Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65553

church. Admission to Organization B is open

to all members of the community for a fee.

Organization B advertises in publications of

general distribution appealing to the elderly

and maintains its name on nondenominational listings of available

retirement homes. Therefore, Organization B

offers its services for sale to the general

public on more than an incidental basis.

Organization B receives a cash contribution

of $50,000 annually from the church. Fees

received by Organization B from its residents

total $100,000 annually. Organization B does

not receive any government support or

contributions from the general public. Total

support is $150,000 ($100,000 + $50,000),

and $100,000 of that total is from receipts

from the performance of services (662⁄3% of

total support). Therefore, Organization B

receives more than 50 percent of its support

from receipts from the performance of

services. Organization B is not internally

supported and is not an integrated auxiliary.

Example 3. Organization C is a hospital

that is described in sections 501(c)(3) and

509(a)(1). Organization C is affiliated (within

the meaning of this paragraph (h)) with a

church. Organization C is open to all persons

in need of hospital care in the community,

although most of Organization C’s patients

are members of the same denomination as the

church with which Organization C is

affiliated. Organization C maintains its name

on hospital listings used by the general

public, and participating doctors are allowed

to admit all patients. Therefore, Organization

C offers its services for sale to the general

public on more than an incidental basis.

Organization C annually receives $250,000 in

support from the church, $1,000,000 in

payments from patients and third party

payors (including Medicare, Medicaid and

other insurers) for patient care, $100,000 in

contributions from the public, $100,000 in

grants from the federal government (other

than Medicare and Medicaid payments) and

$50,000 in investment income. Total support

is $1,500,000 ($250,000 + $1,000,000 +

$100,000 + $100,000 + $50,000), and

$1,200,000 ($1,000,000 + $100,000 +

$100,000) of that total is support from

receipts from the performance of services,

government sources, and public

contributions (80% of total support).

Therefore, Organization C receives more than

50 percent of its support from receipts from

the performance of services, government

sources, and public contributions.

Organization C is not internally supported

and is not an integrated auxiliary.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: November 27, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95–30839 Filed 12–19–95; 8:45 am]

BILLING CODE 4830–01–U

26 CFR Parts 1, 301 and 602

[TD 8632]

RIN 1544–AM00

Section 482 Cost Sharing Regulations

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations relating to qualified cost

sharing arrangements under section 482

of the Internal Revenue Code. These

regulations reflect changes to section

482 made by the Tax Reform Act of

1986, and provide guidance to revenue

agents and taxpayers implementing the

changes.

DATES: These regulations are effective

January 1, 1996.

These regulations are applicable for

taxable years beginning on or after

January 1, 1996.

FOR FURTHER INFORMATION CONTACT: Lisa

Sams of the Office of Associate Chief

Counsel (International), IRS (202) 622–

3840 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information

contained in these final regulations have

been reviewed and approved by the

Office of Management and Budget in

accordance with the Paperwork

Reduction Act (44 U.S.C. 3507) under

control number 1545–1364. Responses

to these collections of information are

required to determine whether an

intangible development arrangement is

a qualified cost sharing arrangement and

who are the participants in such

arrangement.

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.

The estimated average annual burden

per recordkeeper is 8 hours. The

estimated average annual burden per

respondent is 0.5 hour.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to

the Internal Revenue Service, Attn: IRS

Reports Clearance Officer, T:FP,

Washington, DC 20224, and 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.

Books and records relating to these

collections 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 was amended by the Tax

Reform Act of 1986, Public Law 99–514,

100 Stat. 2085, 2561, et. seq. (1986–3

C.B. (Vol. 1) 1, 478). On January 30,

1992, a notice of proposed rulemaking

concerning the section 482 amendment

in the context of cost sharing was

published in the Federal Register

(INTL–0372–88, 57 FR 3571).

Written comments were received with

respect to the notice of proposed

rulemaking, and a public hearing was

held on August 31, 1992. After

consideration of all the comments, the

proposed regulations under section 482

are adopted as revised by this Treasury

decision, and the corresponding

temporary regulations (which contain

the cost sharing regulations as in effect

since 1968) are removed.

Explanation of Provisions

Introduction

The Tax Reform Act of 1986 (the Act)

amended section 482 to require that

consideration for intangible property

transferred in a controlled transaction

be commensurate with the income

attributable to the intangible. The

Conference Committee report to the Act

indicated that in revising section 482,

Congress did not intend to preclude the

use of bona fide research and

development cost sharing arrangements

as an appropriate method of allocating

income attributable to intangibles

among related parties. The Conference

Committee report stated, however, that

in order for cost sharing arrangements to

produce results consistent with the

commensurate-with-income standard,

(a) a cost sharer should be expected to

bear its portion of all research and

development costs, on unsuccessful as

well as successful products, within an

appropriate product area, and the costs

of research and development at all

relevant development stages should be

shared, (b) the allocation of costs

generally should be proportionate to

profit as determined before deduction

for research and development, and (c) to

the extent that one party contributes

funds toward research and development

at a significantly earlier point in time

than another (or is otherwise putting its

funds at risk to a greater extent than the

other) that party should receive an

appropriate return on its investment.

See H.R. Rep. 99–281, 99th Cong., 2d

Sess. (1986) at II–638.
65554 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

The Conference Committee report to

the Act recommended that the IRS

conduct a comprehensive study and

consider whether the regulations under

section 482 (issued in 1968) should be

modified in any respect.

The White Paper

In response to the Conference

Committee’s directive, the IRS and the

Treasury Department issued a study of

intercompany pricing [Notice 88–123

(1988–2 C.B. 458)] on October 18, 1988

(the White Paper). The White Paper

suggested that most bona fide cost

sharing arrangements should have

certain provisions. For example, the

White Paper stated that most product

areas covered by cost sharing

arrangements should be within threedigit Standard Industrial Classification

codes, that most participants should be

assigned exclusive geographic rights in

developed intangibles (and should

predict benefits and divide costs

accordingly) and that marketing

intangibles should be excluded from

bona fide cost sharing arrangements.

Comments on the White Paper

indicated that, in practice, there was a

great deal of variety in the terms of bona

fide cost sharing arrangements, and that

if the White Paper’s suggestions were

incorporated in regulations, the

regulations would unduly restrict the

availability of cost sharing.

The 1992 Proposed Regulations

The IRS issued proposed cost sharing

regulations on January 30, 1992 (INTL–

0372–88, 57 FR 3571). In general, the

proposed regulations allowed more

flexibility than anticipated by the White

Paper, relying on anti-abuse tests rather

than requiring standard cost sharing

provisions.

The proposed regulations stated that

in order to be qualified, a cost sharing

arrangement had to meet the following

five requirements: (1) the arrangement

had to have two or more eligible

participants, (2) the arrangement had to

be recorded in writing

contemporaneously with the formation

of the cost sharing arrangement, (3) the

eligible participants had to share the

costs and risks of intangible

development in return for a specified

interest in any intangible produced, (4)

the arrangement had to reflect a

reasonable effort by each eligible

participant to share costs and risks in

proportion to anticipated benefits from

using developed intangibles, and (5) the

arrangement had to meet certain

administrative requirements. The key

requirements were that participants had

to be eligible and that costs and risks

had to be proportionate to benefits.

Under the proposed regulations, only

a controlled taxpayer that would use

developed intangibles in the active

conduct of its trade or business was

eligible to participate in a cost sharing

arrangement. This requirement was

considered necessary to ensure that

controlled foreign entities were not

established simply to participate in cost

sharing arrangements without

performing any other meaningful

function, and to ensure that each

participant’s share of anticipated

benefits was measurable.

The proposed regulations allowed

costs to be divided based on any

measurement that would reasonably

predict cost sharing benefits (e.g.,

anticipated units of production or

anticipated sales). However, the basis

for measuring anticipated benefits and

dividing costs was checked by a cost-tooperating-income ratio. The method for

dividing costs was presumed to be

unreasonable if a U.S. participant’s ratio

of shared costs to operating income

attributable to developed intangibles

was grossly disproportionate to the costto-operating-income ratio of the other

participants.

If a U.S. participant’s cost-tooperating-income ratio was not grossly

disproportionate, a section 482

allocation could still be made under

three circumstances: (a) if the cost-tooperating-income ratio was

disproportionate (allocation of costs), (b)

if the pool of costs shared was too broad

or too narrow, so that the U.S.

participant was paying for research that

it would not use (allocation of costs), or

(c) if the cost-to-operating-income ratio

was substantially disproportionate, such

that a transfer of an intangible could be

deemed to have occurred (allocation of

income).

Under the proposed regulations, the

IRS could also make an allocation of

income to reflect a buy-in or buy-out

event, that is, a transfer of an intangible

that could occur, for example, when a

participant joined or left a cost sharing

arrangement.

Comments on the 1992 Proposed

Regulations

The 1992 proposed cost sharing

regulations were generally well

received. However, there were five areas

of particular concern to commenters.

The first was the mechanical use of costto-operating-income ratios as a standard

for measuring the reasonableness of an

effort to share costs in proportion to

anticipated benefits. Commenters noted

that operating income attributable to

developed intangibles was difficult to

measure, and that other bases for

measuring benefits might produce more

reliable results. Commenters also

believed that the ratios might be

overused, leading to adjustments to

costs in every year, and to many deemed

transfers of intangibles. In addition,

commenters stated that the ratios did

not provide any certainty that a cost

sharing arrangement would not be

disregarded, since a ‘‘grossly

disproportionate’’ ratio was not

numerically defined.

The second area of concern was the

eligible participant requirement.

