization under foreign law.

\(ii\) [PCT Payments]{.underline}. A PCT Payor's payment required under
paragraphs (b)(1)(ii) and (b)(3) of this section is deemed to be reduced
to the extent of any payments owed to it under such paragraphs from
other controlled participants. Each PCT Payment received by a PCT Payee
will be treated as coming pro rata out of payments made by all PCT
Payors. PCT Payments will be characterized consistently with the
designation of the type of transaction involved in the RT pursuant to
paragraph (b)(iv) of this section. Depending on such designation, such
payments will be treated as either consideration for a transfer of an
interest in intangible property or for services.

\(iii\) [Examples]{.underline}. The following examples illustrate this
paragraph (j)(3):

[Example 1]{.underline}. U.S. Parent (USP) and its wholly owned Foreign
Subsidiary (FS) form a CSA to develop a miniature widget, the Small R.
Based on RAB shares, USP agrees to bear 40% and FS to bear 60% of the
costs incurred during the term of the agreement. The principal IDCs are
operating costs incurred by FS in Country Z of 100X annually, and costs
incurred by USP in the United States also of 100X annually. Of the total
costs of 200X, USP's share is 80X and FS's share is 120X. The payment
will be treated as a reimbursement of 20X of USP's costs in the United
States. Accordingly, USP's Form 1120 will reflect an 80X deduction on
account of activities performed in the United States for purposes of
allocation and apportionment of the deduction to source. The Form 5471
for FS will reflect a 100X deduction on account of activities performed
in Country Z, and a 20X deduction on account of activities performed in
the United States.

[Example 2]{.underline}. The facts are the same as in [Example
1]{.underline}, except that the 100X of costs borne by USP consist of 5X
of costs incurred by USP in the United States and 95X of arm's length
rental charge, as described in paragraph (d)(1) of this section, for the
use of a facility in the United States. The depreciation deduction
attributable to the U.S. facility is 7X. The 20X net payment by FS to
USP will first be applied in reduction pro rata of the 5X deduction for
costs and the 7X depreciation deduction attributable to the U.S.
facility. The 8X remainder will be treated as rent for the U.S.
facility.

[Example 3]{.underline}. (i) Four members A, B, C, and D of a controlled
group form a CSA to develop the next generation technology for their
business. Based on RAB shares, the participants agree to bear shares of
the costs incurred during the term of the agreement in the following
percentages: A 40%; B 15%; C 25%; and D 20%. The arm\'s length values of
the external contributions they respectively own are in the following
amounts for the taxable year: A 80X; B 40X; C 30X; and D 30X. The
provisional (before offsets) and final PCT Payments among A, B, C, and D
are shown in the table as follows:

(All amounts stated in X's)

A B C D

Payments . . . . . . . . . . . \<40\> \<21\> \<37.5\> \<30\>

Receipts . . . . . . . . . . . . 48 34 22.5 24

\_\_ \_\_ \_\_\_ \_\_

Final . . . . . . . . . . . . . . . 8 13 \<15\> \< 6\>

\(ii\) The first row/first column shows A\'s provisional PCT Payment
equal to the product of 100X (sum of 40X, 30X, and 30X) and A\'s RAB
share of 40%. The second row/first column shows A\'s provisional PCT
receipts equal to the sum of the products of 80X and B\'s, C\'s, and
D\'s RAB shares (15%, 25%, and 20%, respectively). The other entries in
the first two rows of the table are similarly computed. The last row
shows the final PCT receipts/payments after offsets. Thus, for the
taxable year, A and B are treated as receiving the 8X and 13X,
respectively, pro rata out of payments by C and D of 15X and 6X,
respectively.

\(k\) [CSA contractual, documentation, accounting, and reporting
requirements]{.underline} \-- (1) [CSA contractual
requirements]{.underline} \-- (i) [In general]{.underline}. A CSA that
is described in paragraph (b)(1) of this section must be recorded in
writing in a contract that is contempor­aneous with the formation (and
any revision) of the CSA and that includes the contractual provisions
described in this paragraph (k)(1).

