[Federal Register Volume 70, Number 166 (Monday, August 29, 2005)]
[Proposed Rules]
[Pages 51116-51163]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-16626]



[[Page 51115]]

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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Parts 1 and 301



Section 482: Methods To Determine Taxable Income in Connection With a 
Cost Sharing Arrangement; Proposed Rules

  Federal Register / Vol. 70, No. 166 / Monday, August 29, 2005 / 
Proposed Rules  

[[Page 51116]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

[REG-144615-02]
RIN 1545-BB26


Section 482: Methods To Determine Taxable Income in Connection 
With a Cost Sharing Arrangement

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that provide 
guidance regarding methods under section 482 to determine taxable 
income in connection with a cost sharing arrangement. These proposed 
regulations potentially affect controlled taxpayers within the meaning 
of section 482 that enter into cost sharing arrangements as defined 
herein. This document also provides a notice of public hearing on these 
proposed regulations.

DATES: Written or electronic comments must be received November 28, 
2005. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for November 16, 2005, at 10:00 a.m. must be 
received by October 26, 2005.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-144615-02), room 5203, 
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
144615-02), Courier's desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC 20044, or sent electronically, via the IRS 
Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal 
at www.regulations.gov (IRS and REG-144615-02). The public hearing will 
be held in the IRS Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Jeffrey L. Parry or Christopher J. Bello, (202) 435-5265; concerning 
submissions of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, LaNita Van Dyke, (202) 622-
7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)).
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The collection of information requirements are in proposed Sec.  
1.482-7(b)(1)(iv)-(vii) and (k). Responses to the collections of 
information are required by the IRS to monitor compliance of controlled 
taxpayers with the provisions applicable to cost sharing arrangements.
    Estimated total annual reporting and/or recordkeeping burden: 1250 
hours.
    Estimated average annual burden hours per respondent and/or 
recordkeeper: 2.5 hours.
    Estimated number of respondents and/or recordkeepers: 500.
    Estimated frequency of responses: Annually.
    Comments on the collection of information should be sent to the 
Office of Management and Budget, Attn: Desk Officer for the Department 
of the Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 
20224. Comments on the collection of information should be received by 
October 28, 2005.
    Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information-
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 482 of the Internal Revenue Code generally provides that 
the Secretary may allocate gross income, deductions, credits, and 
allowances between or among two or more taxpayers that are owned or 
controlled by the same interests in order to prevent evasion of taxes 
or clearly to reflect income of a controlled taxpayer. The second 
sentence of section 482 added by the Tax Reform Act of 1986 enunciates 
the ``commensurate with income'' standard that in the case of any 
transfer (or license) of intangible property (within the meaning of 
section 936(h)(3)(B)), the income with respect to such transfer or 
license shall be commensurate with the income attributable to the 
intangible. Public Law 99-5143, 1231(e)(1), reprinted in 1986-3 C.B. 
(Vol. 1) 1, 479-80.
    Comprehensive regulations under section 482 were published in the 
Federal Register (33 FR 5849) on April 16, 1968, and were revised and 
updated by transfer pricing regulations in the Federal Register (59 FR 
34971, 60 FR 65553, 61 FR 21955, and 68 FR 51171) on July 8, 1994, 
December 20, 1995, May 13, 1996, and August 26, 2003, respectively.
    The 1968 regulations contained guidance regarding the sharing of 
costs and risks. See Sec.  1.482-2A(d)(4). The 1968 regulations were 
replaced in 1996 by Sec.  1.482-7 regarding the sharing of costs and 
risks (the 1996 regulations were further modified in 2003 with respect 
to stock-based compensation).
    Experience in the administration of existing Sec.  1.482-7 has 
demonstrated the need for additional regulatory guidance to improve 
compliance with, and administration of, the cost sharing rules. In 
particular, there is a need for additional guidance regarding the 
external contributions for which arm's length consideration must be 
provided as a condition to entering into a cost sharing arrangement. 
The consideration for this type of external contributions is referred 
to in the existing regulations as the buy-in. Furthermore, additional 
guidance is needed on methods for valuing these external contributions. 
The proposed regulations also provide the opportunity to address other 
technical and procedural issues that have arisen in the course of the 
administration of the cost sharing rules.

[[Page 51117]]

Explanation of Provisions

A. Overview

    Under a cost sharing arrangement, related parties agree to share 
the costs and risks of intangible development in proportion to their 
reasonable expectations of the extent to which they will relatively 
benefit from their separate exploitation of the developed intangibles. 
The existing Sec.  1.482-7 regulations and these proposed regulations 
provide rules governing cost sharing arrangements consistent with the 
commensurate income standard under the statute and the general arm's 
length standard under the section 482 regulations.
    Comment letters and other information available to the Treasury 
Department and IRS have provided limited information on third-party 
arrangements that are asserted to be similar to cost sharing 
arrangements. Typically, in the context of discussion concerning the 
current Sec.  1.482-7 regulations, information has been provided on 
certain arrangements involving cost plus research and development or 
government contracts, which, while no doubt arm's length transactions, 
are not viewed by the Treasury Department and IRS as analogous to cost 
sharing arrangements.
    Thus, in accordance with Sec.  1.482-1(b)(1), the task is to 
provide guidance relative to cost sharing arrangements regarding ``the 
results that would have been realized if uncontrolled taxpayers had 
engaged in the same transaction under the same circumstances.'' 
(Emphasis added.) This guidance is necessary because of the fundamental 
differences in cost sharing arrangements between related parties as 
compared to any superficially similar arrangements that are entered 
into between unrelated parties. Such other arrangements typically 
involve a materially different division of costs, risks, and benefits 
than in cost sharing arrangements under the regulations. For example, 
other arrangements may contemplate joint, rather than separate, 
exploitation of results, or may tie the division of actual results to 
the magnitude of each party's contributions (for example, by way of 
preferential returns). Those types of arrangements are not analogous to 
a cost sharing arrangement in which the controlled participants divide 
contributions in accordance with reasonably anticipated benefits from 
separate exploitation of the resulting intangibles.
    For purposes of determining the results that would have been 
realized under an arm's length cost sharing arrangement, the proposed 
regulations adopt as a fundamental concept an investor model for 
addressing the relationships and contributions of controlled 
participants in a cost sharing arrangement. Under this model, each 
controlled participant may be viewed as making an aggregate investment, 
attributable to both cost contributions (ongoing share of intangible 
development costs) and external contributions (the preexisting 
advantages which the parties bring into the arrangement), for purposes 
of achieving an anticipated return appropriate to the risks of the cost 
sharing arrangement over the term of the development and exploitation 
of the intangibles resulting from the arrangement. In particular, the 
investor model frames the guidance in the proposed regulations for 
valuing the external contributions that parties at arm's length would 
not invest, along with their ongoing cost contributions, in the absence 
of an appropriate reward. In this regard, valuations are not 
appropriate if an investor would not undertake to invest in the 
arrangement because its total anticipated return is less than the total 
anticipated return that could have been achieved through an alternative 
investment that is realistically available to it.
    The investor model is grounded in the legislative history of the 
Tax Reform Act of 1986 which provided in pertinent part as follows:

    In revising section 482, the conferees do not intend to preclude 
the use of certain bona fide cost-sharing arrangements as an 
appropriate method of allocating income attributable to intangibles 
among related parties, if and to the extent such agreements are 
consistent with the purposes of this provision that the income 
allocated among the parties reasonably reflect the actual economic 
activity undertaken by each. Under such a bona fide cost-sharing 
arrangement, the cost-sharer would be expected to bear its portion 
of all research and development costs, on successful as well as 
unsuccessful products within an appropriate product area, and the 
cost of research and development at all relevant developmental 
stages would be included. In order for cost-sharing arrangements to 
produce results consistent with the changes made by the Act to 
royalty arrangements, it is envisioned that the allocation of R&D 
cost-sharing arrangements generally should be proportionate to 
profit as determined before deduction for research and development. 
In addition, to the extent, if any, that one party is actually 
contributing funds toward research and development at a 
significantly earlier point in time than the other, or is otherwise 
effectively putting its funds at risk to a greater extent than the 
other, it would be expected that an appropriate return would be 
provided to such party to reflect its investment.

H.R. Conf. Rep. No. 99-841 at II-638 (1986)(emphasis supplied).

    There are special implications that are derived from determining 
the arm's length compensation for external contributions in line with 
the investor model. In evaluating that arm's length compensation, it is 
appropriate, consistent with the investor model, to determine (1) what 
an investor would pay at the outset of a cost sharing arrangement for 
an opportunity to invest in that arrangement, and (2) what a 
participant with external contributions would require as compensation 
at the outset of a cost sharing arrangement to allow an investor to 
join in the investment. The appropriate ``price'' of undertaking a 
risky investment is typically determined at the time the investment is 
undertaken, based on the ex ante expectations of the investors. Given 
the uncertainty about whether and to what extent intangibles will be 
successfully developed under a cost sharing arrangement, ex post 
interpretations of ex ante expectations are inherently unreliable and 
susceptible to abuse. Accordingly, an important implication of 
determining the arm's length result under the investor model, reflected 
in the methods, is that compensation for external contributions is 
analyzed and valued ex ante. The ex ante perspective is fundamental to 
achieving arm's length results.
    Accordingly, the proposed regulations provide guidance under 
section 482 that would replace the existing regulations under Sec.  
1.482-7 relating to cost sharing arrangements. They revise Sec.  1.482-
7 in light of the experience of both the IRS and taxpayers with the 
existing regulations. The proposed regulations also restructure the 
format of the existing regulations to be more consistent with that of 
the 1994 regulations (for example, Sec. Sec.  1.482-3 and 1.482-4) and 
to add organizational clarity.
    The proposed regulations begin by specifying the transactions 
relevant to a cost sharing arrangement. Importantly, the proposed 
regulations acknowledge that in a typical cost sharing arrangement, at 
least one controlled participant provides resources or capabilities 
developed, maintained, or acquired externally to the arrangement that 
are reasonably anticipated to contribute to the development of 
intangibles under the arrangement, namely what are referred to as 
external contributions. Thus, the proposed regulations integrate into 
the definition of a cost sharing arrangement both ``cost sharing 
transactions'' regarding the

[[Page 51118]]

ongoing sharing of intangible development costs as well as 
``preliminary or contemporaneous transactions'' by which the controlled 
participants compensate each other for their external contributions to 
the arrangement (that is, what the existing regulations refer to as the 
``buy-in''). The proposed regulations provide that Sec.  1.482-7 only 
governs arrangements that are within (or which the controlled taxpayers 
reasonably concluded to be within) the definition of a cost sharing 
arrangement. Arrangements outside that definition must be analyzed 
under the other sections of the section 482 regulations to determine 
whether they achieve arm's length results.
    The proposed regulations provide supplemental guidance on the 
valuation of the arm's length amount to be charged in a preliminary or 
contemporaneous transaction. The proposed regulations clarify that the 
valuation of the rights associated with the external contribution that 
is compensated in a preliminary or contemporaneous transaction cannot 
be artificially limited by purported conditions or restrictions. 
Rather, the arm's length compensation, and the applicable method used 
to determine that compensation, must reflect the type of transaction 
and contractual terms of a ``reference transaction'' by which the 
benefit of exclusive and perpetual rights in the relevant resources or 
capabilities are provided. This compensation will be determined by a 
method that will yield a value for the obligation of any given 
controlled participant that is consistent with that participant's share 
of the combined value of the external contribution to all controlled 
participants.
    The proposed regulations set forth new specified methods and 
provide rules for application of existing specified methods, for 
purposes of determining the arm's length compensation due with respect 
to external contributions in preliminary or contemporaneous 
transactions. The proposed regulations also enunciate general 
principles governing all methods, specified and unspecified, for these 
purposes.
    The proposed regulations provide guidance on allocations that the 
Commissioner may make to more clearly reflect arm's length results for 
the controlled taxpayers' cost sharing transactions and preliminary or 
contemporaneous transactions. In particular, building again on the 
investor model, the proposed regulations provide guidance on the 
periodic adjustments that the Commissioner may make in situations where 
the actually experienced results of a controlled participant's 
investment attributable to cost contributions and external 
contributions is widely divergent from reasonable expectations at the 
time of the investment. Exceptions are provided, including one under 
which the taxpayer may establish that the differential is due to events 
beyond its control that are extraordinary and not reasonably 
anticipated (including business growth that was not reasonably 
anticipated). The proposed regulations provide that periodic 
adjustments may only be made by the Commissioner.
    Finally, the proposed regulations include provisions to facilitate 
administration of, and compliance with, the cost sharing rules. These 
include contractual provisions required for cost sharing arrangements, 
documentation that must be maintained (and produced upon request by the 
IRS), accounting requirements, and reporting requirements. Transition 
rules are provided for modified compliance in the case of qualified 
cost sharing arrangements under existing Sec.  1.482-7, as well as 
rules for terminating such grandfather status. The proposed regulations 
also make conforming and other changes to provisions of the current 
regulations under sections 482 and 6662 that are related to this 
guidance.

B. Basic Rules Applicable to CSAs

1. General Rule--Proposed Sec.  1.482-7(a)
    Consistent with the rules governing other controlled transactions 
(for example, transfers of tangibles and intangibles under existing 
Sec. Sec.  1.482-3 and 1.482-4), proposed Sec.  1.482-7(a) provides 
that the arm's length amount charged in a controlled transaction 
reasonably anticipated to contribute to developing intangibles pursuant 
to a cost sharing arrangement must be determined under a method 
described in the proposed regulations.
    The controlled participants must share intangible development costs 
of the intangibles developed or to be developed (the cost shared 
intangibles) in cost sharing transactions in proportion to their shares 
of reasonably anticipated benefits (RAB shares) from exploiting cost 
shared intangibles.
    The controlled participants must also compensate other controlled 
participants for their external contributions in preliminary or 
contemporaneous transactions. The arm's length amount charged in a 
preliminary or contemporaneous transaction must be determined pursuant 
to the method or methods under the other provision or provisions of the 
section 482 regulations, as supplemented by proposed Sec.  1.482-7(g), 
applicable to the reference transaction reflected by the preliminary or 
contemporaneous transaction. Such method will yield a value for the 
obligation of each obligor in the preliminary or contemporaneous 
transaction that is consistent with the product of the combined value 
to all controlled participants of the external contribution that is the 
subject of the preliminary or contemporaneous transaction multiplied by 
the obligor's RAB share.
    Contributions to developing the cost shared intangibles made by a 
controlled taxpayer that is not a controlled participant in the cost 
sharing arrangement must be determined pursuant to Sec.  1.482-
4(f)(3)(iii) (Allocations with respect to assistance to the owner). 
Arm's length consideration for the transfer by a controlled participant 
of an interest in a cost shared intangible at any time (whether during 
the term, or upon or after the termination of a cost sharing 
arrangement) must be determined under the rules of Sec. Sec.  1.482-1 
and 1.482-5 through 1.482-6.
    The proposed regulations provide that if an arrangement comes 
within the definition of a cost sharing arrangement, it is subject to 
Sec.  1.482-7 (see next section of this Preamble for discussion of the 
definition of a cost sharing arrangement). Other arrangements that are 
not cost sharing arrangements (or are not treated as such) must be 
analyzed under the other provisions of the section 482 regulations to 
determine whether they achieve arm's length results.
2. Definition of a CSA--Proposed Sec.  1.482-7(b)
a. CSA Transactions in General
    Under Sec.  1.482-1(b)(1), a ``controlled transaction meets the 
arm's length standard if the results of the transaction are consistent 
with the results that would have been realized if uncontrolled 
taxpayers had engaged in the same transaction under the same 
circumstances.'' (Emphasis added.) Thus, it is important to define with 
reasonable precision the category of arrangements treated as cost 
sharing arrangements, their terms, and the functions and risks assumed 
by the participants in such arrangements. The determination of what 
``would have been'' the arm's length results of such transactions is 
based on those definitions.
    Proposed Sec.  1.482-7(b) identifies two groups of transactions 
that are integral

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to a cost sharing arrangement--cost sharing transactions and 
preliminary or contemporaneous transactions. A cost sharing transaction 
or CST is a transaction in which the controlled participants share the 
intangible development costs of one or more cost shared intangibles in 
proportion to their respective shares of reasonably anticipated 
benefits from their individual exploitation of their interests in the 
cost shared intangibles that they obtain under the arrangement. CSTs 
reflect the results that would have been expected in a cost sharing 
agreement between uncontrolled taxpayers that did not bring any 
external contributions to the arrangement. In other words, if 
uncontrolled taxpayers started in a true ``green field,'' they would be 
expected to agree to split ongoing costs of the research in proportion 
to the relative value of their respective reasonably anticipated 
benefits from the arrangement.
    The proposed regulations are premised in part, however, on the fact 
that at least one controlled participant typically provides external 
contributions to a cost sharing arrangement. Thus, the proposed 
regulations integrate into the definition of a cost sharing arrangement 
not only the CSTs for the ongoing sharing of intangible development 
costs, but also the preliminary or contemporaneous transactions or PCTs 
by which the controlled participants compensate one another for their 
respective external contributions. The necessity of PCTs in connection 
with cost sharing arrangements was anticipated in the legislative 
history of the Tax Reform Act of 1986:

    In addition, to the extent, if any, that one party is actually 
contributing funds toward research and development at a 
significantly earlier point in time than the other, or is otherwise 
effectively putting its funds at risk to a greater extent than the 
other, it would be expected that an appropriate return would be 
provided to such party to reflect its investment.

H.R. Conf. Rep. No. 99-841 at II-638 (1986).

b. Constituent Elements of a CSA--Proposed Sec.  1.482-7(b)(1)
    The proposed regulations define a cost sharing arrangement or CSA 
as a contractual agreement to share the costs of one or more 
intangibles that meet three substantive and four administrative 
requirements. The term CSA, as defined, would replace the term 
qualified cost sharing arrangement employed in the existing 
regulations. The substantive requirements are that the controlled 
participants (1) divide all interests in cost shared intangibles on a 
territorial basis, (2) enter into and effect all CSTs and all PCTs, and 
(3) as a result, individually own and exploit their respective 
interests in the cost shared intangibles without any further obligation 
to compensate one another for such interests. The administrative 
requirements are that the controlled participants substantially comply 
with (1) the CSA contractual requirements, (2) the CSA documentation 
requirements, (3) the CSA accounting requirements, and (4) the CSA 
reporting requirements.
    The Treasury Department and the IRS recognize that a CSA, as 
defined, represents one possible arrangement by which parties may 
choose to share the costs, risks, and benefits of intangible 
development. Other arrangements, however, may involve a materially 
different division of costs, risks, and benefits in contrast to a CSA. 
For example, other arrangements may contemplate joint, rather than 
separate, exploitation of results, or may tie the division of actual 
results to the magnitude of each party's contributions (for example, by 
way of preferential returns), rather than divide contributions in 
accordance with reasonably anticipated benefits from separate 
exploitation. Given such differences, the guidance under Sec.  1.482-7, 
as applicable to CSAs, is not appropriate to evaluate what would have 
been the arm's length results of these other arrangements that do not 
constitute CSAs when they are undertaken among controlled taxpayers. In 
such cases the proposed regulations direct taxpayers to guidance under 
other provisions of the section 482 regulations to determine whether 
such arrangements achieve arm's length results.
c. External Contributions and PCTs--Proposed Sec.  1.482-7(b)(3)(i) 
Through (iv)
    PCTs are the transactions by which the controlled participants 
compensate one another for their external contributions to the CSA. 
External contributions are any resources or capabilities which one or 
more controlled participants bring to a CSA that were developed, 
maintained, or acquired externally to the CSA (whether prior to or 
during the course of the CSA), and that are reasonably anticipated to 
contribute to developing cost shared intangibles. For example, one 
controlled participant may have promising in-process technology, or a 
developed and successful first generation technology, that may 
reasonably be anticipated to provide a platform for future generation 
technology to be developed under the CSA. As another example, one 
controlled participant may have an experienced research team that could 
reasonably be anticipated to be particularly suited to carrying out the 
development contemplated under the CSA. The proposed regulations 
exclude land, depreciable tangible property, and other resources 
acquired by intangible development costs, since they are compensated by 
CSTs. See discussion of proposed Sec.  1.482-7(d).
    The Treasury Department and the IRS believe that uncontrolled 
parties entering into a long term commitment to share intangible 
development costs would require an agreement upfront that all external 
contributions be made available to the fullest extent for the full 
period over which they are reasonably anticipated to be needed. 
Accordingly, the proposed regulations introduce the concept of the 
reference transaction or RT in order to ensure that compensation for 
external contributions to the CSA reflects the full economic value of 
resources or capabilities that a participant brings to the CSA. The RT 
is a transaction providing the benefit of all rights, exclusively and 
perpetually, in a resource or capability described above, apart from 
the rights to exploit an existing intangible without further 
development (see section of Preamble below regarding Sec.  1.482-7(c) 
(Make-or-sell rights excluded)). The arm's length compensation pursuant 
to the PCT, and the applicable method used to determine such 
compensation, must reflect the type of transaction and contractual 
terms of the RT. The controlled participants must enter into a PCT as 
of the earliest date (whether on or after the date the CSA is entered 
into) on which the external contribution is reasonably anticipated to 
contribute to developing cost shared intangibles (the date of a PCT). 
The controlled participants are not required to actually enter into the 
RT and the compensation due from any controlled participant will be 
limited to its RAB share of the total value of the external 
contribution, the scope of which is defined by the RT.
    The concept of the RT was developed in response to arguments that 
have been encountered in the examination experience of the IRS under 
the existing regulations. In numerous situations taxpayers have 
purported to convey only limited availability of resources or 
capabilities for purposes of the intangible development activity (IDA) 
under a CSA. An example is a short-term license of an existing 
technology. Under the existing regulations, such cases may, of course, 
be examined to assess whether the purported