Commenters argued that separate

research entities (with no separate

active trade or business) should be

allowed to participate in cost sharing

arrangements, as should marketing

affiliates. Commenters also argued that

transfers of intangibles to unrelated

entities should not disqualify a

participant, and that foreign-to-foreign

transfers should not necessarily be

monitored. Some comments also stated

that controlled entities should be able to

participate even if their cost sharing

payments would be characterized

differently for purposes of foreign law.

The third area of concern was the

regulations’ requirement that every

participant be able to benefit from every

intangible developed under a cost

sharing arrangement. Commenters

stated that the regulations should allow

both single-product cost sharing

arrangements and umbrella cost sharing

arrangements (i.e., cost sharing

arrangements under which a broad

category of a controlled group’s research

and development would be covered).

The fourth area of concern was the

buy-in and buy-out rules. There were

some suggestions for clarifying and

simplifying the rules. For example,

comments urged that the regulations

provide that one participant’s

abandonment of its rights would not

necessarily confer benefits on the other

participants, and that a new participant

need not always make a buy-in payment

when joining a cost sharing

arrangement. Suggestions for

simplifying the rules generally consisted

of proposed safe harbors for valuing

intangibles.

The final general area of concern was

the administrative requirements. Several

commenters suggested that annual

adjustments to the method used to share

costs should not be required.

Commenters also suggested that

taxpayers not be required to attach their

cost sharing arrangements to their

returns, and that the time period for

producing records be increased.

In addition to these general areas of

concern, commenters noted that there

should be more guidance about when

the IRS would deem a cost sharing
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65555

arrangement to exist. Commenters also

argued that existing cost sharing

arrangements should be grandfathered,

or that there should be a longer

transition period. Commenters

suggested that financial accounting

rules be used to calculate costs to be

shared, and that the IRS address the

impact of currency fluctuations on the

cost-to-operating-income ratios. Finally,

commenters asked that the regulations

clarify that a cost sharing arrangement

would not be deemed to create a

partnership or a U.S. trade or business.

The Final Regulations

Without fundamentally altering the

policies of the 1992 proposed

regulations, the final regulations reflect

numerous modifications in response to

the comments described above. They

also reflect the approach of the final

section 482 regulations relating to

transfers of tangible and intangible

property.

Section 1.482–7(a)(1) defines a cost

sharing arrangement as an agreement for

sharing costs in proportion to

reasonably anticipated benefits from the

individual exploitation of interests in

the intangibles that are developed. In

order to claim the benefits of the safe

harbor, a taxpayer must also satisfy

certain formal requirements

(enumerated in § 1.482–7(b)). The

district director may apply the cost

sharing rules to any arrangement that in

substance constitutes a cost sharing

arrangement, notwithstanding any

failure to satisfy particular requirements

of the safe harbor. It is further provided

that a qualified cost sharing

arrangement, or an arrangement treated

in substance as such, will not be treated

as a partnership. (A corresponding

provision is added to § 301.7701–3

pertaining to the definition of a

partnership.) Neither will a foreign

participant be treated as engaged in a

trade or business within the United

States solely by virtue of its

participation in such an arrangement.

Section 1.482–7(a)(2) restates the

general rule of cost sharing in a manner

intended to emphasize its limitation on

allocations: no section 482 allocation

will be made with respect to a qualified

cost sharing arrangement, except to

make each controlled participant’s share

of the intangible development costs

equal to its share of reasonably

anticipated benefits.

Section 1.482–7(b) contains the

requirements for a qualified cost sharing

arrangement. This provision

substantially tracks the proposed

regulations. A modification was made in

the second requirement which now

directs that the arrangement provide a

method to calculate each controlled

participant’s share of intangible

development costs, based on factors that

can reasonably be expected to reflect

anticipated benefits. The new standard

is intended to ensure that cost sharing

arrangements will not be disregarded by

the IRS as long as the factors upon

which an estimate of benefits was based

were reasonable, even if the estimate

proved to be inaccurate.

Section 1.482–7(b)(4) requires that a

cost sharing arrangement be set forth in

writing and contain a number of

specified provisions, including the

interest that each controlled participant

will receive in any intangibles

developed pursuant to the arrangement.

The intangibles developed under a cost

sharing arrangement are referred to as

the ‘‘covered intangibles.’’ It is possible

that the research activity undertaken

may result in development of intangible

property that was not foreseen at the

inception of the cost sharing

arrangement; any such property is also

included within the definition of the

term covered intangibles. The

prescriptive rules in relation to the

scope of the intangible development

area under the proposed regulations are

eliminated in favor of a flexible

definition that encompasses any

research and development actually

undertaken under the cost sharing

arrangement.

Section 1.482–7(c) provides rules for

being a participant in a qualified cost

sharing arrangement. Unlike the

proposed regulations, the final

regulations permit participation by

unrelated persons, which are referred to

as ‘‘uncontrolled participants.’’

Controlled taxpayers may be

participants, referred to as ‘‘controlled

participants,’’ if they satisfy the

conditions set forth in these rules. These

qualification rules replace the proposed

regulations’ concept of ‘‘eligible

participant.’’ The tax treatment of

controlled taxpayers that do not qualify

as controlled participants provided in

§ 1.482–7(c)(4) essentially tracks the

treatment provided for ineligible

participants under the proposed

regulations.

The requirements for being a

controlled participant are basically the

same as in the proposed regulations. In

particular, a controlled participant must

use or reasonably expect to use covered

intangibles in the active conduct of a

trade or business. Thus, an entity that

chiefly provides services (e.g., as a

contract researcher) may not be a

controlled participant. These provisions

are necessary for the reason that they are

necessary to the proposed regulations:

to prevent foreign controlled entities

from being established simply to

participate in cost sharing arrangements.

In accordance with § 1.482–7(c)(4)

mentioned above, service entities (such

as contract researchers) may furnish

research and development services to

the members of a qualified cost sharing

arrangement, with the appropriate

consideration for such assistance in the

research and development undertaken

in the intangible development area

being governed by the rules in § 1.482-

4(f)(3)(iii) (Allocations with respect to

assistance provided to the owner). In the

case of a controlled research entity, the

appropriate arm’s length compensation

would generally be determined under

the principles of § 1.482–2(b)

(Performance of services for another).

Each controlled participant would be

deemed to incur as part of its intangible

development costs a share of such

compensation equal to its share of

reasonably anticipated benefits.

As under the proposed regulations,

the activity of another person may be

attributed to a controlled taxpayer for

purposes of meeting the active conduct

requirement. However, modified

language is adopted to be more precise

concerning the intended requirements

for attribution. These requirements were

phrased in the proposed regulations as

bearing the risk and receiving the

benefits of the attributed activity. Under

the final regulations, the attribution will

be made only in cases in which the

controlled taxpayer exercises substantial

managerial and operational control over

the attributed activities.

As under the proposed regulations, a

principal purpose to use cost sharing to

accomplish a transfer or license of

covered intangibles to uncontrolled or

controlled taxpayers will defeat

satisfaction of the active conduct

requirement. However, a principal

purpose will not be implied where there

are legitimate business reasons for

subsequently licensing covered

intangibles.

The subgroup rules of the proposed

regulations are eliminated. Their major

purpose is accomplished by a simpler

provision (see the discussion of § 1.482–

7(h)). In addition, the final regulations

treat all members of a consolidated

group as a single participant.

Section 1.482–7(d) defines intangible

development costs as operating

expenses other than depreciation and

amortization expense, plus an arm’s

length charge for tangible property made

available to the cost sharing

arrangement. Costs to be shared include

all costs relating to the intangible

development area, which, as noted,

comprises any research actually

undertaken under the cost sharing
65556 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

arrangement. As under the proposed

regulations, the district director may

adjust the pool of costs shared in order

to properly reflect costs that relate to the

intangible development area.

Section 1.482–7(e) defines anticipated

benefits as additional income generated

or costs saved by the use of covered

intangibles. The pool of benefits may

also be adjusted in order to properly

reflect benefits that relate to the

intangible development area.

Section 1.482–7(f) governs cost

allocations by the district director in

order to make a controlled participant’s

share of costs equal to its share of

reasonably anticipated benefits.

Anticipated benefits of uncontrolled

participants will be excluded from

anticipated benefits in calculating the

benefits shares of controlled

participants. A share of reasonably

anticipated benefits will be determined

using the most reliable estimate of

benefits. This rule echoes the best

method rule for determining the most

reliable measure of an arm’s length

result under § 1.482–1(c).

The reliability of an estimate of

benefits principally depends on two

factors: the reliability of the basis for

measuring benefits used and the

reliability of the projections used. The

cost-to-operating-income ratio used in

the proposed regulations to check the

reasonableness of an effort to share costs

in proportion to anticipated benefits has

not been included in the final

regulations. Rather, the final regulations

provide that an allocation of costs or

income may be made if the taxpayer did

not use the most reliable estimate of

benefits, which depends on the facts

and circumstances of each case.

Section 1.482–7(f)(3)(ii) provides that

in estimating a controlled participant’s

share of benefits, the most reliable basis

for measuring anticipated benefits must

be used, taking into account the factors

set forth in § 1.482–1(c)(2)(ii). The

measurement basis used must be

consistent for all controlled

participants. The regulations provide

that benefits may be measured directly

or indirectly. In addition, regardless of

whether a direct or indirect basis of

measurement is employed, it may be

necessary to make adjustments to

account for material differences in the

activities that controlled participants

perform in connection with exploitation

of covered intangibles, such as between

wholesale and retail distribution.