\(ii\) [Contractual provisions]{.underline}. The written contract
described in this paragraph (k)(1) must include provisions that \--

\(A\) List the controlled participants and any other members of the
controlled group that are reasonably anticipated to benefit from the use
of the cost shared intangibles, including the address of each domestic
entity and the country of organization of each foreign entity;

\(B\) Describe the scope of the IDA to be undertaken, including each
cost shared intangible or class of cost shared intangibles that the
controlled participants intend to develop under the CSA;

\(C\) Specify the functions and risks that each controlled partici­pant
will undertake in connection with the CSA;

\(D\) Divide among the controlled participants all interests in cost
shared intangibles and specify each controlled participant's territorial
interest in the cost shared intangibles, as described in paragraph
(b)(4) of this section, that it will own and exploit without any further
obligation to compensate any other controlled participant for such
interest;

\(E\) Provide a method to calculate the controlled participants' RAB
shares, based on factors that can reasonably be expected to reflect the
participants' shares of anticipated benefits, and require that such RAB
shares must be updated, as described in paragraph (e)(1) of this section
(see also paragraph (k)(2)(ii)(F) of this section);

\(F\) Enumerate all categories of IDCs to be shared under the CSA;

\(G\) Specify that the controlled participants must use a consistent
method of accounting to determine IDCs and RAB shares, as described in
paragraphs (d) and (e) of this section, respectively, and must translate
foreign currencies on a con­sistent basis;

\(H\) Require the controlled participants to enter into CSTs covering
all IDCs, as described in paragraph (b)(2) of this section, in
connection with the CSA;

\(I\) Require the controlled participants to enter into PCTs covering
all external contributions, as described in paragraph (b)(3) of this
section, in connection with the CSA; and

\(J\) Specify the duration of the CSA, the conditions under which the
CSA may be modified or terminated, and the consequences of a
modifi­cation or termination (including consequences described under the
rules of paragraph (f) of this section).

\(iii\) [Meaning of contemporaneous]{.underline} \-- (A) [In
general]{.underline}. For purposes of this paragraph (k)(1), a written
contractual agreement is contemporaneous with the formation (or
revision) of a CSA if, and only if, the controlled participants record
the CSA, in its entirety, in a document that they sign and date no later
than 60 days after the first occurrence of any IDC described in
paragraph (d) of this section to which such agreement (or revision) is
to apply.

\(B\) [Example]{.underline}. The following example illustrates the
principles of this paragraph (k)(1)(iii):

[Example]{.underline}. Companies A and B, both of which are members of
the same controlled group, commence an IDA on March 1, Year 1. Company A
pays the first IDCs in relation to the IDA, as cash salaries to A's
research staff, for the staff's work during the first week of March,
Year 1. A and B, however, do not sign and date any written contractual
agreement until August 1, Year 1, whereupon they execute a "Cost Sharing
Agreement" that purports to be "effective as of" March 1 of Year 1. The
arrangement fails the requirement that the partici­pants record their
arrangement in a written contractual agreement that is contempor­aneous
with the formation of a CSA.

\(2\) [CSA documentation requirements]{.underline} \-- (i) [In
general]{.underline}. The controlled participants must timely update and
maintain sufficient documentation to establish that the participants
have met the CSA contractual requirements of paragraph (k)(1) of this
section and the additional CSA documentation requirements of this
paragraph (k)(2).

