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By David Ernick, Esq.
PricewaterhouseCoopers LLP, Washington, DC
Multinational enterprises (MNEs) making use of cost sharing arrangements (CSAs) under Reg. §1.482-7 to share the costs and risks of developing intangibles should be aware of recent OECD proposals that would fundamentally alter cost contribution arrangements (CCAs) – the OECD's terminology for CSAs.1 The OECD's April 29 discussion draft on CCAs2 (CCA Discussion Draft) is inconsistent with the framework provided for CSAs under U.S. rules in three key aspects. The proposed changes would: (1) require any participant in a CCA to have the "capability and authority to control the risks associated with the risk-bearing opportunity" under the CCA; (2) require all contributions to the CCA (including ongoing services required to develop intangible property) to be based on "value" rather than cost; and (3) make it easier for tax authorities to disregard part or all of the terms of a CCA. If adopted in their current form, the proposed changes could very well make "cost contribution arrangements" a misnomer. In addition, the inconsistencies with U.S. rules and the increased ability of tax authorities to disregard contractual terms could impair the future usefulness of CSAs.
Action 8 of the BEPS Action Plan3 promised to develop new transfer pricing rules to prevent "base erosion and profit shifting" that is attributed to the movement of intangibles among the members of an MNE. The first installment of this work involved proposals to change the guidance on transfer pricing aspects of intangibles,4 which focused primarily on providing modifications to Chapter VI of the OECD Transfer Pricing Guidelines (Guidelines). The CCA Discussion Draft responds to the mandate under Action 8 to update the guidance on CCAs provided in Chapter VIII of the Guidelines.
Function of CSAs
CSAs allow group members of an MNE to share the costs and risks of developing intangibles. In return for that sharing, each participant to a CSA has an interest in any intangible property that may be developed, which it can separately exploit without the payment of royalties to any other group member. In that manner, CSAs "can provide a mechanism for replacing a web of separate intra-group arm's length payments with a more streamlined system of netted payments, based on aggregated benefits and aggregated contributions associated with all the covered activities."5 CSAs thus provide for simplification and streamlining of intra-group development of intangibles. CSAs to develop intangibles are not equivalent to a series of licensing agreements for intangibles, however, as CSAs involve sharing of the risks of failure before development or exploitation of the intangibles has begun.
OECD's Proposed New Risk Requirement
One key area of divergence of the CCA Discussion Draft from the U.S. rules for CSAs relates to determining the members of an MNE group that are eligible to participate in a CSA. The CCA Discussion Draft introduces a requirement that each participant in a CCA have the "capability and authority to control the risks associated with the risk-bearing opportunity" under the CCA.6 While this approach may be consistent with the overall theme of the BEPS project of focusing on "substance," this would be a paradigm change for CCAs.
Such a substance requirement seems geared toward preventing the use of what the OECD refers to as "cash-box" entities, with little or no functionality, in CSAs in order to shift profits to low-tax jurisdictions. It is reminiscent of the requirement in the Treasury Department's CSA regulations finalized in 1995 that a controlled taxpayer may be a controlled participant only if it uses or reasonably expects to use covered intangibles in the active conduct of a trade or business.7 The Preamble to those regulations expressed the same concerns with "substance" that the OECD has expressed as part of the BEPS project:Under the proposed regulations, only a controlled taxpayer that would use developed intangibles in the active conduct of its trade or business was eligible to participate in a cost sharing arrangement. This requirement was considered necessary to ensure that controlled foreign entities were not established simply to participate in cost sharing arrangements without performing any other meaningful function, and to ensure that each participant's share of anticipated benefits was measurable .… The requirements for being a controlled participant are basically the same as in the proposed regulations. In particular, a controlled participant must use or reasonably expect to use covered intangibles in the active conduct of a trade or business. Thus, an entity that chiefly provides services (e.g., as a contract researcher) may not be a controlled participant. These provisions are necessary for the reason that they are necessary to the proposed regulations: to prevent foreign controlled entities from being established simply to participate in cost sharing arrangements.8
However, the active conduct requirement was retroactively eliminated in May 1996 amendments to the 1995 regulations. A general rule was substituted instead, providing that a controlled taxpayer may be a controlled participant in a CSA only if it reasonably anticipates that it will derive benefits.9
Issues Raised by OECD Proposal
That is a practical requirement, as one of the main benefits of entering into a CSA is the streamlining of controlling the risks associated with intangible development. It is also practical because the determination of costs is relatively simple and objective, whereas the determination of the value of contributions may be complex, at least in the absence of a reliable comparable uncontrolled transaction.
Leaving aside the significant definitional questions regarding what it means to have the "capability and authority to control the risks associated with the risk-bearing opportunity" under the CCA Discussion Draft, one main benefit of entering into CSAs is the elimination of the need to enter complicated cross-licensing arrangements, such as would be required where a single location performs R&D and licenses the resulting intangible. In a CSA, R&D can be performed in a single location, and each entity sharing the contributions and risks acquires effective ownership of the resulting intangible.
Those efficiency benefits would be lost under the OECD's proposed changes if MNEs were required to set up redundant R&D offices with the capability and authority to control all the risks associated with developing intangibles as part of the CSA. Allowing for centralization of R&D in a single location is also consistent with arm's-length arrangements under joint ventures between unrelated parties, where one entity provides funding and another entity supplies the R&D capabilities. It is not clear what would be gained by requiring each participant in a CSA to actually perform R&D activities in order to be entitled to the returns from the intangible to be developed or how this would promote intangible development.
