internal_revenue_service p o box cincinnati oh release number release date date date department of the treasury employer_identification_number contact person - id number contact telephone number legend uil x scholarship fund h affiliated companies dear you asked for advance approval of your employer-related scholarship grant procedures under internal_revenue_code sec_4945 this approval is required because you are a private_foundation that is exempt from federal_income_tax you requested approval of your scholarship program to fund the education of certain qualifying students our determination we approved your procedures for awarding employer-related scholarships based on the information you submitted and assuming you will conduct your program as proposed we determined that your procedures for awarding employer-related scholarships meet the requirements of code sec_4945 as a result expenditures you make under these procedures won't be taxable also awards made under these procedures are scholarship or fellowship grants and are not taxable to the recipients if they use them for qualified_tuition_and_related_expenses subject_to the limitations provided in code sec_117 description of your request your letter indicates you will operate an employer-related scholarship program called x your purpose is to make distributions for charitable and educational_purposes within the meaning of sec_501 of the internal_revenue_code the purpose of x is to provide educational scholarships to the lineal_descendants of employees of h by selecting qualified individuals to receive grants to advance their education lineal_descendants include but are not limited to children step-children adopted children and grandchildren of eligible employees of h an eligible_employee is one that has completed one year of continuous full-time service with h prior to the date the letter catalog number 58264e scholarship will be awarded eligibility is not based upon the employee's position job title within h nor is it conditioned upon the employee’s continued employment with h all students who have graduated from high school and plan to attend an accredited post- secondary educational_institution are encouraged to apply for a scholarship all students are considered regardless of their sex race age color national origin religion marital status handicap veteran status or parental status the post-secondary educational_institution must be accredited by the north central association of colleges and secondary schools or an equivalent as determined by the scholarship committee the scholarship committee consists of five community representatives who are separate and independent from h the size of the scholarship award will be determined by the scholarship committee based upon the annual employee contributions in the year preceding the deadline date for applications the number of scholarship awards will be dependent upon the number of students who are eligible or who apply for an award in each year the number of awards will not exceed the lesser_of i twenty-five percent of the number of students who are considered by the scholarship committee or ii ten percent of the number of individuals who can be shown to be eligible for the awards if more than one scholarship award is granted in a given year each award will be in identical amounts in any year that the percentages tests are not met awards will not be granted and the funds will accumulate for the following year each award is granted for a one -year period with possible renewals awards do not automatically renew students must reapply every year when reapplying a student recipient in a prior year will be considered eligible even if the student's employee sponsor is no longer employed by h x is communicated through employees’ newsletters mailings to employees’ homes company bulletin boards presentations at employees’ meetings inserts in employees’ checks news releases to the media and any other reasonable form of communication in all communications the scholarship will not be portrayed as an independent incentive a recruitment device or as additional employee compensation selection is based on financial need scholarship recommendations test scores class ranking and extra-curricular involvement the application requests letter catalog number 58264e a one-page essay detailing the applicant's high school years or if re-applying post-secondary years and activities as well as plans for the future the essay should include extra-curricular activities such as school-related community sports work and or religious involvement copy of the applicant’s most recent form_1040 copy of the applicant’s college acceptance letter graduating seniors copy of the applicant’s most recent high school or college grades showing all years attended two letters of recommendation - one from a teacher and one from an individual who is not a teacher or a relative applicants are rated based on academic performance scholastic records grade point average extracurricular activities community activities financial need full-time status personal interview essay designed to show the applicant’s motivation character ability and potential students will provide the scholarship committee a progress report at the end of the first quarter or semester of the academic year and at the end of the academic year the progress report must include a copy of the student’s grade card or transcripts for the academic year and a short letter summarizing the student’s progress and the importance of the award to the student’s academic progress in renewing an award the items provided will be considered the scholarship committee shall maintain the following records for each scholarship grant awarded statement of the objective and non-discriminatory procedures used to select a recipients adequate information regarding each applicant including all information that the b scholarship committee secures to evaluate the qualifications of the applicant cc identification of the applicant specification of the award amount and demonstration of the sec_117 purposes for d which the award was used qualified_tuition_and_related_expenses letter catalog number 58264e verification of the appropriate publication of the scholarship award program and e results and information which the scholarship committee obtains regarding follow-up f investigation including follow-up reports required from all recipients scholarship funds will be disbursed to the educational_institution which the award recipient is attending the scholarship committee will investigate any misuse of funds and withhold further payments to the extent possible if the scholarship committee does not receive a required report or if reports or other information indicate that grant proceeds are not being used for the purpose for which the grants were made the scholarship committee will take all reasonable and necessary steps to recover grant funds or to ensure restoration of the funds and their dedication to the purposes the grant funds are financing basis for our determination the law imposes certain excise_taxes on the taxable_expenditures of private_foundations code sec_4945 a taxable_expenditure is any amount a private_foundation pays as a grant to an individual for travel study or other similar purposes however a grant that meets all of the following requirements of code sec_4945 is not a taxable_expenditure the foundation awards the grant on an objective and nondiscriminatory basis the irs approves in advance the procedure for awarding the grant the grant is a scholarship or fellowship subject_to code sec_117 the grant is to be used for study at an educational_organization described in code sec_170 revproc_76_47 1976_2_cb_670 provides guidelines to determine whether grants a private_foundation makes under an employer-related program to employees or children of employees are scholarship or fellowship grants subject_to the provisions of code sec_117 if the program satisfies the seven conditions in sections dollar_figure through dollar_figure of revproc_76_47 and meets the applicable_percentage tests described in section dollar_figure of revproc_76_47 we will assume the grants are subject_to the provisions of code sec_117 you represented that your grant program will meet the requirements of either the percent or percent percentage_test in revproc_76_47 these tests require that e the number of grants awarded to employees’ children in any year won't exceed percent of the number of employees’ children who were eligible for grants were applicants for grants and were considered by the selection committee for grants or letter catalog number 58264e the number of grants awarded to employees’ children in any year won't exceed percent of the number of employees’ children who were eligible for grants whether or not they submitted an application or the number of grants awarded to employees in any year won't exceed percent of the number of employees who were eligible for grants were applicants for grants and were considered by the selection committee for grants you further represented that you will include only children who meet the eligibility standards described in revproc_85_51 1985_2_cb_717 when applying the percent test applicable to employees’ children in determining how many employee children are eligible for a scholarship under the percent test a private_foundation may include only those children who submit a written_statement or who meet the foundation's eligibility requirements they must also satisfy certain enrollment conditions you represented that your procedures for awarding grants under this program will meet the requirements of revproc_76_47 in particular an independent selection committee whose members are separate from you your creator and the employer will select individual grant recipients you will not use grants to recruit employees nor will you end a grant if the employee leaves the employer you will not limit the recipient to a course of study that would particularly benefit you or the employer other conditions that apply to this determination this determination only covers the grant program described above this approval will apply to succeeding grant programs only if their standards and procedures don’t differ significantly from those described in your original request this determination is in effect as long as your procedures comply with sections dollar_figure through dollar_figure of revproc_76_47 and with either of the percentage tests of sec_4 if you establish another program covering the same individuals that program must also meet the percentage_test this determination applies only to you it may not be cited as a precedent you cannot rely on the conclusions in this letter if the facts you provided have changed substantially you must report any significant changes to your program to the cincinnati office of exempt_organizations at internal_revenue_service exempt_organizations determinations p o box cincinnati oh letter catalog number 58264e e e e you cannot award grants to your creators officers directors trustees foundation managers or members of selection committees or their relatives all funds distributed to individuals must be made on a charitable basis and further the purposes of your organization you cannot award grants for a purpose that is inconsistent with code sec_170 you should keep adequate_records and case histories so that you can substantiate your grant distributions with the irs if necessary we've sent a copy of this letter to your representative as indicated in your power_of_attorney please keep a copy of this letter in your records if you have questions please contact the person listed at the top of this letter sincerely stephen a martin director exempt_organizations rulings and agreements letter catalog number 58264e