\(ii\) [Additional CSA documentation requirements]{.underline}. The
controlled participants to a CSA must timely update and maintain
documentation sufficient to \--

\(A\) Identify the cost shared intangibles that the controlled
participants have developed or intend to develop under the CSA, together
with each controlled participant's interest therein;

\(B\) Establish that each controlled participant reasonably anticipates
that it will derive benefits from exploiting cost shared intangibles;

\(C\) Describe the functions and risks that each controlled partici­pant
has undertaken during the term of the CSA;

\(D\) Provide an overview of each controlled participant's business
segments, including an analysis of the economic and legal factors that
affect CST and PCT pricing;

\(E\) Establish the amount of each controlled participant's IDCs for
each taxable year under the CSA, including all IDCs attributable to
stock-based compensa­tion, as described in paragraph (d)(3) of this
section (including the method of measure­ment and timing used in
determining such IDCs, and the data, as of the date of grant, used to
identify stock-based compensation with the IDA);

\(F\) Describe the method used to estimate each controlled
participant\'s RAB share for each year during the course of the CSA,
including \--

([1]{.underline}) All projections used to estimate benefits;

([2]{.underline}) All updates of the RAB shares in accordance with
paragraph (e)(1) of this section; and

([3]{.underline}) An explanation of why that method was selected and why
the method provides the most reliable measure for estimating RAB shares;

\(G\) Describe all external contributions, as described in paragraph
(b)(3)(ii) of this section;

\(H\) Describe the RT for each PCT or group of PCTs;

\(I\) Specify the form of payment due under each PCT or group of PCTs;

\(J\) Describe and explain the method selected to determine the arm's
length payment due under each PCT, including \--

([1]{.underline}) An explanation of why the method selected constitutes
the best method, as described in §1.482-1(c)(2), for measuring an arm's
length result;

([2]{.underline}) The economic analyses, data, and projections relied
upon in developing and selecting the best method, including the source
of the data and projections use;

([3]{.underline}) Each alternative method that was considered, and the
reason or reasons that the alternative method was not selected;

([4]{.underline}) Any data that the controlled participant obtains,
after the CSA takes effect, that would help determine if the controlled
participant method selected has been applied in a reasonable manner;

([5]{.underline}) The discount rate, where applicable, used to value
each payment due under a PCT, and a demonstration that the discount rate
used is consistent with the principles of paragraph (g)(2)(vi) of this
section;

([6]{.underline}) The estimated arm's length values of any external
contributions as of the dates of the relevant PCTs, in accordance with
paragraph (g)(2)(ii) of this section;

([7]{.underline}) A discussion, where applicable, of why transactions
were or were not aggregated under the principles of paragraph (g)(2)(v)
of this section;

([8]{.underline}) The method payment form and any conversion made from
the method payment form to the specified payment form, as described in
paragraph (g)(2)(ix) of this section; and

([9]{.underline}) If applicable under paragraph (i)(6)(iv) of this
section, the WACC of the controlled group that includes the controlled
participants.

\(iii\) [Coordination rules and production of documents]{.underline} \--
(A) [Coordination with penalty regulations]{.underline}. See
§1.6662-6(d)(2)(iii)(D) regarding coordination of the rules of this
paragraph (k) with the documentation requirements for purposes of the
accuracy-related penalty under section 6662(e) and (h).

\(B\) [Production of documentation]{.underline}. Each controlled
participant must provide to the Commissioner, within 30 days of a
request, the items described in paragraphs (k)(2) and (3) of this
section. The time for compliance described in this paragraph
(k)(2)(iii)(B) may be extended at the discretion of the Commissioner.

\(3\) [CSA accounting requirements]{.underline} \-- (i) [In
general]{.underline}. The controlled participants must maintain books
and records (and related or underlying data and information) that are
sufficient to \--

\(A\) Establish that the controlled participants have used (and are
using) a consistent method of accounting to measure costs and benefits;

\(B\) Translate foreign currencies on a consistent basis; and

\(C\) To the extent that the method materially differs from U.S.
generally accepted accounting principles, explain any such material
differences.

\(ii\) [Reliance on financial accounting]{.underline}. For purposes of
this section, the controlled participants may not rely solely upon
financial accounting to establish satisfaction of the accounting
requirements of this paragraph (k)(3). Rather, the method of accounting
must clearly reflect income. [Thor Power Tools Co. v.
Commissioner]{.underline}, 439 U.S. 522 (1979).

