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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
The 2009 cost-sharing regulations at Regs. §1.482-7T endeavored to draw boundaries around certain areas of cost-sharing practice in which taxpayers previously enjoyed some flexibility. One of those boundaries is expressed in the "divisional interests" requirement of Regs. §1.482-7T(b)(1)(iii) and (b)(4). That rule states, in general, that "each controlled participant must receive a non-overlapping interest in the cost shared intangibles without further obligation to compensate another controlled participant for such interest."
When these regulations were initially proposed, they would have allowed taxpayers to divide interests in cost shared intangibles only through an exclusive, non-overlapping territorial division of interests. In response to comments, the Treasury and IRS expanded the rule to specifically allow divisions by territory and field of use, or by some other division if certain measurement and predictability requirements are met.
That expansion of possible ways to comply with the divisional interests rule certainly was a welcome improvement over the proposed regulations. Nevertheless, even the liberalized rule as eventually promulgated presents some challenges for e-commerce companies. This commentary will endeavor to propose an interpretative approach that should both protect the interests of the Treasury as well as allow most e-commerce businesses to comply with the stated requirements to enter into a cost-sharing arrangement.1
As will be seen, the challenge here is one commonly seen when applying the tax law to e-commerce businesses. The examples given in the regulations interpret the rules only in the context of the manufacture and sale of tangible property. Where taxation concepts do not easily translate to an e-commerce business model, taxpayers and tax administrators should endeavor to apply the law in a way that respects the economic reality of the transactions, while certainly not subjecting e-commerce transactions to different or more burdensome taxation than that which is imposed on analogous offline businesses.
As noted, the final regulations elaborate the general rule by providing two specific types of acceptable divisional interests, and then by authorizing taxpayers to adopt a different base for dividing interests, if that different base can meet four specified requirements. The two specific acceptable bases for dividing interests are: (1) by territory; and (2) by field of use. The regulations specify that a division of interests based on one of these bases must allocate to the cost-sharing participants the perpetual and exclusive right to exploit the cost shared intangibles through the use, consumption, or disposition of property or services in the territory assigned to it, in the case of a territorial division of interests, or the perpetual and exclusive right to exploit the cost shared intangibles through the fields of use assigned to it, in the case of a field-of-use division of interests.
There can be cases where neither the territorial nor the field-of-use division makes sense in light of the taxpayer's business model. For those cases, the regulations provide that a different division of interests could be used, but set out some strict boundaries within which the taxpayer must operate in order to employ that different division. In general, the first three are relatively straightforward — the basis used must "clearly and unambiguously" divide all interests in the cost shared intangibles, the controlled participants must be able to verify the consistent use of that basis, and the rights of each party must be non-overlapping, exclusive, and perpetual. The interpretative issues arise with the fourth requirement: the resulting benefits associated with each controlled participant's interest in the cost shared intangibles must be "predictable with reasonable reliability."
On its face, that requirement seems reasonable; after all, the taxpayer needs to determine the shares of reasonably anticipated benefits to be enjoyed by each of the cost-sharing participants just to properly allocate the intangible development costs between (or among) the parties. Two of the three examples illustrating this regulation, however, seem to interpret the "reasonable reliability" requirement to mean "locked in stone."
In those examples,2 the parties chose to divide their interests in the cost shared intangibles based on the site of manufacturing, which is not one of the two specified bases. In the first example, both parties own facilities to manufacture the product, the relative capacities of the sites are known, all facilities are operating at near capacity, and are expected to continue to do so, so that it "will not be feasible to shift production" between the facilities of the two participants. Due to the lead time required to build a new facility, it would not be possible to build a new facility during the time that the cost shared product is on the market. The Example concludes that, under these facts, the relative benefits of the participants are predictable with reasonable reliability.
The second example comes to the opposite conclusion. There, the facts were the same as in the prior example except that the manufacturing facilities were not expected to be operating at full capacity at the time the cost shared product was put on the market. The facts noted that production could be shifted at any time between the two sites, although neither of the parties intended to shift production as a result of the cost-sharing agreement. The example concludes that this division of interests is not acceptable on the basis that the parties' relative shares of benefits are not predictable with reasonable reliability. For good measure, the example concludes with the statement that the fact that neither party intends to shift production is irrelevant.
This is a tough interpretation of a "reasonable reliability" standard. Even outside the e-commerce context, the interpretation seems unnecessarily restrictive. This rule is not the only available tool to police taxpayer behavior around the allocation of benefits; the regulations contain various other provisions to ensure that each party bears its fair share of the intangible development costs. On the front end, the basic rule governing the allocation of costs is that each party must bear costs in proportion to its reasonably anticipated benefits from exploiting the developed intangibles.3 Any platform contribution transaction (PCT) entered into at the commencement or during the life of a cost-sharing arrangement will be measured in light of the reasonably anticipated benefits (RABs) of the PCT payor.4 The definition of "reasonably anticipated benefits" leaves no doubt that the parties must comprehensively and continuously assess and update the expected benefits to be derived by each of the parties over the entire period of exploitation, both past and future, even as the parties may experience changes in economic conditions, their business operations and practices, and the ongoing development of intangibles under the cost-sharing arrangement.5 Finally, in new protection at the back end, the regulations specifically provide that in cases where the parties have selected a division of interests other than by territory or field of use, a "capability variation" arises if the parties' "relative capabilities or capacities to benefit from the cost shared intangibles are materially altered."6 The consequence of such a "capability variation" is that a party which sees its RAB share increase is obliged to make an arm's-length payment to the party whose RAB share has decreased, in the same way as if the party with the decreasing RAB share had transferred part of its interest in the cost shared intangibles to the other party.
