lnternal IRS guidance on IP valuation in cost sharing arrangements with 367(d) transfers
lnternal IRS guidance on IP valuation in cost sharing arrangements with 367(d) transfers
LB&I Virtual Library Transaction Unit, “IRC 367(d) Transactions in Conjunction with Cost Sharing Arrangements (CSA).”
In an International Practice Unit (IPU), IRS’s Large Business and International division has provided guidance to IRS auditors on when it might be necessary to aggregate Code Sec. 367(d) transactions with platform contribution transactions in connection with a cost sharing arrangement, for purposes of valuing transferred intangible property (IP). IRS noted that some taxpayers are valuing the IP separately despite the fact that it will be exploited on a combined basis and provide greater value than it would in isolation.
Background—outbound transfers. Under Code Sec. 367(a)(1), if a U.S. person transfers property to a foreign corporation in connection with an exchange described in Code Sec. 332, Code Sec. 351 , Code Sec. 354, Code Sec. 356, or Code Sec. 361, then the foreign corporation generally isn’t considered a corporation for purposes of determining gain on the transfer. As a result of the Code Sec. 367(a)(1) rule, transfers of property to a foreign corporation that would otherwise be tax-free are treated as taxable exchanges. However, there are a number of exceptions to the Code Sec. 367(a)(1) rule.
Code Sec. 367(d), sometimes referred to as the “disposition rule,” provides special rules for the outbound transfer of IP—generally defined within the meaning of Code Sec. 936(h)(3)(B) as including patents, copyrights, trademarks, methods, and other similar items with substantial value independent of the services of any individual. Except as provided in regs, under Code Sec. 367(d)(1), if a U.S. transferor transfers any IP to a foreign corporation in an exchange described in Code Sec. 351 or Code Sec. 361, the U.S. transferor is generally treated as having sold the property in exchange for payments that are contingent upon the productivity, use, or disposition of the property, and as receiving amounts that reasonably reflect what would have been received annually in the form of such payments over the shorter of the property’s useful life (Code Sec. 367(d)(2)(A)(ii)(I)) or 20 years. (Reg. § 1.367(d)-1T(c)(3)) These amounts must be commensurate with the income attributable to the intangible. Under Reg. § 1.367(d)-1T(c)(1), the transferor must report income that “represents an appropriate arms-length charge for the use of the property” as determined in accordance with Code Sec. 482 and its regs.
Background—cost-sharing arrangements (CSAs). Code Sec. 482 authorizes IRS to allocate income and expenses among related entities to prevent tax evasion and to ensure that taxpayers “clearly reflect income” relating to transactions between related entities. To achieve a clear reflection of each entity’s income, IRS considers what each entity’s income would be had the controlled entities been dealing with each other at arm’s length (i.e., if the parties weren’t under common control). (Reg. § 1.482-1(b)(1))
In the case of any transfer or license of intangible property, the income with respect to such transfer or license must be “commensurate with the income attributable to the intangible.” (Code Sec. 482) This is referred to below as the “commensurate-with-income standard,” and IRS’s authority to allocate income pursuant to it as its “commensurate-with-income authority.”
Under Reg. § 1.482-7, controlled corporations (i.e., owned or controlled directly or indirectly by the same interests) may enter into a CSA to develop intangible property. In a CSA, controlled participants must share intangible development costs in proportion to their shares of reasonably anticipated benefits.
One requirement of a CSA is that all controlled participants must engage in “platform contribution transactions” (PCTs) to the extent that there are “platform contributions” (i.e., any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity that is reasonably anticipated to contribute to developing cost shared intangibles). In a PCT, when a controlled participant provides a platform contribution, each other controlled participant is obligated to make arm’s length payments for the contribution. (Reg. § 1.482-7(c)(1))
Reg. § 1.482-1T(f)(2)(i) provides that an arm’s length amount of compensation must account for all of the value provided between the parties in a controlled transaction without regard to the form or character of the transaction.
Code Sec. 367(d) transactions in conjunction with CSAs. According to the IPU, “[s]trategic global deployment of high value IP has become a frequent form of global tax management.” This high value IP is typically transferred to a related party located in a jurisdiction that imposes little, if any, tax on the income from it. Some U.S. taxpayers that own high value IP may transfer it offshore as part of a strategy to reduce their effective tax rate.