internal_revenue_service number release date index number ----------------------------- -------------------------------------------------------- ---------------------------------- ---------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ------------------------------- ------------ telephone number -------------------- refer reply to cc psi b01 plr-126808-14 date date legend x state date date year year a b c d e dear------------------ -------------------------------------------------------------------------------------------- ------------ --------------------------- --------------------- ------ ------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------ -------------------------------------------------------- ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------- plr-126808-14 this responds to a letter dated date submitted on behalf of x by its authorized representatives requesting relief under sec_1362 of the internal_revenue_code the code facts the information submitted states that x was incorporated on date in state and elected to be treated as an s_corporation effective date from year to year x made disproportionate distributions to its shareholders a b c d and e x’s articles of incorporation provide that there shall only be one class of x stock each share of which shall have equal powers preferences and rights in year x made corrective distributions to a c d and e in an effort to eliminate the cumulative amount of the disproportionate distributions x represents that neither x nor its shareholders intended to terminate x’s subchapter_s_election in addition x represents that x and its shareholders agree to make any adjustments required as a condition of obtaining relief under the inadvertent_termination_rule as provided under sec_1362 that may be required by the secretary law and analysis sec_1361 provides that the term s_corporation means with respect to the taxable_year a small_business_corporation for which an election under sec_1362 is in effect for the year sec_1361 provides that the term small_business_corporation means a domestic_corporation that among other things does not have more than one class of stock accordingly s_corporations may not have more than one class of stock sec_1_1361-1 of the income_tax regulations provides that a corporation that has more than one class of stock does not qualify as a small_business_corporation except as provided in sec_1_1361-1 relating to instruments obligations or arrangements treated as a second class of stock a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock sec_1_1361-1 provides that the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter articles of incorporation bylaws applicable state law and binding agreements relating to distribution and liquidation proceeds collectively the governing provisions a commercial contractual agreement such as a lease employment agreement or loan agreement is not a binding agreement relating to distribution and liquidation proceeds and thus is not a governing provision unless a plr-126808-14 principal purpose of the agreement is to circumvent the one class of stock requirement although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights any distributions including actual constructive or deemed distributions that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances sec_1362 provides that an election under sec_1362 shall be terminated whenever at any time on or after the 1st day of the taxable_year for which the corporation is an s_corporation such corporation ceases to be a small_business_corporation sec_1362 further provides that the termination shall be effective on and after the date of cessation sec_1362 provides that if an election under sec_1362 by any corporation was terminated under sec_1362 or the secretary determines that the circumstances resulting in such termination were inadvertent no later than a reasonable period of time after discovery of the circumstances resulting in the termination steps were taken so that the corporation is a small_business_corporation and the corporation and each person who was a shareholder of the corporation at any time during the period specified under sec_1362 agrees to make the adjustments consistent with the treatment of the corporation as an s_corporation as may be required by the secretary for that period then notwithstanding the circumstances resulting in such termination the corporation shall be treated as an s_corporation during the period specified by the secretary conclusion based solely on the facts submitted and the representations made we conclude that if the disproportionate distributions that x made to its shareholders in year through year caused x’s s_corporation_election to terminate the termination was inadvertent within the meaning of sec_1362 therefore x will be treated as an s_corporation effective date and thereafter provided x’s s_corporation_election is not otherwise terminated under sec_1362 however disproportionate and corrective distributions must be given appropriate tax effect except as specifically set forth above we express or imply no opinion as to the federal tax consequences of the above facts under any other provision of the code specifically we express or imply no opinion concerning whether x’s s_corporation_election is valid under sec_1362 this ruling is directed only to the taxpayer who requested it sec_6110 of the code provides that it may not be used or cited as precedent plr-126808-14 in accordance with the power_of_attorney on file with this office a copy of this letter is being sent to x’s authorized representative sincerely joy c spies joy c spies senior technician reviewer branch passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes cc


department of the treasury internal_revenue_service washington d c date number release date cc intl br6 tl-n-3368-98 uilc internal_revenue_service national_office field_service_advice memorandum for from subject steven a musher branch chief cc intl br6 this field_service_advice responds to your memorandum dated date field_service_advice is not binding on examination or appeals and is not a final case determination this document is not to be used or cited as precedent legend a b c d e f g h i j k l m n o p q r tl-n-3368-98 amount a amount b amount c amount d amount e amount f assembly city a component component continent a contractor x country a country b country c country d date date fsub industry x product y product z product line product line product line product line state a taxable_year taxable_year taxable_year test uscorp usgroup tl-n-3368-98 year year year year year year issues which sec_482 treasury regulations govern the buy-in payment for taxable_year with regard to usgroup’s date cost_sharing_arrangement whether the buy-in payment from fsub to usgroup must be computed as a lump sum or as a royalty if the buy-in payment must be computed as a royalty must a net present_value of the intangibles nevertheless be estimated for that purpose as of the date of entry into the cost_sharing_arrangement if the buy-in payment must be computed as a royalty over what period of time must the royalty extend conclusions the final sec_482 regulations in particular sec_1_482-1 and sec_1_482-4 through govern the buy-in payment for taxable_year the buy-in payment for taxable_year should be determined in the form of a royalty the amount of such royalty for taxable_year is subject_to adjustment in accordance with the sec_482 regulations there is no general requirement that a transfer_pricing_methodology for determining a buy-in payment in relation to a given taxable_year must estimate a net present_value of the relevant intangibles it is for examination to determine under the best_method_rule which among competing applications of potential transfer_pricing methodologies for computing the buy-in payment provides the most reliable measure of an arm’s length result sec_1_482-1 any inconsistency of taxpayer’s reported results with available market evidence of the present_value of the intangibles is a tl-n-3368-98 factor that should be taken into account in the best_method analysis see sec_1_482-1 this advice discusses some considerations which may tend to support examination’s conclusion that the purported application of the residual profit method under taxpayer’s sec_6662 penalty documentation does not provide as reliable a measure of an arm’s length result as the transfer_pricing methodologies that examination is exploring as either primary alternative or confirming bases of proposed adjustments relating to the buy-in payment for taxable_year the buy-in payment for taxable_year should generally be computed as what would be the royalty for such year in a stream of commensurate with income royalties determined as of such year extending over the remaining useful_life of the existing technology and work-in-process technology facts a background uscorp is a publicly-held state a corporation headquartered in city a state a that is the common parent of usgroup an affiliated_group filing consolidated income_tax returns since year usgroup has designed product y and product z core components of industry x technology product y is a subcomponent of product z usgroup operates worldwide through a number of wholly-owned foreign subsidiaries and foreign branches in year usgroup established fsub a country a corporation which processes third party-manufactured product z and ships the processed product z to usgroup in year fsub began manufacturing product z for usgroup usgroup - fsub relationship prior to the date cost sharing_agreement between year and date usgroup designed product y and product z usgroup would then contract with contractor x an unrelated third party to manufacture component which is a beginning stage component of product y after contractor x manufactured component either contractor x or usgroup would test component after component was tested it was sent to an unrelated third party for assembly the final output was product y the unrelated third party then sent product y to either usgroup or fsub for final testing tl-n-3368-98 if fsub performed the final testing it was done on a consignment basis once fsub completed the final testing fsub either attached product y to component to make product z that it had manufactured for usgroup and then sent product z to original equipment manufacturers other customers such as wholesalers alternatively fsub sent only product y to customers in the former case title in product y was transferred from usgroup to fsub at cost fsub then resold the final product z to usgroup at cost plus profit and usgroup subsequently sold product z to the customers in the latter case where fsub sent only product y to customers title in product y remained with usgroup after date contractor x began to test some component that it had manufactured for usgroup and fsub contractor x then sent the tested component