Baker & McKenzie LLP, Palo Alto, CA

The new cost-sharing regulations, effective January 5, 2009, preserve in Regs. §1.482-7T(j)(3)(ii) the so-called “netting rule” for platform contribution transactions (PCTs), as was provided in the prior version of the cost-sharing regulations for buy-in payments at Regs. §1.482-7(g)(2) (December 19, 1995). This rule is a useful and practical treatment for the payments that otherwise would need to be made when parties enter into a cost-sharing arrangement and more than one of the parties is making available to the arrangement a resource, capability, or right that the controlled participant had developed, maintained, or acquired externally to the intangible development activity. While the regulation refers expressly only to payments with respect to a PCT as required under Regs. §1.482-7T(b)(1)(ii), there may be various circumstances besides the initial formation of the arrangement during the life of a cost-sharing arrangement when certain rights of the parties may need to be adjusted. There are good reasons why the netting concept of Regs. §1.482-7T(j)(3)(ii) should be applied in many of these circumstances as well.

The express reference to applying netting concepts in the cost-sharing environment emerged in the 1995 cost-sharing regulations. In the section of those regulations dealing with the transfer of pre-existing intangibles into the arrangement, the regulations provided that a controlled participant's required payment (the “buy-in,” as the payment was described in those regulations) was deemed to be reduced to the extent of any payments owed to it under those rules from other controlled participants. Regs. §1.482-7(g)(2) (December 19, 1995). The Preamble to those regulations provided important context to the rule, as follows:

To the extent some participants furnish a disproportionately greater amount of existing intangibles to the arrangement, they must be compensated by royalties by the participants who furnish a disproportionately lesser amount of existing intangibles to the arrangement. Buy-in payments owed are netted against payments owing, and only the net payment is treated as a royalty. No implication is intended that netting of cross royalties is permissible outside of the qualified cost sharing safe harbor rules.¹

The placement of the rule in the overall framework of the regulations changed slightly in the 2009 regulations, as the rule is now contained in a section dealing with the character of PCT and cost-sharing payments. Nevertheless, the Preamble to these regulations, when originally proposed in 2005, made clear that the netting concept as expressed in the 1995 regulations would continue into the new regulations. The Preamble states:

The proposed regulations continue to provide for the netting of PCT Payments made to, and received by, a controlled participant.²

The only example given in either the 1995 or the 2009 regulations illustrating the netting rule applies the rule in the context of the original formation of a cost-sharing arrangement.

A similar concept, however, is expressed in the provisions of the 2009 regulations dealing with changes in participation between the participants.

The 1995 regulations provided that arm's-length consideration must be paid in cases where a new controlled party enters into the cost-sharing arrangement and acquires an interest in the covered intangibles, or where a controlled participant in a cost-sharing arrangement acquires an interest in a covered intangible because another controlled participant transfers, abandons, or otherwise relinquishes an interest under the arrangement, to the benefit of the first participant. In both cases, the amount of the consideration was to be tested under the normal transfer pricing rules of Regs. §§1.482-1 and 1.482-4 through 1.482-6.

The 2009 regulations elaborated on the treatment in the 1995 regulations regarding the consequences of a change of the allocation of interests between the participants. In particular, the 2009 regulations added specific rules relating to changes in participation under a cost-sharing arrangement. A change in participation, in principle, requires arm's-length consideration. As before, the amount is to be tested under the normal transfer pricing rules, suggesting that the character of the payment would be a royalty or sales proceeds.

A change in participation occurs when there is either a controlled transfer of interests or a capability variation. A controlled transfer of interests occurs when a participant in a CSA transfers all or part of its interests in cost-shared intangibles under the CSA in a controlled transaction, and the transferee assumes the associated obligations under the CSA. A capability variation occurs when, in a CSA in which interests in cost-shared intangibles are divided on a basis other than territory or field of use, the controlled participants' division of interests or their relative capabilities or capacities to benefit from the cost-shared intangibles are materially altered.

In these cases, the regulations helpfully and prudently provide that an actual payment will be due under these circumstances only if the net effect of the transaction is to change the future economic expectations of the parties. A capability variation results in a change in participation only to the extent that the RAB shares of the parties change. Similarly, the arm's-length consideration to be paid for a change in participation is to be determined according to the anticipated incremental change in the returns to be experienced by the affected parties.