Section 1.482–7(f)(3)(iii) describes the

scope of various indirect bases for

measuring benefits, such as units, sales,

and operating profit. Indirect bases

other than those enumerated may be

employed as long as they bear a

relationship to benefits.

Section 1.482–7(f)(3)(iv) discusses

projections used to estimate benefits.

Projections required for this purpose

generally include a determination of the

time period between the inception of

the research and development 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 intangible will

generate benefits. However, the

regulations note that in certain

circumstances, current annual benefit

shares may be used in lieu of

projections.

Section 1.482–7(f)(3)(iv)(B) states that

a significant divergence between

projected and actual benefit shares may

indicate that the projections were not

reliable. A significant divergence is

defined as divergence in excess of 20%

between projected and actual benefit

shares. If there is a significant

divergence, which is not due to an

unforeseeable event, then the district

director may use actual benefits as the

most reliable basis for measuring

benefits. Conversely, no allocation will

be made based on a divergence that is

not considered significant as long as the

estimate is made using the most reliable

basis for measuring benefits.

For purposes of the 20% test, all nonU.S. controlled participants are treated

as a single controlled participant in

order that a divergence by a foreign

controlled participant with a very small

share of the total costs will not

necessarily trigger an allocation (section

1.482–7(f)(3)(iv)(D), Example 8,

illustrates this rule). Section 1.482–

7(f)(3)(iv)(B) and (C) notes that

adjustments among foreign controlled

participants will only be made if the

adjustment will have a substantial U.S.

tax impact, for example, under subpart

F.

Section 1.482–7(f)(4) states that cost

allocations must be reflected for tax

purposes in the year in which costs

were incurred. This reflects a change

from the rule in the 1992 proposed

regulations, which stated that cost

allocations would be included in

income in the taxable year under

review, even if the costs to be allocated

were incurred in a prior taxable year.

The purpose of the change was to match

up cost adjustments with the year to

which they relate in accordance with

the clear reflection of income principle

of section 482.

Section 1.482–7(g) provides buy-in

and buy-out rules that are similar to the

rules in the proposed regulations.

However, some of the clarifications

suggested by commenters have been

incorporated in these rules. A

‘‘substantially disproportionate’’ cost-tooperating-income ratio will no longer

trigger an adjustment to income under

these rules. However, if, after any cost

allocations authorized by § 1.482–

7(a)(2), the economic substance of the

arrangement is inconsistent with the

terms of the arrangement over a period

of years (for example, through a

consistent pattern of one controlled

participant bearing an inappropriately

high or low share of the cost of

intangible development), then the

district director may impute an

agreement consistent with the course of

conduct. In that case, one or more of the

participants would be deemed to own a

greater interest in covered intangibles

than provided under the arrangement,

and must receive buy-in payments from

the other participants.

The rules do not provide safe harbor

methods for valuing intangibles, but rely

on the intangible valuation rules of

§§ 1.482–1 and 1.482–4 through 1.482–

6. To the extent some participants

furnish a disproportionately greater

amount of existing intangibles to the

arrangement, they must be compensated

by royalties by the participants who

furnish a disproportionately lesser

amount of existing intangibles to the

arrangement. Buy-in payments owed are

netted against payments owing, and

only the net payment is treated as a

royalty. No implication is intended that

netting of cross royalties is permissible

outside of the qualified cost sharing safe

harbor rules.

Section 1.482–7(h) provides rules

regarding the character of payments

made pursuant to a qualified cost

sharing arrangement. Cost sharing

payments received are generally treated

as reductions of research and

development expense. A net approach is

applied to foster simplicity and

generally preserve the character of items

actually incurred by a participant to the

extent not reimbursed. In addition, 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–

8(e). Finally, any payment that in

substance constitutes a cost sharing

payment will be treated as such,

regardless of its characterization under

foreign law. This rule is intended to

enable foreign entities to participate in

cost sharing arrangements with U.S.

controlled participants even if foreign

law does not recognize cost sharing.

This rule obviated the main reason for

the subgroup rules which, as noted,

have accordingly been eliminated.
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65557

Section 1.482–7(i) requires that

controlled participants must use a

consistent accounting method for

measuring costs and benefits, and must

translate foreign currencies on a

consistent basis. To the extent that the

accounting method materially differs

from U.S. generally accepted accounting

principles, any such material

differences must be documented, as

provided in § 1.482–7(j)(2)(iv).

Section 1.482–7(j) provides simplified

recordkeeping and reporting

requirements. It is anticipated that many

of the background documents necessary

for purposes of this section will be kept

pursuant to section 6662(e) and the

regulations thereunder.

Section 1.482–7(k) provides that this

regulation is effective for taxable years

beginning on or after January 1, 1996.

Section 1.482–7(l) allows a one-year

transition period for taxpayers to

conform their cost sharing arrangements

with the requirements of the final

regulations. A longer period was not

considered necessary, given the

increased flexibility and the reduced

number of administrative requirements

of the final regulations.

Special Analyses

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory

assessment is not required. It also has

been determined that section 553(b) of

the Administrative Procedure Act (5

U.S.C. chapter 5) and the Regulatory

Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and,

therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to

section 7805(f) of the Internal Revenue

Code, the notice of proposed rulemaking

preceding these regulations was

submitted to the Small Business

Administration for comment on its

impact on small business.

Drafting Information

The principal author of these

regulations is Lisa Sams, Office of

Associate Chief Counsel (International),

IRS. However, other personnel from the

IRS and Treasury Department

participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

26 CFR Part 301

Employment taxes, Estate taxes,

Excise taxes, Gift taxes, Income taxes,

Penalties, Reporting and recordkeeping

requirements.

26 CFR Part 602

Reporting and recordkeeping

requirements.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 1, 301 and

602 are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority for part 1

is amended by adding an entry for

section 1.482–7 to read as follows:

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

Section 1.482–7 is also issued under

26 U.S.C. 482. * * *

Par. 2. Section 1.482–0 is amended

by:

1. Removing the entry for § 1.482–7T.

2. Adding the entry for § 1.482–7 to

read as follows:

§ 1.482–0 Outline of regulations under 482.

* * * * *

§ 1.482–7 Sharing of costs.

(a) In general.

(1) Scope and application of the rules in

this section.

(2) Limitation on allocations.

(3) Cross references.

(b) Qualified cost sharing arrangement.

(c) Participant.

(1) In general.

(2) Active conduct of a trade or business.

(i) Trade or business.

(ii) Active conduct.

(iii) Examples.

(3) Use of covered intangibles in the active

conduct of a trade or business.

(i) In general.

(ii) Example.

(4) Treatment of a controlled taxpayer that

is not a controlled participant.

(i) In general.

(ii) Example.

(5) Treatment of consolidated group.

(d(d) Costs.

(1) Intangible development costs.

(2) Examples.

(e) Anticipated benefits.

(1) Benefits.

(2) Reasonably anticipated benefits.

(f) Cost allocations.

(1) In general.

(2) Share of intangible development costs.

(i) In general.

(ii) Example.

(3) Share of reasonably anticipated

benefits.

(i) In general.

(ii) Measure of benefits.

(iii) Indirect bases for measuring

anticipated benefits.

(A) Units used, produced or sold.

(B) Sales.

(C) Operating profit.

(D) Other bases for measuring anticipated

benefits.

(E) Examples.

(iv) Projections used to estimate

anticipated benefits.

(A) In general.

(B) Unreliable projections.

(C) Foreign-to-foreign adjustments.

(D) Examples.

(4) Timing of allocations.

(g) Allocations of income, deductions or

other tax items to reflect transfers of

intangibles (buy-in).

(1) In general.

(2) Pre-existing intangibles.

(3) New controlled participant.

(4) Controlled participant relinquishes

interests.

(5) Conduct inconsistent with the terms of

a cost sharing arrangement.

(6)Failure to assign interests under a

qualified cost sharing arrangement.

(7) Form of consideration.

(i) Lump sum payments.

(ii) Installment payments.

(iii) Royalties.

(8) Examples.e

(h) Character of payments made pursuant

to a qualified cost sharing arrangement.

(1) In general.

(2) Examples.

(i) Accounting requirements.

(j) Administrative requirements.

(1) In general.

(2) Documentation.

(3) Reporting requirements.

(k) Effective date.

(l) Transition rule.

* * * * *

Par. 3. Section 1.482–7 is added to

read as follows:

§ 1.482–7 Sharing of costs.

(a) In general—(1) Scope and

application of the rules in this section.

A cost sharing arrangement is an

agreement under which the parties agree

to share the costs of development of one

or more intangibles in proportion to

their shares of reasonably anticipated

benefits from their individual

exploitation of the interests in the

intangibles assigned to them under the

arrangement. A taxpayer may claim that

a cost sharing arrangement is a qualified

cost sharing arrangement only if the

agreement meets the requirements of

paragraph (b) of this section. Consistent

with the rules of § 1.482–1(d)(3)(ii)(B)

(Identifying contractual terms), the

district director may apply the rules of

this section to any arrangement that in

substance constitutes a cost sharing

arrangement, notwithstanding a failure

to comply with any requirement of this

section. A qualified cost sharing

arrangement, or an arrangement to

which the district director applies the

rules of this section, will not be treated

as a partnership to which the rules of

subchapter K apply. See § 301.7701–3(e)

of this chapter. Furthermore, a

participant that is a foreign corporation

or nonresident alien individual will not

be treated as engaged in trade or

business within the United States solely
65558 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

by reason of its participation in such an

arrangement. See generally § 1.864–2(a).