to a third party who assembled component into product y at this point usgroup no longer held title to product y and fsub bought product y from the third party to perform testing fsub then either sold product y directly to customers sold product y to usgroup which in turn resold product y to customers or retained product y for use in final products manufactured at its site in country a for taxable_year which includes date a of product y to which fsub took title was sold directly to usgroup whereas fsub sold the remaining b to other entities usgroup - fsub relationship after date cost sharing_agreement on date a date after year but prior to date uscorp and fsub entered into a cost_sharing_arrangement governing research_and_development of industry x technology the cost_sharing_arrangement was effective for the last q months of usgroup’s taxable_year usgroup stated in its sec_6662 penalty documentation for taxable_year that research_and_development is fundamental to its worldwide operations success usgroup has a number of research_and_development centers in the united_states which employ over l engineers total approximately i of usgroup’s employees worldwide engage in research_and_development during taxable_year sec_1 and usgroup spent dollar_figureamount a j of net sales dollar_figureamount b k of net sales and dollar_figureamount c k of net sales respectively on research_and_development activities worldwide additionally fsub maintained a development center in country a since year a year prior to date in taxable_year this development center employed we have been provided with what appears to be the principal documents or a part thereof prepared by the taxpayer for taxable_year see sec_1 iii b tl-n-3368-98 approximately m employees to focus on several areas of research_and_development on date the legal relationship between usgroup and fsub was memorialized in several agreements including a technology license agreement license agreement a technology research and cost sharing_agreement csa a trademark license agreement trademark agreement and a corporate agreement this advice focuses mainly on the license agreement and csa which covered three categories of technology existing technology work-in-process technology and developed technology the license agreement covered existing technology intangible_property in existence as of date that related to or may have related to products in existence as of date whereas the csa treated the sharing of the costs of development of the developed technology intangible_property that did not exist as of date and that was developed pursuant to the cost_sharing_arrangement and in that connection addressed the buy-in for work- in-process technology intangible_property contributed to the cost_sharing_arrangement by uscorp which existed as of date and related or may have related to products which did not yet exist as of date the consideration for existing technology and work-in-process technology under the license agreement and the csa respectively were structured as two-year declining royalties payable from fsub to uscorp a license agreement the purpose of the date license agreement between uscorp and fsub was to facilitate uscorp’s license of certain rights to existing technology to fsub thus permitting fsub to manufacture assemble and sell licensed products which incorporated existing technology uscorp granted fsub a nonexclusive license to use existing technology for the sole purpose of manufacturing testing assembling using selling and marketing the licensed products anywhere in the world license agreement sec_2_1 this advice uses the term buy-in payment to refer both to the consideration for existing technology and work-in-process technology use of this terminology however is unrelated to whether examination may decide to propose separate adjustments for existing technology and work-in-process technology additionally we note that although the taxpayer structured its legal agreements separately with license fees for existing technology and buy-in royalties for work-in-process technology its application of the residual_profit_split method in its taxable_year sec_6662 penalty documentation does not appear to distinguish between existing technology and work-in-process technology see infra issue tl-n-3368-98 although existing technology was not defined in the license agreement it was defined in the csa as a ny and all patents copyrights trade secrets and similar intellectual_property rights including without limitation any patent applications pending thereto and any know-how which exist as of date and which relate or may relate to the manufacturing assembling or testing of products existing as of date the existing products csa sec_1 pursuant to the license agreement licensed products meant those specific existing products which are listed on an exhibit attached to the license agreement and other products which might be added to the list from time to time by uscorp and fsub license agreement sec_1 the license agreement was effective for two years from date provided the csa remained in effect and was automatically renewed annually thereafter unless uscorp or fsub gave thirty days written notice of intent to terminate the license agreement license agreement sec_5 additionally fsub acknowledged that uscorp owned all existing technology and value associated with it and that a ll rights to existing technology not expressly or explicitly granted by uscorp to fsub existing products referred to in the csa are apparently the licensed products listed in an exhibit to the license agreement there are approximately n existing products licensed by uscorp to fsub when combined with the o work-in- process technology projects contributed by uscorp to the csa this effectively constitutes a transfer of g of uscorp’s preexisting technology additionally we note that although the csa and license agreement both contain a clause explaining that each agreement constitutes the entire and exclusive agreement between the parties on the respective subject matters the csa and license agreement cross reference each other in various sections as noted above examination has learned that both the license agreement and the csa were renewed at least once upon the expiration of the initial two year term although the buy-in royalty rates for both the license agreement and the csa were decreased in the respective renewals additional information about the methodology used to establish arm’s length royalty rates for the additional years has not been otherwise obtained or reviewed tl-n-3368-98 in the license agreement are expressly reserved to uscorp license agreement sec_3_1 and sec_2 in consideration for the license of rights to existing technology fsub agreed to pay uscorp a fee equal to a percent age of fsub’s product line gross revenues license agreement sec_4 product line gross revenues included intercompany transfer_pricing ie sales from fsub to usgroup as well as third party sales there were four product lines for which gross revenue percentages were determined for year and year the first two years of the csa and license agreement the license fees specified in the license agreement as a percentage of product line gross revenues were as follows for product line c of fsub’s product line gross revenues in year declining to d in year for product line c of fsub’s product line gross revenues in year declining to d in year for product line e of fsub’s product line gross revenues in year declining to f in year for product line d of fsub’s product line gross revenues in year declining to e in year the license agreement did not provide license fee percentages for years subsequent to year and year b csa on date uscorp and fsub entered into a two year cost_sharing_arrangement because they c onsider ed it beneficial that certain research_and_development activities concerning technology to be developed and incorporated in fsub was given the right to grant a license or sublicense of its rights to use existing technology to third parties contingent upon approval and consent of uscorp license agreement sec_2 product line gross revenues was defined as a ll gross revenues accrued by fsub from the sale lease or license of any licensed product within a specific product line less sale or use vat gst or similar taxes imposed on sales transportation and insurance charges billed separately to customers and credits allowances and returns granted to customers in the fiscal quarter to which such credits discounts allowances or returns are actually allowed or granted license agreement sec_1 product lines were groups of products divided by type function use or other criteria agreed upon by uscorp and fsub license agreement sec_1 tl-n-3368-98 industry x products be conducted by both parties for the benefit of each party and to pool their respective resources for the purpose of conducting research_and_development concerning such products by sharing the risks and costs of such research_and_development activities csa recitals the csa was effective for two years beginning on date and automatically was renewed annually thereafter unless either uscorp or fsub gave thirty days written notice of intent to terminate the csa csa upon termination of the csa due to a breach by fsub a buy-out payment was required based on the appraised values of the developed technology and the work-in- process technology section a provided the following a ll rights owned by fsub in the work-in-process technology or in the developed technology as of the date of termination and any beneficial_ownership of any rights pertaining to the developed technology held by fsub hereunder shall be subject_to a reasonable buy-out fee for fsub’s rights both in the work-in-process technology and in the developed technology in an amount to be based on the appraised values of the developed technology and of the work-in- process technology and on fsub’s total cost share under this csa including the buy-in royalties paid_by fsub csa a in the event of termination of the csa pursuant to other circumstances uscorp and fsub may decide to enter into a reasonable mutual buy- out agreement pursuant to which either party may buy out the rights in the work-in-process technology and or in the developed technology of the other party or both for a fee in an amount to be based on the appraised values of the developed technology and of the work-in- process technology and on the selling party’s total cost share under this csa including any buy-in royalties paid_by the parties csa b all research_and_development activities termed research program were identified and administered by a cost sharing committee comprised of representatives from uscorp and fsub csa sec_2 uscorp and fsub agreed to share the costs of the research program in accordance with the reasonably_anticipated_benefits to be derived by each from selling developed tl-n-3368-98 products7 within product lines csa sec_3_2 additionally uscorp and fsub determined that the most reliable measure of reasonably_anticipated_benefits to be derived from the cost_sharing_arrangement for the purpose of sharing costs was the relative gross_profit of each party derived from the sale of developed products id uscorp and fsub agreed to share costs of research_and_development on an e and g basis respectively csa sec_3_3 the csa included a provision that