This apparently means that the parties to a cost-sharing arrangement may engage in real commercial transactions to reallocate interests, but there would be no payment required to the extent that the reallocation does not change the reasonably anticipated benefits to be realized by the parties. While not expressed as a netting rule, the policy point would seem to be the same. The effect of the two rules apparently is that taxpayers seem to have a good deal of flexibility upon the formation of a cost-sharing arrangement to extend the necessary rights to each other, and during the existence of a cost-sharing arrangement to rearrange those rights, and not make payments between themselves as long as the value of the contributions remains balanced. In concept, then, once taxpayers have entered a cost-sharing arrangement, the most significant element to determine whether payments other than cost-sharing contributions need to be made between the parties is whether any transfers of rights have caused a change in the relative expectations of future benefits.

As an example, under this approach it would seem that two participants in a cost-sharing arrangement could swap rights to exploit two territories, and no payments would be due as long as the expected benefits to be derived from those two territories were equal. While the regulations speak only of whether consideration is due under the principles of §482, the intention presumably is that the transaction itself is analyzed on a net basis for all purposes. If the rule were different, taxpayers would be faced with thorny questions of gain recognition by one or both participants which are exchanging rights, Subpart F inclusions arising from actual or deemed payments to foreign participants, withholding tax on actual or deemed payments to foreign participants, and the like.

This is a useful approach, because there can be many circumstances where the participants need to engage in commercial transactions between themselves that are best analyzed for tax purposes on a net basis. For example, the choice between extending a license to the foreign cost-sharing participant on an exclusive or a nonexclusive basis can have significant IP law consequences. (There was more flexibility on this point before the 2009 regulations, which require a nonoverlapping division of interests for newly formed cost-sharing arrangements.) In general, only the owner or an exclusive licensee can bring a claim against infringers for lost profits, so the proper party in such a claim will be affected by the choice of license terms in the cost-sharing agreement. IP counsel reviewing an old cost-sharing arrangement license may wish to rearrange the allocation of rights on this score, perhaps to reflect a new approach to IP protection in the group. There is no doubt that such a change is a significant change in the legal relationships between the parties, but if there is no resulting change in the expected benefits to be derived by the parties under the cost-sharing arrangement, it is entirely appropriate that such a transaction not give rise to any tax consequences. Similarly, a group that acquires a target group that also has a cost-sharing structure may inherit a different set of IP rights allocations among the target foreign entities. The difficulty of managing a group's IP increases if the principal foreign operating entities hold different rights to different elements of the group's IP. This confusion would be exacerbated as the technologies continue to develop and the acquired technology merges and blends with the legacy IP. In this case also, companies should have the ability to rationalize and conform their IP ownership structure without fear of tax consequences.

As a final example, a group already in cost-sharing may acquire a foreign target. Overseas acquisitions frequently are made by the foreign cost-sharing participant. That entity then has IP that is to be contributed to the existing cost-sharing arrangement. If the U.S. participant also has acquired intangible property that constitutes a PCT and must be contributed to the cost-sharing arrangement, it is appropriate for those two contributions to be treated on a net basis.

One further point to mention. The 2009 regulations separate the concept of a PCT from so-called “make-or-sell” rights, leading to the question of whether the netting concept should apply only to PCTs. Therefore, it is important to note that the regulatory netting concepts discussed above relate to both PCT and non-PCT transactions. The amount of the PCT payment is determined by the rules of Regs. §1.482-7T. In contrast, the arm's-length price for the make-or-sell rights is determined under the general (not cost-sharing) rules of Regs. §§1.482-1 and 1.482-4 through 1.482-6.³

The provisions allowing the netting of PCT payments refer expressly only to PCTs. The provisions on changes in participation, in contrast, refer expressly to the consideration that otherwise would be due under the normal transfer pricing rules of Regs. §§1.482-1 and 1.482-4 through 1.482-6. The message should be that within the context of a cost-sharing arrangement, the rearrangement of rights should be addressed on a net basis, regardless whether the rights being transferred constitute PCTs, make-or-sell rights, cross-operating contributions, or some other type of right.

A cost-sharing arrangement is not a partnership but, as a shared economic endeavor, it has many attributes similar to those of a partnership. Consistent with that overall view, the participants should have the flexibility to allocate and reallocate rights among themselves as necessary, without triggering tax consequences, as long as the transactions do not affect the reasonable expectations of the parties as to their relative benefits to be derived from the arrangement. If those relative benefits are affected, of course, the net payment required would need to be characterized and accounted for according to the normal rules.

This commentary also will appear in the November 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Warner and McCawley, 887 T.M., Transfer Pricing: The Code and Regulations, Levi, 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, and ¶7110, Foreign Income Taxation: General Principles.