IRS issues new final cost sharing regulation provisions Pricing Knowledge Network Alert

Pricing Knowledge Network Alert
Tax Controversy and Dispute Resolution Alert
IRS issues new final cost sharing
regulation provisions
August 27, 2013
In brief
On August 26, 2013, the Internal Revenue Service (IRS) and the Treasury Department finalized the
portion the cost sharing regulations issued on December 16, 2011 that was reserved at the time of release.
In addition to the final cost sharing regulations issued at that time, the December 2011 regulations had
included certain provisions issued in the form of temporary regulations and proposed regulations. These
temporary and proposed regulation provisions, designed to limit certain analytical approaches taken by
taxpayers in applying the income method, have now been finalized. Our PKN Alert issued on December
21, 2011, previously summarized and discussed these regulations.
The newly finalized regulations provide additional guidance and testing around the selection and use of
discount rates under an income method analysis. The stated intent of this guidance is to address what
the IRS views to be "unreasonable positions" taken by taxpayers in relation to the selection of discount
rates under the income method and resultant "material distortions and . . . potential for [platform
contribution transaction] payments not in accordance with the arm's length standard."
From a practical perspective, taxpayers that engage in cost sharing platform contribution transactions
(PCTs) can expect that their selection of discount rates, a central parameter in an income method
analysis, will be subject to additional scrutiny and tests. The likely consequences are an additional
compliance burden for taxpayers along with a greater possibility of disputes.
In detail
As discussed in our alert dated
December 21, 2011, the final
cost sharing regulations issued
in December 2011 (the Final
Regulations) contained
additional discussion on the
selection of different discount
rates under the income method
so as to prevent what the IRS
perceived as instances of
taxpayers incorrectly applying
this method to produce
understated PCT values. To this
end, the Final Regulations
included a section specifically
dedicated to the use of different
discount rates for the two
alternatives typically considered
under the income method – the
cost sharing alternative and the
licensing alternative. The
guidance in this section of the
Final Regulations (Treasury
Regulation § 1.4827(g)(4)(i)(C)) requires that the
two discount rates being used by
a taxpayer to evaluate the cost
sharing and the licensing
alternatives respectively have to
be closely tied on account of the
common financial projections
underlying the alternatives.
At the time, the Final
Regulations reserved certain
guidance regarding discount
rates, which was provided in the
form of the 2011 Temporary
Regulations and the 2011
Proposed Regulations. The 2011
Temporary Regulations
specified an additional analysis
to test the reasonableness of the
discount rate assumptions used
in an income method
calculation. As part of this test,
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these regulations introduced two
additional concepts – the "differential
income stream" and the "implied
discount rate." The "differential
income stream" was defined as the
difference between the undiscounted
income streams under the cost
sharing and licensing alternatives.
The concept is analogous to the
concept of a "residual" income stream.
Based on this concept, the "implied
discount rate" was defined as the
discount rate which, when used to
discount the projected "differential
income stream," yields a net present
value (NPV) of such an income stream
exactly equal to the value of the PCT
as determined under the income
method using different discount rates
(for the cost sharing and licensing
alternatives). To analyze the
reasonableness of the different
discount rates used for the two
alternatives under the income
method, the 2011 Temporary
Regulations called for a comparison of
the "implied discount rate" with
"reliable direct evidence" on the
discount rates applicable for activities
expected to generate an income
stream with characteristics similar to
the "differential income stream."
Example 8 provided in the 2011
Temporary Regulations applied this
test by basing the "reliable direct
evidence" on discount rates calculated
for uncontrolled companies whose
income streams are attributable to
resources, capabilities and rights
similar to the platform contributions
being valued under the income
method. In the example, an "implied
discount rate" found to be
significantly in excess of the discount
rates observed for the uncontrolled
comparables is taken as an indication
of the inherent unreliability of the
taxpayer's application of the income
method based on the discount rates
for the two alternatives.
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The 2011 Proposed Regulations
extended the concepts introduced in
the 2011 Temporary Regulations to
propose an alternative specification of
the income method. Under this
specification, the PCT value is
determined as the NPV of the
"differential income stream"
discounted at an appropriate discount
rate. The appropriate discount rate
for the "differential income stream" is
determined in a manner analogous to
what is used to test the "implied
discount rate" (i.e., based on reliable
direct evidence) as illustrated via
Example 9 in the 2011 Proposed
Regulations.
The new regulations issued on August
26, 2013, finalize the 2011 Temporary
Regulations and the 2011 Proposed
Regulations without change. The final
cost sharing regulations, therefore,
now stipulate a test based on the
"differential income stream" and the
"implied discount rate" as a
consideration in assessing the best
method. In particular, the test would
consider the reliability of a "general
application of the income method" –
based on a use of different discount
rates for the cost sharing and licensing
alternatives – by evaluating the extent
to which the "implied discount rate"
under the analysis can be supported
by direct evidence.
Furthermore, the new final
regulations adopt the "differential
income stream application of the
income method" as a new
specification of the income method.
Under this specification, the NPV of
the "differential income stream"
calculated using an appropriate
discount rate is taken to represent the
present value of an arm's length PCT
payment.
The new guidance on the use of an
"implied discount rate" to test the
reliability of an income method
analysis is applicable to taxable years
beginning on or after December 19,
2011 (the date the 2011 Temporary
Regulations were published). The
new final regulations specifying the
"differential income stream"
application of the income method are
applicable to taxable years beginning
on or after the date the new final
regulations are published in the
Federal Register.
The takeaway
The new final regulations, along with
the section on discount rates in the
2011 Final Regulations, confirm the
IRS's intent to closely scrutinize the
discount rates used by taxpayers in
the application of the income method.
The guidance can be viewed as an
attempt to constrain the use of
discount rates in the application of the
income method so as to prevent what
the IRS considers to be understated
PCT values.
At the very least, these new provisions
can be expected to impose additional
burdens on taxpayers to defend the
assumptions and parameters used in
an income method analysis.
Furthermore, a test based on the
"implied discount rate" may involve
certain conceptual and practical
challenges which may increase the
possibility and scope of disputes.
Among these challenges is the task of
identifying companies whose observed
overall income stream is attributable
to intangible development activities
and risks that can viewed as
comparable to those conducted under
the cost sharing arrangement and
whose observed discount rates,
therefore, can be used as benchmarks
for the "implied discount rate." Such
a task is likely to be far more
challenging, subjective and prone to
dispute than the identification of more
routine companies used in the
determination of the discount rate
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applicable for the licensing alternative
under the "general application of the
income method." Furthermore, in the
absence of public information on
suitable companies (e.g., owing to the
fact that many such candidate
companies may be in a start-up and
thus, "pre-IPO" phase), taxpayers may
need to look elsewhere for "reliable
direct evidence."
Let’s talk
For more information, please contact:
APMA and TP Controversy Practice
Richard F. Barrett, Washington D.C.
+1 202 414 1480
[email protected]
Gregory J. Ossi, Washington D.C.
+1 202 414 1409
[email protected]
W. Joe Murphy, Washington Metro
+1 703 918 3518
[email protected]
Kartikeya Singh, Washington D.C.
+1 202 312 7721
[email protected]
Ward Connolly, San Jose
+1 408 817 8234
[email protected]
© 2013 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership),
which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.
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