permitted the cost sharing committee to review and determine adjustments to the e and g cost sharing ratio respectively csa sec_3_4 such periodic adjustments were permitted from time-to-time and at least annually if it is determined by the cost sharing committee that a modification of the cost sharing ratio is appropriate in order to ensure that the cost sharing ratio accurately reflects the benefits each party derives from using developed technology the parties will negotiate with each other in good_faith to modify the cost sharing ratio on a prospective basis csa sec_3_4 rights and ownership of developed technology and work-in-process technology pursuant to the terms of the csa uscorp was the owner of existing technology as covered by the license agreement supra and work-in-process technology which was to be used as the basis for developing the developed technology specifically the csa stated uscorp is the owner of certain work-in-process technology being developed in connection with the manufacturing assembling testing promotion and distribution of future industry x products and both uscorp and fsub agree that this work-in-process technology should be used as the basis for further developing the developed technology csa recitals work-in-process technology identified in an exhibit attached to the csa meant developed products were defined as products utilizing or incorporating developed technology csa sec_1 tl-n-3368-98 a ny and all patents copyrights trade secrets and similar intellectual_property rights including without limitation any patent applications pertaining thereto and any know-how sic which exists as of date but which relate or may relate to the manufacturing assembling or testing of products which do not exist as of date csa sec_1 whereas fsub made a buy-in payment in the form of declining royalties for the existing technology pursuant to the terms of the license agreement fsub also agreed to pay uscorp buy-in royalties8 under the csa in an amount equal to percentages of fsub’s new product line gross revenues which were based on the sale lease or license of products that did not exist as of date and which incorporated work-in-process technology or developed technology new products csa sec_3_1 sec_1 and the buy-in royalties specified in the csa as a percentage of new product line gross revenues were as follows for product line c of fsub’s product line gross revenues in year declining to d in year for product line c of fsub’s product line gross revenues in year declining to d in year for product line e of fsub’s product line gross revenues in year declining to f in year for product line d of fsub’s product line gross revenues in year declining to e in year developed technology was defined as a ny and all patents copyrights trade secrets and similar intellectual_property rights including without limitation any patent applications pertaining thereto and any know-how sic which does not exist as of date which relate or may relate to the manufacturing assembling or testing of products which do not exist as of the date and were developed in the research program csa sec_1 uscorp was the beneficial_owner and retained the exclusive rights to manufacture have manufactured assemble and test and have assembled and tested developed products and products incorporating work-in-process technology in north america csa sec_5 a and a fsub retained the exclusive rights to manufacture have manufactured assemble and test and have assembled and tested developed products and products incorporating work-in-process technology outside north america csa sec_5 b and b with reference to the division of selling and use rights both uscorp and fsub were neither the csa nor license agreement define buy-in royalties tl-n-3368-98 t he beneficial_owner s of the perpetual and non-exclusive right to sell developed products and products incorporating work-in-process technology worldwide and the right to use any of the developed technology and work-in-process technology worldwide csa sec_5 a and b both uscorp and fsub retained the right to license any rights to developed technology or work-in-process technology without consultation or approval of the other party csa sec_5 legal_title to and protection of developed technology and work-in-process technology uscorp retained bare_legal_title to the developed and work-in-process technology because it was best able to protect intellectual_property rights associated with the technologies csa sec_5 additionally uscorp was required to perform all actions and incur all costs necessary to protect the developed technology and work-in- process technology in any jurisdiction worldwide csa sec_5 such costs incurred by uscorp were to be shared by uscorp and fsub based on the e and g cost share ratio respectively id c trademark license agreement on date uscorp and fsub entered into a trademark license agreement trademark agreement pursuant to which uscorp licensed certain existing uscorp trademarks to fsub enabling fsub to manufacture assemble test and sell licensed and developed products or products incorporating work-in-process technology anywhere in the world by using the licensed trademarks trademark agreement recitals and sec_2_1 existing uscorp trademarks was defined to mean a ll trade names trademarks service marks logos trade dress and other trade designations adopted and owned exclusively by uscorp prior to date trademark agreement sec_1 licensed trademarks meant existing uscorp trademarks and any other trademarks added to the list by uscorp and fsub we note that fsub’s worldwide use rights described in csa sec_5 imply a right to use developed technology and work-in-process technology worldwide which is in apparent contradiction to uscorp’s exclusive right to manufacture developed products and products incorporating work-in-process technology in north america tl-n-3368-98 trademark agreement sec_1 pursuant to the trademark agreement uscorp retained ownership of and goodwill associated with the licensed trademarks trademark agreement sec_3_1 in consideration of the grant of the license fsub agreed to pay uscorp h of its third-party gross revenues meaning any gross revenues accrued by fsub from the sale lease or license of any product incorporating a licensed trademark to any party other than uscorp trademark agreement sec_1 the initial term of the trademark agreement was two years from date provided that the csa remained in effect and was automatically renewed for additional one year terms thereafter unless either uscorp or fsub provided thirty days written notice of intent to terminate the agreement trademark agreement sec_5 d corporate agreement the date corporate agreement between usgroup and fsub governed usgroup’s purchase of products that were manufactured finished tested packaged and shipped by fsub to usgroup fsub’s ability to provide certain logistical services10 to usgroup throughout the service territory and usgroup’s ability to provide support service sec_12 to fsub throughout the service territory corporate agreement recitals with reference to the pricing of products purchased by usgroup from fsub prices were based on an arms-length sic basis in compliance with the regulations under sec_482 of the internal_revenue_code corporate agreement sec_3_2 service fees were accrued for services provided by usgroup to fsub and by fsub to usgroup and were computed as fsub was responsible for providing the following services to usgroup assisting with distribution marketing selling and servicing of usgroup’s products in country a coordination of activities with third party distributors and sales representatives direct sales coverage for usgroup’s major customers in country a providing marketing support and training for usgroup’s third party distributors and sales representatives participation in trade shows and exhibitions business planning and product demand forecasting in country a corporate agreement exhibit d service territory was defined to mean all of continent a except country b including country c and country d corporate agreement exhibits a and d support services provided by usgroup to fsub were mainly financial management and included the following cash management investment management risk management advice regarding insurance coverage for business risks management information services and support the power to deposit or withdraw fsub funds to meet obligations incurred by fsub corporate agreement exhibit a tl-n-3368-98 costs incurred in provision of the services without mark-up corporate agreement exhibits a and d the initial period of the corporate agreement was for two years from date and was automatically renewable for two year terms thereafter unless either usgroup or fsub gave written notice of intent to terminate corporate agreement sec_11 the term of the corporate agreement was not contingent upon the effectiveness of the csa unlike the license and trademark agreements b examination of the buy-in payment for usgroup’s taxable_year usgroup’s taxable_year sec_1 and are currently under examination examination does not seek advice on issues relating to taxable_year sec_1 and taxable_year the first year for which the cost_sharing_arrangement was effective is the subject of this advice following its review of usgroup’s cost sharing documentation examination preliminarily proposed a dollar_figureamount d adjustment for usgroup’s taxable_year with regard to the buy-in payment for work-in-process technology based on a significant undervaluation of the technology which usgroup made available to fsub via the csadollar_figure examination has determined that usgroup did not receive adequate compensation in taxable_year for existing technology and work-in- process technology contributed to the cost_sharing_arrangement in light of their net present values as of the date effective dates for the license agreement and csa additionally examination inquires regarding the appropriate period of time over which to consider adjustments for the buy-in_payments in taxable_year and subsequent years since usgroup has structured its csa and license agreement with fsub as open-ended agreements and has failed to provide information on the useful_life of existing technology and work-in-process technology in its transfer_pricing adjustments examination valued the work-in-process technology as of the time of the buy-in payment at dollar_figureamount e the preliminary proposed adjustments spread this valuation over p months which in the absence of information from usgroup is deemed to be the useful_life of the existing technology and work-in-process technology governed by the license agreement and csa respectively dollar_figureamount d represents the preliminary proposed_adjustment for taxable_year given the number of months during which the csa was effective examination also proposed a separate transfer_pricing adjustment for taxable_year related to existing technology transferred pursuant to the date license agreement in the amount of dollar_figureamount f tl-n-3368-98 below we provide a brief description of the transfer_pricing_methodology employed by usgroup regarding the buy-in payment as well as a brief discussion of methodologies which examination is considering as either primary alternative or confirming bases of proposed adjustments relating to the buy-in payment for taxable_year