[[Page 51120]]

limitations conform to economic substance and the parties' conduct. See 
Sec.  1.482-1(d)(3)(ii)(B) (Identifying contractual terms). In 
addition, even if the short-term license were respected, the continued 
availability of the contribution past the initial license term would 
require new license terms to be negotiated taking into account relevant 
factors, such as whether the likelihood of success of the IDA had 
materially changed in the interim. The proposed regulations address the 
problems in administering such approaches more directly by requiring an 
upfront valuation of all external contributions which would be much 
more difficult to calculate if it involved the valuation of a series of 
short-term licenses with terms contingent on such interim changes. 
Accordingly, the proposed regulations assume a reference transaction 
that does not allow for contingencies based on the expiration of short-
term licenses that might require further renegotiation of the 
compensation for the external contribution. No inference is intended 
concerning the outcome of such limitations under the existing 
regulations.
    Thus, for example, consider a CSA for the development of future 
generations of an existing technology owned by one controlled 
participant. The PCT compensation obligation of the other controlled 
participant or participants would be determined by reference to the RT 
consisting of the transfer of all rights to the existing technology 
apart from the rights to exploit the existing technology without 
further development (see section of Preamble below regarding Sec.  
1.482-7(c) (Make-or-sell rights excluded)). The rights transferred in 
the RT would include the exclusive right to use the technology for 
purposes of research. They would also include the right to exploit any 
resulting products that incorporated the technology and any resulting 
products the development of which is otherwise assisted by the 
technology. Moreover, the rights transferred in the RT would cover a 
term extending as long as the exploitation of future generations of the 
technology continued. The RT provides the basis for selection and 
application of the method used to value the compensation owed under the 
PCT by each other controlled participant. The compensation obligation 
is limited to each such other controlled participant's RAB share of the 
total value of the rights in the existing technology that would have 
been transferred in the RT.
    Issues have arisen regarding whether an existing research team in 
place constitutes intangible property for which compensation is due, in 
addition to sharing the ongoing compensation and other costs of 
maintaining such team, for purposes of the buy-in provisions under the 
existing regulations. The Treasury Department and the IRS believe that 
the proper arm's length treatment is to include the obligation to 
compensate such external contributions of in-place research 
capabilities in PCTs. At arm's length, an uncontrolled taxpayer seeking 
to invest in a research project involving the experienced in-place 
researchers would require a commitment of the experienced team in place 
for purposes of the project, rather than assuming the risks presented 
by an inexperienced team. The Treasury Department and the IRS believe 
that a contribution of such an experienced team in place would result 
in the contribution of intangible property within the meaning of Sec.  
1.482-4(b) and section 936(h)(3)(B).
    The proposed regulations, however, do not restrict the type of 
transaction that may be the subject of the RT. An RT may consist of the 
provision of services as well as the transfer of intangible property. 
For example, in the case of an experienced research team in place, 
therefore, the RT could be the services agreement to commit the team to 
the research project under the CSA.
    Under the proposed regulations, the controlled participants may 
designate the type of transaction involved in the RT, if different 
economically equivalent types of RTs are possible with respect to the 
relevant resource or capability. If the controlled participants fail to 
make such a designation, the Commissioner may do so.
    Exacting compensation for an external contribution pursuant to a 
PCT is distinguishable from charging for another's business 
opportunity. Any taxpayer, controlled or uncontrolled, is free to 
undertake the business opportunity of trying to develop an intangible 
on its own. In that case, the taxpayer is bearing all costs and risks, 
and has no obligation to compensate anyone for taking free advantage of 
the opportunity. Where, however, the benefit of existing resources or 
capabilities belonging to another are desired that are reasonably 
anticipated to contribute to the development effort, then, at arm's 
length, the supplier of such resources or capabilities would not 
contribute them absent appropriate compensation.
d. Form of PCT Payment and Post Formation Acquisitions--Proposed Sec.  
1.482-7(b)(3)(v) and (vi)
    Under the proposed regulations, the general rule is that the 
consideration owing pursuant to a PCT for an external contribution, 
referred to as the PCT Payments, may take the form of fixed payments, 
payments contingent on the exploitation of the cost shared intangibles, 
or a combination of both. The selected payment form must be specified 
no later than the date of the PCT. The payor of PCT Payments is 
referred to as the PCT Payor, and the payee is referred to as the PCT 
Payee.
    In the case of resources or capabilities developed, maintained, or 
acquired prior to the time they are reasonably concluded to contribute 
to developing cost shared intangibles (for example, resources or 
capabilities that predate the CSA), the controlled participants have 
the flexibility to structure PCT Payments in any of the available 
forms, subject to conforming to contractual terms, economic substance, 
and the parties' conduct. See Sec.  1.482-1(d)(3)(ii)(B) (Identifying 
contractual terms). A CSA generally contemplates that the participants 
undertake costs and risks in parallel and in proportion to their RAB 
shares, but this result cannot be achieved in the case of external 
contributions that are the product of previously incurred costs and 
risks. So, for such resources or capabilities, the proposed regulations 
allow the controlled participants to provide for the applicable payment 
form by the date of the PCT.
    A post formation acquisition (PFA) is an external contribution 
representing resources or capabilities acquired by a controlled 
participant in an uncontrolled transaction that takes place after 
formation of the CSA and that, as of the date of the acquisition, are 
reasonably anticipated to contribute to developing cost shared 
intangibles. Resources or capabilities may be acquired in a PFA either 
directly or indirectly through the acquisition of an interest in an 
entity or tier of entities.
    The Treasury Department and the IRS believe that the form of PCT 
Payments for PFAs must be consistent with the principle that 
allocations of cost and risk among controlled participants after a CSA 
has commenced should be in proportion to their respective RAB shares. 
Accordingly, the proposed regulations provide that the consideration 
under a PCT for a PFA must follow the form of payment in the 
uncontrolled transaction in which the PFA was acquired. For example, if 
subsequent to the formation of a CSA one controlled participant makes a 
stock acquisition of a target the assets of which consist of resources 
and capabilities reasonably anticipated as of the date of the 
acquisition to contribute to developing cost shared intangibles,

[[Page 51121]]

the PCT Payment by each other controlled participant must be in a lump 
sum. To avoid the possibility that any payments are inappropriately 
characterized by the participants, neither PCT Payments, nor cost 
sharing payments, may be paid in shares of stock in the payor.
e. Territorial Division of Interests--Proposed Sec.  1.482-7(b)(4)
    Controlled participants in a CSA own interests in the cost shared 
intangibles and are able to exploit those intangibles without any 
obligation to compensate other participants (other than pursuant to 
CSTs or PCTs). Controlled participants must share intangible 
development costs in proportion to their reasonably anticipated 
benefits from their individual exploitation of such interests. 
Taxpayers have entered into cost sharing arrangements in which the 
controlled participants receive nonexclusive, indivisible worldwide 
interests in cost shared intangibles. Taxpayers have taken the position 
under the existing regulations that such interests are susceptible to 
being individually exploited, and that the participants' respective 
shares of benefits from such exploitation are susceptible to being 
reasonably estimated.
    The proposed regulations require that controlled participants 
receive non-overlapping territorial interests in the cost shared 
intangibles that in the aggregate utilize all the available territories 
worldwide. The proposed regulations also require that a controlled 
participant be entitled to the perpetual and exclusive right to cost 
shared intangible profits of any other controlled taxpayer in the same 
controlled group as the participant from transactions with uncontrolled 
taxpayers regarding property or services for use, consumption, or 
disposition within the participant's territory or territories. For 
example, where one controlled participant sells part of its output into 
a territory belonging to another controlled participant, the former 
must pay the latter participant arm's length compensation to ensure 
that the intangible profit on the sale is realized by the latter 
participant. These territoriality requirements facilitate the ability 
to individually exploit, and estimate the reasonably anticipated 
benefits from individual exploitation of, interests in cost shared 
intangibles. No inference is intended as to the permissibility of 
nonexclusive interests under the existing regulations.
    Comments are requested concerning whether alternatives should be 
provided to territorial division of interests in cost shared 
intangibles. Proposed alternatives should further the goal of dividing 
the universe of interests into exclusive, non-overlapping segments to 
promote measurability of anticipated benefits and administrability both 
by taxpayers and the IRS. Comments are also requested about how to 
facilitate attribution of sales to territories, or other non-
overlapping divisions of interests, such as in the case of sales via 
electronic commerce. Comments are also requested on the division, 
territorially or otherwise, of interests in exploiting cost shared 
intangibles in space.
f. CSAs in Substance or Form--Proposed Sec.  1.482-7(b)(5)
    Pursuant to proposed Sec.  1.482-7(b)(5)(i), as under the existing 
regulations, the Commissioner may, consistently with Sec.  1.482-
1(d)(3)(ii)(B) (Identifying contractual terms), apply the Sec.  1.482-7 
rules to any arrangement that in substance constitutes a CSA in 
accordance with the three substantive requirements enumerated in 
proposed Sec.  1.482-7(b)(1)(i) through (iii), notwithstanding a 
failure otherwise to meet the Sec.  1.482-7 requirements.
    Provided a taxpayer has followed the formal requirements enumerated 
in proposed Sec.  1.482-7(b)(1)(iv) through (vii), the Commissioner 
must treat the arrangement as a CSA if the taxpayer reasonably 
concluded the arrangement to be a CSA. The Commissioner may also treat 
any other arrangement as a CSA, if the taxpayer has followed such 
formal requirements.
3. Exclusion of Make-or-Sell Rights--Proposed Sec.  1.482-7(c)
    Disputes have arisen under the existing regulations regarding the 
buy-in related to a CSA to develop future generations of an intangible 
that is being exploited in its then current version by the PCT Payee. 
For example, there may be licenses of the current generation intangible 
to uncontrolled taxpayers, perhaps with certain rights to make 
adaptations for their customers. Taxpayers have asserted that a make-
and-sell license of this type satisfies the requirement for a buy-in in 
the CSA under the current regulations. Such a position misconstrues the 
existing regulations, which focus the buy-in on the availability of the 
pre-existing intangibles ``for purposes of research in the intangible 
development area'' under the CSA. See Sec.  1.482-7(g)(2).
    The proposed regulations expressly exclude from the scope of a CSA 
any provision to the extent it relates to exploiting an existing 
intangible without further development, such as the right to make or 
sell existing products. The proposed regulations do, however, allow the 
aggregate valuation of controlled transactions relating to make-or-sell 
rights with PCT Payments, where such aggregate evaluation provides a 
more reliable measure of an arm's length result than a separate 
valuation of the transactions. See proposed Sec.  1.482-7(g)(2)(v).
4. Intangible Development Costs--Proposed Sec.  1.482-7(d)
    The proposed regulations restate the provisions defining intangible 
development costs or IDCs that are shared pursuant to CSTs under a CSA 
to coordinate with the conceptual framework of the proposed regulations 
and with the stock-based compensation provisions added in 2003.
    As discussed, CSTs and PCTs are the two major groupings of 
transactions entered into pursuant to a CSA. In CSTs, the controlled 
participants share all ongoing costs of developing intangibles. In 
contrast, in PCTs they compensate one another for resources or 
capabilities developed, maintained, or acquired externally to the CSA 
(whether prior to or during the course of the CSA). It is necessary to 
define IDCs shared in CSTs in a comprehensive manner that does not 
overlap with the definition of external contributions compensated in 
PCTs.
    The proposed regulations, accordingly, define IDCs as all costs, in 
cash or in kind (including stock-based compensation), but excluding 
costs for land and depreciable property, in the ordinary course of 
business after the formation of a CSA that, based on analysis of the 
facts and circumstances, are directly identified with, or are 
reasonably allocable to, the IDA. The IDA replaces the concept of the 
intangible development area under the existing regulations. The self-
contained IDC definition eliminates the need for the cross-reference to 
operating expenses as defined in Sec.  1.482-5(d)(3) of the existing 
regulations and thus eliminates potential disputes over the interaction 
of these sections.
    The proposed regulations also avoid overlapping definitions of IDCs 
and external contributions. IDCs are limited to costs in the ordinary 
course of business incurred after the formation of a CSA and that are 
directly identified with, or reasonably allocable to, the IDA. Thus, 
for example, the expected value over and above ongoing compensation and 
other costs of an experienced research team would be compensated by 
PCTs, but the ongoing compensation and other costs of the team 
attributable to the IDA would be

[[Page 51122]]

IDCs shared in CSTs. Moreover, costs for depreciable property, which 
under section 197(f)(7) would include amortization of any amortizable 
section 197 intangible, are carved out from IDCs. Instead, to the 
extent such intangibles are reasonably anticipated to contribute to 
developing cost shared intangibles, they would be compensated in PCTs.
    Land and depreciable tangible property (for example, use of a 
laboratory facility) would represent an external contribution. The 
proposed regulations, however, continue the practical approach of the 
existing regulations of treating the arm's length rental charge under 
Sec.  1.482-2(c) (Use of tangible property) for such land and 
depreciable tangible property as IDCs, since typically these items can 
be readily valued.
    In line with the direction in the 1986 legislative history to 
reflect ``the actual economic activity'' undertaken pursuant to a CSA, 
the proposed regulations expressly provide that generally accepted 
accounting principles or federal income tax accounting rules may 
provide a useful starting point, but will not be conclusive regarding 
inclusion of costs in IDCs. As under the existing regulations, IDCs 
exclude interest expense, foreign income taxes, and domestic income 
taxes.
    The balance of the proposed regulations restate the existing 
regulations with conforming changes in light of the new terminology and 
framework. Technical amendments were made to the special transition 
rule on time and manner of making the election with respect to certain 
stock-based compensation and the consistency rules for measurement and 
timing with respect to such stock-based compensation.
    Except for such technical amendments, these proposed regulations 
incorporate the existing provisions relating to the elective method of 
measurement and timing permitted with respect to certain options on 
publicly traded stock. However, the Treasury Department and the IRS are 
considering extending availability of the elective method to other 
forms of publicly traded stock-based compensation. The Treasury 
Department and the IRS request comments on which forms of publicly 
traded stock-based compensation should be eligible for the elective 
method.
5. Reasonably Anticipated Benefits Share (RAB Share)--Proposed Sec.  
1.482-7(e)
    Proposed Sec.  1.482-7(e) restates existing Sec.  1.482-7(f)(3)(i) 
through (iv)(A) with some technical clarifications and changes to 
conform to the new terminology and framework. The proposed regulations 
provide, as is implicit in existing Sec.  1.482-7(b)(3), (e)(2), and 
(f)(3), that for purposes of determining RAB shares at any given time, 
reasonably anticipated benefits must be estimated over the entire 
period, past and future, of exploitation of the cost shared 
intangibles, and must reflect appropriate updates to take into account 
the most current reliable data regarding past and projected future 
results as is available at such time.
6. Changes in Participation Under a CSA--Proposed Sec.  1.482-7(f)
    Proposed Sec.  1.482-7(f) replaces existing Sec.  1.482-7(g)(3) and 
(4), as well as the third and fourth sentences of existing Sec.  1.482-
7(g)(1). This provision clarifies the application of the rules of Sec.  
1.482-7 in the event of a change in participation under a CSA. A change 
in participation includes the transfer between controlled participants 
of all or part of a participant's territorial rights coupled with the 
assumption by the transferee of the associated obligations under the 
CSA, the entry into a CSA of a new controlled participant that acquires 
any territorial rights and associated obligations under the CSA, and 
the withdrawal of a controlled participant or other relinquishment or 
abandonment of territorial rights and associated obligations under the 
CSA. In the event of a change in participation, the transferee of the 
territorial rights and associated obligations under the CSA succeeds to 
the transferor's prior history under the CSA, including IDCs borne, 
benefits derived, and compensation expenditures pursuant to any PCTs. 
The transferor must receive an arm's length amount of consideration 
from the transferee under the rules of Sec. Sec.  1.482-1 and 1.482-4 
through 1.482-6.
    Proposed Sec.  1.482-7(e)(2)(i) provides that in the case of 
transfers of cost shared intangibles between controlled participants, 
other than by way of a change in participation described in proposed 
Sec.  1.482-7(f), the transferor's benefits for purposes of RAB share 
determination are measured on a look-through basis with reference to 
the transferee's benefits, disregarding any consideration paid by the 
transferee (such as a royalty pursuant to a license agreement).

C. Supplemental Guidance on Methods Applicable to PCTs

    The Treasury Department and the IRS recognize that taxpayers and 
the IRS need additional guidance on the appropriate methods for 
valuation of external contributions to a CSA. A typical challenge to 
valuing nonroutine intangibles is the uncertainty as to the 
profitability of their exploitation. In the case of a CSA, however, 
there is also the uncertainty whether and to what extent any intangible 
will be successfully developed under the CSA. Accordingly, proposed 
Sec.  1.482-7(g) provides supplemental guidance on evaluating external 
contributions compensated by PCTs, including general principles for 
specified and unspecified methods, guidance on the application of 
existing specified methods, and new specified methods.
    The investor model informs the guidance on valuation. The guidance 
generally aims at valuation of the amount charged in a PCT such that a 
controlled participant's aggregate net investment in a CSA attributable 
to cost contributions and external contributions may be expected to 
earn a return appropriate to the riskiness of the CSA.
1. General Rule--Proposed Sec.  1.482-7(g)(1)
    As discussed, PCTs are one of two major categories of transactions 
(the other being CSTs) entered into pursuant to a CSA. In PCTs, the 
controlled participants compensate one another for their respective 
external contributions that they bring into a CSA, that is, the 
resources or capabilities they have developed, maintained, or acquired 
externally to (whether prior to or during the course of) the CSA that 
are reasonably anticipated to contribute to developing cost shared 
intangibles.
    Pursuant to Sec.  1.482-1(b)(2), different sections of the section 
482 regulations apply to different types of transactions, such as 
transfers of tangible and intangible property, services, loans or 
advances, and rentals. The method or methods most appropriate to the 
calculation of arm's length results for controlled transactions in each 
category must be selected. When interrelated controlled transactions 
are of different types, the participants, depending on what produces 
the most reliable means of measuring arm's length results, may either 
(1) apply different methods to the different transactions or (2) 
aggregate the transactions for valuation purposes. See also Sec.  
1.482-1(f)(2)(i) and proposed Sec.  1.482-7(g)(2)(v) regarding 
aggregation of transactions.