\(4\) [CSA reporting requirements]{.underline} \-- (i) [CSA
Statement]{.underline}. Each controlled participant must file with the
Internal Revenue Service, in the manner described in this
paragraph (k)(4), a "Statement of Controlled Participant to §1.482-7
Cost Sharing Arrangement" (CSA Statement) that complies with the
requirements of this paragraph (k)(4).

\(ii\) [Content of CSA Statement]{.underline}. The CSA Statement of each
controlled participant must \--

\(A\) State that the participant is a controlled participant in a CSA;

\(B\) Provide the controlled participant's taxpayer identification
number;

\(C\) List the other controlled participants in the CSA, the country of
organization of each such participant, and the taxpayer identification
number of each such participant;

\(D\) Specify the earliest date that any IDC described in paragraph
(d)(1) of this section occurred; and

\(E\) Indicate the date on which the controlled participants formed (or
revised) the CSA and, if different from such date, the date on which the
controlled participants recorded the CSA (or any revision)
contemporaneously in accordance with paragraphs (k)(1)(i) and (iii) of
this section.

\(iii\) [Time for filing CSA Statement]{.underline} \-- (A) [90-day
rule]{.underline}. Each controlled participant must file its original
CSA Statement with the Internal Revenue Service Ogden Campus, no later
than 90 days after the first occurrence of an IDC to which the
newly-formed CSA applies, as described in paragraph (k)(1)(iii)(A) of
this section, or, in the case of a taxpayer that became a controlled
participant after the formation of the CSA, no later than 90 days after
such taxpayer became a controlled participant. A CSA Statement filed in
accordance with this paragraph (k)(4)(iii)(A) must be dated and signed,
under penalties of perjury, by an officer of the controlled participant
who is duly authorized (under local law) to sign the statement on behalf
of the controlled participant.

\(B\) [Annual return requirement]{.underline} \-- ([1]{.underline}) [In
general]{.underline}. Each controlled participant must attach to its
U.S. income tax return, for each taxable year for the duration of the
CSA, a copy of the original CSA Statement that the controlled
participant filed in accordance with the 90-day rule of paragraph
(k)(4)(iii)(A) of this section. In addition, the controlled participant
must update the information reflected on the original CSA Statement
annually by attaching a schedule that documents changes in such
information over time.

([2]{.underline}) [Special filing rule for annual return
requirement]{.underline}. If a controlled participant is not required to
file a U.S. income tax return, the participant must ensure that the copy
or copies of the CSA Statement and any updates are attached to Schedule
M of any Form 5471, any Form 5472, or any Form 8865, filed with respect
to that participant.

\(iv\) [Examples.]{.underline} The following examples illustrate this
paragraph (k)(4). In each example, Companies A and B are members of the
same controlled group. The examples are as follows:

[Example 1]{.underline}. A and B, both of which file U.S. tax returns,
agree to share the costs of developing a new chemical formula in
accordance with the provisions of this section. On March 30, Year 1, A
and B record their agreement in a written contract styled, "Cost Sharing
Agreement." The contract applies by its terms to IDCs occurring after
March 1, Year 1. The first IDCs to which the CSA applies occurred on
March 15, Year 1. To comply with paragraph (k)(4)(iii)(A) of this
section, A and B individually must file separate CSA Statements no later
than 90 days after March 15, Year 1 (June 13, Year 1). Further, to
comply with paragraph (k)(4)(iii)(B) of this section, A and B must
attach copies of their respective CSA Statements to their respective
Year 1 U.S. income tax returns.

