Expansive View in Preamble Goes Beyond Text of Cost Sharing Rules, Practitioners Say

Taxpayers wanting to glean some insight into the way the Internal Revenue Service plans to enforce its new cost sharing regulations should pay close attention to the language in the preamble to the document, John M. Peterson Jr., of Baker & McKenzie in Palo Alto, Calif., told Bloomberg BNA Jan. 31.

"There is a lot of rhetoric in the preamble that is not necessarily reflected in the language of the regulations," he said.

The preamble reflects the way the IRS can be expected to interpret the regulations, but it is the text of the regulations is that legally governs, he said. Taxpayers should regard the preamble in the same light as legislative history—providing guidance for interpretation of ambiguous passages.

"If the underlying language is not ambiguous, the preamble may have little legal effect," Peterson said. "Of course, any taxpayer wishing to ignore language in the preamble can expect a challenge on audit."

Peterson was one of several practitioners who spoke during a Jan. 27 webinar on transfer pricing issues sponsored by Baker & McKenzie and Bloomberg BNA. During the webinar, Peterson and Baker & McKenzie economist Richard Boykin discussed differences between the final cost sharing regulations issued Dec. 22, 2011, and the temporary regulations released in 2009 (20 Transfer Pricing Report 682, 1/12/12).

Section 367(d) Contributions.

Because the language in the preamble is somewhat expansive, Peterson suggested, taxpayers may have the mistaken notion that the final regulations are markedly changed from the temporary regulations. In reality, the two documents are not significantly different, but certain discrepancies between the preamble to the final regulations and the regulations themselves give rise to some concerns.
For example, he cited statements in the preamble about how Section 367(d) contributions to a cost sharing arrangement may be aggregated with platform contribution transactions (PCT) where appropriate. However, the language of the underlying regulations has not changed.

And Peterson raised doubts that such aggregation could be forced.

"If some bundle of intangibles has been transferred to a foreign [cost sharing] participant under Sections 351 and 367(d), the amount of deemed royalty under Section 367(d) is legally governed by—and limited by—the Section 936(h)(3)(B) definition of `intangibles,' and the exemption in the Section 367 regulations for foreign goodwill and going concern value," he said. "Any such transferred intangibles would then become part of the PCT of the foreign participant."

Once transferred in a 351/367 contribution, the cost sharing regulations could not require the foreign participant to pay more for the bundled intangibles than is required by Section 367(d) and its related regulations by aggregating it with a PCT, he said.

In fact, he said, any PCT valuation method that attempted to value all the intangibles in the aggregate would be over-inclusive and, therefore, unreliable if that valuation included income from intangibles that had been transferred under Sections 351 and 367 and for which compensation was not legally required under Section 367.

If the IRS attempted to force such a valuation, he said, it could be the basis for a legal challenge.

Broad View of PCT.

Another example of the "rhetoric" of the preamble exceeding the grasp of the regulations arises in reference to the breadth of the PCT.

"There is all this language about core entrepreneurial functions like product selection, market positioning, research strategy, research determination and management," Peterson said. "These things in many respects boil down to business model, things that anybody could observe by watching a company and anybody who chose to could copy."

Such elements are not legally protectable, Peterson told Bloomberg BNA. "In such a case, a third party could not be expected to pay for them at arm's length, as it would be free to copy them for free. The regulations may seek to include this sort of thing in the definition of a PCT, but they seem to be going beyond arm's-length behavior in doing so."

Another case in which the language of the preamble seems to conflict with language in the regulations is related to the notion of "useful life," according to Boykin, a principal economist in Baker & McKenzie's Global Transfer Pricing group, based in Washington, D.C., and Palo Alto.

"The IRS came out with temporary regulations and told us that a PCT is a gift that keeps on giving, forever and forever," he said. "That obviously poses difficulties for taxpayers trying to make cost sharing work, because nothing lasts forever."

Nevertheless, Boykin said, there are indicators that "the IRS is perhaps starting to creep back from ledge of that position."

Meaning of 'Returns' Questioned.

In the temporary regulations—with the exception of "one strange example" that he said still persists in the final regulations—there was little to indicate that a taxpayer could treat a PCT as "anything other than perpetual." However, Boykin added, "there was language in the preamble that said technology may be reasonably expected to achieve incremental improvements for only a finite period—and then things go back to how they would have been if there had been no cost sharing arrangement."

In the final regulations, that language in the preamble had been tweaked to say that the "duration of the CSA [cost sharing arrangement] activity may, or may not, correspond to the conventional concept of useful life with respect to any of the underlying economic contributions; it represents the period over which the controlled participants reasonably anticipate returns from the CSA activity."

But it is not entirely clear what the IRS means by "returns from CSA activity," Peterson said.

In its action on decision following the 2009 ruling in Veritas Software Corp. v. Comr., 133 T.C. No. 14, he noted, the IRS articulated its view of the time period over which income must be included in the income method. In a footnote to the AOD, he said, the IRS states that the time period is limited to that period over which the initial PCT continues to contribute to the income earned from cost shared intangibles (19 Transfer Pricing Report 793, 11/18/10).

"In contrast, the preamble says the income method should include all income from the cost shared intangibles for the duration of the CSA activity," Peterson said. "If the 'CSA activity' is considered to include only the further development of the starting PCT intangibles, then the time periods would be the same. However, if the CSA includes all [research and development] done under the CSA—even after the initial PCT is no longer contributing to the effort—the time frame under the preamble would be longer."

By Dolores W. Gregory