[[Page 51123]]

    A key concept in valuing PCTs is the RT. The RT is a transaction 
providing the benefit of all rights, exclusively and perpetually, in a 
resource or capability that is the subject of the external 
contribution, apart from the rights to exploit an existing intangible 
without further development. If in fact, the resource or capability is 
reasonably anticipated to contribute both to developing or exploiting 
cost shared intangibles and to other business activities of a PCT 
Payee, the proposed regulations provide that the otherwise applicable 
value of the relevant PCT Payments may need to be prorated between the 
CSA and any other business activities on a reasonable basis that 
reflects the relative economic values of the different business 
activities.
    For purposes of the selection of the category of method applicable 
to a controlled transaction pursuant to Sec.  1.482-1(b)(2)(ii), 
proposed Sec.  1.482-7(b)(3)(iii) provides that the applicable method 
used to determine the compensation for a PCT shall reflect the type of 
transaction of the RT. For example, in the case of an external 
contribution consisting of an in-process intangible, the RT could be a 
transfer of intangibles generally to be evaluated pursuant to 
Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6. As a further example, 
in the case of an external contribution consisting of an experienced 
research team in place, the RT could be the provision of services 
generally to be evaluated pursuant to Sec.  1.482-2(b). If different 
economically equivalent types of RTs are possible with respect to the 
relevant resource or capability, the controlled participants may 
designate the type of transaction involved in the RT.
    Proposed Sec.  1.482-7(a)(2) provides that the arm's length amount 
charged in a PCT must be determined pursuant to the method or methods 
applicable to the RT under the relevant provision or provisions of the 
section 482 regulations (as those methods are supplemented by proposed 
Sec.  1.482-7(g)). Such method will yield a value for the obligation of 
each obligor in the PCT (PCT Payor) consistent with the product of the 
combined value to all controlled participants of the external 
contribution that is the subject of the PCT multiplied by the PCT 
Payor's RAB share. Although some specified and unspecified methods may 
involve measuring PCT Payments with reference to the value of 
exploiting cost shared intangibles in one or more controlled 
participants' territories, the application of such methods must still 
yield a value that is consistent with the foregoing RAB share of the 
total value of the external contribution to all controlled 
participants.
    Proposed Sec.  1.482-7(g) sets forth new specified methods for 
purposes of determining the arm's length compensation due under a PCT, 
namely, the income method, the acquisition price method, and the market 
capitalization method. The proposed regulations also provide rules for 
application of existing specified methods, such as the comparable 
uncontrolled transaction method and the residual profit method. The 
proposed regulations also enunciate general principles governing all 
methods, specified and unspecified, for these purposes. Proposed Sec.  
1.482-7(g)(1) provides that each method must be applied in accordance 
with the provisions of Sec.  1.482-1, including the best method rule of 
Sec.  1.482-1(c), the comparability analysis of Sec.  1.482-1(d), and 
the arm's length range of Sec.  1.482-1(e), except as those provisions 
are modified in Sec.  1.482-7(g).
2. General Principles--Proposed Sec.  1.482-7(g)(2)
a. In General--Proposed Sec.  1.482-7(g)(2)(i)
    The proposed regulations provide general principles for valuing PCT 
Payments, applicable for both specified and unspecified methods.
b. Valuation Consistent With Upfront Contractual Terms and Risk 
Allocations--Proposed Sec.  1.482-7(g)(2)(ii)
    Existing Sec.  1.482-1(d)(3)(ii) and (iii) generally provide that 
contractual terms and risk allocations are significant factors in 
evaluating the most reliable measure of arm's length results. The 
proposed regulations provide for particular contractual terms and 
allocations of risk with regard to PCTs determined no later than the 
date of the PCT. See, for example, proposed Sec.  1.482-7(b)(1)(ii), 
(b)(3), and (k)(1). Proposed Sec.  1.482-7(g)(ii) accordingly 
reiterates the requirement that any method applied at any time for 
purposes of valuing PCT Payments must be consistent with the applicable 
contractual terms and allocation of risk under the CSA and proposed 
Sec.  1.482-7 as of the date of a PCT, unless there has been a change 
in such terms or allocation made in return for arm's length 
consideration.
    It may be particularly important to maintain consistency with 
upfront contractual terms and allocation of risk for CSAs, since PCT 
Payments may extend over a period of years. Thus, for example, PCT 
Payments may become due in subsequent years when actual economic 
results may have departed from those reasonably anticipated as of the 
date of the PCT. Subject to the Commissioner's ability to make periodic 
adjustments (see proposed Sec.  1.482-7(i)(6)), the method for 
determining the PCT Payments due in the subsequent year must remain 
consistent with the contractual terms and allocation of risks as of the 
date of the PCT. Cost sharing participants, like unrelated investors, 
are held to the terms of their deal at the outset of the investment. 
For example, under the proposed income method, this upfront 
contractual-risk consistency principle is illustrated by the use of the 
applicable rate on sales or profits determined as of the date of the 
PCT. Thus, while actual sales or profits may depart from projections, 
the upfront risk allocation continues to be respected by use of the 
applicable rate determined as of the date of the PCT. Note, while a 
taxpayer may defend the amount of its PCT Payment in a subsequent year 
as arm's length based on a different method than that applied in 
earlier years, it may only do so to the extent the other method also 
satisfies the upfront contractual-risk consistency principle.
    Proposed Sec.  1.482-7(b)(3)(vi) provides that the form of payment 
for a PCT must be specified no later than the date of the PCT. The form 
of payment of a PCT, that is, fixed and/or contingent payments, 
involves an allocation of risk among the controlled participants. In 
the case of PCT Payments regarding a PFA, the form of payment in the 
uncontrolled acquisition must be followed. However, in the case of 
other PCT Payments, the taxpayer has flexibility in the choice of form, 
subject to economic substance and the parties' conduct.
    As the result of the upfront contractual-risk consistency 
principle, it will be possible for the taxpayer to compute a present 
value, as of the date of the PCT, of the total arm's length amount of 
all PCT Payments. Under the CSA documentation requirements in proposed 
Sec.  1.482-7(k)(2)(ii)(J)(6) and (k)(2)(iii)(B), the taxpayer is 
required to maintain documentation of such upfront valuation and 
produce it to the IRS within 30 days of a request.
c. Projections--Proposed Sec.  1.482-7(g)(2)(iii)
    Since PCT Payments often extend over a period of years and may be 
contingent on items (for example, sales, costs, and operating profit) 
in such future periods, the valuation method, specified or unspecified, 
may rely on projections of such items. The reliability of the valuation 
method will in such

[[Page 51124]]

cases depend on the reliability of such projections. The proposed 
regulations provide that, for these purposes, projections that have 
been prepared for non-tax purposes are generally more reliable than 
projections that have been prepared solely for purposes of PCT Payment 
valuations.
d. Realistic Alternatives--Proposed Sec.  1.482-7(g)(2)(iv)
    Regardless of the method or methods used, evaluation of the arm's 
length charge for a PCT should take into account the general principle 
that uncontrolled taxpayers dealing at arm's length would evaluate the 
terms of a transaction, and would enter into a particular transaction 
only if none of the alternatives is preferable. See Sec.  1.482-
1(d)(3)(iv)(H) (The alternatives realistically available to the buyer 
and seller). Based on that principle, PCT valuations would not meet the 
foregoing condition where, for any controlled participant, the total 
anticipated value, as of the date of the PCT, is less than the total 
anticipated value that could have been achieved through a realistically 
available alternative investment (whether it is an alternative 
arrangement for the development of the cost shared intangibles or an 
alternative with a similar risk profile to the CSA). In other words, a 
controlled participant, like any rational investor, would not enter 
into an investment when a better alternative investment is available. 
Examples are provided illustrating the application of the realistic 
alternatives principle in the CSA context.
e. Aggregation of Transactions--Proposed Sec.  1.482-7(g)(2)(v)
    The proposed regulations provide that multiple PCTs, or one or more 
PCTs and one or more transactions not governed by proposed Sec.  1.482-
7 (such as a make-or-sell license excluded from CSA coverage by 
proposed Sec.  1.482-7(c)), may be aggregated for purposes of 
valuation, subject to consideration of whether such aggregate valuation 
yields a more reliable measure of an arm's length result than would 
separate valuations. See also Sec.  1.482-1(f)(2)(i) (Aggregation of 
transactions). For example, assume the CSA involves a PCT for an 
external contribution of an existing intangible for purposes of 
developing future generations of the intangible. Also assume that there 
is a license to the other controlled participants of make-and-sell 
rights with respect to the current generation of the intangible. The 
reliability of an aggregate analysis of the PCT and the license will be 
affected by the degree to which the relative current exploitation 
benefits from the existing intangible of the controlled participants 
may be expected to match up with the RAB shares regarding exploitation 
of the future generations of the intangible. Though it will not 
generally be necessary to allocate a reliable aggregate arm's length 
charge as between the various transactions, in certain cases such an 
allocation may be necessary, for example, in applying the periodic 
adjustment rules in proposed Sec.  1.482-7(i)(6).
f. Discount Rate--Proposed Sec.  1.482-7(g)(2)(vi)
    Specified and unspecified methods for valuing PCT Payments may 
involve converting future or past monetary sums into a present value as 
of the date of a PCT. The proposed regulations recognize that there may 
be different risks and, hence, different discount rates associated with 
different activities undertaken by a taxpayer. Consistent with the 
investor model, for items relating to a CSA, the discount rate employed 
should be that which most appropriately reflects, as of the date of the 
PCT, the risks of development and exploitation of the intangibles 
anticipated to result from the CSA. In other words, this follows the 
approach that unrelated investors would take to making an ex ante 
evaluation of a prospective investment. Namely, the expected value of 
the investment would equal the projected future cash flows discounted 
using a discount rate that appropriately reflects the anticipated level 
of risk being undertaken.
    The proposed regulations enumerate several possibilities for 
choosing an appropriate discount rate. Where there are publicly traded 
entities that would be comparables dedicated to similar development and 
exploitation activities, their weighted average cost of capital (WACC) 
may provide a reliable basis for derivation of an appropriate discount 
rate. Or, if the taxpayer's group's activities are dedicated to 
development and exploitation of the contemplated cost shared 
intangibles, then the taxpayer's own WACC may provide a reliable basis 
for derivation of an appropriate discount rate. In other cases, 
depending upon the facts and circumstances, a taxpayer's internal 
hurdle rate for investments having a comparable risk profile may 
provide a reliable basis for derivation of an appropriate discount 
rate.
g. Accounting Principles--Proposed Sec.  1.482-7(g)(2)(vii)
    The proposed regulations provide that, while allocations and 
valuations for accounting purposes may provide a useful starting point, 
they will not be determinative of PCT Payments to the extent that the 
accounting treatment is not consistent with economic value. For 
example, with respect to an acquisition of a target business consisting 
of wanted assets (that are reasonably anticipated to contribute to 
developing cost shared intangibles) and of unwanted assets (that will 
be abandoned immediately after the acquisition), an allocation of a 
portion of the acquisition price to the abandoned assets done for 
accounting purposes, under the proposed regulations, would not prevent 
the proper allocation of the entire acquisition price, in line with 
economic reality, to the wanted assets for purposes of PCT Payment 
valuation. Similarly, with respect to an acquisition of a target 
business consisting only of an in-process intangible and an experienced 
research team in place, an allocation of a portion of the acquisition 
price to ``goodwill'' for accounting purposes would not, under the 
proposed regulations, prevent the proper allocation of the entire 
acquisition price, in line with the economic reality, to the in-process 
intangible and experienced research team in place for purposes of PCT 
Payment valuation. On the other hand, if the target conducts an 
operating business with exploitation already at an advanced stage of 
the current generation of the intangible to be further developed under 
the CSA, then an accounting allocation to goodwill may suggest the need 
for further consideration of the reliability of an acquisition price 
method for valuing an external contribution whose value excluded the 
value of such existing goodwill.
h. Valuation Consistent With the Investor Model--Proposed Sec.  1.482-
7(g)(2)(viii)
    As has been discussed, the proposed regulations require that PCT 
valuations be consistent with an investor model for cost sharing. Under 
the investor model, the amount charged in a PCT must be consistent with 
the assumption that each controlled participant is making a net 
aggregate investment, as of the date of a PCT, attributable to both 
external contributions and cost contributions, for purposes of 
achieving an anticipated return appropriate to the risks of the CSA 
over the entire term of development and exploitation of the intangibles 
resulting from the CSA.
    The investor model is based on two key principles regarding PCT 
valuations. The first principle is that, ex ante, the aggregate 
investment in an IDA would be expected to yield a rate return equal to 
the appropriate discount rate for the CSA. If the anticipated rate of

[[Page 51125]]

return exceeds the appropriate discount rate for the CSA, either 
anticipated profits have been overstated or the amount of investment 
has been understated. If the projections of IDCs and profits are 
reliable, then the implication could be that the portion of the 
investment attributable to external contributions has been undervalued. 
Thus, a valuation method for PCTs is less likely to be reliable if it 
results in a rate of return to any controlled participant's aggregate 
investment that is not equal to the appropriate discount rate for the 
CSA.
    The second principle is that, ex ante, the appropriate return to 
the aggregate investment in an IDA is measured over the entire period 
of development and exploitation of cost shared intangibles. Included in 
this principle is the concept that no part of the investment should be 
viewed as separately earning a return over a more limited period. As a 
general matter, successful completion of each step in a research 
program is a necessary condition for the completion of the program as a 
whole and its contribution continues over the entire life of the 
project. As an example, a project to develop a new commercial aircraft 
would not be considered successfully completed if all parts of the 
aircraft had been designed except the tail assembly. Neither does the 
fact that the tail assembly is completed last imply that its usefulness 
in the manufacture and sale of aircraft extends beyond the usefulness 
of any components completed earlier in the design process. Each step of 
the project continues to have value as long as the aircraft continues 
to be built and used. For this reason, each aspect of the research 
program must be viewed as contributing to the success of the program as 
a whole (and not just its success for some limited period of time). 
Thus, a valuation method for PCTs is likely to be less reliable if it 
assumes a useful life for any contribution to the CSA that does not 
extend through the entire anticipated period of development and 
exploitation.
    The IRS has examined cases in which CSAs were entered into to 
utilize current generation intangibles as the base or platform for 
future generation intangibles, with buy-ins structured as declining 
royalties over the limited useful life of the current generation 
intangible. The structure of these buy-ins effectively diminish the 
value of the buy-in payments, such that the return to a controlled 
participant making the depressed buy-in payments has an expected return 
significantly in excess of the appropriate discount rate for the CSA. 
Furthermore, a buy-in based on declining royalties over a shortened 
useful life for the contributed intangibles, on its face, is not 
consistent with the principle that the return to the aggregate 
investment in an IDA should be measured over the entire period of 
development and exploitation of cost shared intangibles.
i. Coordination of Best Method Rule and Form of Payment--Proposed Sec.  
1.482-7(g)(2)(ix)
    Any method for valuing the amount charged in a PCT under the 
proposed regulations, whether specified or unspecified, will assume a 
particular form of payment (method payment form) for PCT Payments. For 
example, as will be discussed, the proposed income method assumes 
contingent payments in the form of an applicable rate on sales or 
profits, and the market capitalization method assumes a lump sum method 
payment form. Except for PCT Payments in respect of PFAs, the proposed 
regulations allow taxpayers to convert the reasonably anticipated 
present value, as of the date of the PCT, of the total arm's length 
amount of all PCT Payments determined under the method payment form 
into another form of payment (specified payment form). For purposes of 
the best method rule of Sec.  1.482-1(c), the analysis among competing 
methods will be undertaken without regard to whether their method 
payment forms corresponds to the taxpayer's specified payment form for 
PCT Payments. A best method analysis determines which valuation method 
is most reliable from the perspective of comparability, completeness 
and accuracy of the data, and reliability of the underlying 
assumptions. If the method payment form of the best method determined 
under this analysis differs from the taxpayer's specified payment form, 
then the Commissioner will effect a conversion of the best method 
results into the specified payment form on a reasonable basis, giving 
due regard to the taxpayer's conversion basis if the taxpayer's method 
was determined to be the best method as to its method payment form.
j. Coordination of the Valuations of Prior and Subsequent PCTs--
Proposed Sec.  1.482-7(g)(2)(x)
    Cases may arise where, after the date of one PCT, another PCT is 
required for other resources or capabilities of a controlled 
participant which only as of a subsequent date are reasonably 
anticipated to contribute to the development of cost shared intangibles 
and therefore are external contributions only as of such subsequent 
date. In such cases where there are PCTs with different dates, 
coordination of the valuations of the prior and subsequent PCTs must be 
effected pursuant to a method that provides the most reliable measure 
of an arm's length result.
    In some instances the coordination will be straightforward. As an 
example, in the case of a subsequent PCT entered into with respect to a 
PFA, the PCT Payments are determined based on the related acquisition, 
independent of any prior PCT. For purposes of determining PCT Payments 
under a prior PCT, the proposed regulations provide that the PCT 
Payments with respect to the subsequent PCT in this case are treated 
the same as unanticipated IDCs. A divergence between actual IDCs and 
IDCs anticipated on the date of a PCT does not change the method for 
determining PCT Payments with respect to that PCT. Accordingly, 
unanticipated payments under a subsequent PCT entered into with respect 
to a PFA will not affect the method for determining PCT Payments in 
respect of a prior PCT.
    The coordination in other cases will depend on the facts and 
circumstances. If the external contributions that were the subjects of 
the respective prior and subsequent PCTs were nonroutine contributions, 
an approach which may be appropriate would be to determine PCT Payments 
both for the prior and subsequent PCTs going forward from the date of 
the subsequent PCT pursuant to a residual profit split method, as 
described in proposed Sec.  1.482-7(g)(7). Such application of the 
residual profit split method would include as nonroutine contributions 
all of the following: the external contribution(s) that were the 
subject of the prior PCT(s), the external contribution that is the 
subject of the subsequent PCT, and the interests of the controlled 
participants in the portion of cost shared intangibles in process of 
development under the CSA that does not reflect any external 
contributions.
k. Proration of PCT Payments to the Extent Allocable to Other Business 
Activities--Proposed Sec.  1.482-7(g)(2)(xi)
    The proposed regulations provide that the otherwise applicable 
value of PCT Payments may need to be prorated between the CSA and any 
other business activities (other than current make-or-sell activities) 
to which the resource or capability that is the subject of the PCT is 
reasonably anticipated to contribute as of the date of the PCT. A 
proration will only be necessary if the method used for valuing the PCT 
Payment includes the value of the contribution of the resource or 
capability to the other business activities. For example, an 
application

[[Page 51126]]

of the acquisition price method is based on the full value of a 
resource or capability and therefore includes the value of any 
contributions to other business activities, whereas the CUT and CPM 
applications of the income method are based only on the sales or 
profits of exploiting cost shared intangibles, and therefore do not 
include any value of contributions to other business activities. For 
purposes of the best method rule under Sec.  1.482-1(c), the 
reliability of the analysis under a method that requires proration is 
reduced relative to the reliability of an analysis under a method that 
does not require proration. Any proration must be done on a reasonable 
basis that reflects the relative economic values of the different 
business activities.
3. Comparable Uncontrolled Transaction (CUT) Method--Proposed Sec.  
1.482-7(g)(3)
    The comparable uncontrolled transaction (CUT) method described in 
Sec.  1.482-4(c), and the arm's length charge described in Sec.  1.482-
2(b)(3)(first sentence) based on a comparable uncontrolled transaction, 
may be applied to evaluate whether the amount charged in a PCT is arm's 
length by reference to the amount charged in a comparable uncontrolled 
transaction. When applied in the manner described in Sec.  1.482-4(c), 
or where a comparable uncontrolled transaction provides the most 
reliable measure of the arm's length charge described in Sec.  1.482-
2(b)(3)(first sentence), the CUT method, or the arm's length charge in 
the comparable uncontrolled transaction, will typically yield an arm's 
length total value for the external contribution that is the subject of 
the PCT. That value must then be multiplied by each PCT Payor's 
respective RAB share in order to determine the arm's length PCT Payment 
due from each PCT Payor. A territorial CUT may also be reliably used to 
the extent the value of the PCT Payment under the territorial CUT is 
consistent with the RAB share of the worldwide external contribution 
value.
4. Income Method--Proposed Sec.  1.482-7(g)(4)
    The income method, a new specified method under the proposed 
regulations, follows from the realistic alternatives principle. The 
income method determines PCT Payments in amounts such that the present 
value, as of the date of the PCT, to a controlled participant of 
entering into a CSA equals the present value of the PCT Payee's best 
realistic alternative.
    The proposed regulations provide two specific (but nonexclusive) 
applications of the income method, one based on the comparable 
uncontrolled transaction (CUT) method of Sec.  1.482-4(c), and the 
other based on the comparable profit method (CPM) of Sec.  1.482-5. 
These applications may include certain simplifying assumptions and are 
meant to provide examples of possible applications of the general 
income method, not to exclude other possible applications of this 
method. Both applications compute the arm's length PCT Payment for each 
year as the product of an applicable rate on sales or profit. The 
applicable rate is equal to the alternative rate less the cost 
contribution adjustment. The alternative rate represents the rate on 
sales or profit which the PCT Payee could have earned by exploiting 
cost shared intangibles in the PCT Payor's territory if the PCT Payee 
alone had borne the risks and costs of developing the cost share 
intangibles. The CUT application determines the alternative rate from 
the perspective of a licensor as the royalty rate it would have charged 
under a license to exploit the cost shared intangibles in the 
territory, based on comparable third party license arrangements. The 
CPM application determines the alternative rate from the perspective of 
a licensee as the royalty rate it would have paid such that it earned 
only a market return for its routine contributions to the exploitation 
of the cost shared intangibles, based on comparable returns earned by 
uncontrolled taxpayers engaged in similar routine activities. The cost 
contribution adjustment is the reduction of the alternative rate to 
reflect the anticipated costs and risks the PCT Payor will take on by 
entering into the CSA.
    The income method is typically used in cases where only one 
controlled participant, namely the PCT Payee, brings nonroutine 
contributions into the CSA. In such circumstances, the other controlled 
participant or participants, that is, the PCT Payors, essentially only 
commit to bearing their respective shares of anticipated IDCs and bring 
only routine contributions for purposes of exploiting cost shared 
intangibles. Under the investor model, what is essentially a routine 
financing investment by the PCT Payors in the development of 
intangibles, represented by bearing their share of anticipated IDCs, 
would be expected to earn an ex ante rate of return appropriate to the 
risks associated with the CSA and reflected in the discount rate. The 
cost contribution adjustment effectively represents the appropriate 
return to that routine financing investment, as of the date of the PCT, 
expressed as a rate on sales or profit.
    The use of the applicable rate on sales or profit, determined as of 
the date of the PCT under the income method, also reflects the 
principle of consistency with the original contractual allocation of 
risk. Thus, while actual sales may depart from projections, the upfront 
risk allocation continues to be respected by use of the applicable rate 
determined as of the date of the PCT.
    Under the CUT and CPM applications of the income method, any 
routine contributions that are external contributions (routine external 
contributions) are treated similarly to cost contributions.
    The reliability of the income method may decrease if more than one 
controlled participant brings nonroutine contributions into the CSA.
5. Acquisition Price Method--Proposed Sec.  1.482-7(g)(5)
    The acquisition price method is an application of the CUT method 
pursuant to Sec.  1.482-4(c) and the arm's length charge pursuant to 
Sec.  1.482-2(b)(3). This method ordinarily applies only when 
substantially all of the nonroutine resources and capabilities of a 
recently acquired target's business constitute external contributions, 
that is, they are reasonably anticipated to contribute to developing 
cost shared intangibles. Thus, when these circumstances are present, 
this method may be expected to be appropriate for valuing PCT Payments 
for PFAs.
    Under the acquisition price method, the arm's length charge to each 
PCT Payor is the product of the adjusted acquisition price, multiplied 
by such PCT Payor's RAB share. The adjusted acquisition price seeks to 
isolate that portion of the acquisition price of the target business 
attributable to the external contributions. The adjusted acquisition 
price is equal to the acquisition price of the target, increased by 
relevant liabilities, and decreased by the value of tangible property 
(separately accounted for under proposed Sec.  1.482-7(d)) and by the 
value of any other resources and capabilities not covered by PCTs. The 
reliability of this method is reduced to the extent the acquisition 
price must be adjusted to take into account significant difficult-to-
value tangible property or resources or capabilities of the target not 
covered by a PCT.
6. Market Capitalization Method--Proposed Sec.  1.482-7(g)(6)
    The market capitalization method is also an application of the CUT 
method pursuant to Sec.  1.482-4(c) and the arm's