[Example 2]{.underline}. The facts are the same as in [Example
1]{.underline}, except that a year has passed and C, which files a U.S.
tax return, joined the CSA on May 9, Year 2. To comply with the annual
filing requirement described in paragraph (k)(4)(iii)(B) of this
section, A and B must each attach copies of their respective CSA
Statements (as filed for Year 1) to their respective Year 2 income tax
returns, along with a schedule updated appropriately to reflect the
changes in information described in paragraph (k)(4)(ii) of this section
resulting from the addition of C to the CSA. To comply with both the
90-day rule described in paragraph (k)(4)(iii)(A) of this section and
the annual filing requirement described in paragraph (k)(4)(iii)(B) of
this section, C must file a CSA Statement no later than 90 days after
May 9, Year 2 (August 7, Year 2), and must attach a copy of such CSA
Statement to its Year 2 income tax return.

\(l\) [Effective date]{.underline}. This section applies on the date of
publication of this document as a final regulation in the **Federal
Register**.

\(m\) [Transition rule]{.underline} \-- (1) [In general]{.underline}.
Subject to paragraph (m)(2) of this section, an arrangement in existence
before the date of publication of this document as a final regulation in
the **Federal Register** will be considered a CSA, as described under
paragraph (b) of this section, if, prior to such date, it was a
qualified cost sharing arrangement under the provisions of §1.482-7 (as
contained in the 26 CFR part 1 edition revised as of January 1, 1996,
hereafter referred to as "former §1.482-7"), but only if the written
contract, as described in paragraph (k)(1) of this section, is amended,
if necessary, to conform with the provisions of this section, as
modified by paragraph (m)(3) of this section, by the close of the 120th
day after the date of publication of this document as a final regulation
in the **Federal Register**.

\(2\) [Termination of grandfather status]{.underline}. Notwithstanding
paragraph (m)(1) of this section, an arrangement otherwise therein
described will not be considered a CSA from the earliest of \--

\(i\) A failure of the controlled participants to substantially comply
with the provisions of this section, as modified by paragraph (m)(3) of
this section;

\(ii\) A material change in the scope of the arrangement, such as a
material expansion of the activities undertaken beyond the scope of the
intangible development area, as described in former §1.482-7(b)(4)(iv),
as of the date of publication of this document as a final regulation in
the **Federal Register**; or

\(iii\) The date 50 percent or more of the value of the interests in
cost shared intangibles are owned directly or indirectly by a person or
persons that were not direct or indirect owners of such interests as of
the date of publication of this document as a final regulation in the
**Federal Register**.

\(3\) [Transitional modification of applicable provisions]{.underline}.
For purposes of this paragraph (m), conformity and substantial
compliance with the provisions of this section shall be determined with
the following modifications:

\(i\) CSTs and PCTs occurring prior to the date of publication of this
document as a final regulation in the **Federal Register** shall be
subject to the provisions of former §1.482-7 rather than this section.
Notwithstanding the foregoing, PCTs of a CSA will be subject to the
provisions of this section if there is a Periodic Trigger for such CSA
for which a subsequent PCT, occurring on or after the date of
publication of this document as a final regulation in the **Federal
Register**, is the Trigger PCT.

\(ii\) Paragraph (b)(1)(i) and paragraph (b)(4) of this section shall
not apply.

\(iii\) Paragraph (k)(1)(ii)(D) of this section shall not apply.

\(iv\) Paragraph (k)(1)(ii)(H) and paragraph (k)(1)(ii)(I) of this
section shall be construed as applying only to transactions entered into
on or after the date of publication of this document as a final
regulation in the **Federal Register**.

\(v\) The deadline for recordation of the revised written contractual
agreement pursuant to paragraph (k)(1)(iii) of this section shall be no
later than the 120th day after the date of publication of this document
as a final regulation in the **Federal Register**.

\(vi\) Paragraphs (k)(2)(ii)(G) through (J) of this section shall be
construed as applying only with reference to PCTs entered into on or
after the date of publication of this document as a final regulation in
the **Federal Register**.

\(vii\) Paragraph (k)(4)(iii)(A) shall be construed as requiring a CSA
Statement with respect to the revised written contractual agreement
described in paragraph (m)(3)(iv) of this section no later than the
180th day after the date of publication of this document as a final
regulation in the **Federal Register**.