(2) Limitation on allocations. The

district director shall not make

allocations with respect to a qualified

cost sharing arrangement except to the

extent necessary to make each

controlled participant’s share of the

costs (as determined under paragraph

(d) of this section) of intangible

development under the qualified cost

sharing arrangement equal to its share of

reasonably anticipated benefits

attributable to such development, under

the rules of this section. If a controlled

taxpayer acquires an interest in

intangible property from another

controlled taxpayer (other than in

consideration for bearing a share of the

costs of the intangible’s development),

then the district director may make

appropriate allocations to reflect an

arm’s length consideration for the

acquisition of the interest in such

intangible under the rules of §§ 1.482–

1 and 1.482–4 through 1.482–6. See

paragraph (g) of this section. An interest

in an intangible includes any

commercially transferable interest, the

benefits of which are susceptible of

valuation. See § 1.482–4(b) for the

definition of an intangible.

(3) Cross references. Paragraph (c) of

this section defines participant.

Paragraph (d) of this section defines the

costs of intangible development.

Paragraph (e) of this section defines the

anticipated benefits of intangible

development. Paragraph (f) of this

section provides rules governing cost

allocations. Paragraph (g) of this section

provides rules governing transfers of

intangibles other than in consideration

for bearing a share of the costs of the

intangible’s development. Rules

governing the character of payments

made pursuant to a qualified cost

sharing arrangement are provided in

paragraph (h) of this section. Paragraph

(i) of this section provides accounting

requirements. Paragraph (j) of this

section provides administrative

requirements. Paragraph (k) of this

section provides an effective date.

Paragraph (l) provides a transition rule.

(b) Qualified cost sharing

arrangement. A qualified cost sharing

arrangement must—

(1) Include two or more participants;

(2) Provide a method to calculate each

controlled participant’s share of

intangible development costs, based on

factors that can reasonably be expected

to reflect that participant’s share of

anticipated benefits;

(3) Provide for adjustment to the

controlled participants’ shares of

intangible development costs to account

for changes in economic conditions, the

business operations and practices of the

participants, and the ongoing

development of intangibles under the

arrangement; and

(4) Be recorded in a document that is

contemporaneous with the formation

(and any revision) of the cost sharing

arrangement and that includes—

(i) A list of the arrangement’s

participants, and any other member of

the controlled group that will benefit

from the use of intangibles developed

under the cost sharing arrangement;

(ii) The information described in

paragraphs (b)(2) and (b)(3) of this

section;

(iii) A description of the scope of the

research and development to be

undertaken, including the intangible or

class of intangibles intended to be

developed;

(iv) A description of each

participant’s interest in any covered

intangibles. A covered intangible is any

intangible property that is developed as

a result of the research and development

undertaken under the cost sharing

arrangement (intangible development

area);

(v) The duration of the arrangement;

and

(vi) The conditions under which the

arrangement may be modified or

terminated and the consequences of

such modification or termination, such

as the interest that each participant will

receive in any covered intangibles.

(c) Participant—(1) In general. For

purposes of this section, a participant is

a controlled taxpayer that meets the

requirements of this paragraph (c)(1)

(controlled participant) or an

uncontrolled taxpayer that is a party to

the cost sharing arrangement

(uncontrolled participant). See § 1.482–

1(i)(5) for the definitions of controlled

and uncontrolled taxpayers. A

controlled taxpayer may be a controlled

participant only if it—

(i) Uses or reasonably expects to use

covered intangibles in the active

conduct of a trade or business, under

the rules of paragraphs (c)(2) and (c)(3)

of this section;

(ii) Substantially complies with the

accounting requirements described in

paragraph (i) of this section; and

(iii) Substantially complies with the

administrative requirements described

in paragraph (j) of this section.

(2) Active conduct of a trade or

business—(i) Trade or business. The

rules of § 1.367(a)–2T(b)(2) apply in

determining whether the activities of a

controlled taxpayer constitute a trade or

business. For this purpose, the term

controlled taxpayer must be substituted

for the term foreign corporation.

(ii) Active conduct. In general, a

controlled taxpayer actively conducts a

trade or business only if it carries out

substantial managerial and operational

activities. For purposes only of this

paragraph (c)(2), activities carried out

on behalf of a controlled taxpayer by

another person may be attributed to the

controlled taxpayer, but only if the

controlled taxpayer exercises substantial

managerial and operational control over

those activities.

(iii) Examples. The following

examples illustrate this paragraph (c)(2):

Example 1. Foreign Parent (FP) enters into

a cost sharing arrangement with its U.S.

Subsidiary (USS) to develop a cheaper

process for manufacturing widgets. USS is to

receive the right to exploit the intangible to

make widgets in North America, and FP is to

receive the right to exploit the intangible to

make widgets in the rest of the world.

However, USS does not manufacture widgets;

rather, USS acts as a distributor for FP’s

widgets in North America. Because USS is

simply a distributor of FP’s widgets, USS

does not use or reasonably expect to use the

manufacturing intangible in the active

conduct of its trade or business, and thus

USS is not a controlled participant.

Example 2. The facts are the same as in

Example 1, except that USS contracts to have

widgets it sells in North America made by a

related manufacturer (that is not a controlled

participant) using USS’ cheaper

manufacturing process. USS purchases all

the manufacturing inputs, retains ownership

of the work in process as well as the finished

product, and bears the risk of loss at all times

in connection with the operation. USS

compensates the manufacturer for the

manufacturing functions it performs and

receives substantially all of the intangible

value attributable to the cheaper

manufacturing process. USS exercises

substantial managerial and operational

control over the manufacturer to ensure

USS’s requirements are satisfied concerning

the timing, quantity, and quality of the

widgets produced. USS uses the

manufacturing intangible in the active

conduct of its trade or business, and thus

USS is a controlled participant.

(3) Use of covered intangibles in the

active conduct of a trade or business—

(i) In general. A covered intangible will

not be considered to be used, nor will

the controlled taxpayer be considered to

reasonably expect to use it, in the active

conduct of the controlled taxpayer’s

trade or business if a principal purpose

for participating in the arrangement is to

obtain the intangible for transfer or

license to a controlled or uncontrolled

taxpayer.

(ii) Example. The following example

illustrates the absence of such a

principal purpose:

Example. Controlled corporations A, B,

and C enter into a qualified cost sharing

arrangement for the purpose of developing a

new technology. Costs are shared equally
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65559

among the three controlled taxpayers. A, B,

and C have the exclusive rights to

manufacture and sell products based on the

new technology in North America, South

America, and Europe, respectively. When the

new technology is developed, C expects to

use it to manufacture and sell products in

most of Europe. However, for sound business

reasons, C expects to license to an unrelated

manufacturer the right to use the new

technology to manufacture and sell products

within a particular European country owing

to its relative remoteness and small size. In

these circumstances, C has not entered into

the arrangement with a principal purpose of

obtaining covered intangibles for transfer or

license to controlled or uncontrolled

taxpayers, because the purpose of licensing

the technology to the unrelated manufacturer

is relatively insignificant in comparison to

the overall purpose of exploiting the

European market.

(4) Treatment of a controlled taxpayer

that is not a controlled participant—(i)

In general. If a controlled taxpayer that

is not a controlled participant (within

the meaning of this paragraph (c))

provides assistance in relation to the

research and development undertaken

in the intangible development area, it

must receive consideration from the

controlled participants under the rules

of § 1.482–4(f)(3)(iii) (Allocations with

respect to assistance provided to the

owner). For purposes of paragraph (d) of

this section, such consideration is

treated as an operating expense and

each controlled participant must be

treated as incurring a share of such

consideration equal to its share of

reasonably anticipated benefits (as

defined in paragraph (f)(3) of this

section).

(ii) Example. The following example

illustrates this paragraph (c)(4):

Example. (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 cost sharing agreement

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 Europe,

where each presently manufactures and sells

various existing product lines. R+D, whose

activity consists solely in carrying out

research for the group, is assigned the rights

to exploit the new technology in Asia, where

no group member presently operates, but

which is reliably projected to be a major

market for product A. R+D will license the

Asian rights to an unrelated third party. It is

reliably projected that the shares of

reasonably anticipated benefits of USP and

FS (i.e., not taking R+D into account) will be

66 2⁄3% and 33 1⁄3%, respectively. The

parties’ agreement provides that USP and FS

will reimburse 40% and 20%, respectively,

of the intangible development costs 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

(c) of this section. 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

§ 1.482–4(f)(3)(iii). Such consideration must

be treated as intangible development costs

incurred by USP and FS in proportion to

their shares of reasonably anticipated

benefits (i.e., 66 2⁄3% and 33 1⁄3%,

respectively). R+D will not be considered to

bear any share of the intangible development

costs under the arrangement.

(iii) The Asian rights nominally assigned to

R+D under the agreement must be treated as

being held by USP and FS in accordance

with their shares of the intangible

development costs (i.e., 66 2⁄3% and 33 1⁄3%,

respectively). See paragraph (g)(6) of this

section. Thus, since under the cost sharing

agreement the Asian rights are owned by

R+D, the district director may make

allocations to reflect an arm’s length

consideration owed by R+D to USP and FS

for these rights under the rules of §§ 1.482–

1 and 1.482–4 through 1.482–6.

(5) Treatment of consolidated group.

For purposes of this section, all

members of the same affiliated group

(within the meaning of section 1504(a))

that join in the filing of a consolidated

return for the taxable year under section

1501 shall be treated as one taxpayer.