[[Page 51127]]

length charge pursuant to Sec.  1.482-2(b)(3). This method ordinarily 
applies only when substantially all of the nonroutine resources and 
capabilities of the PCT Payee's business constitute external 
contributions, that is, they are reasonably anticipated to contribute 
to developing cost shared intangibles.
    Under the market capitalization method, the arm's length charge to 
each PCT Payor is the product of the adjusted average market 
capitalization, multiplied by such PCT Payor's RAB share. The adjusted 
average market capitalization seeks to determine that portion of the 
market capitalization of the PCT Payee's business attributable to the 
external contributions. The adjusted average market capitalization is 
equal to the 60-day (ending on the date of the PCT) average of the 
daily market capitalizations of the PCT Payee, increased by 
liabilities, and decreased by the value of tangible property separately 
accounted for under proposed Sec.  1.482-7(d) and by the value of any 
other resources and capabilities not covered by PCTs. The daily market 
capitalization is calculated on each day the PCT Payee's stock is 
actively traded as the total number of shares outstanding multiplied by 
the stock's closing price on that day (as adjusted, for example, for 
dividends, stock splits, and restructurings to the extent such 
adjustment can be done reliably). The reliability of this method is 
reduced to the extent the market capitalization must be adjusted to 
take into account significant difficult to value tangible property or 
resources or capabilities of the target not covered by a PCT. The 
reliability of this method is also reduced to the extent the facts and 
circumstances demonstrate the likelihood of a material divergence 
between the average market capitalization of the PCT Payee and the 
value of its resources and capabilities for which reliable adjustments 
cannot be made.
7. Residual Profit Split Method--Proposed Sec.  1.482-7(g)(7)
    The proposed regulations provide needed guidance on the proper 
application of the residual profit split method (RPSM) of Sec.  1.482-6 
in the context of the development and exploitation of intangibles 
pursuant to a CSA. The guidance is necessary in order to implement the 
general principles of proposed Sec.  1.482-7(g)(2), such as consistency 
with the upfront contractual terms and risk allocation under the CSA 
and with the investor model. A purported application of RPSM not in 
accordance with this guidance would constitute an unspecified method 
for purposes of the sections 482 and 6662(e) and (h) regulations.
    Under the proposed regulations, the RPSM may not be applied where 
only one controlled participant makes significant nonroutine 
contributions to the development and exploitation of cost shared 
intangibles. (An RPSM in such a situation would be logically equivalent 
to the income method using an applicable rate on profit, and is best 
considered under that method.) The RPSM divides operating profit or 
loss before any expense or amortization on account of IDCs, routine 
external contributions, and nonroutine contributions, from developing 
and exploiting cost shared intangibles in a controlled participant's 
territory (territorial operating profit or loss) in three steps.
    In the first step of the RPSM, each controlled participant is 
allocated an amount of income that is subtracted from its territorial 
operating profit or loss to provide a market return to its routine 
contributions, other than cost contributions (that is, a controlled 
participant's IDCs borne, gross of cost sharing payments made, and net 
of cost sharing payments received).
    In the second step of the RPSM, each controlled participant is 
allocated a portion of the residual of its territorial profit or loss, 
after the first step allocation, attributable to its cost 
contributions. The second step cost contribution share is a fraction of 
such residual operating profit or loss. The numerator is the present 
value, determined as of the date of the PCTs, of the summation, over 
the entire period of developing and exploiting cost shared intangibles, 
of the total value of the territorial owner's total anticipated cost 
contributions. The denominator of the territorial owner's cost 
contribution fraction is the present value, determined as of the date 
of the PCTs, of the summation, over the same period, of the territorial 
owner's total anticipated territorial operating profits, reduced by a 
market return for routine contributions (other than cost contributions) 
to the relevant business activity in the territory.
    The cost contribution share under the second step of the RPSM 
corresponds to the cost contribution adjustment under the income 
method. The cost contribution share under the RPSM, similar to the cost 
contribution adjustment under the income method, is a reflection of the 
investor model. What is essentially a routine financing investment in 
the development of intangibles by the controlled participants, 
represented by bearing their share of anticipated IDCs, would be 
expected to earn a return appropriate to the risks associated with the 
CSA. The cost contribution share effectively represents the appropriate 
return to that financing investment, as of the date of the PCTs, 
expressed as a share of territorial operating profit or loss.
    In the third step of the RPSM, the residual territorial profit or 
loss remaining after the first and second step allocations is divided 
among all the controlled participants based on the relative value, as 
of the date of the PCTs, of their nonroutine contributions. The 
relative value of the nonroutine contributions may be measured with 
reference to external benchmarks that reflect their fair market value, 
or with reference to estimated capitalized development costs as 
appropriately grown or discounted so that all contributions may be 
valued on a comparable dollar base as of the date of the PCTs.
    Any amount of a controlled participant's territorial operating 
profit that is allocated to another controlled participant's nonroutine 
external contributions under the third step of the RPSM represents the 
amount of the PCT Payment due to that other controlled participant for 
its external contributions.
    Under the RPSM, the determinations as of the date of the PCT of the 
second step cost contribution share and the third step relative 
nonroutine contribution values reflect the principle of consistency 
with the original contractual allocation of risk. Thus, while actual 
territorial operating profit or loss may depart from projections, the 
upfront risk allocation continues to be respected through the use of 
the cost contribution shares and relative nonroutine contribution 
values determined as of the date of the PCTs.
    In applying the RPSM, any routine contributions that are external 
contributions (routine external contributions) are treated similarly to 
cost contributions.
    The proposed regulations set forth comparability and reliability 
considerations appropriate for application of the RPSM in the CSA 
context.
8. Unspecified Methods--Proposed Sec.  1.482-7(g)(8)
    The proposed regulations also provide general rules applicable for 
methods not specified in proposed Sec.  1.482-7(g)(3) through (7).

D. Coordination With the Arm's Length Standard--Proposed Sec.  1.482-
7(h)

    Transactions in connection with a CSA must produce results 
consistent

[[Page 51128]]

with the arm's length standard. The proposed regulations, therefore, 
dispel the misconception that cost sharing is a safe harbor.
    In accordance with Sec.  1.482-1(b)(1), the proposed regulations 
provide guidance appropriate in the context of a CSA regarding ``the 
results that would have been realized if uncontrolled taxpayers had 
engaged in the same transaction under the same circumstances.'' 
(Emphasis added.) In a CSA where the resulting intangibles may only be 
exploited in a controlled participant's territory, the arm's length 
result would require a participant to bear IDCs only in proportion to 
the expected relative values of its territory, that is, in proportion 
to its respective RAB shares. The same is true for PCTs. Where a 
controlled participant brings external contributions into the 
arrangement, at arm's length that participant would only agree to make 
the external contributions if it received compensation from the other 
participants for the anticipated benefits to their respective 
territories attributable to the external contributions.
    Therefore, the proposed regulations provide that a CSA, and the 
CSTs and PCTs required in connection with a CSA, produce results that 
are consistent with an arm's length result within the meaning of Sec.  
1.482-1(b) if, and only if, each controlled participant's IDC share 
equals its RAB share, and all other requirements are satisfied, 
including those with respect to PCT Payments.
    The Treasury Department and IRS recognize that a CSA, as defined, 
represents only one possible arrangement pursuant to which parties may 
choose to share the costs, risks, and benefits of intangible 
development. Other arrangements, however, may involve a different 
division of costs, risks, and benefits than those arising pursuant to a 
CSA. Given such differences, the guidance under Sec.  1.482-7 is not 
appropriate to evaluate what would have been arm's length results of 
those other arrangements when undertaken among controlled taxpayers. As 
discussed, in such cases the proposed regulations instead would point 
taxpayers to the guidance under the other provisions of the section 482 
regulations to determine whether such arrangements achieve arm's length 
results.

E. Allocations by the Commissioner in Connection With CSAs--Proposed 
Sec.  1.482-7(i)

1. Consolidation of Existing Allocation Provisions--Proposed Sec.  
1.482-7(i)(1) Through (4)
    Proposed Sec.  1.482-7(i) assembles in one section, provisions 
regarding allocations by the Commissioner that currently are spread 
throughout existing Sec.  1.482-7, with conforming changes to reflect 
the terminology and framework of the proposed regulations. Thus, under 
Sec.  1.482-7(i)(1), the Commissioner is generally authorized to make 
allocations to adjust the results of a controlled transaction in 
connection with a CSA so that the results are consistent with an arm's 
length result.
    Under proposed Sec.  1.482-7(i)(2), the Commissioner may make 
appropriate adjustments to CSTs to bring IDC shares in line with RAB 
shares. Such adjustments include adding or removing costs from IDCs, 
allocating costs between the IDA and other business activities, 
improving the reliability of the benefits measurement basis used or the 
projections used to estimate RAB shares, and allocating among the 
controlled participants any unallocated territorial interests in cost 
shared intangibles. CST adjustments must be reflected in the year in 
which the IDCs are incurred, along with any appropriate allocation of 
arm's length interest to the date of payment.
    Under proposed Sec.  1.482-7(i)(3), the Commissioner may make 
appropriate allocations to adjust PCT Payments in accordance with the 
proposed regulations. Thus, the Commissioner may examine the taxpayer's 
method for determining the amount charged in a PCT in accordance with 
the provisions of the section 482 regulations as supplemented by 
proposed Sec.  1.482-7(g). The Commissioner may either propose 
adjustments to the taxpayer's method or apply another method to adjust 
the results reported by the taxpayer consistent with an arm's length 
result.
    Under proposed Sec.  1.482-7(i)(4), the Commissioner may make 
appropriate allocations regarding changes in participation in 
accordance with proposed Sec.  1.482-7(f).
2. Allocations When CSTs Are Consistently and Materially 
Disproportionate to RAB Shares--Proposed Sec.  1.482-7(i)(5)
    The fundamental requirement of a CSA with regard to CSTs is for the 
controlled participants to share IDCs in proportion to their respective 
RAB shares. Under proposed Sec.  1.482-7(e)(1), RAB shares must be 
updated to account for changes in economic conditions, the business 
operations and practices of the participants and the ongoing 
development of intangibles. Such updates must reflect a comprehensive 
revision over the entire past and projected future period of intangible 
exploitation in light of the most current reliable data.
    To the extent the controlled participants consistently and 
materially fail to bear IDC shares equal to their respective RAB 
shares, the Commissioner would be able to exercise its authority 
pursuant to existing Sec.  1.482-1(d)(3)(ii)(B) (Identifying 
contractual terms) to impute an agreement that is consistent with the 
controlled participants' course of conduct. Thus, a participant that 
bears a disproportionately greater IDC share may be allocated an 
undivided interest in another territory or territories of exploitation 
of the cost shared intangibles, and would be allocated arm's length 
consideration from any other controlled participant whose IDC share is 
less than its RAB share over time.
    Current Sec.  1.482-7(g)(5) provides that these allocations be 
``after any cost allocations authorized by [Sec.  1.482-7(a)(2)]'' is 
eliminated. Some have interpreted this reference to mean that the 
Commissioner must make cost allocations, and failure to do so would bar 
the Commissioner from making an allocation pursuant to existing Sec.  
1.482-7(g)(5). This interpretation, if accepted, defeats the 
expectation that controlled participants must themselves act 
consistently with their CST deal and maintain their RAB shares current 
for that purpose. No inference is intended regarding the outcome under 
the existing regulations.
3. Periodic Adjustments--Proposed Sec.  1.482-7(i)(6)
    In 1986, Congress indicated a significant degree of skepticism 
about related-party transfers of high-profit potential intangibles for 
relatively insignificant lump sum or royalty consideration that 
effectively place all the intangible development downside risk in one 
controlled taxpayer and all the upside profit potential in another. See 
H.R. Rep. 99-426, at 424-25 (1985). See also Notice 88-123 (the White 
Paper), 1988-2 C.B. 458, 472-74, 477-480. The legislative history also 
notes that it is especially difficult to obtain realistic comparables 
with respect to such intangibles because they seldom if ever are 
transferred to unrelated parties. See id.
    The Commissioner's ability to evaluate controlled participants' 
deals

[[Page 51129]]

with regard to high-profit potential intangibles is hampered, not only 
by the absence of comparables, but by an asymmetry of information vis-
a-vis the taxpayer. The taxpayer is in the best position to know its 
business and prospects. The Commissioner faces real challenges in 
ascertaining the reliability of the ex ante expectations of taxpayer's 
initial arrangements in light of significantly different ex post 
outcomes. While risk and uncertain outcomes are typically the hallmarks 
of high-profit potential intangibles, significantly different results 
raise concerns whether the form of the initial arrangement matches its 
substance. These concerns are particularly problematic given the 
information asymmetry between taxpayers and the IRS. Periodic 
adjustments effectively permit the IRS to impute an arm's length 
arrangement that appropriately reflects the profit potential of 
transferred intangibles where the IRS believes that the taxpayers' 
arrangement does not appropriately reflect such profit potential. 
Because the guidance on periodic adjustments is intended to address the 
problem of information asymmetry, and because it is exceedingly 
unlikely that a taxpayer would use information asymmetry for anything 
other than a tax-advantaged result, periodic adjustments of this type 
can only be exercised by the Commissioner.
    Accordingly, taxpayers cannot exercise periodic adjustments of this 
type. This prohibition is necessary for proper administration of these 
rules. Moreover, taxpayers are not inappropriately disadvantaged by 
this rule because they have the ability to structure their related-
party arrangements in line with the economic prospects of their 
business. A taxpayer can always protect itself against periodic 
adjustments by adopting an arrangement that appropriately reflects the 
profit potential and risks associated with an intangible transfer, 
which it is in the best position to evaluate in an economically 
realistic way. There are various forms of consideration that taxpayers 
at arm's length might adopt in the face of uncertainty and risk. In 
some cases, uncontrolled taxpayers might find that projections of 
anticipated profits are sufficiently reliable to fix the pricing for 
the transaction at the outset on the basis of those projections. In 
other cases the uncertainty in valuing intangible property might lead 
them to adopt from the outset contingent terms of different varieties 
and degrees that allow for adjustment in light of actual profit 
experience. This does not mean that the taxpayer must adopt an 
arrangement that tilts the risks in a way that necessarily always 
involves reporting income without regard to later actual results. For 
example, contingent arrangements may appropriately reflect profit 
potential and yet appropriately tie in with later outcomes. In such 
arrangements, less income may properly result if the outcomes are less 
successful than reasonably anticipated, or greater income will result 
if the outcomes are more successful. Taxpayers simply are in the best 
position to structure their arrangements upfront to accommodate a range 
of potential outcomes.
    Proposed Sec.  1.482-7(j)(6) provides guidance on how periodic 
adjustments may be made in the context of a CSA. The goal is to conform 
the results of CSTs and PCTs to the arm's length standard. In 
accordance with the 1986 legislative history, achieving that goal 
requires that the ``income allocated among the parties reasonably 
reflect the actual economic activity undertaken by each'' and that ``to 
the extent, if any, that one party is actually contributing funds 
toward research and development at a significantly earlier point in 
time than the other, or is otherwise effectively putting its funds at 
risk to a greater extent than the other, it would be expected that an 
appropriate return would be provided to such party to reflect its 
investment.'' H.R. Conf. Rep. No. 99-841 at II-638 (1986). (Emphasis 
supplied.)
    The proposed regulations build the CSA periodic adjustment 
provisions upon the previously discussed investor model. The taxpayer's 
arrangement will be respected so long as a controlled participant's 
actually experienced return ratio (AERR), equal to the present value of 
its actually experienced operating profits from exploiting cost shared 
intangibles divided by its investment in the CSA (consisting of the 
present value sum of its cost contributions and PCT Payments), is 
within a specified periodic return ratio range (PRRR). The PRRR 
provides a band of comfort for actual return ratios of no more than 2 
and no less than \1/2\ (unless there is a failure to substantially 
comply with the administrative requirements of proposed Sec.  1.482-
7(k), in which case the comfort band consists of actual return ratios 
of no more than 1.5 and no less than .67). Results above or below these 
respective thresholds typically warrant a more thorough and detailed 
examination of the arm's length nature of the initial taxpayer 
arrangement, as well as a means to impute an alternative arrangement 
that more reliably reflects an arm's length result, as described below.
    In determining a controlled participant's AERR, the present values 
of its operating profits and CSA investments are measured from the 
period beginning on the commencement of the CSA through the end of the 
year of adjustment. For these purposes, present values are determined 
using an applicable discount rate (ADR) appropriate to the risks 
associated with the given CSA, as the Commissioner may determine under 
the guidance of proposed Sec.  1.482-7(g)(2)(vi). Where the stock of 
the PCT Payor, or another company that owns stock in the PCT Payor and 
is in a consolidated group with the PCT Payor for financial accounting 
purposes is publicly traded, the Commissioner may treat the ADR as 
equal to the publicly traded company's weighted average cost of 
capital, as determined pursuant to the capital asset pricing model, 
subject to the taxpayer's ability to show another discount rate is more 
appropriate in the facts and circumstances to the satisfaction of the 
Commissioner. Where there is no publicly traded company in the PCT 
Payor group, the ADR will be determined under the general principles 
applicable for discount rates, subject to such adjustments as the 
Commissioner determines is appropriate.
    In determining the AERR and, thus, whether the AERR is within or 
without the PRRR, it is intended that the items entering into the 
computation (e.g., operating profits, cost contributions, and PCT 
Payments) are those items as adjusted (including as the result of any 
prior IRS adjustments).
    The guidance on periodic adjustments is not intended, for example, 
to systematically reallocate above-market returns after-the-fact, since 
such returns may in whole or in part reward legitimate ex ante risk-
taking by CSA investors. Accordingly, an AERR outside the PRRR does not 
necessarily mean that adjustments will ultimately be warranted. Rather, 
the PRRR provides comfort to taxpayers that within the PRRR they will 
not be subject to periodic adjustments. If the AERR is outside the 
PRRR, the proposed regulations provide exceptions pursuant to which 
periodic adjustments will not be made where a taxpayer can demonstrate 
that its deal was nevertheless arm's length. These exceptions adapt the 
exceptions in existing Sec.  1.482-4(f)(2)(ii), along with three 
additional exceptions appropriate in the CSA context. One exception 
effectively would avoid ``start up'' triggers from return ratios below 
the low end of the PRRR by delaying low end trigger testing until after 
the first five years of substantial exploitation of cost

[[Page 51130]]

shared intangibles resulting from the CSA. A similar exception would 
enable a taxpayer to avoid a low end trigger that it can establish to 
the satisfaction of the Commissioner results from the ``cut off'' from 
consideration of anticipated profits, cost contributions, or PCT 
Payments beyond the end of the year of adjustment. For purposes of the 
foregoing exception, the taxpayer may assume that the yearly average of 
past operating profits for the years up through the year of adjustment 
in which there has been substantial exploitation of cost shared 
intangibles will continue into the future. The third additional 
exception would enable a taxpayer to avoid a high end trigger that it 
can establish to the satisfaction of the Commissioner results from 
routine contributions to its profitability, or from nonroutine 
contributions, including its own external contributions.
    In the event that the AERR is outside the PRRR, and no exception 
applies, then the Commissioner may adjust the taxpayer's PCT Payments 
to the level of an equivalent stream of contingent royalties as would 
be determined under a modified RPSM. The modified RPSM would vary 
depending on whether the periodic adjustment was triggered by an AERR 
above the high end or below the low end of the PRRR.
    In the event of a trigger above the high end of the PRRR, the 
arrangement going forward beginning with the year of adjustment would 
effectively treat the past cost contribution shares of all controlled 
participants as bought out and would determine new fractions for cost 
contribution shares as of the start of the year of adjustment (if 
development activity is then continuing under the CSA). Prior cost 
contributions and operating profits, therefore, would not be taken into 
account in the second step of the modified RPSM. The relative valuation 
of nonroutine contributions, including external contributions, in the 
third step of the modified RPSM would still be determined as of the 
original date of the PCTs, but taking into account any data relevant to 
such relative valuation as may be available up through the date of the 
periodic adjustment.
    In the event of a trigger below the low end of the PRRR, the 
arrangement going forward beginning with the year of adjustment would 
effectively recompute the original cost contribution share fractions by 
substituting projections as revised in light of actual experience up 
through the date of the periodic adjustment.
    For these purposes only, the residual profit split method may be 
used even where only one controlled participant makes significant 
nonroutine contributions to the CSA Activity. (As mentioned above in 
the discussion of the residual profit split method, applying the 
residual profit split method in such a situation is logically 
equivalent to applying the income method using an applicable rate on 
profit. For convenience, the proposed regulations apply the residual 
profit split method to all periodic adjustments rather than separately 
describing an equivalent modified income method for the situation in 
which only one controlled participant makes significant nonroutine 
contributions to the CSA Activity.) If only one controlled participant 
provides all the external contributions and other nonroutine 
contributions, then the third step residual profit or loss belongs 
entirely to such controlled participant.
    It should be emphasized that the Commissioner's determination 
whether or not to make periodic adjustments would be informed by 
whether the outcome as adjusted more reliably reflects an arm's length 
result.