\(viii\) Paragraph (k)(4)(iii)(B) shall be construed as only applying
for taxable years ending after the filing of the CSA Statement described
in paragraph (m)(3)(vii) of this section.

Par. 9. Section 1.482-8 is amended by adding [Examples 10]{.underline}
through [15]{.underline} at the end of the section to read as follows:

[§1.482-8 Examples of the best method rule]{.underline}.

\* \* \* \* \*

[Example 10]{.underline}. [Preference for acquisition price
method]{.underline}. (i) USP develops, manufacturers, and distributes
ethical pharmaceutical products. USP and FS, USP's wholly-owned
subsidiary, enter into a CSA to develop a new oncological drug, Oncol.
Immediately prior to entering into the CSA, USP acquires Company X, an
unrelated U.S. pharmaceutical company. Company X is solely engaged in
oncological pharmaceutical research, and its only significant resources
and capabilities are its workforce and its sole patent, which is
associated with Compound Y, a promising molecular compound derived from
a rare plant, which USP reasonably anticipates will contribute to
developing Oncol. All of Company X researchers will be engaged solely in
research that is reasonably anticipated to contribute to developing
Oncol as well. The RT Rights in the Compound X and the commitment of
Company X's researchers to the development of Oncol are external
contributions for which compensation is due from FS as part of a PCT.
Under the terms of the CSA, USP is to be compensated for its external
contributions on a lump sum basis.

\(ii\) In this case, the acquisition price method, based on the lump sum
price paid by USP for Company X, is likely to provide a more reliable
measure of an arm's length PCT Payment due to USP than the application
of any other method.

[Example 11]{.underline}. [Preference for market capitalization
method]{.underline}. (i) Company X is a publicly traded U.S. company
solely engaged in oncological pharmaceutical research and its only
significant resources and capabilities are its workforce and the its
sole patent, which is associated with Compound Y, a promising molecular
compound derived from a rare plant. Company X has no marketable
products. Company X enters into a CSA with FS, a newly-formed foreign
subsidiary, to develop a new oncological drug, Oncol, derived from
Compound Y. Compound X is reasonably anticipated to contribute to
developing Oncol. All of Company X researchers will be engaged solely in
research that is reasonably anticipated to contribute to the developing
Oncol under the CSA. The RT Rights in Compound Y and the commitment of
Company X's researchers are external contributions for which
compensation is due from FS as part of a PCT. Under the terms of the
CSA, Company X is to be compensated for its external contributions on a
lump sum basis.

\(ii\) In this case, given that Company X's external contributions
covered by PCTs relate to its entire economic value, the application of
the market capitalization method, based on the market capitalization of
Company X, is likely to provide a more reliable measure of an arm's
length result for Company X's PCTs to the CSA than the application of
any other method.

[Example 12]{.underline}. [Preference for market capitalization
method]{.underline}. (i) MicroDent, Inc. (MDI) is a publicly traded
company that developed a new dental surgical microscope ScopeX-1, which
drastically shortens many surgical procedures. On January 1 of Year 1,
MDI entered into a CSA with a wholly-owned foreign subsidiary (FS) to
develop ScopeX-2, the next generation of ScopeX-1. The RT Rights
associated with ScopeX-1, as well as MDI's research capabilities are
reasonably anticipated to contribute to the development of ScopeX-2 and
are therefore external contributions for which compensation is due from
FS as part of a PCT. Under the terms of the CSA, MDI is to be
compensated for its external contributions on a lump sum basis. At the
time of the PCT, MDI\'s only product was the ScopeX-I microscope,
although MDI was in the process of developing ScopeX-2. Concurrent with
the CSA, MDI separately transfers exclusive and perpetual exploitation
rights associated with ScopeX-1 to FS in the same specified geographic
area as assigned to FS in the CSA.