(d) Costs—(1) Intangible development

costs. For purposes of this section, a

controlled participant’s costs of

developing intangibles for a taxable year

mean all of the costs incurred by that

participant related to the intangible

development area, plus all of the cost

sharing payments it makes to other

controlled and uncontrolled

participants, minus all of the cost

sharing payments it receives from other

controlled and uncontrolled

participants. Costs incurred related to

the intangible development area consist

of the following items: operating

expenses as defined in § 1.482–5(d)(3),

other than depreciation or amortization

expense, plus (to the extent not

included in such operating expenses, as

defined in § 1.482–5(d)(3)) the charge

for the use of any tangible property

made available to the qualified cost

sharing arrangement. If tangible

property is made available to the

qualified cost sharing arrangement by a

controlled participant, the

determination of the appropriate charge

will be governed by the rules of § 1.482–

2(c) (Use of tangible property).

Intangible development costs do not

include the consideration for the use of

any intangible property made available

to the qualified cost sharing

arrangement. See paragraph (g)(2) of this

section. If a particular cost contributes

to the intangible development area and

other areas or other business activities,

the cost must be allocated between the

intangible development area and the

other areas or business activities on a

reasonable basis. In such a case, it is

necessary to estimate the total benefits

attributable to the cost incurred. The

share of such cost allocated to the

intangible development area must

correspond to covered intangibles’ share

of the total benefits. Costs that do not

contribute to the intangible

development area are not taken into

account.

(2) Examples. The following examples

illustrate this paragraph (d):

Example 1. Foreign Parent (FP) and U.S.

Subsidiary (USS) enter into a qualified cost

sharing arrangement to develop a better

mousetrap. USS and FP share the costs of

FP’s research and development 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 but

does not contribute to the research and

development activities in any measurable

way. In this case, the cost of the conference

facility must be excluded from the amount of

intangible development costs.

Example 2. U.S. Parent (USP) and Foreign

Subsidiary (FS) enter into a qualified cost

sharing arrangement to develop a new

device. USP and FS share the costs of a

research and development facility, the

salaries of researchers, and reasonable

overhead costs attributable to the project.

USP also incurs costs related to field testing

of the device, but does not include them in

the amount of intangible development costs

of the cost sharing arrangement. The district

director may determine that the field testing

costs are intangible development costs that

must be shared.

(e) Anticipated benefits—(1) Benefits.

Benefits are additional income

generated or costs saved by the use of

covered intangibles.

(2) Reasonably anticipated benefits.

For purposes of this section, a

controlled participant’s reasonably

anticipated benefits are the aggregate

benefits that it reasonably anticipates

that it will derive from covered

intangibles.

(f) Cost allocations—(1) In general.

For purposes of determining whether a

cost allocation authorized by paragraph

(a)(2) of this section is appropriate for a

taxable year, a controlled participant’s

share of intangible development costs

for the taxable year under a qualified

cost sharing arrangement must be

compared to its share of reasonably

anticipated benefits under the

arrangement. A controlled participant’s

share of intangible development costs is

determined under paragraph (f)(2) of

this section. A controlled participant’s

share of reasonably anticipated benefits

under the arrangement is determined

under paragraph (f)(3) of this section. In
65560 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

determining whether benefits were

reasonably anticipated, it may be

appropriate to compare actual benefits

to anticipated benefits, as described in

paragraph (f)(3)(iv) of this section.

(2) Share of intangible development

costs—(i) In general. A controlled

participant’s share of intangible

development costs for a taxable year is

equal to its intangible development

costs for the taxable year (as defined in

paragraph (d) of this section), divided

by the sum of the intangible

development costs for the taxable year

(as defined in paragraph (d) of this

section) of all the controlled

participants.

(ii) Example. The following example

illustrates this paragraph (f)(2):

Example. (i) U.S. Parent (USP), Foreign

Subsidiary (FS), and Unrelated Third Party

(UTP) enter into a cost sharing arrangement

to develop new audio technology. In the first

year of the arrangement, the controlled

participants incur $2,250,000 in the

intangible development area, all of which is

incurred directly by USP. In the first year,

UTP makes a $250,000 cost sharing payment

to USP, and FS makes a $800,000 cost

sharing payment to USP, under the terms of

the arrangement. For that year, the intangible

development costs borne by USP are

$1,200,000 (its $2,250,000 intangible

development costs directly incurred, minus

the cost sharing payments it receives of

$250,000 from UTP and $800,000 from FS);

the intangible development costs borne by FS

are $800,000 (its cost sharing payment); and

the intangible development costs borne by all

of the controlled participants are $2,000,000

(the sum of the intangible development costs

borne by USP and FS of $1,200,000 and

$800,000, respectively). Thus, for the first

year, USP’s share of intangible development

costs is 60% ($1,200,000 divided by

$2,000,000), and FS’s share of intangible

development costs is 40% ($800,000 divided

by $2,000,000).

(ii) For purposes of determining whether a

cost allocation authorized by paragraph

§ 1.482–7(a)(2) is appropriate for the first

year, the district director must compare

USP’s and FS’s shares of intangible

development costs for that year to their

shares of reasonably anticipated benefits. See

paragraph (f)(3) of this section.

(3) Share of reasonably anticipated

benefits—(i) In general. A controlled

participant’s share of reasonably

anticipated benefits under a qualified

cost sharing arrangement is equal to its

reasonably anticipated benefits (as

defined in paragraph (e)(2) of this

section), divided by the sum of the

reasonably anticipated benefits (as

defined in paragraph (e)(2) of this

section) of all the controlled

participants. The anticipated benefits of

an uncontrolled participant will not be

included for purposes of determining

each controlled participant’s share of

anticipated benefits. A controlled

participant’s share of reasonably

anticipated benefits will be determined

using the most reliable estimate of

reasonably anticipated benefits. 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 anticipated benefits—

(A) The reliability of the basis used

for measuring benefits, as described in

paragraph (f)(3)(ii) of this section; and

(B) The reliability of the projections

used to estimate benefits, as described

in paragraph (f)(3)(iv) of this section.

(ii) Measure of benefits. In order to

estimate a controlled participant’s share

of anticipated benefits from covered

intangibles, the amount of benefits that

each of the controlled participants is

reasonably anticipated to derive from

covered intangibles must be measured

on a basis that is consistent for all such

participants. See paragraph (f)(3)(iii)(E),

Example 8, of this section. Anticipated

benefits are measured either on a direct

basis, by reference to estimated

additional income to be generated or

costs to be saved by the use of covered

intangibles, or on an indirect basis, by

reference to certain measurements that

reasonably can be assumed to be related

to income generated or costs saved.

Such indirect bases of measurement of

anticipated benefits are described in

paragraph (f)(3)(iii) of this section. A

controlled participant’s anticipated

benefits must be measured on the most

reliable basis, whether direct or indirect.

In determining which of two bases of

measurement of reasonably anticipated

benefits 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 covered

intangibles. See Example 6 of paragraph

(f)(3)(iii)(E) of this section.

(iii) Indirect bases for measuring

anticipated benefits. Indirect bases for

measuring anticipated benefits from

participation in a qualified cost sharing

arrangement include the following:

(A) Units used, produced or sold.

Units of items used, produced or sold by

each controlled participant in the

business activities in which covered

intangibles are exploited may be used as

an indirect basis for measuring its

anticipated benefits. This basis of

measurement will be more reliable 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 covered

intangibles per unit of the item or items

used, produced or sold. This

circumstance is most likely to arise

when the covered intangibles are

exploited by the controlled participants

in the use, production or sale of

substantially uniform items under

similar economic conditions.

(B) Sales. Sales by each controlled

participant in the business activities in

which covered intangibles are exploited

may be used as an indirect basis for

measuring its anticipated benefits. This

basis of measurement will be more

reliable to the extent that each

controlled participant is expected to

have a similar increase in net profit or

decrease in net loss attributable to

covered intangibles per dollar of sales.

This circumstance is most likely to arise

if the costs of exploiting covered

intangibles are not substantial relative to

the revenues generated, or if the

principal effect of using covered

intangibles is to increase the controlled

participants’ revenues (e.g., 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 benefits

unless each controlled participant

operates at the same market level (e.g.,

manufacturing, distribution, etc.).

(C) Operating profit. Operating profit

of each controlled participant from the

activities in which covered intangibles

are exploited may be used as an indirect

basis for measuring its anticipated

benefits. This basis of measurement will

be more reliable to the extent that such

profit is largely attributable to the use of

covered intangibles, or if the share of

profits attributable to the use of covered

intangibles is expected to be similar for

each controlled participant. This

circumstance is most likely to arise

when covered intangibles are integral to

the activity that generates the profit and
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65561

the activity could not be carried on or

would generate little profit without use

of those intangibles.

(D) Other bases for measuring

anticipated benefits. 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 covered 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 the

use of covered intangibles.

(E) Examples. The following examples

illustrate this paragraph (f)(3)(iii):

Example 1. Foreign Parent (FP) and U.S.

Subsidiary (USS) both produce a feedstock

for the manufacture of various highperformance 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 cost sharing arrangement 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 X% of its

other production costs and rates for each are

expected to remain similar in the future. How

much the new process, if it is successful, will

reduce the amount of electricity required to

produce a unit of the feedstock is uncertain,

but it will be about the same amount for both

companies. Therefore, the cost savings each

company is expected to achieve after

implementing the new process are similar

relative to the total amount of the feedstock

produced. Under the cost sharing

arrangement 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 benefits and dividing the

intangible development costs because each

participant is expected to have a similar

decrease in costs per unit of the feedstock

produced.

Example 2. The facts are the same as in

Example 1, except that USS pays X% of its

other production costs for electricity while

FP pays 2X% of its other production costs.