F. Definitions and Special Rules--Proposed Sec.  1.482-7(j)

    Proposed Sec.  1.482-7(j) provides definitions and special rules 
relevant to CSAs.
1. Controlled Participant--Proposed Sec.  1.482-7(j)(1)(i)
    The proposed regulations incorporate the existing definitions and 
examples with regard to a controlled participant with conforming 
changes to reflect the new framework and terminology. Thus, a 
controlled participant is a controlled taxpayer that is a party to the 
CSA contractual agreement that reasonably anticipates that it will 
derive benefits from exploiting one or more cost shared intangibles.
    The proposed regulations dispense with the possibility of an 
uncontrolled participant in a CSA. The Treasury Department and the IRS 
are not aware of any uncontrolled participants in any CSAs. The 
elimination of uncontrolled participants simplified various provisions 
of the proposed regulations. The Treasury Department and the IRS 
request comments in this regard.
2. Cost Shared Intangible--Proposed Sec.  1.482-7(j)(1)(ii)
    The term cost shared intangible replaces the term covered 
intangible from existing Sec.  1.482-7(b)(4)(iv). A cost shared 
intangible means any intangible developed or to be developed as a 
result of the IDA. Thus, cost shared intangibles include both the 
intangibles that are contemplated to result from the IDA as well as any 
which serendipitously may result from the IDA.
    Cost shared intangibles include any portion thereof that may be 
attributable to an external contribution and, therefore, do not simply 
represent the incremental results of the IDA. For example, if a new 
generation software resulting from the IDA incorporates elements of the 
prior generation software, the cost shared intangible is the total 
result of the prior and subsequent contributions. No inference is 
intended as to the outcome under the existing regulations.
3. Interest In An Intangible--Proposed Sec.  1.482-7(j)(1)(iii)
    The proposed regulations employ the same general definition of an 
interest in an intangible found in existing Sec.  1.482-7(a)(2). It 
should be noted, however, that the proposed regulations provide that 
the interests in cost shared intangibles must be divided among the 
controlled participants on a territorial basis. See proposed Sec.  
1.482-7(b)(1)(i) and (b)(4).
4. Benefits--Proposed Sec.  1.482-7(j)(1)(iv)
    The proposed regulations clarify the definition of benefits found 
in existing Sec.  1.482-7(e)(1). Benefits means the sum of additional 
revenue generated, plus cost savings, minus any cost increases from 
exploiting cost shared intangibles.
5. Reasonably Anticipated Benefits--Proposed Sec.  1.482-7(j)(1)(v)
    The proposed regulations effectively employ the same definition of 
reasonably anticipated benefits found in existing Sec.  1.482-7(e)(2).
6. Territorial Operating Profit or Loss--Proposed Sec.  1.482-
7(j)(1)(vi)
    The proposed regulations define territorial operating profit or 
loss as the operating profit or loss as separately earned by each 
controlled participant in its geographic territory from the CSA 
Activity, determined before an expense (including amortization) on 
account of IDCs, routine external contributions, and nonroutine 
contributions.
7. CSA Activity--Proposed Sec.  1.482-7(j)(1)(vii)
    The proposed regulations define CSA Activity as the activity of 
developing and exploiting cost shared intangibles.
8. Consolidated Group--Proposed Sec.  1.482-7(j)(2)(i)
    In line with existing Sec.  1.482-7(c)(3), the proposed regulations 
treat all members of a U.S. group filing consolidated income tax 
returns as one taxpayer for purposes of the CSA provisions. The 
proposed regulations

[[Page 51131]]

would also treat all members of a foreign fiscal unity as one taxpayer 
for these purposes.
9. No Trade or Business and Partnership--Proposed Sec.  1.482-
7(j)(2)(ii) and (iii)
    In line with existing Sec. Sec.  1.482-7(a)(1) and 301.7701-1(c), 
the proposed regulations provide that participation in a CSA, of 
itself, does not constitute a U.S. trade or business or result in the 
creation of a partnership for federal income tax purposes.
10. Character of Payments--Proposed Sec.  1.482-7(j)(3)
    In line with existing Sec.  1.482-7(h), the proposed regulations 
provide ordering rules for characterizing cost sharing payments with 
regard to the items they reimburse. PCT Payments will be characterized 
consistently with the designation of the type of transaction involved 
in the RT. The proposed regulations continue to provide for the netting 
of PCT Payments made to, and received by, a controlled participant.

G. Administrative Provisions--Proposed Sec.  1.482-7(k)

    The proposed regulations include provisions to facilitate 
administration of, and compliance with, the cost sharing rules. Thus, 
under a CSA, the controlled participants must substantially comply with 
certain contractual, documentation, accounting, and reporting 
requirements. Similar requirements are spread throughout the existing 
regulations in Sec.  1.482-7(b), (c)(1), (i), and (j). In the proposed 
regulations, the substantial compliance standard is included in 
proposed Sec.  1.482-7(b)(1)(iv) through (vii), and the specific 
requirements are assembled together in Sec.  1.482-7(k).
1. CSA Contractual Requirements--Proposed Sec.  1.482-7(k)(1)
    Under proposed Sec.  1.482-7(k)(1)(i), a CSA must be recorded in 
writing in a contract that is contemporaneous with the formation (and 
any revision) of the CSA. The written CSA must incorporate the 
contractual provisions set forth in proposed Sec.  1.482-7(k)(1)(ii). 
Proposed Sec.  1.482-7(k)(1)(iii) provides that a written contractual 
agreement is contemporaneous with the formation (or revision) of a CSA 
if, and only if, the controlled participants record the CSA, in its 
entirety, in a document that they sign and date no later than 60 days 
after the first occurrence of any IDC to which such agreement (or 
revision) is to apply. By requiring that CSAs be memorialized 
contemporaneously with formation (or revision), the CSA contractual 
provisions are more likely to reliably reflect (without hindsight) the 
relative risks of the controlled participants.
2. CSA Documentation Requirements--Proposed Sec.  1.482-7(k)(2)
    Under proposed Sec.  1.482-7(k)(2)(i), the controlled participants 
must timely update and maintain sufficient documentation to establish 
that the participants have met the contractual requirements of proposed 
Sec.  1.482-7(k)(1). In addition, the controlled participants must 
timely update and maintain documentation sufficient to establish and 
support the items listed in proposed Sec.  1.482-7(k)(2)(ii) regarding 
the ongoing implementation of the CSA, CSTs, and PCTs. Thus, each 
controlled participant must at timely intervals update and maintain the 
documentation required by proposed Sec.  1.482-7(k)(2)(i) and (ii) on 
an ongoing basis from the outset of the formation of the CSA. To the 
extent that additional documentation is required by the new 
availability of information or the occurrence of post-formation events, 
each controlled participant must maintain such documentation in a 
manner such that the controlled participant retains and supplements 
(but does not replace) the documentation maintained from the outset.
    Proposed Sec.  1.482-7(k)(2)(iii), which replaces existing Sec.  
1.482-7(j)(2)(ii), cross-references proposed Sec.  1.6662-
6(d)(2)(iii)(D) for the coordination of the CSA documentation rules 
with the specified method documentation rules under the section 6662 
transfer pricing penalty regulations. Proposed Sec.  1.6662-
6(d)(2)(iii)(D) provides that satisfaction of the CSA documentation 
requirements satisfies the specified method principal documentation 
requirements with respect to the CSTs and PCTs, other than the 
requirements to provide a description of the relevant organizational 
structure and an index of principal and background documents, provided 
that such documentation is sufficient to establish that the taxpayer 
reasonably concluded that its method and application provided the most 
reliable measure of an arm's length result. Each controlled participant 
must provide such documentation to the IRS within 30 days of a request, 
subject to extension in the Commissioner's discretion.
3. CSA Accounting Requirements--Proposed Sec.  1.482-7(k)(3)
    Proposed Sec.  1.482-7(k)(3)(i) tracks the existing regulations in 
requiring that the controlled participants establish a consistent 
method of accounting, translate foreign currencies on a consistent 
basis, and explain any material differences from U.S. generally 
accepted accounting principles. Under proposed Sec.  1.482-7(k)(3)(ii), 
controlled participants may not rely solely upon financial accounting 
rules to establish satisfaction of the accounting requirements. Rather, 
the method of accounting must clearly reflect income.
4. CSA Reporting Requirements--Proposed Sec.  1.482-7(k)(4)
    Proposed Sec.  1.482-(7)(k)(4)(i) requires that each controlled 
participant must file with the Ogden Campus a statement regarding its 
participation in a CSA (CSA Statement). The CSA Statement must provide 
the information enumerated in proposed Sec.  1.482-7(k)(4)(ii), 
including the earliest date that any IDC occurred, the date on which 
the controlled participants formed (or revised) the CSA, and (if 
different from the immediately preceding date) the date on which the 
controlled participants recorded the CSA (or revision) in accordance 
with the contemporaneous recordation requirement.
    Pursuant to proposed Sec.  1.482-7(k)(4)(iii)(A), each controlled 
participant must file an original CSA Statement with the IRS no later 
than 90 days after the first occurrence of an IDC to which the newly-
formed CSA applies or, in the case of a taxpayer that became a 
controlled participant after the formation of the CSA, no later than 90 
days after such taxpayer became a controlled participant. The CSA 
Statement must be dated and signed, under penalties of perjury, by an 
officer of the controlled participant who is duly authorized (under 
local law) to sign the statement on behalf of the controlled 
participant.
    In addition to the 90-day rule described above, proposed Sec.  
1.482-7(k)(4)(iii)(B) contains an annual reporting requirement. Each 
controlled participant must attach to its U.S. income tax return, for 
each taxable year for the duration of the CSA, a copy of the original 
CSA Statement that the controlled participant filed in accordance with 
the 90-day rule. Further, the annual reporting by the controlled 
participant must update the information reflected on the original CSA 
Statement by attaching a schedule that documents changes in such 
information over time. If a controlled participant does not file a U.S. 
income tax return, then it must ensure that the foregoing CSA Statement 
and updated schedule are attached to any Schedule M of Form 5471, to 
any Form 5472, or

[[Page 51132]]

to any Form 8865 with respect to that participant.

H. Effective Date and Transition Rule--Proposed Sec. Sec.  1.482-7(l) 
and (m)

    The proposed regulations are proposed to be applicable on the date 
of publication of the proposed regulations as a final regulation in the 
Federal Register. Thus, CSAs commencing on or after such date, and CSTs 
and PCTs occurring after such date with respect to CSAs existing as of 
the effective date, will be subject to Sec.  1.482-7, as then finally 
revised. Conversely, other transactions not reasonably anticipated to 
contribute to developing intangibles pursuant to an arrangement 
constituting a CSA described in Sec.  1.482-7(b)(1) or (5) will be 
subject to other applicable section 482 regulations. See proposed Sec.  
1.482-7(a)(3)(iii).
    The proposed regulations provide transition rules under which an 
existing arrangement that constituted a qualified cost sharing 
arrangement under the regulations before the effective date will be 
considered a CSA and will be allowed an additional period to conform to 
the new rules with certain modifications. Although certain 
documentation requirements are delayed and certain substantive 
requirements concerning pre-effective date matters are relaxed for a 
grandfathered CSA described in the previous sentence, the controlled 
participants' CSTs and PCTs that occur after the effective date would 
have to comply with the substantive requirements of these regulations 
beginning immediately after such date. CSTs and PCTs occurring prior to 
the effective date are subject to these regulations only in the event 
that PCT Payments become subject to periodic adjustment under paragraph 
(i)(6) as a result of a subsequent PCT occurring on or after the 
effective date.
    The proposed regulations specify circumstances under which the 
grandfathered status of pre-effective date arrangements would 
terminate. Accordingly, an otherwise grandfathered arrangement would 
cease to be so grandfathered from the earliest of a failure of the 
controlled participants to substantially comply with the regulations as 
transitionally modified, a material change in the scope of the CSA as 
contemplated in the underlying contractual arrangement (such as a 
material expansion of the activities undertaken in the CSA beyond those 
undertaken as of the effective date), or a 50 percent change in the 
beneficial ownership of the interests in cost shared intangibles.

I. Changes to Other Provisions

    The proposed regulations make conforming changes to Sec.  1.367(a)-
1T, Sec.  1.861-17, and Sec. Sec.  1.482-1 et seq. of the section 482 
regulations to reflect the new terminology and framework of the CSA 
provisions.
    The proposed regulations redesignate current Sec.  1.482-7 as Sec.  
1.482-7A which would continue to apply for dates prior to the 
publication of this document as a final regulation in the Federal 
Register and to the extent applicable under the transition rule of 
proposed Sec.  1.482-7(m).
    The proposed regulations add examples to Sec.  1.482-8 to 
illustrate the application of the best method rule in connection with 
the new specified methods under proposed Sec.  1.482-7(g).
    As previously stated, proposed Sec.  1.6662-6(d)(2)(iii)(D) 
coordinates the CSA documentation requirements of proposed Sec.  1.482-
7(k)(2) with the specified method documentation requirements of the 
section 6662 transfer pricing penalty regulations.
    In line with the penultimate sentence of existing Sec.  1.482-
7(a)(1) and proposed Sec.  1.482-7(j)(2)(iii), proposed Sec.  301.7701-
1(c) provides that participation in a CSA, of itself, does not give 
rise to a separate entity.

Special Analysis

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has been 
determined also that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collections of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based on the fact that few small 
entities are expected to enter into cost sharing agreements, as defined 
herein, and that for those that do, the burdens imposed under proposed 
Sec.  1.482-7(b)(1)(iv) through (vii) and (k) would be minimal. 
Therefore, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f), this notice of proposed rulemaking will be submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The Treasury Department and the IRS specifically request comments 
on the clarity of the proposed regulations and how they may be made 
easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for November 16, 2005, at 10 
a.m., in the auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Due to building security procedures, 
visitors must enter at the Constitution Avenue entrance. In addition, 
all visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance more than 30 minutes before the hearing starts. 
For information about having your name placed on the building access 
list to attend the hearing, see the FOR FURTHER INFORMATION CONTACT 
section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by October 26, 2005. A period of 10 minutes will be allotted to each 
person for making comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Jeffrey L. 
Parry of the Office of Chief Counsel (International). However, other 
personnel from the Treasury Department and the IRS participated in 
their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

    Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income 
taxes, Penalties, Reporting and recordkeeping requirements.

[[Page 51133]]

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 301 are proposed to be amended as 
follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.482-7A also issued under 26 U.S.C. 482. * * *

    Par 2. Section 1.367(a)-1T is amended by revising the second 
sentence of paragraph (d)(3) to read as follows:


Sec.  1.367(a)-1T  Transfers to foreign corporations subject to section 
367(a): In general (temporary).

* * * * *
    (d) * * *
    (3) Transfer. * * * A person's entering into a cost sharing 
arrangement under Sec.  1.482-7 or acquiring rights to intangible 
property under such an arrangement shall not be considered a transfer 
of property described in section 367(a)(1). * * *
* * * * *
    Par. 3. Section 1.482-7 is redesignated Sec.  1.482-7A and an 
undesignated centerheading preceding Sec.  1.482-7A is added to read as 
follows:
    Regulations applicable on or before the date of publication of this 
document as a final regulation in the Federal Register.
    Par. 4. Section 1.482-0 is amended by revising the entry for Sec.  
1.482-7 to read as follows:


Sec.  1.482-0  Outline of regulations under section 482.

* * * * *


Sec.  1.482-7  Methods to determine taxable income in connection with a 
cost sharing arrangement.

    (a) In general.
    (1) RAB share method for cost sharing transactions (CSTs).
    (2) Methods for preliminary or contemporaneous transactions 
(PCTs).
    (3) Methods for other controlled transactions.
    (i) Contribution to a CSA by a controlled taxpayer that is not a 
controlled participant.
    (ii) Transfer of interest in a cost shared intangible.
    (iii) Controlled transactions not in connection with a CSA.
    (b) Cost sharing arrangement (CSA).
    (1) In general.
    (2) CSTs.
    (i) In general.
    (ii) Example.
    (3) PCTs.
    (i) In general.
    (ii) External contributions.
    (iii) PCT Payments.
    (iv) Reference transaction (RT).
    (v) PFAs.
    (vi) Form of payment.
    (A) In general.
    (B) PFAs.
    (C) No PCT Payor stock.
    (vii) Date of a PCT.
    (viii) Examples.
    (4) Territorial division of interests.
    (i) In general.
    (ii) Examples.
    (5) CSAs in substance or form .
    (i) CSAs in substance.
    (ii) CSAs in form.
    (iii) Example.
    (6) Treatment of CSAs.
    (c) Make-or-sell rights excluded.
    (1) In general.
    (2) Examples.
    (d) Intangible development costs (IDCs).
    (1) Costs included in IDCs.
    (2) Allocation of costs.
    (3) Stock-based compensation.
    (i) In general.
    (ii) Identification of stock-based compensation with the IDA.
    (iii) Measurement and timing of stock-based compensation IDC.
    (A) In general.
    (1) Transfers to which section 421 applies.
    (2) Deductions of foreign controlled participants.
    (3) Modification of stock option.
    (4) Expiration or termination of CSA.
    (B) Election with respect to options on publicly traded stock.
    (1) In general.
    (2) Publicly traded stock.
    (3) Generally accepted accounting principles.
    (4) Time and manner of making the election.
    (C) Consistency.
    (4) IDC share.
    (5) Examples.
    (e) Reasonably anticipated benefit shares (RAB shares).
    (1) In general.
    (2) Measure of benefits.
    (i) In general.
    (ii) Indirect bases for measuring benefits.
    (A) Units used, produced, or sold.
    (B) Sales.
    (C) Operating profit.
    (D) Other bases for measuring anticipated benefits.
    (E) Examples.
    (iii) Projections used to estimate benefits.
    (A) In general.
    (B) Examples.
    (f) Changes in participation under a CSA.
    (g) Supplemental guidance on methods applicable to PCTs.
    (1) In general.
    (2) General principles.
    (i) In general.
    (ii) Valuation consistent with upfront contractual terms and 
risk allocations.
     (iii)Projections.
    (iv) Realistic alternatives.
    (A) In general.
    (B) Examples.
    (v) Aggregation of transactions.
    (vi) Discount rate.
    (A) In general.
    (B) Examples.
    (vii) Accounting principles.
    (A) In general.
    (B) Examples.
    (viii) Valuation consistent with the investor model.
    (A) In general.
    (B) Example.
    (ix) Coordination of best method rule and form of payment.
    (x) Coordination of the valuations or prior and subsequent PCTs.
    (xi) Proration of PCT Payments to the extent allocable to other 
business activities.
    (3) Comparable uncontrolled transaction method.
    (4) Income method.
    (i) In general.
    (ii) Determination of arm's length charge.
    (A) In general.
    (B) Example.
    (iii) Application of income method using a CUT.
    (A) In general.
    (B) Determination of arm's length charge.
    (1) In general.
    (2) Applicable rate.
    (3) Alternative rate.
    (4) Cost contribution adjustment.
    (C) Example.
    (iv) Application of income method using CPM.
    (A) In general.
    (B) Determination of arm's length charge based on sales.
    (1) In general.
    (2) Applicable rate.
    (3) Alternative rate.
    (4) Cost contribution adjustment.
    (C) Determination of arm's length charge based on profit.
    (1) In general.
    (2) Alternative rate.
    (3) Cost contribution adjustment.
    (D) Example.
    (v) Routine external contributions.
    (vi) Comparability and reliability considerations.
    (A) In general.
    (B) Application of the income method using a CUT.
    (C) Application of the income method using CPM.
    (5) Acquisition price method.
    (i) In general.
    (ii) Determination of arm's length charge.
    (iii) Adjusted acquisition price.
    (iv) Reliability and comparability considerations.
    (v) Example.
    (6) Market capitalization method.
    (i) In general.
    (ii) Determination of arm's length charge.
    (iii) Average market capitalization.
    (iv) Adjusted average market capitalization.
    (v) Reliability and comparability considerations.
    (vi) Examples.
    (7) Residual profit split.
    (i) In general.
    (ii) Appropriate share of profits and losses.
    (iii) Profit split.
    (A) In general.
    (B) Allocate income to routine contributions other than cost 
contributions.