\(ii\) Although the transactions between MDI and FS under the CSA are
distinct from the transactions between MDI and FS relating to the
exploitation rights for ScopeX-1, it is likely to be more reliable to
evaluate the combined effect of the transactions than to evaluate them
in isolation. This is because the combined transactions between MDI and
FS relate to all of the economic value of MDI (that is, the exploitation
rights and research rights associated with ScopeX-1, as well as the
research capabilities of MDI). In this case, application of the market
capitalization method, based on the enterprise value of MDI on January 1
of Year 1, is likely to provide a more reliable measure of an arm's
length payment for the aggregated transactions than the application of
any other method.

\(iii\) Notwithstanding that the market capitalization method provides
the most reliable measure of the aggregated transactions between MDI and
FS, see paragraph (g)(2)(v) of this section for further considerations
of when further analysis may be required to distinguish between the
remuneration to MDI associated with PCTs under the CSA (for research
rights and capabilities associated with ScopeX-1) and the remuneration
to MDI for the exploitation rights associated with ScopeX-1.

[Example 13]{.underline}. [Income method (CPM-based) preferred to
acquisition price method]{.underline}. The facts are the same as
[Example 10]{.underline}, except that the acquisition occurred
significantly in advance of formation of the CSA, and reliable
adjustments cannot be made for this time difference. In addition,
Company X has other valuable molecular patents and associated research
capabilities, apart from Compound Y, that are not reasonably anticipated
to contribute to the development of Oncol and that cannot be reliably
valued. Under the terms of the CSA, USP will undertake all R&D
(consisting of laboratory research and clinical testing) and
manufacturing associated with Oncol, as well as the distribution
activities for its assigned area (the United States). FS will distribute
Oncol in its assigned area (the rest of the world). FS's distribution
activities are routine in nature, and the profitability from its
activities may be reliably determined from third-party comparables. FS
does not furnish any external contributions. At the time of the PCT,
reliable (ex ante) financial projections associated with the development
of Oncol and its separate exploitation in each of USP's and FSub's
assigned geographical territories are undertaken. In this case,
application of the income method is likely to provide a more reliable
measure of an arm's length result than application of the acquisition
price method based on the price paid by USP for Company X.

[Example 14]{.underline}. [Evaluation of alternative
methods]{.underline}. (i) The facts are the same as [Example
10]{.underline}, except that the acquisition occurred sometime prior to
the CSA, and Company X has some areas of promising research that are not
reasonably anticipated to contribute to developing Oncol. In general,
the Commissioner determines that the acquisition price data is useful in
informing the arm's length price, but not necessarily determinative.
Under the terms of the CSA, USP will undertake all R&D (consisting of
laboratory research and clinical testing) and manufacturing associated
with Oncol, as well as the distribution activities for its assigned area
(the United States). FS will distribute Oncol in its assigned area (the
rest of the world). FS's distribution activities are routine in nature,
and the profitability from its activities may be reliably determined
from third-party comparables. At the time of the PCT, financial
projections associated with the development of Oncol and its separate
exploitation in each of USP's and FSub's assigned geographical
territories are undertaken.

\(ii\) Under the facts, it is possible that the acquisition price method
or the CPM-based income method might reasonably be applied. Whether the
acquisition price method or the income method provides the most reliable
evidence of the arm's length price of USP' contributions depends on a
number of factors, including the reliability of the financial
projections, the reliability of the discount rate chosen, and the extent
to which the acquisition price of Company X can be reliably adjusted to
account for changes in value over the time period between the
acquisition and the formation of the CSA and to account for the value of
the in-process research done by Company X that does not constitute
external contributions to the CSA.

[Example 15]{.underline}. [Evaluation of alternative
methods]{.underline}. (i) The facts are the same as [Example
14]{.underline}, except that FS has a patent on Compound Y, which the
parties reasonably anticipate will be useful in mitigating potential
side effects associated with Compound X and thereby contribute to the
development of Oncol. The RT Rights in Compound Y constitute an external
contribution for which compensation is due from USP as part of a PCT.
The value of FS's external contribution cannot be reliably measured by
market benchmarks.