usgroup’s transfer_pricing_methodology regarding the buy-in payment for taxable_year the taxpayer’s sec_6662 penalty documentation with regard to taxable_year purports to apply the residual profit method pursuant to sec_1_482-6 in order to evaluate the buy-in payment with regard to existing technology and work-in-process technology for such year the analysis in the documentation separately considers the appropriate level of royalties for such technologies - ie usgroup’s residual profit share described below as a percentage of worldwide consolidated sales - for the part of taxable_year preceding the effectiveness of the csa first r months and the part succeeding the coming into effect of the csa and the license agreement last q months for the first r months the documentation in the first step of its residual_profit_split method allocates returns to what it characterizes as routine contributions of in usgroup’s sec_6662 penalty documentation prepared with respect to taxable_year the date cost_sharing_arrangement repeatedly was referred to as a qualified_cost_sharing_arrangement we note that the final cost sharing regulations to which the sec_6662 penalty documentation refers do not govern usgroup’s taxable_year cost_sharing_arrangement see discussion infra issue the temporary cost sharing regulations which govern treatment as a bona_fide cost_sharing_arrangement were effective for taxable_year and therefore govern the year at issue in this advice while use of the qualified_cost_sharing_arrangement nomenclature as applied to taxable_year may be incorrect it is unclear whether usgroup attempted to indicate in its taxable_year sec_6662 penalty documentation that the date cost_sharing_arrangement met the sec_1_482-7 requirements for qualified_cost_sharing_arrangement treatment ipso facto without making conforming amendments see sec_1_482-7 although for the first r months no royalty was actually charged with regard to products or services provided by fsub to usgroup taxpayer’s position concerning the level of consideration owing on account of usgroup’s intangibles was reflected in the transfer price for products or services fsub provided to usgroup tl-n-3368-98 usgroup and fsub r d manufacturing and distribution in the second step the documentation apparently would justify an allocation to fsub of the residual profit up to the absolute amount of manufacturing cost savings asserted to exist as between fsub and external benchmarks with the balance of the residual profit being allocated to usgroup by assumption on account of usgroup’s intangible contribution the documentation does not appear to attempt any measure with reference to either external or internal benchmarks of usgroup’s intangible contribution to compare against a corresponding measure of fsub’s intangible contribution for purposes of arriving at a relative value of usgroup’s and fsub’s contributions of intangible_property for the first r months for the last q months the documentation in the first step of its residual_profit_split method allocates returns to what it characterizes as the routine activities of usgroup only distribution and fsub manufacturing and distribution in the second step the documentation appears to increase the residual allocation share of fsub and decrease the residual allocation share of usgroup compared with the first r months simply based on the assertion that necessarily fsub’s share should increase and usgroup’s share should decrease in light of fsub’s greater risks assumed under the csadollar_figure the documentation again does not appear to attempt any measure with reference to either external or internal benchmarks of usgroup’s intangible contribution to compare against a corresponding measure of fsub’s intangible contribution for purposes of arriving at a relative value of usgroup’s and fsub’s contributions of intangible_property for the last q months transfer_pricing methodologies under consideration by examination regarding the buy-in payment for taxable_year examination is considering several transfer_pricing methodologies including the two discussed below as either primary alternative or confirming bases of proposed adjustments relating to the buy-in payment for taxable_year although the documentation speaks in terms of fsub savings vis-à-vis external market benchmarks the documentation apparently never identifies these benchmarks but appears rather to enumerate internal cost savings examination may wish to consider further developing the facts in this area the documentation then extrapolates what such decreased usgroup share of residual profits would have been for each of the prior three years and the first r months as a percentage of worldwide consolidated sales for such periods and compares such rates to the rate equal to such share of the residual profits as a percentage of worldwide consolidated sales for the last q months tl-n-3368-98 examination is considering what it would view to be a more appropriate application of the residual profit method pursuant to sec_1_482-6 in order to evaluate the buy-in payment with regard to existing technology and work-in-process technology for such year in the first step returns would be allocated to the manufacturing and marketing functions of fsub and usgroup and in the second step the residual profit pre-r d would be split in accordance with the relative value of the intangible contributions of fsub and usgroup for these purposes examination may consider agreeing that fsub contributes intangibles to the extent of its past level of direct r d as well as after the csa commences to the extent of its share of the r d under the csa as capitalized and amortized on an appropriate basis usgroup would be viewed as contributing intangibles to the extent of its past and ongoing level of r d less cost sharing payments from fsub under the csa after that commences as capitalized and amortized on an appropriate basis importantly under the approach presently being considered examination would estimate the relative value of fsub’s and usgroup’s respective intangible contributions with regard to their respective shares of such r d a second approach under consideration would measure the buy-in payment based on the market capitalization value of usgroup determined with reference to uscorp’s publicly traded stock price contemporaneous with the entry into the csa less amounts appropriately computed on account of tangible assets marketing intangibles and manufacturing intangibles ie other than those related to existing technology and work-in-process technology a buy-in payment for taxable_year would then be derived from such amount taking into account among other circumstances the useful_life of the existing technology and work-in-process technologydollar_figure law and analysis issue the final regulations govern the buy-in payment for taxable_year sec_482 provides in any case of two or more organizations trades_or_businesses whether or not incorporated whether or not organized in the united_states and whether or not affiliated owned or controlled directly or indirectly by the same interests the secretary may distribute as noted the taxpayer has not provided information concerning the useful_life of the existing technology and work-in-process technology tl-n-3368-98 apportion or allocate gross_income deductions credits or allowances between or among such organizations trades_or_businesses if he determines that such distribution apportionment or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations trades_or_businesses in the case of any transfer or license of intangible_property within the meaning of sec_936 the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible sec_482 emphasis added the legislative_history of the tax_reform_act_of_1986 indicates that congress amended sec_482 by adding the second sentence highlighted above due to concern over income_tax deferral and effective tax exemptions where u s_corporations transfer intangible_property without receiving adequate_consideration from related foreign_corporations in low tax jurisdictions joint_committee on taxation staff general explanation of the tax_reform_act_of_1986 99th cong 2d sess jct explanation the second sentence requires that where a transfer or license of intangible_property occurs between controlled parties the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible tax_reform_act_of_1986 publaw_99_514 100_stat_2085 et seq 1986_3_cb_1 emphasis added commensurate with income is a standard by which to ensure that allocation of income between related parties reasonably reflects economic activity and risks undertaken by each see h_r rep no 99th cong 1st sess c b jct explanation at dollar_figure in revising sec_482 congress did not intend to preclude the use of certain bona_fide research_and_development cost-sharing_arrangements as an appropriate method of allocating income attributable to intangibles among related parties if and to the extent such agreements are consistent with the purposes of this the temporary and final sec_482 regulations note that the commensurate_with_income_standard is to be applied for taxable years beginning after the date effective date of the statutory amendment but prior to the effective dates of the and regulations using any reasonable method consistent with the statute temp sec_1_482-1t sec_1_482-1 a reasonable method includes one which applies the regulations or their general principles id tl-n-3368-98 provision that the income allocated among the parties reasonably reflect the economic activity undertaken by each h_r conf_rep no 99th cong 2d sess 1986_4_cb_638 jct explanation pincite however congress singled out the issue of buy-in_payments and noted they must be measured independently of the allocation of cost shares t o the extent if any that one party is actually contributing funds toward research_and_development at a significantly earlier point in time than the other or is otherwise effectively putting its funds at risk to a greater extent than the other it would be expected that an appropriate return would be required to such party to reflect its investment id the cost sharing provisions of sec_1_482-7 are effective for taxable years beginning on or after date sec_1_482-7 there is no election to apply such regulations retroactively for any open taxable yeardollar_figure instead a transition rule is provided for preexisting cost sharing arrangements to the effect that a cost_sharing_arrangement that was prior to date a bona_fide cost_sharing_arrangement under the provisions of sec_1_482-7t will be considered a qualified_cost_sharing_arrangement under sec_1_482-7 but only if the arrangement is amended if necessary to conform with the provisions of sec_1_482-7 by date sec_1_482-7 taxable_year is a year beginning prior to date accordingly sec_1_482-7 is inapplicable for such year the date cost_sharing_arrangement is thus a preexisting cost_sharing_arrangement whose status for purposes of taxable years beginning on or after date depends on whether it constituted a bona_fide cost_sharing_arrangement under the prior compare sec_1_482-1 the provisions of sec_1_482-7t of the temporary regulations are identical to the corresponding provisions of sec_1_482-2a of the regulations tl-n-3368-98 regulations and whether any necessary conforming amendments were made by december dollar_figure