[[Page 51134]]

    (C) Allocate residual profit.
    (1) In general.
    (2) Cost contribution share of residual profit or loss.
    (3) Nonroutine contribution share of residual profit or loss.
    (4) Determination of PCT Payments.
    (5) Routine external contributions.
    (iv) Comparability and reliability considerations.
    (A) In general.
    (B) Comparability.
    (C) Data and assumptions.
    (D) Other factors affecting reliability.
    (v) Example.
    (8) Unspecified methods.
    (h) Coordination with the arm's length standard.
    (i) Allocations by the Commissioner in connection with a CSA.
    (1) In general.
    (2) CST allocations.
    (i) In general.
    (ii) Adjustments to improve the reliability of projections used 
to RAB shares.
    (A) Unreliable projections.
    (B) Foreign-to-foreign adjustments.
    (C) Correlative adjustments to PCTs.
    (D) Examples.
    (iii) Timing of CST allocations.
    (3) PCT allocations.
    (4) Allocations regarding changes in participation under a CSA.
    (5) Allocations when CSTs are consistently and materially 
disproportionate to RAB shares.
    (6) Periodic adjustments.
    (i) In general.
    (ii) PRRR.
    (iii) AERR.
    (A) In general.
    (B) PVTP.
    (C) PVI.
    (iv) ADR.
    (A) In general.
    (B) Publicly traded companies.
    (C) Publicly traded.
    (D) PCT Payor WACC.
    (E) Generally accepted accounting principles.
    (v) Determination of periodic adjustments.
    (vi) Exceptions to periodic adjustments.
    (A) Transactions involving the same external contributions as in 
the PCT.
    (B) Results not reasonably anticipated.
    (C) Reduced AERR does not cause Periodic Trigger.
    (D) Increased AERR does not cause Periodic Trigger.
    (E) 10-year period.
    (F) 5-year period.
    (vii) Examples.
    (viii) Documentation.
    (j) Definitions and special rules.
    (1) Definitions.
    (2) Special rules.
    (i) Consolidated group.
    (ii) Trade or business.
    (iii) Partnership.
    (3) Character.
    (i) In general.
    (ii) PCT Payments.
    (iii) Examples.
    (k) CSA contractual, documentation, accounting, and reporting 
requirements.
    (1) CSA contractual requirements.
    (i) In general.
    (ii) Contractual provisions.
    (iii) Meaning of contemporaneous.
    (A) In general.
    (B) Example.
    (2) CSA documentation requirements.
    (i) In general.
    (ii) Additional CSA documentation requirements.
    (iii) Coordination rules and production of documents.
    (A) Coordination with penalty regulations.
    (B) Production of documentation.
    (3) CSA accounting requirements.
    (i) In general.
    (ii) Reliance on financial accounting.
    (4) CSA reporting requirements.
    (i) CSA Statement.
    (ii) Content of CSA Statement.
    (iii) Time for filing CSA Statement.
    (A) 90-day rule.
    (B) Annual return requirement.
    (1) In general.
    (2) Special filing rule for annual return requirement.
    (iv) Examples.
    (l) Effective date.
    (m) Transition rule.
    (1) In general.
    (2) Termination of grandfather status.
    (3) Transitional modification of applicable provisions.
* * * * *
    Par. 5. Section 1.482-1 is amended by:
    1. Revising the second sentence of paragraph (b)(2)(i).
    2. Revising the last sentence of paragraph (c)(1).
    The revisions read as follows:


Sec.  1.482-1  Allocation of income and deductions among taxpayers.

* * * * *
    (b) * * *
    (2) * * *
    (i) * * * Section 1.482-7 provides the methods to be used to 
evaluate whether a cost sharing arrangement produces results consistent 
with an arm's length result.
* * * * *
    (c) * * *
    (1) * * * See Sec.  1.482-7 for the applicable methods in the case 
of a cost sharing arrangement.
* * * * *
    Par. 6. Section 1.482-4 is amended by
    1. Redesignating paragraph (f)(3)(iv) as paragraph (f)(3)(v).
    2. Adding a new paragraph (f)(3)(iv).
    The addition reads as follows:


Sec.  1.482-4  Methods to determine taxable income in connection with a 
transfer of intangible property.

* * * * *
    (f) * * *
    (3) * * *
    (iv) Cost sharing arrangements. The rules in this paragraph (f)(3) 
regarding ownership and assistance with respect to cost shared 
intangibles and cost sharing arrangements will apply only as provided 
in Sec.  1.482-7.
* * * * *
    Par. 7. Section 1.482-5 is amended by revising the last sentence of 
paragraph (c)(2)(iv) to read as follows:


Sec.  1.482-5  Comparable profits method.

* * * * *
    (c) * * *
    (2) * * *
    (iv) * * * As another example, it may be appropriate to adjust the 
operating profit of a party to account for material differences in the 
utilization of or accounting for stock-based compensation (as defined 
by Sec.  1.482-7(d)(3)(i)) among the tested party and comparable 
parties.
* * * * *
    Par. 8. Section 1.482-7 is revised to read as follows:


Sec.  1.482-7  Methods to determine taxable income in connection with a 
cost sharing arrangement.

    (a) In general. The arm's length amount charged in a controlled 
transaction reasonably anticipated to contribute to developing 
intangibles pursuant to a cost sharing arrangement (CSA), as described 
in paragraph (b) of this section, must be determined under a method 
described in this section. Each method must be applied in accordance 
with the provisions of Sec.  1.482-1, except as those provisions are 
modified in this section.
    (1) RAB share method for cost sharing transactions (CSTs). The 
controlled participants that are parties to a cost sharing transaction 
(CST), as described in paragraph (b)(2) of this section, must share the 
intangible development costs (IDCs) of the cost shared intangibles in 
proportion to their shares of reasonably anticipated benefits (RAB 
shares). See paragraph (j)(1) of this section for the definitions of 
controlled participant, cost shared intangible, benefits, and 
reasonably anticipated benefits, and paragraphs (d) and (e) of this 
section regarding IDCs and RAB shares, respectively.
    (2) Methods for preliminary or contemporaneous transactions (PCTs). 
The arm's length amount charged in a preliminary or contemporaneous 
transaction (PCT), as described in paragraph (b)(3) of this section, 
must be determined under the method or methods under the other section 
or sections of the section 482 regulations, as supplemented by 
paragraph (g) of this section, applicable to the reference transaction 
(RT) reflected by the PCT. See Sec.  1.482-1(b)(2)(ii) (Selection of 
category of method applicable to

[[Page 51135]]

transaction), paragraph (b)(3)(iv) of this section (Reference 
transaction), and paragraph (g) of this section (Supplemental guidance 
on methods applicable to PCTs).
    (3) Methods for other controlled transactions--(i) Contribution to 
a CSA by a controlled taxpayer that is not a controlled participant. If 
a controlled taxpayer that is not a controlled participant contributes 
to developing the cost shared intangibles, it must receive 
consideration from the other controlled participants under the rules of 
Sec.  1.482-4(f)(3)(iii) (Allocations with respect to assistance 
provided to the owner). Such consideration will be treated as an 
intangible development cost for purposes of paragraph (d) of this 
section.
    (ii) Transfer of interest in a cost shared intangible. If at any 
time (during the term, or upon or after the termination, of a CSA) a 
controlled participant transfers an interest in a cost shared 
intangible to another controlled taxpayer, the controlled participant 
must receive an arm's length amount of consideration from the 
transferee under the rules of Sec. Sec.  1.482-1 and 1.482-4 through 
1.482-6.
    (iii) Controlled transactions not in connection with a CSA. This 
section does not apply to a controlled transaction reasonably 
anticipated to contribute to developing intangibles pursuant to an 
arrangement that is not a CSA described in paragraph (b)(1) or 
paragraph (b)(5) of this section. Whether the results of any such 
controlled transaction are consistent with an arm's length result must 
be determined under the applicable rules of the section 482 regulations 
without regard to this section. For example, an arrangement for 
developing intangibles in which one controlled taxpayer's costs of 
developing the intangibles significantly exceeds its share of 
reasonably anticipated benefits from exploiting the developed 
intangibles would not in substance be a CSA, as described in paragraphs 
(b)(1)(i) through (iii) or paragraph (b)(5)(i) of this section. In such 
a case, unless the rules of this section are applicable by reason of 
paragraph (b)(5)(ii) of this section, the arrangement must be analyzed 
under other applicable sections of the section 482 regulations to 
determine whether it achieves arm's length results, and if not, to 
determine any allocations by the Commissioner that are consistent with 
such other section 482 regulations.
    (b) Cost sharing arrangement (CSA)--(1) In general. A CSA to which 
the provisions of this section apply is a contractual agreement to 
share the costs of developing one or more intangibles under which the 
controlled participants--
    (i) At the outset of the arrangement divide among themselves all 
interests in cost shared intangibles on a territorial basis as 
described in paragraph (b)(4) of this section;
    (ii) Enter into and effect CSTs covering all IDCs and PCTs covering 
all external contributions, as described in paragraphs (b)(2) and 
(b)(3) of this section, for purposes of developing the cost shared 
intangibles under the CSA;
    (iii) As a result, individually own and exploit their respective 
interests in the cost shared intangibles without any further obligation 
to compensate one another for such interests;
    (iv) Substantially comply with the CSA contractual requirements 
that are described in paragraph (k)(1) of this section;
    (v) Substantially comply with the CSA documentation requirements 
that are described in paragraph (k)(2) of this section;
    (vi) Substantially comply with the CSA accounting requirements that 
are described in paragraph (k)(3) of this section; and
    (vii) Substantially comply with the CSA reporting requirements that 
are described in paragraph (k)(4) of this section.
    (2) CSTs--(i) In general. CSTs are controlled transactions between 
or among controlled participants in which such participants share the 
IDCs of one or more cost shared intangibles in proportion to their 
respective RAB shares from their individual exploitation of their 
interests in the cost shared intangibles that they obtain under the 
CSA. Cost sharing payments may not be paid in shares of stock in the 
payor. See paragraphs (b)(4), (d), and (e) of this section for the 
rules regarding interests in cost shared intangibles, IDCs, and RAB 
shares, respectively.
    (ii) Example. The following example illustrates the principles of 
this paragraph (b)(2):

    Example.  Companies C and D, who are members of the same 
controlled group, enter into a CSA that is described in paragraph 
(b)(1) of this section. In the first year of the CSA, C and D 
conduct the IDA, as described in paragraph (d)(1) of this section. 
The total IDCs in regard to such activity are $3,000,000 of which C 
and D pay $2,000,000 and $1,000,000, respectively, directly to third 
parties. As between C and D, however, their CSA specifies that they 
will share all IDCs in accordance with their RAB shares (as 
described in paragraph (e)(1) of this section), which are 60% for C 
and 40% for D. It follows that C should bear $1,800,000 of the total 
IDCs (60% of total IDCs of $3,000,000) and D should bear $1,200,000 
of the total IDCs (40% of total IDCs of $3,000,000). D makes a CST 
payment to C of $200,000, that is, the amount by which D's share of 
IDCs in accordance with its RAB share exceeds the amount of IDCs 
initially borne by D ($1,200,000 -$1,000,000), and which also equals 
the amount by which the total IDCs initially borne by C exceeds its 
share of IDCs in accordance with its RAB share ($2,000,000 -
$1,800,000). As a result of D's CST payment to C, C and D will bear 
amounts of total IDCs in accordance with their respective RAB 
shares.

    (3) PCTs--(i) In general. A PCT is a controlled transaction in 
which each other controlled participant (PCT Payor) is obligated to 
compensate a controlled participant (PCT Payee) for an external 
contribution of the PCT Payee.
    (ii) External contributions. An external contribution consists of 
the rights set forth under the reference transaction (RT) in any 
resource or capability that is reasonably anticipated to contribute to 
developing cost shared intangibles and that a PCT Payee has developed, 
maintained, or acquired externally to (whether prior to or during the 
course of) the CSA. For purposes of this section, external 
contributions do not include rights in depreciable tangible property or 
land, and do not include rights in other resources acquired by IDCs. 
See paragraphs (b)(2) and (d)(1) of this section.
    (iii) PCT Payments. The arm's length amount of the compensation due 
under a PCT (PCT Payment) will be determined under a method pursuant to 
paragraphs (a)(2) and (g) of this section applicable to the RT, as 
described in paragraph (b)(3)(iv) of this section. The applicable 
method will yield a value for the compensation obligation of each PCT 
Payor consistent with the product of the combined value to all 
controlled participants of the external contribution that is the 
subject of the PCT multiplied by the PCT Payor's RAB share.
    (iv) Reference transaction (RT). An RT is a transaction providing 
the benefits of all rights (RT Rights), exclusively and perpetually, in 
a resource or capability described in paragraph (b)(3)(ii) of this 
section, excluding any rights to exploit an existing intangible without 
further development. See paragraph (c) of this section (Make-or-sell 
rights excluded). If a resource or capability is reasonably anticipated 
to contribute both to developing or exploiting cost shared intangibles 
and to other business activities of the PCT Payee, other than 
exploiting an existing intangible without further development, then the 
PCT Payment that would otherwise be determined with reference to the RT 
(which generally presumes a provision of exclusive and perpetual 
rights) may need to be prorated as described in

[[Page 51136]]

paragraph (g)(2)(xi) of this section. For purposes of Sec.  1.482-
1(b)(2)(ii) and paragraph (a)(2) of this section, the controlled 
participants must include the type of transaction involved in the RT as 
part of the documentation of the RT required under paragraph 
(k)(2)(ii)(H) of this section. If different economically equivalent 
types of RTs are possible with respect to the relevant resource or 
capability, the controlled participants may designate the type of 
transaction involved in the RT. If the controlled participants fail to 
make this designation in their documentation, the Commissioner may make 
a designation consistent with the RT and other facts and circumstances. 
While the PCT Payee and PCT Payors must enter into the PCT providing 
for the relevant compensation obligation, they are not required to 
actually enter into the RT that is referenced for purposes of 
determining the magnitude of the compensation obligation under the PCT.
    (v) PFAs. A post formation acquisition (PFA) is an external 
contribution that is acquired by a controlled participant in an 
uncontrolled transaction that takes place after the formation of the 
CSA and that as of the date of acquisition is reasonably anticipated to 
contribute to developing cost shared intangibles. Resources or 
capabilities may be acquired in a PFA either directly, or indirectly 
through the acquisition of an interest in an entity or tier of 
entities.
    (vi) Form of payment--(A) In general. The consideration under a PCT 
for an external contribution other than a PFA may take one or a 
combination of both of the following forms--
    (1) Payments of a fixed amount, either paid in a lump sum payment 
or in installment payments spread over a specified period, with 
interest calculated in accordance with Sec.  1.482-2(a) (Loans or 
advances); or
    (2) Payments contingent on the exploitation of cost shared 
intangibles by the PCT Payor. The form of payment selected for any PCT, 
including the basis and structure of the payments, must be specified no 
later than the date of that PCT.
    (B) PFAs. The consideration under a PCT for a PFA must be paid in 
the same form as the uncontrolled transaction in which the PFA was 
acquired.
    (C) No PCT Payor Stock. PCT Payments may not be paid in shares of 
stock in the PCT Payor.
    (vii) Date of a PCT. The controlled participants must enter into a 
PCT as of the earliest date on or after the CSA is entered into on 
which the external contribution is reasonably anticipated to contribute 
to developing cost shared intangibles.
    (viii) Examples. The following examples illustrate the principles 
of this paragraph (b)(3). In each example, Companies P and S are 
members of the same controlled group, and execute a CSA that is 
described in paragraph (b)(1) of this section. The examples are as 
follows:

    Example 1. Company P has developed and currently markets version 
1.0 of a new software application XYZ. Company P and Company S 
execute a CSA under which they will share the IDCs for developing 
future versions of XYZ. Version 1.0 is reasonably anticipated to 
contribute to the development of future versions of XYZ and 
therefore the RT rights in version 1.0 constitute an external 
contribution of Company P for which compensation is due from Company 
S pursuant to a PCT. The applicable method and determination of the 
arm's length compensation due pursuant to the PCT will be based on 
the RT. The controlled participants designate the RT as a transfer 
of intangibles that would otherwise be governed by Sec.  1.482-4, if 
entered into by controlled parties. Accordingly, pursuant to 
paragraph (a)(2) of this section, the applicable method for 
determining the arm's length value of the compensation obligation 
under the PCT between Company P and Company S will be governed by 
Sec.  1.482-4 as supplemented by paragraph (g) of this section. The 
RT in this case is the perpetual and exclusive provision of the 
benefit of all rights in version 1.0, other than the rights 
described in paragraph (c) of this section (Make-or-sell rights 
excluded). This includes the exclusive right to use version 1.0 for 
purposes of research and the right to exploit any products that 
incorporated the platform technology of version 1.0, and would cover 
a term extending as long as the uncontrolled taxpayer were to 
continue to exploit future versions of XYZ or any other product 
based on the version 1.0 platform. Though Company P and Company S 
are not required to actually enter into the transaction described by 
the RT, the value of the compensation obligation of Company S for 
the PCT will reflect the full value of the external contribution 
defined by the RT, as limited by Company S's RAB share.

    Example 2. Company P and Company S execute a CSA under which 
they will share the IDCs for developing Vaccine Z. Company P will 
commit its research team that has successfully developed a number of 
other vaccines to the project. The expertise and existing 
integration of the research team is a unique resource or capability 
of Company P which is reasonably anticipated to contribute to the 
development of Vaccine Z and therefore the RT Rights in the research 
team constitute an external contribution for which compensation is 
due from Company S as part of a PCT. The applicable method and 
determination of the arm's length compensation due pursuant to the 
PCT will be based on the RT. The controlled parties designate the RT 
as a provision of services that would otherwise be governed by Sec.  
1.482-2(b)(3)(first sentence) if entered into by controlled parties. 
Accordingly, pursuant to paragraph (a)(2) of this section, the 
applicable method for determining the arm's length value of the 
compensation obligation under the PCT between Company P and Company 
S will be governed by Sec.  1.482-2(b)(3)(first sentence) as 
supplemented by paragraph (g) of this section. The RT in this case 
is the perpetual and exclusive provision of the benefits by Company 
P of its research team to the development of Vaccine Z by the 
uncontrolled party. Because the IDCs include the ongoing 
compensation of the researchers, the compensation obligation under 
the PCT is only for the value of the commitment of the research team 
by Company P to the CSA's development efforts net of such researcher 
compensation. Though Company P and Company S are not required to 
actually enter into the transaction described by the RT, the value 
of the compensation obligation of Company S for the PCT will reflect 
the full value of provision of services described in the RT, as 
limited by Company S's RAB share.

    Example 3. In Year 1, Company P and Company S execute a CSA 
under which they will share the IDCs for developing Product X. In 
Year 3, Company P acquires technology intangibles that it 
anticipates will contribute to the development of Product X from an 
uncontrolled party for a lump sum consideration. Because the 
technology intangibles are reasonably anticipated to contribute to 
the development on the date of the acquisition and the acquisition 
is an uncontrolled transaction that takes place after the formation 
of the CSA, the RT Rights in the technology intangibles are an 
external contribution acquired as part of a PFA. Accordingly, 
Company P and Company S must enter into a PCT in which Company S 
compensates Company P for the RT Rights in the technology 
intangibles and pursuant to paragraph (b)(3)(vi)(B) of this section, 
the form of payment of the PCT must mirror the lump sum form of 
payment of the PFA.