Basing Contributions on Risk or "Value"
With respect to how contributions of services should be accounted for within a CSA, the existing Guidelines allow for use of costs or arm's-length pricing. Although contributions of pre-existing intangibles must be accounted for on the basis of "value" or arm's-length pricing, the term "cost sharing arrangement" explicitly recognizes that at arm's-length unrelated parties will assess ongoing contributions of items such as R&D services at cost. The CCA Discussion Draft, however, asserts that consistency with the arm's-length principle requires that all contributions to a CCA (including for ongoing R&D services) be accounted for on the basis of "value" or arm's-length pricing, and not cost.10
That proposed requirement, however, is inconsistent with arrangements that exist between unrelated parties. Indeed, the Internal Revenue Service in its §482 "White Paper" defined a CSA as "an agreement between two or more persons to share the costs and risks of research and development as they are incurred in exchange for a specified interest in any property that is developed."11 The White Paper also referred to the long history of joint ventures between unrelated parties to share the costs of development products or property, noting that "[c]ost sharing arrangements have long existed at arm's length between unrelated parties."12
Consequently, the proposed requirement from the OECD to account for all contributions to a CCA based on value rather than costs would be in contravention of joint funding arrangements commonly seen between unrelated parties and thus inconsistent with the arm's-length principle. It would also make "cost contribution arrangements" a misnomer going forward and eliminate much of their usefulness for taxpayers. There would seem to be no point in entering into CCAs under Chapter VIII of the Guidelines. Alternatively, taxpayers might consider entering into partnership arrangements and justifying the sharing of costs by consistency with the types of joint venture arrangements referred to in the White Paper.
Tax Administration Problems
Finally, the CCA Discussion Draft continues the trend of other discussion drafts under BEPS Action Items 8-10 of proposing changes that would make it easier for tax authorities to disregard taxpayers' related-party transactions, rather than simply making transfer pricing adjustments.
The first proposal would allow tax authorities to disregard part or all of the terms of a CSA simply based on the fact that one or more of the "claimed" participants has a "small" share of expected benefits:In some cases, the facts and circumstances may indicate that the reality of an arrangement differs from the terms purportedly agreed by the participants. For example, one or more of the claimed participants may not have any reasonable expectation of benefit from the CCA activity. Although in principle the smallness of a participant's share of expected benefits is no bar to eligibility, if a participant that is performing all of the subject activity is expected to have only a small fraction of the overall expected benefits, it may be questioned whether the reality of the arrangements for that party is to share in mutual benefits or whether the appearance of sharing in mutual benefits has been constructed to obtain more favourable tax results.13
Although that proposal attempts to be justified as merely aligning substance with form, it is not apparent why there is any abuse or misalignment of substance compared to form simply because a participant has an (undefined) "small" share of expected benefits. It would seem that aligning the sharing of costs proportionately with expected benefits should be all that is required; there is no principled reason for requiring that a participant's expected benefits exceed a certain magnitude.
Another proposal for recharacterization provides that:A tax administration may also disregard part or all of the purported terms of a CCA where over time there has been a substantial discrepancy between a participant's proportionate share of contributions (adjusted for any balancing payments) and its proportionate share of expected benefits, and the commercial reality is that the participant bearing a disproportionately high share of the contributions should be entitled to a greater interest in the subject of the CCA.14
Again, it is not clear what principle would allow for disregarding part or all of the terms of a CSA in this situation. A substantial discrepancy between a participant's share of contributions and its share of expected benefits could be corrected with a simple pricing adjustment; there are no grounds in the Guidelines or the arm's-length principle for disregarding part or all of the terms of the CSA.
CSAs have always been an important area in transfer pricing, and it is appropriate that tax administrations be concerned with whether contributions are consistent with expected benefits. However, that task would become more difficult and substantially more complex if contributions can no longer be valued at cost. Such an approach also would be inconsistent with the arm's-length principle and could backfire by forcing taxpayers to simply enter into partnerships or other joint ventures to share the costs and risks of intangible development.
Similarly, the new proposal in the OECD's Discussion Draft to require all participants in a CSA to have the "capability and authority to control the risks associated with the risk-bearing opportunity" under the CCA also raises questions regarding consistency with the arm's-length principle. It could also unnecessarily increase the complexity (and reduce the usefulness) of CSAs, and force controlled taxpayers to set up redundant R&D offices, thereby reducing efficiency and impeding intangible development. Although the proposal may seem consistent with the overall BEPS project theme of focusing on "substance," in this instance it would seem to be a formalistic application of that concept with no apparent benefit.
Finally, the new proposals for disregarding part or all of the terms of a CSA appear to be an incorrect application of the substance-over-form test. Concerns in this area could be much more easily dealt with through simple transfer pricing adjustments.
All three of these issues should be resolved in the final version of this report consistently with the arm's-length principle and the U.S. cost sharing regulations. That would allow CSAs to remain an important tool for MNEs to develop intangibles efficiently and in a cost-effective manner.
This commentary also will appear in the August 2015 issue of the Tax Management International Journal. For more information, in the 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"), Chip, Culbertson, and Maruca, 6936 T.M., Transfer Pricing: OECD Transfer Pricing Guidelines, and in Tax Practice Series, see ¶3600, Section 482 — Allocation of Income and Deductions Between Related Taxpayers.
Copyright©2015 by The Bureau of National Affairs, Inc.
2 BEPS Action 8: Revisions to Chapter VIII of the Transfer Pricing Guidelines on Cost Contribution Arrangements (CCAs) (Apr. 29, 2015), available at http://www.oecd.org/ctp/transfer-pricing/public-comments-beps-action-8-cost-contribution-arrangements.pdf.
4 Guidance on Transfer Pricing Aspects of Intangibles (Sept. 16, 2014), available at http://www.oecd-ilibrary.org/docserver/download/2314291e.pdf?expires=1436112244&id=id&accname=guest&checksum=67BB4D2E2795B2C0174FF2291CD40317.
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