In this case, units produced is not the most

reliable basis for measuring benefits and

dividing the intangible development costs

because the participants do not expect to

have a similar decrease in costs per unit of

the feedstock produced. The district director

determines that the most reliable measure of

benefit 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 per unit of the

feedstock would be twice USS’s savings from

any new process eventually developed.

Example 3. The facts are the same as in

Example 2, 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 benefit shares. In

order to reliably determine benefit shares, the

district director offsets the reasonably

anticipated costs of adopting the new process

against the reasonably anticipated total

savings in electricity costs.

Example 4. U.S. Parent (USP) and Foreign

Subsidiary (FS) enter into a cost sharing

arrangement 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

European market. 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 U.S., whereas

drug prices are regulated in many European

countries. In this case, the controlled

taxpayers’ basis for measuring benefits is the

most reliable.

Example 5. (i) Foreign Parent (FP) and U.S.

Subsidiary (USS) both manufacture and sell

fertilizers. They enter into a cost sharing

arrangement to develop a new pellet form of

a common agricultural fertilizer that is

currently available only in powder form.

Under the cost sharing arrangement, 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 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. 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 taxpayers’

basis for measuring benefits is the most

reliable.

Example 6. The facts are the same as in

Example 5, 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 benefits unless adjustments are

made to account for the difference in market

levels at which the sales occur.

Example 7. Foreign Parent (FP) and U.S.

Subsidiary (USS) enter into a cost sharing

arrangement 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

divide costs based on the number of entrylevel employees hired by each. Rather, they

divide costs based on compensation paid to

the entry-level employees hired by each. In

this case, the basis used for measuring

benefits 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. U.S. Parent (USP), Foreign

Subsidiary 1 (FS1) and Foreign Subsidiary 2

(FS2) enter into a cost sharing arrangement

to develop computer software that each will

market and install on customers’ computer

systems. The participants divide costs on the

basis of projected sales by USP, FS1, and FS2

of the software in their respective geographic

areas. However, FS1 plans for sound business

reasons not only to sell but also to license the

software, 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 participant is not the most

reliable because all of the benefits received

by participants are not taken into account. In

order to reliably determine benefit 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 participants’ projected

benefits from sales (e.g., all participants

might measure their benefits on the basis of

operating profit).

(iv) Projections used to estimate

anticipated benefits—(A) In general.

The reliability of an estimate of

anticipated benefits 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 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 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
65562 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

benefit shares are expected to vary

significantly over the years in which

benefits will be received, it may be

necessary to use the present discounted

value of the projected benefits to

reliably determine each controlled

participant’s share of those benefits. If it

is not anticipated that benefit shares

will significantly change over time,

current annual benefit shares may

provide a reliable projection of

anticipated benefit shares. This

circumstance is most likely to occur

when the cost sharing arrangement is a

long-term arrangement, the arrangement

covers a wide variety of intangibles, the

composition of the covered intangibles

is unlikely to change, the covered

intangibles are unlikely to generate

unusual profits, and each controlled

participant’s share of the market is

stable.

(B) Unreliable projections. A

significant divergence between

projected benefit shares and actual

benefit shares may indicate that the

projections were not reliable. In such a

case, the district director may use actual

benefits as the most reliable measure of

anticipated benefits. 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. Projections

will not be considered unreliable based

on a divergence between a controlled

participant’s projected benefit share and

actual benefit share if the amount of

such divergence for every controlled

participant is less than or equal to 20%

of the participant’s projected benefit

share. Further, the district director will

not make an allocation based on such

divergence if the difference is due to an

extraordinary event, beyond the control

of the participants, that could not

reasonably have been anticipated at the

time that costs were shared. For

purposes of this paragraph, all

controlled participants that are not U.S.

persons will be treated as a single

controlled participant. Therefore, an

adjustment based on an unreliable

projection will be made to the cost

shares of foreign controlled participants

only if there is a matching adjustment

to the cost shares of controlled

participants that are U.S. persons.

Nothing in this paragraph (f)(3)(iv)(B)

will prevent the district director from

making an allocation if the taxpayer did

not use the most reliable basis for

measuring anticipated benefits. For

example, if the taxpayer measures

anticipated benefits based on units sold,

and the district director 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.

(C) Foreign-to-foreign adjustments.

Notwithstanding the limitations on

adjustments provided in paragraph

(f)(3)(iv)(B) of this section, adjustments

to cost 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.

(D) Examples. The following

examples illustrate this paragraph

(f)(3)(iv):

Example 1. (i) Foreign Parent (FP) and U.S.

Subsidiary (USS) enter into a cost sharing

arrangement to develop a new car model. The

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

662⁄3% of each year’s intangible development

costs and FP bears 331⁄3% of such costs.

(ii) USS typically begins producing and

selling new car models a year after FP begins

producing and selling new car models. The

district director determines that in order to

reflect USS’ one-year lag in introducing new

car models, a more reliable projection of each

participant’s share of benefits would be based

on a projection of all four years of sales for

each participant, discounted to present value.

Example 2. U.S. Parent (USP) and Foreign

Subsidiary (FS) enter into a cost sharing

arrangement to develop new and improved

household cleaning products. Both

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 participant. The participants

divide costs on the basis of each participant’s

current sales of household cleaning products.

In this case, the participants’ future benefit

shares are reliably projected by current sales

of cleaning products.

Example 3. The facts are the same as in

Example 2, except that FS’s market share is

rapidly expanding because of the business

failure of a competitor in its geographic area.

The district director determines that the

participants’ future benefit shares are not

reliably projected by current sales of cleaning

products and that FS’s benefit projections

should take into account its growth in sales.

Example 4. Foreign Parent (FP) and U.S.

Subsidiary (USS) enter into a cost sharing

arrangement to develop synthetic fertilizers

and insecticides. FP and USS share costs on

the basis of each participant’s current sales

of fertilizers and insecticides. The market

shares of the participants have been stable for

fertilizers, but FP’s market share for

insecticides has been expanding. The district

director determines that the participants’

projections of benefit shares are reliable with

regard to fertilizers, but not reliable with

regard to insecticides; a more reliable

projection of benefit shares would take into

account the expanding market share for

insecticides.

Example 5. U.S. Parent (USP) and Foreign

Subsidiary (FS) enter into a cost sharing

arrangement 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 district director examines the

participants’ method for dividing costs. USP

and FS actually accounted for 42% and 58%

of total sales, respectively. The district

director 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 actual and projected

benefit shares are less than 20% of their

projected benefit shares, the projection of

future benefits for year 3 is reliable.

Example 6. The facts are the same as in

Example 5, except that the in year 3 USP and

FS actually accounted for 35% and 65% of

total sales, respectively. The divergence

between USP’s projected and actual 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

participants. The district director concludes

that the projection of anticipated benefit

shares was unreliable, and uses actual

benefits as the basis for an adjustment to the

cost shares borne by USP and FS.

Example 7. U.S. Parent (USP), a U.S.

corporation, and its foreign subsidiary (FS)

enter a cost sharing arrangement 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 participants’

projections, the district director compares

these actual benefit shares to the projected

benefit shares. Although USP’s actual benefit

share (50%) is within 20% of its projected

benefit share (60%), FS’s actual benefit share

(50%) is not within 20% of its projected

benefit share (40%). Based on this

discrepancy, the district director may

conclude that the participants’ projections

were not reliable and may use actual benefit

shares as the basis for an adjustment to the

cost shares borne by USP and FS.

Example 8. Three controlled taxpayers,

USP, FS1 and FS2 enter into a cost sharing

arrangement. FS1 and FS2 are foreign. USP

is a United States corporation that controls

all the stock of FS1 and FS2. The participants

project that they will share the total benefits

of the covered intangibles in the following

percentages: USP 50%; FS1 30%; and FS2

20%. Actual benefit shares are as follows:

USP 45%; FS1 25%; and FS2 30%. In

evaluating the reliability of the participants’

projections, the district director compares

these actual benefit shares to the projected

benefit shares. For this purpose, FS1 and FS2

are treated as a single participant. The actual

benefit share received by USP (45%) is

within 20% of its projected benefit share
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65563

(50%). In addition, the non-US participants’

actual benefit share (55%) is also within 20%

of their projected benefit share (50%).

Therefore, the district director concludes that

the participants’ projections of future benefits

were reliable, despite the fact that FS2’s

actual benefit share (30%) is not within 20%

of its projected benefit share (20%).

Example 9. The facts are the same as in

Example 8. In addition, the district director

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 district

director concludes that the 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 § 1.482–7 (f)(3)(iv)(C),

the district director 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 actual and projected benefits had

the effect of substantially reducing USP’s

U.S. income tax liability (on account of FS1

subpart F income).

Example 10. (i)(A) Foreign Parent (FP) and

U.S. Subsidiary (USS) enter into a cost

sharing arrangement 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

1997 ...................................... 5 10

1998 ...................................... 20 20

1999 ...................................... 30 30

2000 ...................................... 40 40

2001 ...................................... 40 40

2002 ...................................... 40 40

2003 ...................................... 40 40

2004 ...................................... 20 20

2005 ...................................... 10 10

2006 ...................................... 5 5

(B) In 1997, 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

first year, 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 the year 2002 the district

director examines the cost sharing

arrangement. USS and FP have obtained the

following sales results through the year 2001:

SALES

[In millions of dollars]

Year USS FP

1997 ...................................... 0 17

1998 ...................................... 17 35

1999 ...................................... 25 41

2000 ...................................... 38 41

2001 ...................................... 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 the year

2001 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 district

director determines that it is appropriate to

use the original projections for the remaining

years of sales. Combining the actual results

through the year 2001 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 benefit

shares are within 20% of the benefit shares

calculated based on the original sales

projections, the district director determines

that, based on the difference between actual

and projected benefit shares, the original

projections were not unreliable. No

adjustment is made based on the difference

between actual and projected benefit shares.