the cost sharing provisions of temporary sec_1_482-7t and sec_1_482-2a address only the acquisition of an interest in intangible_property that is developed pursuant to the cost_sharing_arrangement these cost sharing provisions do not address the license transfer or acquisition of an interest in any preexisting intangible_property ie intangible_property developed prior to participation in a cost_sharing_arrangement typically referred to as the buy-in with respect to such preexisting intangible_property these regulations provide in pertinent part where a member of a group of controlled entities acquires an interest in intangible_property as a participating party in a bona_fide cost_sharing_arrangement with respect to the development to such intangible_property the district_director shall not make allocations with respect to such acquisition except as may be appropriate to reflect each participant’s arm’s length share of the cost and risks of developing the property a bona_fide cost_sharing_arrangement is an arrangement in writing between two or more members of a group of controlled entities providing for the sharing of the costs and risks of developing intangible_property in return for a specified interest in the intangible_property that may be produced in order for the arrangement to qualify as a bona_fide arrangement it must reflect an effort in good_faith by the participating members to bear their respective shares of all the costs and risks of development on an arm’s length basis in order for the sharing of costs and risks to be considered on an arm’s length basis the terms and conditions must be comparable to those which would have been adopted by unrelated parties similarly situated had they entered into such an arrangement temp sec_1_482-7t sec_1_482-2a emphasis added rather a buy-in between controlled taxpayers with respect to preexisting intangibles - in this case the existing technology and work-in-process technology - is governed by the general provisions under the regulations relating to the transfer of intangible_property since taxable_year is a taxable_year beginning after date the final regulations - in particular sec_1_482-1 and sec_1_482-4 through - govern the buy-in see supra footnote tl-n-3368-98 payment for taxable_year sec_1_482-4 for example provides that i f the owner of the rights to exploit an intangible transfers such rights to a controlled_taxpayer the owner must receive an amount of consideration with respect to such transfer that is determined in accordance with the provisions of this section issue the buy-in payment for taxable_year should be determined in the form of a royalty sec_1_482-1 provides that the service will evaluate the results of a transaction as actually structured by the taxpayer unle sec_23 compare sec_1_482-7 of the final cost sharing regulations which provides in pertinent part 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 sec_1_482-1 and sec_1_482-4 through see paragraph g of this section sec_1_482-7 emphasis added the corresponding provision in the regulations sec_1_482-2 provided as follows except as otherwise provided in subparagraph of this paragraph relating to bona_fide cost sharing arrangements for developing new intangibles quoted in the text where intangible_property or an interest therein is transferred sold assigned loaned or otherwise made available in any manner by one member of a group of controlled entities referred to in this paragraph as the transferor to another member of the group referred to in this paragraph as the transferee for other than arm’s length consideration the district_director may make appropriate allocations to reflect an arm’s length consideration for such property or its use sec_1_482-2 emphasis added accord temp sec_1_482-4t e ii tl-n-3368-98 its structure lacks economic_substance for purposes of evaluating the taxpayer’s transactions in comparison to comparables the regulations provide the contractual terms including the consequent allocation of risks that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with economic_substance of the underlying transactions in evaluating economic_substance greatest weight will be given to the actual conduct of the parties and the respective legal rights of the parties see for example sec_1 f ownership of intangible_property if the contractual terms are inconsistent with the economic_substance of the underlying transaction the district_director may disregard such terms that are inconsistent with the economic_substance of the transaction sec_1_482-1 as regards the form of consideration paid for intangible_property the regulations provide if a transferee of an intangible pays nominal or no consideration and the transferor has retained a substantial interest in the property the arm’s length consideration shall be in the form of a royalty unless a different form is demonstrably more appropriate however the regulation goes on to note that even where the taxpayer’s structure has economic_substance the service m ay consider the alternatives available to the taxpayer in determining whether the terms of the controlled_transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances in such cases the district_director may adjust the consideration charged in the controlled_transaction based on the cost or profit of an alternative as adjusted to account for material differences between the alternative and the controlled_transaction as if the alternative had been adopted by the taxpayer see sec_1_482-1 factors for determining comparability contractual terms and risk sec_1_482-3 and sec_1_482-4 unspecified methods id see discussion infra issue tl-n-3368-98 sec_1_482-4 dollar_figure here fsub’s payment to usgroup for existing technology and work-in-process technology pursuant to the date license agreement and csa is structured as a royalty the regulations cited above effectively provide that this form of consideration as a royalty will be respected unless a royalty does not reflect the economic_substance of the buy-in transaction pursuant to the date csa and license agreement or a different form is otherwise demonstrably more appropriatedollar_figure the corresponding provision of the final cost sharing regulations states 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 sec_1_482-4 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 sec_1_482-2 loans or advances and iii royalties royalties or other_payments contingent on the use of the intangible by the transferee sec_1_482-7 accord temp sec_1_482-4t e additionally we note that sec_367 would not generally apply in the case of an express sale or license of intangible_property by a u_s_person to a foreign_corporation temp sec_1_367_d_-1t effective for transfers occurring after date see also temp sec_1_367_d_-1t circumstances under which a purported sale or license may be disregarded for these purposes and the white paper a study of intercompany_pricing under sec_482 of the code 1988_2_cb_458 stating t he commensurate_with_income_standard treats related_party transfers of intangibles as if an intangible had been transferred for a license payment that reflects the intangible’s value throughout its useful_life a result similar to sec_367 a license payment that is less than some specific percentage of the appropriate arm’s length amount could be considered so devoid of economic_substance that the arm’s length charge should be subject_to sec_367 thus those related_party transfers tl-n-3368-98 while the form of the consideration as a royalty must generally be respected the amount of such royalty if not consistent with the arm’s length standard in light of the commensurate with income principle of the second sentence of sec_482 remains subject_to adjustment in accordance with the sec_482 regulations issue inconsistency of results with available evidence of present_value of intangibles should be taken into account in the best_method analysis discussed below are some considerations which may tend to support examination’s conclusion that the purported application of the residual profit method under taxpayer’s sec_6662 penalty documentation does not provide as reliable a measure of an arm’s length result as the transfer_pricing methodologies that examination is exploring as either primary alternative or confirming bases of proposed adjustments relating to the buy-in payment for taxable_year this advice is not intended to constitute a full analysis which examination will need to complete in light of all the facts and circumstances there is no general requirement that a transfer_pricing_methodology for determining a buy-in payment in relation to a given taxable_year must estimate a net present_value of the relevant intangibles the comparable_uncontrolled_transaction cut method does require comparable intangible_property for purposes of such method to have a similar profit potential to the intangible_property involved in the controlled_transaction and profit potential is most reliably measured by directly calculating the net present_value of the benefits to be realized based on prospective profits to be realized or costs to be saved through the use or subsequent transfer of the intangible considering the capital_investment and start-up expenses required the risks to be assumed and other relevant considerations sec_1 c iii b ii moreover an inexact cut or unspecified method might use an estimate of such present_value derived from market data as evidence of a realistic alternative to the controlled_transaction see id sec_1_482-4 by contrast the residual_profit_split method which the taxpayer’s sec_6662 penalty documentation purports to apply contains no similar focus on the absolute present_value of the intangibles see sec_1_482-6dollar_figure which deviate substantially from the proper commensurate with income payment would be subject_to d even if cast in the form of a sale or license we do note however that for purposes of allocating the residual intangible profit pursuant to the second step of the residual_profit_split as prescribed by the regulation one alternative for arriving at a relative value of the of intangible_property tl-n-3368-98 it is for examination to determine under the best_method_rule which among competing applications of potential transfer_pricing methodologies for computing the buy-in payment provides the most reliable measure of an arm’s length result sec_1_482-1 if a cut involves the transfer of the same intangible under the same or substantially the same circumstances as the controlled_transaction the results derived from applying the cut method will generally be the most direct and reliable measure of the arm’s length result for the controlled transfer of an intangible sec_1_482-4 the market_capitalization_method one of the methods under consideration by examination is a type of cut method uscorp’s publicly traded stock price reflects the market price contemporaneous with the entry into the csa for the same intangible_property as is involved in the csa buy-in transaction along with usgroup’s other assets whose value is subtracted in the analysis it may be that in light of the necessary adjustments this should be considered an inexact cut or unspecified method nevertheless depending on consideration of the degree of comparability between the controlled and uncontrolled_transaction sec_28 and the quality of