Thursday, June 23, 2011

Is the IRS Changing Its Approach to Cost Sharing?

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At the kick-off to the BNA-Baker & McKenzie transfer pricing conference June 8, keynote speaker Sam Maruca — the IRS's newly appointed director of transfer pricing operations — indicated the Service may be turning its back on the much-criticized September 2007 coordinated issue paper on cost sharing buy-ins.

Here's an excerpt from his prepared comments:

"I personally believe that our experience with the cost sharing issue teaches a valuable lesson, which is this: coordinated issue papers, however flexible and nuanced, are likely not the best vehicle for transmitting guidance to the field, except maybe with respect to true "cookie-cutter" tax strategies. In the majority of transfer pricing cases, we need to use more fundamental building blocks that are focused on old-fashioned, rigorous fact development and analysis. Put another way, the methodology comes second—the first priority of the IE will be to understand the business and its economics. It takes more time and effort, for sure, but it will optimize outcomes."

This is as close as anyone in the government has come to criticizing the September 2007 CIP, and it may be a hopeful sign that the IRS finally has heard practitioners' chief complaint about the paper — that it imposes a "one size fits all" approach to audits by assuming a particular set of facts.

In another indication that the government is changing its approach to cost sharing, the Joint Committee on Taxation in its June 14 description of the Obama administration's budget proposals called into question the existing framework. In its discussion of the proposal to limit shifting of income through intangible property transfers, the JCT said:

"Although the temporary cost sharing regulations are intended to mitigate abusive cost sharing practices and address criticisms that application of the commensurate with income principle conflicts with the arm's length standard, they do so within the context of the existing framework. Arguably, however, that framework may unintentionally encourage U.S.-based multinational groups to develop intangible property offshore and to shift the economic ownership of developed intangible property to CFCs by prescribing terms under which internal cost sharing arrangements will be respected despite the lack of any comparable arrangement among unrelated parties. Consistent with the 1986 legislative history, the cost sharing regulations seek to establish an arm's length price for these arrangements, even though comparable arrangements rarely occur between uncontrolled parties. Examining the extent to which the existing framework encourages outbound transfers of intangible property may lead to reconsideration of the merits of respecting cost sharing arrangements and suggest a new, more limited framework."

Finally, there appears to have been a meeting of the minds between the lead counsel for Veritas Software Corp. — which prevailed in its Tax Court case on cost sharing buy-in valuation — and the IRS on the interpretation of a cost shared intangible's useful life. In discussing the Service's "action on decision" in the case during the BNA-Baker & McKenzie conference June 9, Mark Oates of Baker & McKenzie characterized the IRS's argument in a way that Christopher Bello, chief of Branch 6 in the IRS Office of Associate Chief Counsel (International), said he agreed with.

 
Oates focused on footnote 4 of the action on decision, which states:

 
"The Court mischaracterizes the Service as contending that the pre-existing intangibles had a "perpetual" useful life. ... The Service's income method effectively valued in the aggregate the lift in business results projected from operating with, as compared to operating without, the benefit of the intangibles and services package. This lift can be represented as the area between two curves mapping such results over time, i.e., with and without the benefit of such package. Because businesses do not tend to project a termination of operations, both curves individually may possibly have infinite tails. Typically, however, there is a time period beyond which the two curves intersect, or after which the remaining area in the tail between the curves is negligible. The time period until the two curves intersect is the useful life of the pre-existing intangibles.
Until the curves intersect or get very close, Oates said, "you should be measuring the lift as being the benefit of the cost sharing" and that lift should be paid for in the buy-in. Because technology turns over rapidly, he said, the footnote is something taxpayers should be able to live with."

--Molly Moses, Managing Editor, Transfer Pricing Report
 

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