    Example 4. Assume the same facts as in Example 3. In Year 4 
Company P acquires Company X in a tax-free stock-for-stock 
acquisition. Company X is a start-up technology company with 
negligible amounts of tangible property and liabilities. Company X 
joins in the filing of a U.S. consolidated income tax return with 
USP and is treated as one taxpayer with Company P under paragraph 
(j)(2)(i) of this section. Accordingly, under paragraph (b)(3)(v) of 
this section, Company P's acquisition of the stock of Company X will 
be treated as an indirect acquisition of the resources and 
capabilities of Company X. The in-process technology and workforce 
of Company X acquired by Company P are reasonably anticipated to 
contribute to the development of product Z and therefore the RT 
Rights in the in-process technology and workforce of Company X are 
external contributions for which compensation is due to Company P 
from Company S under a PCT. Furthermore, because these external 
contributions were acquired by Company P in an uncontrolled 
transaction that took place after the formation of the CSA, they are 
also PFAs. Accordingly, the consideration due from S under the PCT 
must be paid in the same form of payment as Company's P acquisition 
of Company X, which was done in a lump sum payment.

[[Page 51137]]

Therefore, consideration for the PCT must be paid in a lump sum.

    (4) Territorial division of interests--(i) In general. Pursuant to 
paragraph (b)(1)(i) of this section, at the outset of the CSA the 
controlled participants must divide among themselves all interests in 
cost shared intangibles on a territorial basis as follows. The entire 
world must be divided into two or more non-overlapping geographic 
territories. Each controlled participant must receive at least one such 
territory, and in the aggregate all the participants must receive all 
such territories. Each controlled participant must be entitled to the 
perpetual and exclusive right to the profits from transactions of any 
member of the controlled group that includes the controlled participant 
with uncontrolled taxpayers regarding property or services for use, 
consumption, or disposition in such controlled participant's territory 
or territories, to the extent that such profits are attributable to 
cost shared intangibles. Absent the controlled participant's or other 
member of its controlled group's actual knowledge or reason to know 
otherwise, for purposes of the preceding sentence such use, 
consumption, or disposition of property or services will be considered 
to occur at the location(s) to which notices and other communications 
to the uncontrolled taxpayer(s) are to be provided in accordance with 
the contractual provisions of the relevant transactions.
    (ii) Example. The following example illustrates the principles of 
this paragraph (b)(4):

    Example. Companies P and S, both members of the same controlled 
group, enter into a CSA to develop product Z. Under the CSA, P 
receives the interest in product Z in the United States and S 
receives the interest in product Z in the rest of the world, as 
described in paragraph (b)(4)(i) of this section. Both P and S have 
plants for manufacturing product Z located in their respective 
geographic territories. However, for commercial reasons product Z is 
nevertheless manufactured by P in the United States for sale to 
customers in certain locations just outside the United States in 
close proximity to P's U.S. manufacturing plant. Because S owns the 
territorial rights outside the United States, intercompany 
compensation must be provided for between P and S to ensure that S 
realizes all the cost shared intangible profits from sales of 
product Z to customers in such proximate areas, even though the 
manufacturing is done by P in the United States. The pricing of such 
intercompany compensation must also ensure that P realizes an 
appropriate manufacturing return for its efforts. Benefits projected 
with respect to such sales will be included for purposes of 
estimating S's, but not P's, RAB share.

    (5) CSAs in substance or form--(i) CSAs in substance. The 
Commissioner may apply, consistently with the rules of Sec.  1.482-
1(d)(3)(ii)(B) (Identifying contractual terms), the rules of this 
section to any arrangement that in substance constitutes a CSA 
described in paragraphs (b)(1)(i) through (iii) of this section, 
notwithstanding a failure to comply with any requirement of this 
section.
    (ii) CSAs in form. Provided the requirements of paragraphs 
(b)(1)(iv) through (vii) are met with respect to an arrangement among 
controlled taxpayers,
    (A) The Commissioner must apply the rules of this section to any 
such arrangement that the controlled taxpayers reasonably concluded to 
be a CSA, as described in paragraph (b)(1) of this section; and
    (B) Otherwise, the Commissioner may apply the rules of this section 
to any other such arrangement.
    (iii) Examples. The following examples illustrate the principles of 
this paragraph (b)(5). In the examples, assume that Companies P and S 
are both members of the same controlled group. The examples are as 
follows:

    Example 1. (i) P owns the patent on a formula for a capsulated 
pain reliever, P-Cap. P reasonably anticipates, pending further 
research and experimentation, that the P-Cap formula could form the 
platform for a formula for P-Ves, an effervescent version of P-Cap. 
P also owns proprietary software that it reasonably anticipates to 
be critical to the research efforts. P and S execute a CSA by which 
they agree to proportionally share the costs and risks of developing 
a formula for P-Ves. The agreement reflects the various contractual 
requirements described in paragraph (k)(1) of this section and P and 
S comply with the documentation, accounting and reporting 
requirements of paragraphs (k)(2) through (4) of this section. Both 
the patent for P-Cap and the software are reasonably anticipated to 
contribute to the development of P-Ves and therefore are external 
contributions for which compensation is due from S as part of PCTs. 
Though P and S enter into a PCT for the P-Cap patent, they fail to 
enter into a PCT for the software.
    (ii) In this case, P and S have substantially complied with the 
contractual requirements of paragraph (k)(1) of this section and the 
documentation, accounting and reporting requirements of paragraphs 
(k)(2) through (4) of this section and therefore have met the formal 
requirements of paragraphs (b)(1)(iv) through (vii) of this section. 
However, because they did not enter into a PCT, as required under 
paragraph (b)(1)(i) of this section, for the software that was 
reasonably anticipated to be critical to the development of P-Ves, 
they cannot reasonably conclude that their arrangement was a CSA. 
Accordingly, the Commissioner is not required under paragraph 
(b)(5)(ii)(A) of this section to apply the rules of this section to 
their arrangement. Nevertheless, pursuant to paragraph 
(b)(5)(ii)(B), the Commissioner may apply the rules of this section 
and treat P and S as entering into a PCT for the software in 
accordance with the requirements of paragraph (b)(1)(i) of this 
section, and make any appropriate allocations under paragraph (i) of 
this section. Alternatively, the Commissioner may decide that the 
arrangement is not a CSA described in paragraph (b)(1) of this 
section and therefore that this section's provisions do not apply in 
determining whether the arrangement reaches arm's length results. In 
this case, the arrangement would be analyzed under the methods under 
the section 482 regulations, without regard to this section, to 
determine whether the arrangement reaches such results.
    Example 2. The facts are the same as Example 1 except that P and 
S do enter into a PCT for the software. Although the Commissioner 
determines that the PCT Payments for the software were not arm's 
length, nevertheless, under the facts and circumstances at the time 
they entered into the CSA and PCTs, P and S reasonably concluded 
their arrangement to be a CSA. Because P and S have met the 
requirements of paragraphs (b)(1)(iv) through (vii) and reasonably 
concluded their arrangement is a CSA, pursuant to paragraph 
(b)(5)(ii)(A) of this section, the Commissioner must apply the rules 
of this section to their arrangement. Accordingly, the Commissioner 
treats the arrangement as a CSA and makes adjustments to the PCT 
Payments as appropriate under this section to achieve an arm's 
length result for the PCT for the software.

    (6) Treatment of CSAs. See Sec.  301.7701-1(c) of this chapter for 
the treatment of CSAs for purposes of the Internal Revenue Code.
    (c) Make-or-sell rights excluded--(1) In general. Any right to 
exploit an existing intangible without further development, such as the 
right to make or sell existing products, does not constitute an 
external contribution to a CSA, as described in paragraph (b)(3) of 
this section. Thus, the arm's length compensation for such rights does 
not satisfy the compensation obligation under a PCT.
    (2) Examples. The following examples illustrate the principles of 
this paragraph (c):

    Example 1. P and S, who are members of the same controlled 
group, execute a CSA that is described in paragraph (b)(1) of this 
section. Under the CSA, P and S will bear their proportional shares 
of IDCs for developing the second generation of ABC, a computer 
software program. Prior to that arrangement, P had incurred 
substantial costs and risks to develop ABC. Concurrently with 
entering into the arrangement, P (as the licensor) executes a 
license with S (as the licensee) by which S may make and sell copies 
of the existing ABC. Such make-and-sell rights do not constitute an 
external

[[Page 51138]]

contribution to the CSA. The rules of Sec. Sec.  1.482-1 and 1.482-4 
through 1.482-6, without regard to the rules of this section, must 
be applied to determine the arm's length consideration in connection 
with the make-and-sell licensing arrangement. In certain 
circumstances this determination of the arm's length consideration 
may be done on an aggregate basis with the evaluation of 
compensation obligations pursuant to PCTs entered into by P and S in 
connection with the CSA. See paragraph (g)(2)(v) of this section.
    Example 2. (i) P, a software company, has developed and 
currently exploits software program ABC. P and S enter into a CSA to 
develop future generations of ABC. The ABC source code is the 
platform on which future generations of ABC will be built and is 
therefore an external contribution of P for which compensation is 
due from S pursuant to a PCT. Concurrently with entering into the 
CSA, P licenses to S the make-and-sell rights for the current 
version of ABC. P has entered into similar licenses with 
uncontrolled parties calling for sales-based royalty payments at a 
rate of 20%. The current version of ABC has an expected product life 
of three years. P and S enter into a contingent payment agreement to 
cover both the PCT Payments due from S for P's external contribution 
and for the make-and-sell license. Based on the uncontrolled make-
and-sell licenses, P and S agree on a sales-based royalty rate of 
20% in Year 1 that declines on a straight line basis to 0% over the 
3 year product life of ABC.
    (ii) The make-and-sell rights for the current version of ABC are 
not external contributions, though paragraph (g)(2)(v) of this 
section provides for the possibility that the most reliable 
determination of an arm's length charge for the PCT and the make-
and-sell license may be one that values the two transactions in the 
aggregate. A contingent payment schedule based on the uncontrolled 
make-and-sell licenses may provide an arm's length charge for the 
separate make-and-sell license between P and S, provided the royalty 
rates in the uncontrolled licenses similarly decline, but as a 
measure of the aggregate PCT and license payments it does not 
account for the arm's length value of P's external contributions 
which include the RT Rights in the source code and future 
development rights in ABC.

    (d) Intangible development costs (IDCs)--(1) Costs included in 
IDCs. For purposes of this section, IDCs mean all costs, in cash or in 
kind (including stock-based compensation, as described in paragraph 
(d)(3) of this section), but excluding costs for land or depreciable 
property, in the ordinary course of business after the formation of a 
CSA that, based on analysis of the facts and circumstances, are 
directly identified with, or are reasonably allocable to, the activity 
under the CSA of developing or attempting to develop intangibles (IDA). 
IDCs shall also include the arm's length rental charge for the use of 
any land or depreciable tangible property (as determined under Sec.  
1.482-2(c) (Use of tangible property)) directly identified with, or 
reasonably allocable to, the IDA. Reference to generally accepted 
accounting principles or federal income tax accounting rules may 
provide a useful starting point but will not be conclusive regarding 
inclusion of costs in IDCs. IDCs do not include interest expense, 
foreign income taxes (as defined in Sec.  1.901-2(a)), or domestic 
income taxes.
    (2) Allocation of costs. If a particular cost is reasonably 
allocable both to the IDA and to other business activities, the cost 
must be allocated on a reasonable basis between the IDA and such other 
business activities in proportion to the relative economic value that 
the IDA and such other business activities are anticipated to derive 
over time as a result of such cost.
    (3) Stock-based compensation--(i) In general. As used in this 
section, the term stock-based compensation means any compensation 
provided by a controlled participant to an employee or independent 
contractor in the form of equity instruments, options to acquire stock 
(stock options), or rights with respect to (or determined by reference 
to) equity instruments or stock options, including but not limited to 
property to which section 83 applies and stock options to which section 
421 applies, regardless of whether ultimately settled in the form of 
cash, stock, or other property.
    (ii) Identification of stock-based compensation with the IDA. The 
determination of whether stock-based compensation is directly 
identified with, or reasonably allocable to, the IDA is made as of the 
date that the stock-based compensation is granted. Accordingly, all 
stock-based compensation that is granted during the term of the CSA 
and, at date of grant, is directly identified with, or reasonably 
allocable to, the IDA is included as an IDC under paragraph (d)(1) of 
this section. In the case of a repricing or other modification of a 
stock option, the determination of whether the repricing or other 
modification constitutes the grant of a new stock option for purposes 
of this paragraph (d)(3)(ii) will be made in accordance with the rules 
of section 424(h) and related regulations.
    (iii) Measurement and timing of stock-based compensation IDC--(A) 
In general. Except as otherwise provided in this paragraph (d)(3)(iii), 
the cost attributable to stock-based compensation is equal to the 
amount allowable to the controlled participant as a deduction for 
federal income tax purposes with respect to that stock-based 
compensation (for example, under section 83(h)) and is taken into 
account as an IDC under this section for the taxable year for which the 
deduction is allowable.
    (1) Transfers to which section 421 applies. Solely for purposes of 
this paragraph (d)(3)(iii)(A), section 421 does not apply to the 
transfer of stock pursuant to the exercise of an option that meets the 
requirements of section 422(a) or 423(a).
    (2) Deductions of foreign controlled participants. Solely for 
purposes of this paragraph (d)(3)(iii)(A), an amount is treated as an 
allowable deduction of a controlled participant to the extent that a 
deduction would be allowable to a United States taxpayer.
    (3) Modification of stock option. Solely for purposes of this 
paragraph (d)(3)(iii)(A), if the repricing or other modification of a 
stock option is determined, under paragraph (d)(3)(ii) of this section, 
to constitute the grant of a new stock option not identified with, or 
reasonably allocable to, the IDA, the stock option that is repriced or 
otherwise modified will be treated as being exercised immediately 
before the modification, provided that the stock option is then 
exercisable and the fair market value of the underlying stock then 
exceeds the price at which the stock option is exercisable. 
Accordingly, the amount of the deduction that would be allowable (or 
treated as allowable under this paragraph (d)(3)(iii)(A)) to the 
controlled participant upon exercise of the stock option immediately 
before the modification must be taken into account as an IDC as of the 
date of the modification.
    (4) Expiration or termination of CSA. Solely for purposes of this 
paragraph (d)(3)(iii)(A), if an item of stock-based compensation 
identified with, or reasonably allocable to, the IDA is not exercised 
during the term of a CSA, that item of stock-based compensation will be 
treated as being exercised immediately before the expiration or 
termination of the CSA, provided that the stock-based compensation is 
then exercisable and the fair market value of the underlying stock then 
exceeds the price at which the stock-based compensation is exercisable. 
Accordingly, the amount of the deduction that would be allowable (or 
treated as allowable under this paragraph (d)(3)(iii)(A)) to the 
controlled participant upon exercise of the stock-based compensation 
must be taken into account as an IDC as of the date of the expiration 
or termination of the CSA.
    (B) Election with respect to options on publicly traded stock--(1) 
In general. With respect to stock-based compensation in the form of 
options on

[[Page 51139]]

publicly traded stock, the controlled participants in a CSA may elect 
to take into account all IDCs attributable to those stock options in 
the same amount, and as of the same time, as the fair value of the 
stock options reflected as a charge against income in audited financial 
statements or disclosed in footnotes to such financial statements, 
provided that such statements are prepared in accordance with United 
States generally accepted accounting principles by or on behalf of the 
company issuing the publicly traded stock.
    (2) Publicly traded stock. As used in this paragraph 
(d)(3)(iii)(B), the term publicly traded stock means stock that is 
regularly traded on an established United States securities market and 
is issued by a company whose financial statements are prepared in 
accordance with United States generally accepted accounting principles 
for the taxable year.
    (3) Generally accepted accounting principles. For purposes of this 
paragraph (d)(3)(iii)(B), a financial statement prepared in accordance 
with a comprehensive body of generally accepted accounting principles 
other than United States generally accepted accounting principles is 
considered to be prepared in accordance with United States generally 
accepted accounting principles provided that either--
    (i) The fair value of the stock options under consideration is 
reflected in the reconciliation between such other accounting 
principles and United States generally accepted accounting principles 
required to be incorporated into the financial statement by the 
securities laws governing companies whose stock is regularly traded on 
United States securities markets; or
    (ii) In the absence of a reconciliation between such other 
accounting principles and United States generally accepted accounting 
principles that reflects the fair value of the stock options under 
consideration, such other accounting principles require that the fair 
value of the stock options under consideration be reflected as a charge 
against income in audited financial statements or disclosed in 
footnotes to such statements.
    (4) Time and manner of making the election. The election described 
in this paragraph (d)(3)(iii)(B) is made by an explicit reference to 
the election in the written CSA required by paragraph (k)(1) of this 
section or in a written amendment to the CSA entered into with the 
consent of the Commissioner pursuant to paragraph (d)(3)(iii)(C) of 
this section. In the case of a CSA in existence on August 26, 2003, the 
election by written amendment to the CSA may be made without the 
consent of the Commissioner if such amendment is entered into not later 
than the latest due date (with regard to extensions) of a federal 
income tax return of any controlled participant for the first taxable 
year beginning after August 26, 2003.
    (C) Consistency. Generally, all controlled participants in a CSA 
taking options on publicly traded stock into account under paragraph 
(d)(3)(iii)(A) or (d)(3)(iii)(B) of this section must use that same 
method of measurement and timing for all options on publicly traded 
stock with respect to that CSA. Controlled participants may change 
their method only with the consent of the Commissioner and only with 
respect to stock options granted during taxable years subsequent to the 
taxable year in which the Commissioner's consent is obtained. All 
controlled participants in the CSA must join in requests for the 
Commissioner's consent under this paragraph. Thus, for example, if the 
controlled participants make the election described in paragraph 
(d)(3)(iii)(B) of this section upon the formation of the CSA, the 
election may be revoked only with the consent of the Commissioner, and 
the consent will apply only to stock options granted in taxable years 
subsequent to the taxable year in which consent is obtained. Similarly, 
if controlled participants already have granted stock options that have 
been or will be taken into account under the general rule of paragraph 
(d)(3)(iii)(A) of this section, then except in cases specified in the 
last sentence of paragraph (d)(3)(iii)(B)(4) of this section, the 
controlled participants may make the election described in paragraph 
(d)(3)(iii)(B) of this section only with the consent of the 
Commissioner, and the consent will apply only to stock options granted 
in taxable years subsequent to the taxable year in which consent is 
obtained.
    (4) IDC share. A controlled participant's IDC share for a taxable 
year is equal to the controlled participant's cost contribution for the 
taxable year, divided by the sum of all IDCs for the taxable year. A 
controlled participant's cost contribution for a taxable year means all 
of the IDCs initially borne by the controlled participant, plus all of 
the cost sharing payments that the participant makes to other 
controlled participants, minus all of the cost sharing payments that 
the participant receives from other controlled participants.
    (5) Examples. The following examples illustrate this paragraph (d):

    Example 1. Foreign parent (FP) and its U.S. subsidiary (USS) 
enter into a CSA to develop a better mousetrap. USS and FP share the 
costs of FP's R&D facility that will be exclusively dedicated to 
this research, the salaries of the researchers, and reasonable 
overhead costs attributable to the project. They also share the cost 
of a conference facility that is at the disposal of the senior 
executive management of each company. Based on the facts and 
circumstances, the cost of the conference facility cannot be 
directly identified with, and is not reasonably allocable to, the 
IDA. In this case, the cost of the conference facility must be 
excluded from the amount of IDCs.
    Example 2. U.S. parent (USP) and its foreign subsidiary (FS) 
enter into a CSA to develop intangibles for producing a new device. 
USP and FS share the costs of an R&D facility, the salaries of the 
facility's researchers, and reasonable overhead costs attributable 
to the project. Although USP also incurs costs related to field 
testing of the device, USP does not include those costs in the IDCs 
that USP and FS will share under the CSA. The Commissioner may 
determine, based on the facts and circumstances, that the costs of 
field testing are IDCs that the participants must share.
    Example 3. U.S. parent (USP) and its foreign subsidiary (FS) 
enter into a CSA to develop a new process patent. USP employs 
researchers who perform R&D functions in connection both with the 
development of the new process patent and with the development of a 
new design patent the development of which is outside the scope of 
the CSA. During years covered by the CSA, USP compensates such 
employees with cash salaries, stock-based compensation, or a 
combination of both. USP and FS anticipate that the economic value 
attributable to such employees will be derived from the process 
patent and the design patent at a relative proportion of 75% and 
25%, respectively. Applying the principles of paragraph (d)(2) of 
this section, 75% of the compensation of such employees must be 
allocated to the development of the new process patent and, thus, 
treated as IDCs. With respect to the cash salary compensation, the 
IDC is 75% of the face value of the cash. With respect to the stock-
based compensation, the IDC is 75% of the value of the stock-based 
compensation as determined under paragraph (d)(3)(iii) of this 
section.
    Example 4. Foreign parent (FP) and its U.S. subsidiary (USS) 
enter into a CSA to develop a new computer source code. FP's 
executive officers who oversee a research facility and employees 
dedicated solely to the IDA have additional responsibilities, 
including oversight of other research facilities and employees not 
in any way relevant to the development of the new computer source 
code. The full amount of the costs of the research facility and 
employees dedicated solely to the IDA can be directly identified 
with the IDA and, therefore, are IDCs. In addition, the participants 
determine that, of the economic value attributable to the executive 
officers, the new computer source code's share is 50%. Applying the 
principles of paragraph (d)(2) of this section, 50% of the 
compensation of such executives must be

[[Page 51140]]

allocated to the development of the new computer source code and, 
thus, treated as IDCs.