Example 11. (i) The facts are the same as

in Example 10, except that the actual sales

results through the year 2001 are as follows:

SALES

[In millions of dollars]

Year USS FP

1997 ...................................... 0 17

1998 ...................................... 17 35

1999 ...................................... 25 44

2000 ...................................... 34 54

2001 ...................................... 36 55

(ii) Based on the discrepancy between the

projections and the actual results and on

consideration of all the facts, the district

director 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

2002 .................................... 36 55

2003 .................................... 36 55

2004 .................................... 18 28

2005 .................................... 9 14

2006 .................................... 4.5 7

(iii) Combining the actual results through

the year 2001 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

benefit shares diverge by greater than 20%

from the benefit shares calculated based on

the original sales projections, and the district

director determines that, based on the

difference between actual and projected

benefit shares, the original projections were

unreliable. The district director adjusts costs

shares for each of the taxable years under

examination to conform them to the

recalculated shares of anticipated benefits.

(4) Timing of allocations. If the

district director reallocates costs under

the provisions of this paragraph (f), the

allocation must be reflected for tax

purposes in the year in which the costs

were incurred. When a cost sharing

payment is owed by one member of a

qualified cost sharing arrangement to

another member, the district director

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).

(g) Allocations of income, deductions

or other tax items to reflect transfers of

intangibles (buy-in)—(1) In general. A

controlled participant that makes

intangible property available to a

qualified cost sharing arrangement will

be treated as having transferred interests

in such property to the other controlled

participants, and such other controlled

participants must make buy-in

payments to it, as provided in paragraph

(g)(2) of this section. If the other

controlled participants fail to make such

payments, the district director may

make appropriate allocations, under the

provisions of §§ 1.482–1 and 1.482–4

through 1.482–6, to reflect an arm’s

length consideration for the transferred

intangible property. Further, if a group

of controlled taxpayers participates in a

qualified cost sharing arrangement, any

change in the controlled participants’

interests in covered intangibles, whether

by reason of entry of a new participant

or otherwise by reason of transfers

(including deemed transfers) of interests

among existing participants, is a transfer
65564 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

of intangible property, and the district

director may make appropriate

allocations, under the provisions of

§§ 1.482–1 and 1.482–4 through 1.482–

6, to reflect an arm’s length

consideration for the transfer. See

paragraphs (g) (3), (4), and (5) of this

section. Paragraph (g)(6) of this section

provides rules for assigning unassigned

interests under a qualified cost sharing

arrangement.

(2) Pre-existing intangibles. If a

controlled participant makes preexisting intangible property in which it

owns an interest available to other

controlled participants for purposes of

research in the intangible development

area under a qualified cost sharing

arrangement, then each such other

controlled participant must make a buyin payment to the owner. The buy-in

payment by each such other controlled

participant is the arm’s length charge for

the use of the intangible under the rules

of §§ 1.482–1 and 1.482–4 through

1.482–6, multiplied by the controlled

participant’s share of reasonably

anticipated benefits (as defined in

paragraph (f)(3) of this section). A

controlled participant’s payment

required under this paragraph (g)(2) is

deemed to be reduced to the extent of

any payments owed to it under this

paragraph (g)(2) from other controlled

participants. Each payment received by

a payee will be treated as coming pro

rata out of payments made by all payors.

See paragraph (g)(8), Example 4, of this

section. Such payments will be treated

as consideration for a transfer of an

interest in the intangible property made

available to the qualified cost sharing

arrangement by the payee. Any payment

to or from an uncontrolled participant

in consideration for intangible property

made available to the qualified cost

sharing arrangement will be shared by

the controlled participants in

accordance with their shares of

reasonably anticipated benefits (as

defined in paragraph (f)(3) of this

section). A controlled participant’s

payment required under this paragraph

(g)(2) is deemed to be reduced by such

a share of payments owed from an

uncontrolled participant to the same

extent as by any payments owed from

other controlled participants under this

paragraph (g)(2). See paragraph (g)(8),

Example 5, of this section.

(3) New controlled participant. If a

new controlled participant enters a

qualified cost sharing arrangement and

acquires any interest in the covered

intangibles, then the new participant

must pay an arm’s length consideration,

under the provisions of §§ 1.482–1 and

1.482–4 through 1.482–6, for such

interest to each controlled participant

from whom such interest was acquired.

(4) Controlled participant relinquishes

interests. A controlled participant in a

qualified cost sharing arrangement may

be deemed to have acquired an interest

in one or more covered intangibles if

another controlled participant transfers,

abandons, or otherwise relinquishes an

interest under the arrangement, to the

benefit of the first participant. If such a

relinquishment occurs, the participant

relinquishing the interest must receive

an arm’s length consideration, under the

provisions of §§ 1.482–1 and 1.482–4

through 1.482–6, for its interest. If the

controlled participant that has

relinquished its interest subsequently

uses that interest, then that participant

must pay an arm’s length consideration,

under the provisions of §§ 1.482–1 and

1.482–4 through 1.482–6, to the

controlled participant that acquired the

interest.

(5) Conduct inconsistent with the

terms of a cost sharing arrangement. If,

after any cost allocations authorized by

paragraph (a)(2) of this section, a

controlled participant bears costs of

intangible development that over a

period of years are consistently and

materially greater or lesser than its share

of reasonably anticipated benefits, then

the district director may conclude that

the economic substance of the

arrangement between the controlled

participants is inconsistent with the

terms of the cost sharing arrangement.

In such a case, the district director may

disregard such terms and impute an

agreement consistent with the

controlled participants’ course of

conduct, under which a controlled

participant that bore a

disproportionately greater share of costs

received additional interests in covered

intangibles. See § 1.482–1(d)(3)(ii)(B)

(Identifying contractual terms) and

§ 1.482- 4(f)(3)(ii) (Identification of

owner). Accordingly, that participant

must receive an arm’s length payment

from any controlled participant whose

share of the intangible development

costs is less than its share of reasonably

anticipated benefits over time, under the

provisions of §§ 1.482–1 and 1.482–4

through 1.482–6.

(6) Failure to assign interests under a

qualified cost sharing arrangement. If a

qualified cost sharing arrangement fails

to assign an interest in a covered

intangible, then each controlled

participant will be deemed to hold a

share in such interest equal to its share

of the costs of developing such

intangible. For this purpose, if cost

shares have varied materially over the

period during which such intangible

was developed, then the costs of

developing the intangible must be

measured by their present discounted

value as of the date when the first such

costs were incurred.

(7) Form of consideration. The

consideration for an acquisition

described in this paragraph (g) may take

any of the following forms:

(i) Lump sum payments. For the

treatment of lump sum payments, see

§ 1.482–4(f)(5) (Lump sum payments);

(ii) Installment payments. Installment

payments spread over the period of use

of the intangible by the transferee, with

interest calculated in accordance with

§ 1.482–2(a) (Loans or advances); and

(iii) Royalties. Royalties or other

payments contingent on the use of the

intangible by the transferee.

(8) Examples. The following examples

illustrate allocations described in this

paragraph (g):

Example 1. In year one, four members of

a controlled group enter into a cost sharing

arrangement to develop a commercially

feasible process for capturing energy from

nuclear fusion. Based on a reliable projection

of their future benefits, each cost sharing

participant bears an equal share of the costs.

The cost of developing intangibles for each

participant with respect to the project is

approximately $1 million per year. In year

ten, a fifth member of the controlled group

joins the cost sharing group and agrees to

bear one-fifth of the future costs in exchange

for part of the fourth member’s territory

reasonably anticipated to yield benefits

amounting to one-fifth of the total benefits.

The fair market value of intangible property

within the arrangement at the time the fifth

company joins the arrangement is $45

million. The new member must pay one-fifth

of that amount (that is, $9 million total) to

the fourth member from whom it acquired its

interest in covered intangibles.

Example 2. U.S. Subsidiary (USS), Foreign

Subsidiary (FS) and Foreign Parent (FP) enter

into a cost sharing arrangement to develop

new products within the Group X product

line. USS manufactures and sells Group X

products in North America, FS manufactures

and sells Group X products in South

America, and FP manufactures and sells

Group X products in the rest of the world.

USS, FS and FP project that each will

manufacture and sell a third of the Group X

products under development, and they share

costs on the basis of projected sales of

manufactured products. When the new

Group X products are developed, however,

USS ceases to manufacture Group X

products, and FP sells its Group X products

to USS for resale in the North American

market. USS earns a return on its resale

activity that is appropriate given its function

as a distributor, but does not earn a return

attributable to exploiting covered intangibles.

The district director determines that USS’

share of the costs (one-third) was greater than

its share of reasonably anticipated benefits

(zero) and that it has transferred an interest

in the intangibles for which it should receive

a payment from FP, whose share of the
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65565

intangible development costs (one-third) was

less than its share of reasonably anticipated

benefits over time (two-thirds). An allocation

is made under §§ 1.482–1 and 1.482–4

through 1.482–6 from FP to USS to recognize

USS’ one-third interest in the intangibles. No

allocation is made from FS to USS because

FS did not exploit USS’ interest in covered

intangibles.