- 1. Simultaneously with or shortly before entering into a CSA and providing platform contributions (Step 2, below), a U.S. parent transfers a portion of the non-U.S. rights to IP (“rest of world,” or ROW IP) that the U.S. parent had previously developed to its newly formed controlled foreign corporation (CFC) in a low- or no-tax jurisdiction (the Code Sec. 367(d) transaction).
- 2. The next day, the U.S. parent enters into a CSA with its CFC and contributes the remaining rights to the same IP (IP2) in PCTs. CFC claims that it doesn’t need to make a payment for the ROW IP because it was already transferred and accounted for under Code Sec. 367(d) .
Issue. These taxpayers may value the IP transferred in the Code Sec. 367(d) transaction separately from the PCTs that are required under the CSA, even though they will be exploited on a combined basis and have a higher value by virtue of the other. Such a non-aggregate approach may not provide an arm’s length result for the Code Sec. 367(d) transaction and the PCTs, and may ultimately result in the income from the IP indefinitely escaping U.S. taxation.
The IPU notes, that, although the preamble to final cost sharing regs specifically mentions the potential need to aggregate Code Sec. 367(d) transactions with PCTs (T.D. 9568; see Weekly Alert ¶ 10 12/22/2011), some taxpayers may contend that less overall compensation is due for the Code Sec. 367(d) transaction because the scope of IP for Code Sec. 367(d) purposes is not as broad as the scope for PCT purposes.
Guidance to auditors. The IPU addresses how to determine the arm’s length price of the ROW IP transferred under Code Sec. 367(d), the IP2, and any other resources, capabilities, and rights which the U.S. parent contributed to the CSA in PCTs on the next day.
…The first step is initial fact development. Auditors should confirm that the U.S. parent transferred IP to the CFC pursuant to Code Sec. 367(d), using resources such as transfer pricing documentation, an organization chart, and information from Forms 926, 5471, and 1120. Auditors should then confirm that the transferred intangibles were relevant to the CSA.
…Second, auditors should review potential issues. In many instances, the exam team will need to consider the combined effect of multiple transactions, potentially including controlled transactions outside of the CSA, which may need to be evaluated on an aggregate basis where that approach provides the most reliable measure of an arm’s length result. The IPU pointed to relevant regulatory guidance covering the requirements for PCTs, aggregation of transactions, special rules relating to transfers of intangibles, and the appropriate arm’s length charge.
…Third, auditors should determine whether or not to aggregate the Code Sec. 367(d) transaction with the PCT, using resources including the transaction documents, information document request (IDR) responses, and interviews. In making this determination, auditors should also identify any additional resources, capabilities, or rights of the U.S. parent (including IP and provisions of services) that are reasonably anticipated to facilitate developing cost shared intangibles at any time, for potential inclusion in the aggregate valuation; understand the anticipated use and expectations for the IP and other contributions; and ultimately compute whether the combined amount of income inclusions under Code Sec. 367(d) and payments made in the PCTs reflect the aggregate value of the ROW IP, IP2, and other contributed resources.
…Last, auditors should develop their arguments by considering the facts of the Code Sec. 367(d) transfer of ROW IP in combination with the PCTs through a detailed functional analysis, including all the future income anticipated to be generated by the resulting cost shared intangibles. The IPU notes that the U.S. parent may have attempted to minimize the PCT payment by separately valuing the Code Sec. 367(d) transactions and PCTs, and that the auditor should consider focusing on all facts and circumstances in the aggregate.
As applied to the illustration above, the IPU concludes that the U.S. parent contributed valuable IP and other interrelated resources, capabilities, or rights for use in the CSA, so it likely will be more reliable to value them together as a group instead of valuing them separately.
References: For transfers to foreign corporations, see FTC 2d/FIN ¶ F-6000 ; United States Tax Reporter ¶ 3674 ; TG ¶ 4925 . For CSAs, see FTC 2d/FIN ¶ G-4213 ; United States Tax Reporter ¶ 4824.05 .