With all of these protections in place against taxpayers trying to game the system by slipping a little more benefit into the hands of one of the cost-sharing participants, the interpretative gloss given by the two examples discussed above seems like overkill. This is especially so given the draconian consequences of not adopting an acceptable division of interests: in principle the arrangement does not qualify as a cost-sharing arrangement within the scope of the temporary regulations.
So how do these rules impact e-commerce businesses? After all, unlike manufacturing facilities that exist at a physical location and have a specific and limited production capacity, an e-commerce business — especially one that is services-oriented — normally suffers no similar capacity limitations. It is the fondest dream of most e-commerce entrepreneurs to expand quickly to fill their particular market niche. There are no concrete barriers to that expansion akin to the physical constraints of the brick and mortar factories which limit production. The principal barrier to growth normally is the need to win market acceptance of the goods or services the e-commerce business offers.
In some cases, the business model naturally fits with the territorial division-of-interests approach to cost sharing. For many advertiser-supported sites or subscription-based sites, the sales and marketing activity necessary to develop revenue for the cost-sharing participants will be focused on specific geographic markets, and subscribers will be drawn from those markets. In those cases, the cost-sharing rules offer a realistic approach. The participants can allocate exclusive, perpetual, and non-overlapping interests expressed as the right to provide advertising or subscription services to persons located in specific geographic territories.
The fact that these services might be performed through access to servers located in some other place in the world should not be relevant. The purpose of these rules is to direct taxpayers to choose a division of interests that creates predictable economic results. The choice of a hosting location provides no backbone to the allocation here; the providers of cloud-computing site hosting services may host a customer's site and data at any number of places around the world. The geographic location of a market of potential advertisers or subscribers, in contrast, is not mobile. Accordingly, even though the physical location of the "site" may be completely mobile, many e-commerce businesses have properly relied on a territorial division of interests to divide interests in their cost shared intangibles by reference to the location of advertisers or subscribers.
Not all businesses, however, can compartmentalize their users into such neat geographic baskets. The field-of-use division of interests normally is not a solution here, at least where the cost shared intangible property is the copyright to the software platform that operates the website, since the field of use of the copyright is the same for both participants. So what can those companies do?
An example of this type of business would be one that operates a series of websites, each of which may have a particular subject focus, but each of which also may aim to attract subscribers from around the world. For example, a company may host a variety of subscription- or advertising-supported websites that focus on different scientific disciplines, or that are targeted toward persons with interests in particular cultural expressions. The sites may attract subscribers from any country, so it would not seem possible to satisfy the definition of a territorial division of interests. Assuming that each of the websites is based on the same cost shared software platform, the field of use division also seems unavailable. Unlike the case of the factories that were all producing at capacity, there is no structural limit to the additional revenue that might be generated through one or other of the websites during the life of the cost shared property.
The answer must lie in a proper understanding of the purpose of the divisional interests rule. The purpose is to prevent taxpayers from gaming the system by cost-sharing on the basis of one assumption regarding relative expected benefits, then, through some volitional act, shifting exploitation to cause the actual benefits to result a different split.
That power doesn't exist when the commercial offering made through the website has some feature that attracts and keeps specific users on the site, even if they cannot be segregated by territory. For example, a taxpayer that operates separate sites that cater to ballet lovers and hip-hop fans will not be able to cause life-long Balanchine followers to become devotees of The Black Eyed Peas. A variety of features can make a site attractive to specific populations, including language used on the site, currency in which transactions are consummated, market differentiation to appeal to specific populations of users, or other localized elements. As long as the sites exhibit features attract and hold a specific group of users, dividing the cost shared exploitation rights between the two controlled participants by allocating between the participants the right to exploit the market through specified sites, as opposed to a territorial division based strictly on user location, should be respected as one in which the resulting benefits are predictable with reasonable reliability.
This commentary also will appear in the March 2011 issue of BNA's Tax Management International Journal. For more information, in BNA's Tax Management Portfolios, see Levey, Carmichael, van Herksen, Patton, Levi, Krupsky, and Kellar, 890 T.M., Transfer Pricing: Alternative Practical Strategies (Chapter 9, Cost Sharing Arrangements), and in Tax Practice Series, see ¶3600, Section 482—Allocations of Income and Deductions Between Related Taxpayers.
1 In the Preamble to the proposed regulations when originally proposed (70 Fed. Reg. 51116 (8/29/05)), the Treasury and IRS expressly requested comments as to how the territorial divisional interests rule should be applied in the context of e-commerce business models. To this author's knowledge, no commentator took up that invitation.
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