the data and assumptions utilized in the analysis an application of this method based on a present market_value of the intangibles may provide a more reliable measure of an arm’s length result than the one in taxpayer’s sec_6662 penalty documentation that omits any consideration of such present valuationdollar_figure certainly any inconsistency of taxpayer’s reported results with this contributed by each controlled_taxpayer is to look to external market benchmarks that reflect the fair_market_value of such intangible_property id the market_capitalization_method represents a sale price while arguably the license agreement and the csa might be viewed to be short-term transfers however the agreements appear to contemplate that in the event of their termination uscorp would have to make a buy-out of fsub’s rights in the work-in-process and developed technology which makes the position of fsub more like an owner than a short-term licensee alternatively examination might consider whether the apparent short-term arrangement is inconsistent with the economic_substance of the underlying transaction in which fsub agrees to assume g of the ongoing research_and_development costs see sec_1_482-1 and c example contractual terms imputed from economic_substance see also sec_1_482-1 data based on the results of transactions between unrelated parties provides the most objective basis for tl-n-3368-98 available market evidence of the present_value of the intangibles is a factor that should be taken into account in the best_method analysis see sec_1_482-1 we also note the following additional shortcomings of the purported application of the residual_profit_split method under taxpayer’s sec_6662 penalty documentation in comparison to the methodologies that examination is considering the residual_profit_split method pursuant to the regulation contemplates a two-sided analysis of both the routine and non-routine contributions by the controlled taxpayers in particular in the second step the residual profit remaining after the allocation to the routine contributions is to be divided based upon the relative value of the controlled taxpayers’ contributions of intangible_property each measured against a common measuring stick see sec_1_482-6dollar_figure the determining whether the results of a controlled_transaction are arm’s length for convenience the full text of the regulation follows below the allocation of income to the controlled taxpayers’ routine contributions will not reflect profits attributable to the controlled group’s valuable intangible_property where similar_property is not owned by the uncontrolled taxpayers from which the market returns are derived thus in cases where such intangibles are present there normally will be an unallocated residual profit after the allocation of income described in paragraph c i a of this section under this second step the residual profit generally should be divided among the controlled taxpayers based upon the relative value of their contributions of intangible_property to the relevant business activity that was not accounted for as a routine contribution the relative value of the intangible_property contributed by each taxpayer may be measured by external market benchmarks that reflect the fair_market_value of such intangible_property alternatively the relative value of intangible contributions may be estimated by the capitalized cost of developing the intangibles and all related improvements and updates less an appropriate amount of amortization based on the useful_life of each intangible finally if the intangible development_expenditures of the parties are relatively constant over time and the useful_life of the intangible_property of all parties is approximately the same the amount of actual expenditures in recent years may be used to estimate the relative value of intangible contributions if the intangible_property contributed by one of the controlled taxpayers is also used in other business activities such as transactions with other controlled taxpayers an appropriate allocation of the value of the intangibles must tl-n-3368-98 regulation provides that the common measuring stick may consist either of external benchmarks that reflect the fair_market_value of such intangible_property contributions or the capitalized cost of developing the intangibles less an appropriate amount of amortization based on the useful_life of each intangibledollar_figure the rationale is that while the measuring stick employed might only be an indirect indicator that may not yield an absolute value for each of the intangible contributions individually the comparison of the two measurements may provide a reliable relative value of the two intangible contributions for purposes of making the split of the residual profit the residual_profit_split method set forth in taxpayer’s sec_6662 penalty documentation appears to reflect only a one-sided analysis in its second step the documentation apparently would justify an allocation to fsub of the residual profit up to the absolute amount of manufacturing cost savings asserted to exist as between fsub and external benchmarks with the balance of the residual profit being allocated to usgroup by assumption on account of usgroup’s intangible contribution however this approach only involves valuing one party’s intangible contribution namely fsub’s and then only gives usgroup the residual of the residual profit the documentation does not appear to attempt any measure with reference to either external or internal benchmarks of usgroup’s intangible contribution to compare against a corresponding measure of fsub’s intangible contribution for purposes of arriving at a relative value of usgroup’s and fsub’s contributions of intangible_property by contrast examination is considering an application of the residual_profit_split method that is two-sided in the manner prescribed by the regulation examination may consider agreeing that fsub contributes intangibles to the extent of its past be made among all the business activities in which it is used sec_1_482-6 emphasis added the regulation also states the conditions under which the amount of actual expenditures in recent years may be used as the common measuring stick rather than the capitalized cost less amortization namely that the intangible development_expenditures of the parties are relatively constant over time and the useful_life of the intangible_property of all parties is approximately the same id although the documentation speaks in terms of fsub savings vis-à-vis external market benchmarks the documentation apparently never identifies these benchmarks but appears rather to enumerate internal cost savings this may be an area in which examination may wish to consider further developing the facts tl-n-3368-98 level of direct r d as well as after the csa commences to the extent of its share of the r d under the csa as capitalized and amortized on an appropriate basis usgroup would be viewed as contributing intangibles to the extent of its past and ongoing level of r d less cost sharing payments from fsub under the csa after that commences as capitalized and amortized on an appropriate basis importantly under this approach examination would estimate the relative value of both fsub’s and usgroup’s respective intangible contributions with regard to their respective shares of such r d the reliability of the analysis under this method in contrast to the method under the taxpayer’s sec_6662 penalty documentation may be enhanced by the fact that both parties’ intangible contributions would be evaluated under the second step of the residual_profit_split see sec_1_482-6dollar_figure a final observation is that examination is considering several transfer_pricing methodologies as either primary alternative or confirming bases of proposed adjustments relating to the buy-in payment for taxable_year to the extent the results of those methods appropriately and consistently applied are mutually reinforcing and the results of the method under the taxpayer’s sec_6662 penalty documentation are outlying by comparison that is a further factor that suggests the latter method is not as reliable as the former methods under the best_method_rule sec_1_482-1dollar_figure again the discussion in the text is not a full analysis of the relative merits of the various methods under the best_method_rule which examination will need to complete based on all the facts and circumstances for example for the last q months the taxpayer’s documentation relating to the second step of its residual_profit_split appears to increase the residual allocation share of fsub vis-à-vis the first r months and decrease the residual allocation share of usgroup simply based on the assertion that necessarily fsub’s share should increase and usgroup’s share should decrease in light of fsub’s greater risks assumed under the csa thus the reliability of the profit shares for the last q months rests on the reliability of the shares determined for the first r months some of the shortcomings of which are discussed in the text for convenience the full text of the regulation follows below if two or more methods produce inconsistent results the best_method_rule will be applied to select the method that provides the most reliable measure of an arm’s length result if the best_method_rule does not clearly indicate which method should be selected an additional factor that may be taken into account in selecting a method is whether any of the competing methods produce results that are consistent with the results obtained from the appropriate application of another method further in tl-n-3368-98 issue buy-in payment should generally be royalty for the taxable_year in a commensurate with income stream of royalties extending over the remaining useful_life of the transferred intangibles the second sentence of sec_482 provides in the case of any transfer or license of intangible_property within the meaning of sec_936 the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible the regulations regarding periodic adjustments provide in pertinent part if an intangible is transferred under an arrangement that covers more than one year the consideration charged in each taxable_year may be adjusted to ensure that it is commensurate with the income attributable to the intangible adjustments made pursuant to this paragraph f shall be consistent with the arm’s length standard and the provisions of sec_1_482-1 in determining whether to make such adjustments in the taxable_year under examination the district_director may consider all relevant facts and circumstances throughout the period the intangible is used the determination in an earlier year that the amount charged for an intangible was an arm’s length amount will not preclude the district_director in a subsequent taxable_year from making an adjustment to the amount charged for the intangible in the subsequent year a periodic_adjustment under the commensurate with income requirement of sec_482 may be made in a subsequent year without regard to whether the taxable_year of the original transfer remains open for statute_of_limitations purposes for exceptions to this rule see paragraph f ii of this sectiondollar_figure evaluating different applications of the same method the fact that a second method or another application of the first method