Example 3. U.S. Parent (USP), Foreign

Subsidiary 1 (FS1), and Foreign Subsidiary 2

(FS2) enter into a cost sharing arrangement

to develop a cure for the common cold. Costs

are shared USP–50%, FS1–40% and FS2–

10% on the basis of projected units of cold

medicine to be produced by each. After ten

years of research and development, FS1

withdraws from the arrangement, transferring

its interests in the intangibles under

development to USP in exchange for a lump

sum payment of $10 million. The district

director may review this lump sum payment,

under the provisions of § 1.482–4(f)(5), to

ensure that the amount is commensurate

with the income attributable to the

intangibles.

Example 4. (i) Four members A, B, C, and

D of a controlled group form a cost sharing

arrangement to develop the next generation

technology for their business. Based on a

reliable projection of their future benefits, 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 charges,

under the rules of §§ 1.482–1 and 1.482–4

through 1.482–6, for the use of the existing

intangible property they respectively make

available to the cost sharing arrangement are

in the following amounts for the taxable year:

A 80X; B 40X; C 30X; and D 30X. The

provisional (before offsets) and final buy-in

payments/receipts 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 buy-in payment equal to the

product of 100X (sum of 40X, 30X, and 30X)

and A’s share of anticipated benefits of 40%.

The second row/first column shows A’s

provisional buy-in receipts equal to the sum

of the products of 80X and B’s, C’s, and D’s

anticipated benefits 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 buyin 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.

Example 5. A and B, two members of a

controlled group form a cost sharing

arrangement with an unrelated third party C

to develop a new technology useable in their

respective businesses. Based on a reliable

projection of their future benefits, A and B

agree to bear shares of 60% and 40%,

respectively, of the costs incurred during the

term of the agreement. A also makes available

its existing technology for purposes of the

research to be undertaken. The arm’s length

charge, under the rules of §§ 1.482–1 and

1.482–4 through 1.482–6, for the use of the

existing technology is 100X for the taxable

year. Under its agreement with A and B, C

must make a specified cost sharing payment

as well as a payment of 50X for the taxable

year on account of the pre- existing

intangible property made available to the cost

sharing arrangement. B’s provisional buy-in

payment (before offsets) to A for the taxable

year is 40X (the product of 100X and B’s

anticipated benefits share of 40%). C’s

payment of 50X is shared provisionally

between A and B in accordance with their

shares of reasonably anticipated benefits, 30X

(50X times 60%) to A and 20X (50X times

40%) to B. B’s final buy-in payment (after

offsets) is 20X (40X less 20X). A is treated as

receiving the 70X total provisional payments

(40X plus 30X) pro rata out of the final

payments by B and C of 20X and 50X,

respectively.

(h) Character of payments made

pursuant to a qualified cost sharing

arrangement—(1) In general. Payments

made pursuant to a qualified cost

sharing arrangement (other than

payments described in paragraph (g) of

this section) 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

(h), a controlled participant’s payment

required under a qualified cost sharing

arrangement is deemed to be reduced to

the extent of any payments owed to it

under the arrangement from other

controlled or uncontrolled participants.

Each payment received by a payee will

be treated as coming pro rata out of

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 qualified cost sharing

arrangement. Payments received in

excess of such deductions will be

treated as in consideration for use of the

tangible property made available to the

qualified cost sharing arrangement 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–

8(e). Any payment made or received by

a taxpayer pursuant to an arrangement

that the district director determines not

to be a qualified cost sharing

arrangement, or a payment made or

received pursuant to paragraph (g) of

this section, 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.

(2) Examples. The following examples

illustrate this paragraph (h):

Example 1. U.S. Parent (USP) and its

wholly owned Foreign Subsidiary (FS) form

a cost sharing arrangement to develop a

miniature widget, the Small R. Based on a

reliable projection of their future benefits,

USP agrees to bear 40% and FS to bear 60%

of the costs incurred during the term of the

agreement. The principal costs in the

intangible development area are operating

expenses incurred by FS in Country Z of

100X annually, and operating expenses

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,

so that FS must make a payment to USP of

20X. This payment will be treated as a

reimbursement of 20X of USP’s operating

expenses 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. The facts are the same as in

Example 1, except that the 100X of costs

borne by USP consist of 5X of operating

expenses incurred by USP in the United

States and 95X of fair market value rental

cost for 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 operating

expenses and the 7X depreciation deduction

attributable to the U.S. facility. The 8X

remainder will be treated as rent for the U.S.

facility.

(i) Accounting requirements. The

accounting requirements of this

paragraph are that the controlled
65566 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

participants in a qualified cost sharing

arrangement must use a consistent

method of accounting to measure costs

and benefits, and must translate foreign

currencies on a consistent basis.

(j) Administrative requirements—(1)

In general. The administrative

requirements of this paragraph consist

of the documentation requirements of

paragraph (j)(2) of this section and the

reporting requirements of paragraph

(j)(3) of this section.

(2) Documentation. A controlled

participant must maintain sufficient

documentation to establish that the

requirements of paragraphs (b)(4) and

(c)(1) of this section have been met, as

well as the additional documentation

specified in this paragraph (j)(2), and

must provide any such documentation

to the Internal Revenue Service within

30 days of a request (unless an

extension is granted by the district

director). Documents necessary to

establish the following must also be

maintained—

(i) The total amount of costs incurred

pursuant to the arrangement;

(ii) The costs borne by each controlled

participant;

(iii) A description of the method used

to determine each controlled

participant’s share of the intangible

development costs, including the

projections used to estimate benefits,

and an explanation of why that method

was selected;

(iv) The accounting method used to

determine the costs and benefits of the

intangible development (including the

method used to translate foreign

currencies), and, to the extent that the

method materially differs from U.S.

generally accepted accounting

principles, an explanation of such

material differences; and

(v) Prior research, if any, undertaken

in the intangible development area, any

tangible or intangible property made

available for use in the arrangement, by

each controlled participant, and any

information used to establish the value

of pre-existing and covered intangibles.

(3) Reporting requirements. A

controlled participant must attach to its

U.S. income tax return a statement

indicating that it is a participant in a

qualified cost sharing arrangement, and

listing the other controlled participants

in the arrangement. A controlled

participant that is not required to file a

U.S. income tax return must ensure that

such a statement is attached to Schedule

M of any Form 5471 or to any Form

5472 filed with respect to that

participant.

(k) Effective date. This section is

effective for taxable years beginning on

or after January 1, 1996.

(l) Transition rule. A cost sharing

arrangement will be considered a

qualified cost sharing arrangement,

within the meaning of this section, if,

prior to January 1, 1996, the

arrangement was a bona fide cost

sharing arrangement under the

provisions of § 1.482–7T (as contained

in the 26 CFR part 1 edition revised as

of April 1, 1995), but only if the

arrangement is amended, if necessary, to

conform with the provisions of this

section by December 31, 1996.

§ 1.482–7T [Removed]

Par. 4. Section 1.482–7T is removed.

PART 301—PROCEDURE AND

ADMINISTRATION

Par. 5. The authority for part 301

continues to read in part as follows:

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

Par. 6. Section 301.7701–3 is

amended by adding paragraph (e) to

read as follows:

§ 301.7701–3 Partnerships.

* * * * *

(e) Qualified cost sharing

arrangements. A qualified cost sharing

arrangement that is described in

§ 1.482–7 of this chapter and any

arrangement that is treated by the

Service as a qualified cost sharing

arrangement under § 1.482–7 of this

chapter is not classified as a partnership

for purposes of the Internal Revenue

Code. See § 1.482–7 of this chapter for

the proper treatment of qualified cost

sharing arrangements.

PART 602—OMB CONTROL NUMBERS

UNDER THE PAPERWORK

REDUCTION ACT

Par. 7. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 8. In § 602.101, paragraph (c) is

amended by adding an entry to the table

in numerical order to read as follows:

‘‘1.482–7 .......................................1545–1364’’.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: November 30, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95–30617 Filed 12–19–95; 8:45 am]

BILLING CODE 4830–01–U

26 CFR Part 53

[TD 8639]

RIN 1545–AT03

Excise Tax On Self-Dealing By Private

Foundations

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations that clarify the definition of

self-dealing for private foundations.

These regulations modify the

application of the self-dealing rules to

the provision by a private foundation of

directors’ and officers’ liability

insurance to disqualified persons. In

general, these regulations provide that

indemnification by a private foundation

or provision of insurance for purposes

of covering the liabilities of the person

in his/her capacity as a manager of the

private foundation is not self-dealing.

Additionally, the amounts expended by

the private foundation for insurance or

indemnification generally are not

included in the compensation of the

disqualified person for purposes of

determining whether the disqualified

person’s compensation is reasonable.

DATES: These regulations are effective

December 20, 1995.

FOR FURTHER INFORMATION CONTACT:

Terri Harris or Paul Accettura of the

Office of the Associate Chief Counsel

(Employee Benefits and Exempt

Organizations), IRS, at 202–622–6070

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On January 3, 1995 proposed

regulations amending § 53.4941(d)–2(f)

[EE–56–94, 1995–6 I.R.B. 39] under

section 4941 of the Internal Revenue

Code of 1986 were published in the

Federal Register (60 FR 82). The

proposed regulations provided that

generally it would not be self-dealing,

nor treated as the payment of

compensation, if a private foundation

were to indemnify or provide insurance

to a foundation manager in any civil

judicial or civil administrative

proceeding arising out of the manager’s

performance of services on behalf of the

foundation. After IRS and Treasury

consideration of the public comments

received regarding the proposed

regulations, the regulations are adopted

as revised by this Treasury decision.

Explanation of Provisions

Section 4941(a) imposes a tax on each

act of self-dealing between a