\(ii\) Under the facts, it is possible that either the acquisition price
method and the income method together or the residual profit split
method might reasonably be applied to determine the arm's length PCT
Payments due between USP and FS. Under the first option the PCT Payment
for the external contributions related to Company X's workforce and
Compound X would be determined using the acquisition price method
referring to the lump sum price paid by USP for Company X. Because the
value of these external contributions can be determined by reference to
a market benchmark they are considered routine external contributions.
Accordingly, under this option, the external contribution related to
Compound Y would be the only nonroutine external contribution and the
relevant PCT Payment is determined using the income method. Under the
second option, rather than looking to the acquisition price for Company
X, all the external contributions are considered nonroutine and the RPSM
is applied to determine the PCT Payments for each external contribution.
Under either option, the PCT Payments will be netted against each other.

\(iii\) Whether the acquisition price method together with the income
method or the residual profit split method provides the most reliable
evidence of the arm's length price of the external contributions of USP
and FS depends on a number of factors, including the reliability of the
determination of the relative values of the external contributions for
purposes of the RPSM, and the extent to which the acquisition price of
Company X can be reliably adjusted to account for changes in value over
the time period between the acquisition and the formation of the CSA and
to account for the value of the RT Rights in the in-process research
done by Company X that does not constitute external contributions to the
CSA. In these circumstances, it is also relevant to consider whether the
results of each method are consistent with each other, or whether one or
both methods are consistent with other potential methods that could be
applied.

Par. 10. Section 1.861-17 is amended by revising paragraph (c)(3)(iv) to
read as follows:

[§1.861-17 Allocation and apportionment of research and experimental
expenditures]{.underline}.

\* \* \* \* \*

\(c\) \* \* \*

\(3\) \* \* \*

\(iv\) [Effect of cost sharing arrangements]{.underline}. If the
corporation controlled by the taxpayer has entered into a cost sharing
arrangement, in accordance with the provisions of §1.482-7, with the
taxpayer for the purpose of developing intangible property, then that
corporation shall not reasonably be expected to benefit from the
taxpayer's share of the research expense.

\* \* \* \* \*

Par. 11. Section 1.6662-6 is amended by:

1\. Removing the third and fourth sentence of paragraph (d)(2)(i)

2\. Adding paragraph (D) to paragraph (d)(2)(iii).

> The addition reads as follows:

[§1.6662-6 Transaction between persons described in section 482 and net
section 482 transfer price adjustments]{.underline}.

\* \* \* \* \*

\(d\) \* \* \*

\(2\) \* \* \*

\(iii\) \* \* \*

\(D\) Satisfaction of the documentation requirements described in
§1.482-7(k)(2) for the purpose of complying with the rules for CSAs
under §1.482-7 also satisfies all of the documentation requirements
listed in paragraph (d)(2)(iii)(B) of this section, except the
requirements listed in paragraphs ([2]{.underline}) and
([10]{.underline}) of such paragraph, with respect to CSTs and PCTs
described in §1.482-7(b)(2) and (3), provided that the documentation
also satisfies the requirements of paragraph (d)(2)(iii)(A) of this
section.

\* \* \* \* \*

PART 301 \-- Procedure and Administration

Par. 12. The authority for part 301 continues to read, in part, as
follows:

Authority: 26 U.S.C. 7805 \* \* \*

Par. 13. Section 301.7701-1 is amended by revising paragraph (c) to read
as follows:

[§301.7701-1 Classification of organizations for federal tax
purposes]{.underline}.

\* \* \* \* \*

\(c\) [Cost sharing arrangements]{.underline}. A cost sharing
arrangement that is described in §1.482-7 of this chapter, including any
arrangement that the Commissioner treats as

a CSA under §1.482-7(b)(5) of this chapter, is not recognized as a
separate entity for purposes of the Internal Revenue Code. See §1.482-7
of this chapter for the rules regarding CSAs.

\* \* \* \* \*

Mark E. Matthews

Deputy Commissioner for Services and Enforcement.