produces results that are consistent with one of the competing applications may be taken into account sec_1_482-1 confirmation of results by another method it is assumed for purposes of this advice that none of the exceptions under the regulations to the periodic adjustments rules apply in this case tl-n-3368-98 sec_1_482-4 emphasis added consistent with the statute and the foregoing regulations in our view where a buy- in payment for a taxable_year must be computed in the form of a royalty it should generally be set at the amount of the royalty for such year in a stream of commensurate with income royalties determined as of such taxable_year extending over the remaining useful_life of the transferred intangibles this relates to the issue of how to derive a royalty adjustment for taxable_year from a lump sum valuation of the transferred intangiblesdollar_figure the regulations addressing the treatment of a lump sum form of consideration for the transfer of intangibles between controlled taxpayers impliedly confirm our view if an intangible is transferred in a controlled_transaction for a lump sum that amount must be commensurate with the income attributable to the intangible a lump sum is commensurate with income in a taxable_year if the equivalent royalty amount for that taxable_year is equal to an arm’s length royalty the equivalent royalty amount for a taxable_year is the amount determined by treating the lump sum as an advance_payment of a stream of royalties over the useful_life of the intangible or the period covered by an agreement if shorter taking into account the projected sales of the license as of the date of the transfer thus determining the equivalent royalty amount requires a present_value calculation based on the lump sum an appropriate discount rate and the projected sales over the relevant period the equivalent royalty amount is subject_to periodic adjustments under sec_1_482-4 to the same extent as an actual royalty payment pursuant to a license agreement sec_1_482-4 emphasis added the regulation defines an equivalence between a lump sum form of consideration and a royalty form of consideration namely the equivalent royalty our view is that like such an equivalent royalty a buy-in payment in the form of an actual royalty should be evaluated as the amount of a royalty for the taxable_year in a stream of commensurate with income royalties extending over the useful_life of the transferred intangiblesdollar_figure see supra issue compare the provisions in the final cost sharing regulations the consideration for an acquisition described in this paragraph g may tl-n-3368-98 further confirmation is provided by the regulations regarding application of the residual_profit_split method in the second step of allocating the residual intangible profit where the amortized capitalized cost of developing the intangibles is used as the common measuring stick for dividing the residual profit between the parties’ respective contributions of intangible_property the amortization is to be accomplished based on the useful_life of each intangible sec_1 c i b thus where the residual_profit_split is applied on this basis to compute the buy-in payment for intangibles contributed to a cost_sharing_arrangement the buy-in payment royalties will effectively extend over the useful_life of the contributed intangibles in summary in our view the buy-in payment for taxable_year should generally be computed as what would be the royalty for such year in a stream of commensurate with income royalties determined as of such year extending over the remaining useful_life of the existing and work-in-process technology case development hazards and other considerations we note that this advice does not purport to be an exhaustive analysis of the taxpayer’s application of the residual_profit_split method take any of the following forms i lump sum payments for the treatment of lump sum payments see sec_1_482-4 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 sec_1_482-2 loans or advances and iii royalties royalties or other_payments contingent on the use of the intangible by the transferee sec_1_482-7 emphasis added tl-n-3368-98 in issue we concluded that buy-in royalties for the existing technology and work-in-process technology should generally extend over the useful_life of these intangibles our discussion particularly as set forth in issue of the taxpayer’s sec_6662 penalty documentation points out several shortcomings in the purported application therein of the residual_profit_split method to justify taxpayer’s reported results in regard to the buy-in payment for taxable_year ultimately whether application of the sec_6662 or h penalty is appropriate in this instance is a determination within the purview of examination in consultation with the penalty oversight committee please call if you have any further questions by steven a musher chief branch associate chief_counsel international


n _ significant index no third party contacts - company employees oe members of sonata bre sp aie has serpeentng employees empl ting izati tax_exempt_and_government_entities_division internal_revenue_service washington d c apr i hfe hie fe fa re dear company this letter constitutes notice that a conditional waiver of the minimum_funding_standard has been granted for the above-named pension_plan for the plan_year beginning date the conditional waiver has been granted in accordance with sec_412 of the internal_revenue_code the code and sec_303 of the employee_retirement_income_security_act_of_1974 erisa the amount for which the conditional waiver has been granted is the contribution that would otherwise be required to reduce the balance in the funding_standard_account of the plan to zero as of the end of the plan_year the plan is a collectively bargained pension_plan originally effective in of date the plan covered approximately 3mployees represented primarily by as following a long period of accrual rates being held level under the plan those rates were increased in ‘ some higher in order to bring benefit levels in line with industry standards from as of date the ratio of the fair value of plan assets to the plan’s current_liability was accrued liability was accrued liability while the ratio of the fair value of assets to the plan’s based on a current_liability of assets valued at the contribution required to meet the minimum_funding requirement for the plan_year is approximately due each quarter and approximately with approximately due by date the company began service in and is currently the world’s largest _ the terrorist attacks of date the economic recession that began in and world unrest due to the iraq war have had a serious negative financial impact on the ‘industry although the company posted a net profit for the fiscal_year ending date the and fiscal years showed net losses in the fiscal_year exceeding the loss for the fiscal_year with the net_loss for the in order to limit further losses the company eliminated on an annualized basis by reducing employment levels eliminating non-essential capital and spending commitments and nevertheless net after- tax losses and negative cash flows resulted in a decrease of the capacity levels cutting staff and in expenses _ through hedging and pre-purchase of exposure to increased prices for the near future the long-term outlook for prices will continue to have a substantial effect on the company’s prospects for recovery as wellas the __ industry as a whole the company has managed to limit its the company has stated that it should maintain a to manage risks and uncertainties that could arise from an extended economic downturn a prolonged shortfall in revenue due to the actions of other the iraq war costs and possible consequences of spikes in the company has stated that financing agreements with banks require the company maintain a specified minimum amount of liquidity the company has taken actions to effect recovery and increase cash_flow such measures include the reduction of by approximately _ employees in terminating approximately additional measures include furloughing approximately of management in eliminating bonuses for management for and delaying pay increases for senior management from to and eliminating senior management pay increases and bonuses for - savings measures generated savings of over the in the ' _ savings measures yielded permanent savings of million in and a projected ‘in ‘in the company has also entered into an alliance with other airlines in order to reduce costs and enhance revenue on the company announced a system-wide reduction of employees related to the’ the company also announced job cuts of reduction although a complete recovery will depend on unknown factors such as increased company lead it to project positive net_earnings in the near future accordingly this waiver has been granted subject_to the following two conditions and lower’ _ prices the measures taken by the - by date the company will provide the plan with security ina manner satisfactory to the pension_benefit_guaranty_corporation pbgc for the sum of the required quarterly contributions under sec_412 of the code that are due on date and date calculated as if no waiver for the plan_year had been granted by date the company will either a provide the plan with security in a manner satisfactory to the pbgc for the remaining minimum_funding requirement for the plan_year after taking into account the two quarterly contributions for which security is required to be arranged under condition above or b amend the plan to cease all future benefit accruals under the plan effective not later than date at which time the security provided under condition will be released the representatives of the company have acknowledged that they understand these conditions nothing precludes the company from subsequently requesting a modification of these conditions however there is no guarantee that such a request will be granted note that if condition 2b is chosen the plan may be amended to resume benefit accruals only after the waived amount has been fully amortized if the company fails to meet these conditions as stated above or as modified later this waiver is retroactively null and void your attention is called to sec_412 of the code and sec_304 of erisa which describes the consequences which result in the event the plan is amended to increase benefits to change the rate in the accrual_of_benefits or to change the rate of vesting while any portion of the waived amount remains unamortized please note that any amendment to other pension or profit sharing plans maintained by the company to increase the liabilities of those plans would be considered an amendment for purposes of sec_412 of the code and sec_304 of erisa this ruling is directed only to the organization that requested it sec_6110 of the code provides that it may not be used or cited by others as precedent - when filing form_5500 for the plan_year ending date the date of this letter should be entered on schedule b actuarial information we have sent a copy of this letter to the manager and to your authorized representatives form on file with this office if you have any questions concerning this letter please contact toe relating to this letter please refer to in any correspondence ‘ as well oo sincerely hed a it fe carol d gold directo employee_plans