    (e) Reasonably anticipated benefits share (RAB share)--(1) In 
general. A controlled participant's share of reasonably anticipated 
benefits (RAB share) is equal to its reasonably anticipated benefits 
divided by the sum of the reasonably anticipated benefits of all the 
controlled participants. See paragraph (j)(1)(v) of this section 
(defining reasonably anticipated benefits). RAB shares must be updated 
to account for changes in economic conditions, the business operations 
and practices of the participants, and the ongoing development of 
intangibles under the CSA. For purposes of determining RAB shares at 
any given time, reasonably anticipated benefits must be estimated over 
the entire period, past and future, of exploitation of the cost shared 
intangibles, and must reflect appropriate updates to take into account 
the most current reliable data regarding past and projected future 
results as is available at such time. A controlled participant's RAB 
share must be determined by using the most reliable estimate. In 
determining which of two or more available estimates is most reliable, 
the quality of the data and assumptions used in the analysis must be 
taken into account, consistent with Sec.  1.482-1(c)(2)(ii) (Data and 
assumptions). Thus, the reliability of an estimate will depend largely 
on the completeness and accuracy of the data, the soundness of the 
assumptions, and the relative effects of particular deficiencies in 
data or assumptions on different estimates. If two estimates are 
equally reliable, no adjustment should be made based on differences in 
the results. The following factors will be particularly relevant in 
determining the reliability of an estimate of RAB shares--
    (A) The basis used for measuring benefits, as described in 
paragraph (e)(2)(i) of this section; and
    (B) The projections used to estimate benefits, as described in 
paragraph (e)(2)(iii) of this section.
    (2) Measure of benefits--(i) In general. In order to estimate a 
controlled participant's RAB share, the amount of each controlled 
participant's reasonably anticipated benefits must be measured on a 
basis that is consistent for all such participants. See paragraph 
(e)(2)(ii)(E) Example 8 of this section. If a controlled participant 
transfers a cost shared intangible to another controlled taxpayer, 
other than by way of a transfer described in paragraph (f) of this 
section, that participant's benefits from the transferred intangible 
must be measured by reference to the transferee's benefits, 
disregarding any consideration paid by the transferee to the controlled 
participant (such as a royalty pursuant to a license agreement). 
Reasonably anticipated benefits are measured either on a direct basis, 
by reference to estimated benefits to be generated by the use of cost 
shared intangibles, or on an indirect basis, by reference to certain 
measurements that reasonably can be assumed to be related to benefits 
to be generated. Such indirect bases of measurement of anticipated 
benefits are described in paragraph (e)(2)(ii) of this section. A 
controlled participant's reasonably anticipated benefits must be 
measured on the basis, whether direct or indirect, that most reliably 
determines RAB shares. In determining which of two bases of measurement 
is most reliable, the factors set forth in Sec.  1.482-1(c)(2)(ii) 
(Data and assumptions) must be taken into account. It normally will be 
expected that the basis that provided the most reliable estimate for a 
particular year will continue to provide the most reliable estimate in 
subsequent years, absent a material change in the factors that affect 
the reliability of the estimate. Regardless of whether a direct or 
indirect basis of measurement is used, adjustments may be required to 
account for material differences in the activities that controlled 
participants undertake to exploit their interests in cost shared 
intangibles. See Example 6 of paragraph (e)(2)(ii)(E) of this section.
    (ii) Indirect bases for measuring anticipated benefits. Indirect 
bases for measuring anticipated benefits from participation in a CSA 
include the following:
    (A) Units used, produced, or sold. Units of items used, produced, 
or sold by each controlled participant in the business activities in 
which cost shared intangibles are exploited may be used as an indirect 
basis for measuring its anticipated benefits. This basis of measurement 
will more reliably determine RAB shares to the extent that each 
controlled participant is expected to have a similar increase in net 
profit or decrease in net loss attributable to the cost shared 
intangibles per unit of the item or items used, produced, or sold. This 
circumstance is most likely to arise when the cost shared intangibles 
are exploited by the controlled participants in the use, production, or 
sale of substantially uniform items under similar economic conditions.
    (B) Sales. Sales by each controlled participant in the business 
activities in which cost shared intangibles are exploited may be used 
as an indirect basis for measuring its anticipated benefits. This basis 
of measurement will more reliably determine RAB shares to the extent 
that each controlled participant is expected to have a similar increase 
in net profit or decrease in net loss attributable to cost shared 
intangibles per dollar of sales. This circumstance is most likely to 
arise if the costs of exploiting cost shared intangibles are not 
substantial relative to the revenues generated, or if the principal 
effect of using cost shared intangibles is to increase the controlled 
participants' revenues (for example, through a price premium on the 
products they sell) without affecting their costs substantially. Sales 
by each controlled participant are unlikely to provide a reliable basis 
for measuring RAB shares unless each controlled participant operates at 
the same market level (for example, manufacturing, distribution, etc.).
    (C) Operating profit. Operating profit of each controlled 
participant from the activities in which cost shared intangibles are 
exploited, as determined before any expense (including amortization) on 
account of IDCS, may be used as an indirect basis for measuring 
anticipated benefits. This basis of measurement will more reliably 
determine RAB shares to the extent that such profit is largely 
attributable to the use of cost shared intangibles, or if the share of 
profits attributable to the use of cost shared intangibles is expected 
to be similar for each controlled participant. This circumstance is 
most likely to arise when cost shared intangibles are closely 
associated with the activity that generates the profit and the activity 
could not be carried on or would generate little profit without use of 
those intangibles.
    (D) Other bases for measuring anticipated benefits. Other bases for 
measuring anticipated benefits may, in some circumstances, be 
appropriate, but only to the extent that there is expected to be a 
reasonably identifiable relationship between the basis of measurement 
used and additional income generated or costs saved by the use of cost 
shared intangibles. For example, a division of costs based on employee 
compensation would be considered unreliable unless there were a 
relationship between the amount of compensation and the expected income 
of the controlled participants from using the cost shared intangibles.
    (E) Examples. The following examples illustrate this paragraph 
(e)(2)(ii):

    Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) both 
produce a feedstock for the manufacture of various high-performance 
plastic products. Producing the feedstock requires large amounts of

[[Page 51141]]

electricity, which accounts for a significant portion of its 
production cost. FP and USS enter into a CSA to develop a new 
process that will reduce the amount of electricity required to 
produce a unit of the feedstock. FP and USS currently both incur an 
electricity cost of $2 per unit of feedstock produced and rates for 
each are expected to remain similar in the future. The new process, 
if it is successful, will reduce the amount of electricity required 
by each company to produce a unit of the feedstock by 50%. 
Therefore, the cost savings each company is expected to achieve 
after implementing the new process are $1 per unit of feedstock 
produced. Under the CSA, FP and USS divide the costs of developing 
the new process based on the units of the feedstock each is 
anticipated to produce in the future. In this case, units produced 
is the most reliable basis for measuring RAB shares and dividing the 
IDCs because each controlled participant is expected to have a 
similar $1 (50% of current charge of $2) decrease in costs per unit 
of the feedstock produced.

    Example 2. The facts are the same as in Example 1, except that 
currently USS pays $3 per unit of feedstock produced for electricity 
while FP pays $6 per unit of feedstock produced. In this case, units 
produced is not the most reliable basis for measuring RAB shares and 
dividing the IDCs because the participants do not expect to have a 
similar decrease in costs per unit of the feedstock produced. The 
Commissioner determines that the most reliable measure of RAB shares 
may be based on units of the feedstock produced if FP's units are 
weighted relative to USS' units by a factor of 2. This reflects the 
fact that FP pays twice as much as USS as a percentage of its other 
production costs for electricity and, therefore, FP's savings of $3 
per unit of the feedstock (50% reduction of current charge of $6) 
would be twice USS's savings of $1.50 per unit of feedstock (50% 
reduction of current charge of $3) from any new process eventually 
developed.

    Example 3. The facts are the same as in Example 2, except that 
to supply the particular needs of the U.S. market USS manufactures 
the feedstock with somewhat different properties than FP's 
feedstock. This requires USS to employ a somewhat different 
production process than does FP. Because of this difference, it will 
be more costly for USS to adopt any new process that may be 
developed under the cost sharing agreement. In this case, units 
produced is not the most reliable basis for measuring RAB shares. In 
order to reliably determine RAB shares, the Commissioner offsets the 
reasonably anticipated costs of adopting the new process against the 
reasonably anticipated total savings in electricity costs.

    Example 4. U.S. Parent (USP) and Foreign Subsidiary (FS) enter 
into a CSA to develop new anesthetic drugs. USP obtains the right to 
use any resulting patent in the U.S. market, and FS obtains the 
right to use the patent in the rest of the world. USP and FS divide 
costs on the basis of anticipated operating profit from each patent 
under development. USP anticipates that it will receive a much 
higher profit than FS per unit sold because drug prices are 
uncontrolled in the United States, whereas drug prices are regulated 
in many non-U.S. jurisdictions. In both controlled participants' 
territories, the operating profits are almost entirely attributable 
to the use of the cost shared intangible. In this case, the 
controlled participants' basis for measuring RAB shares is the most 
reliable.

    Example 5. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) 
both manufacture and sell fertilizers. They enter into a CSA to 
develop a new pellet form of a common agricultural fertilizer that 
is currently available only in powder form. Under the CSA, USS 
obtains the rights to produce and sell the new form of fertilizer 
for the U.S. market while FP obtains the rights to produce and sell 
the fertilizer for the rest of the world. The costs of developing 
the new form of fertilizer are divided on the basis of the 
anticipated sales of fertilizer in the controlled participants' 
respective markets.
    (ii) If the research and development is successful, the pellet 
form will deliver the fertilizer more efficiently to crops and less 
fertilizer will be required to achieve the same effect on crop 
growth. The pellet form of fertilizer can be expected to sell at a 
price premium over the powder form of fertilizer based on the 
savings in the amount of fertilizer that needs to be used. This 
price premium will be a similar premium per dollar of sales in each 
territory. If the research and development is successful, the costs 
of producing pellet fertilizer are expected to be approximately the 
same as the costs of producing powder fertilizer and the same for 
both FP and USS. Both FP and USS operate at approximately the same 
market levels, selling their fertilizers largely to independent 
distributors.
    (iii) In this case, the controlled participants' basis for 
measuring RAB shares is the most reliable.

    Example 6. The facts are the same as in Example 5, except that 
FP distributes its fertilizers directly while USS sells to 
independent distributors. In this case, sales of USS and FP are not 
the most reliable basis for measuring RAB shares unless adjustments 
are made to account for the difference in market levels at which the 
sales occur.

    Example 7. Foreign Parent (FP) and U.S. Subsidiary (USS) enter 
into a CSA to develop materials that will be used to train all new 
entry-level employees. FP and USS determine that the new materials 
will save approximately ten hours of training time per employee. 
Because their entry-level employees are paid on differing wage 
scales, FP and USS decide that they should not measure benefits 
based on the number of entry-level employees hired by each. Rather, 
they measure benefits based on compensation paid to the entry-level 
employees hired by each. In this case, the basis used for measuring 
RAB shares is the most reliable because there is a direct 
relationship between compensation paid to new entry-level employees 
and costs saved by FP and USS from the use of the new training 
materials.

    Example 8. U.S. Parent (USP), Foreign Subsidiary 1 (FS1) and 
Foreign Subsidiary 2 (FS2) enter into a CSA to develop computer 
software that each will market and install on customers' computer 
systems. The controlled participants measure benefits on the basis 
of projected sales by USP, FS1, and FS2 of the software in their 
respective geographic areas. However, FS1 plans not only to sell but 
also to license the software to unrelated customers, and FS1's 
licensing income (which is a percentage of the licensees' sales) is 
not counted in the projected benefits. In this case, the basis used 
for measuring the benefits of each controlled participant is not the 
most reliable because all of the benefits received by controlled 
participants are not taken into account. In order to reliably 
determine RAB shares, FS1's projected benefits from licensing must 
be included in the measurement on a basis that is the same as that 
used to measure its own and the other controlled participants' 
projected benefits from sales (for example, all controlled 
participants might measure their benefits on the basis of operating 
profit).

    (iii) Projections used to estimate benefits--(A) In general. The 
reliability of an estimate of RAB shares also depends upon the 
reliability of projections used in making the estimate. Projections 
required for this purpose generally include a determination of the time 
period between the inception of the research and development activities 
under the CSA and the receipt of benefits, a projection of the time 
over which benefits will be received, and a projection of the benefits 
anticipated for each year in which it is anticipated that the cost 
shared intangible will generate benefits. A projection of the relevant 
basis for measuring anticipated benefits may require a projection of 
the factors that underlie it. For example, a projection of operating 
profits may require a projection of sales, cost of sales, operating 
expenses, and other factors that affect operating profits. If it is 
anticipated that there will be significant variation among controlled 
participants in the timing of their receipt of benefits, and 
consequently benefit shares are expected to vary significantly over the 
years in which benefits will be received, it normally will be necessary 
to use the present discounted value of the projected benefits to 
reliably determine RAB shares. See paragraph (g)(2)(vi) of this section 
for guidance on discount rates used for this purpose. If it is not 
anticipated that benefit shares will significantly change over time, 
current annual benefit shares may provide a reliable projection of RAB 
shares. This circumstance is most likely to occur when the CSA is a 
long-term arrangement, the arrangement covers a wide variety of 
intangibles, the composition of the cost shared intangibles is unlikely 
to change, the cost shared intangibles are unlikely to

[[Page 51142]]

generate unusual profits, and each controlled participant's share of 
the market is stable.
    (B) Examples. The following examples illustrate the principles of 
this paragraph (e)(2)(iii):

    Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) 
enter into a CSA to develop a new car model. The controlled 
participants plan to spend four years developing the new model and 
four years producing and selling the new model. USS and FP project 
total sales of $4 billion and $2 billion, respectively, over the 
planned four years of exploitation of the new model. Cost shares are 
divided for each year based on projected total sales. Therefore, USS 
bears 66\2/3\% of each year's IDCs and FP bears 33\1/3\% of such 
costs.
    (ii) USS typically begins producing and selling new car models a 
year after FP begins producing and selling new car models. In order 
to reflect USS' one-year lag in introducing new car models, a more 
reliable projection of each participant's RAB share would be based 
on a projection of all four years of sales for each participant, 
discounted to present value.

    Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter 
into a CSA to develop new and improved household cleaning products. 
Both controlled participants have sold household cleaning products 
for many years and have stable market shares. The products under 
development are unlikely to produce unusual profits for either 
controlled participant. The controlled participants divide costs on 
the basis of each controlled participant's current sales of 
household cleaning products. In this case, the controlled 
participants' RAB shares are reliably projected by current sales of 
cleaning products.

    Example 3. The facts are the same as in Example 2, except that 
FS's market share is rapidly expanding because of the business 
failure of a competitor in its geographic area. The controlled 
participants' RAB shares are not reliably projected by current sales 
of cleaning products. FS's benefit projections should take into 
account its growth in sales.

    Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter 
into a CSA to develop synthetic fertilizers and insecticides. FP and 
USS share costs on the basis of each controlled participant's 
current sales of fertilizers and insecticides. The market shares of 
the controlled participants have been stable for fertilizers, but 
FP's market share for insecticides has been expanding. The 
controlled participants' projections of RAB shares are reliable with 
regard to fertilizers, but not reliable with regard to insecticides; 
a more reliable projection of RAB shares would take into account the 
expanding market share for insecticides.

    (f) Changes in participation under a CSA--In the case of any change 
in participation under a CSA as the result of a controlled transfer of 
all or part of a controlled participant's territorial rights under the 
CSA, as described in paragraph (b)(4) of this section, along with the 
assumption by the transferee of the associated obligations under the 
CSA, the transferee will be treated as succeeding to the transferor's 
prior history under the CSA, including the transferor's cost 
contributions, benefits derived, and PCT Payments attributable to such 
rights or obligations. The transferor must receive an arm's length 
amount of consideration from the transferee under the rules of 
Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6, as described in 
paragraph (a)(3)(ii) of this section. For purposes of this section, 
such a change in participation under a CSA includes, for example, any 
transaction in which--
    (1) A controlled participant transfers all or part of its 
territorial rights to another controlled participant that assumes the 
associated obligations under a CSA;
    (2) A new controlled participant enters an ongoing CSA and acquires 
any territorial rights and assumes associated obligations under the 
CSA; or
    (3) A controlled participant withdraws from an ongoing CSA, or 
otherwise abandons or relinquishes territorial rights and associated 
obligations under the CSA.
    (g) Supplemental guidance on methods applicable to PCTs--(1) In 
general. This subsection provides supplemental guidance on applying the 
methods listed below for purposes of evaluating the arm's length amount 
charged in a PCT. Each method must be applied in accordance with the 
provisions of Sec.  1.482-1, including best method rule of Sec.  1.482-
1(c), the comparability analysis of Sec.  1.482-1(d), and the arm's 
length range of Sec.  1.482-1(e), except as those provisions are 
modified in this subsection. The methods are--
    (i) The comparable uncontrolled transaction method described in 
Sec.  1.482-4(c), or the arm's length charge described in Sec.  1.482-
2(b)(3)(first sentence) based on a comparable uncontrolled transaction, 
further described in paragraph (g)(3) of this section;
    (ii) The income method, described in paragraph (g)(4) of this 
section;
    (iii) The acquisition price method, described in paragraph (g)(5) 
of this section;
    (iv) The market capitalization method, described in paragraph 
(g)(6) of this section;
    (v) The residual profit split method, described in paragraph (g)(7) 
of this section; and
    (vi) Unspecified methods, described in paragraph (g)(8) of this 
section.
    (2) General principles--(i) In general. The principles set forth in 
this paragraph (g)(2) apply, as appropriate, to the use of any of the 
methods set forth in this section to determine the arm's length charge 
for a PCT.
    (ii) Valuations consistent with upfront contractual terms and risk 
allocations. The application of any method as of any time must be 
consistent with the applicable contractual terms and allocation of risk 
under the CSA and this section among the controlled participants as of 
the date of the PCT, unless there has been a change in such terms or 
allocation made in return for arm's length consideration.
    (iii) Projections. The reliability of an estimate of the value of 
an external contribution in connection with a PCT will often depend 
upon the reliability of projections used in making the estimate. 
Projections necessary for this purpose may include a projection of 
sales, IDCs, routine operating expenses, and costs of sales. For these 
purposes, projections that have been prepared for non-tax purposes are 
generally more reliable than projections that have been prepared solely 
for purposes of meeting the requirements in this paragraph (g).
    (iv) Realistic alternatives--(A) In general. Regardless of the 
method or methods used, evaluation of the arm's length charge for the 
PCT in question should take into account the general principle that 
uncontrolled taxpayers dealing at arm's length would have evaluated the 
terms of a transaction, and only entered into a particular transaction, 
if no alternative is preferable. This condition is not met, for 
example, where for any controlled participant the total anticipated 
present value from entering into the CSA to that controlled 
participant, as of the date of the PCT, is less than the total 
anticipated present value that could be achieved through an alternative 
arrangement realistically available to that controlled participant. 
When applying the realistic alternatives principle, the reliability of 
the respective net present value calculations may need to be 
considered.
    (B) Examples. The following examples illustrate the principles of 
this paragraph (g)(2)(iv):

    Example 1. (i) P, a corporation, and S, a wholly-owned 
subsidiary of P, enter into a CSA to develop a gyroscopic personal 
transportation device (the product). Under the arrangement, P will 
undertake all of the R&D, and manufacture and market the product in 
Country X. S will make CST payments to P for its appropriate share 
of P's R&D costs, and manufacture and market the product in the rest 
of the world. P owns existing patents and trade secrets associated 
with gyroscopic applications. These patents and trade secrets are 
reasonably anticipated to contribute to the development of the

[[Page 51143]]

product and are therefore the RT Rights in the patents and trade 
secrets are external contributions for which compensation is due 
from S as part of a PCT.
    (ii) S's manufacturing and distribution activities under the CSA 
will be routine in nature, and identical to the activities it would 
undertake if it alternatively licensed the product from P.
    (iii) Reasonably reliable estimates indicate that P could self-
develop and license the product outside of the Country X for a 
royalty of 20% of sales. Based on reliable financial projections 
that include all future development costs and licensing revenue, the 
net present value of this licensing alternative to P for the non-
Country X market (measured as of the date of the PCT) would be $500 
million of operating income. Thus, based on this realistic 
alternative, the anticipated net present value under the CSA to P in 
the non-Country X market (measured as of the date of the PCT), 
including R&D reimbursement and PCT Payments from S, should not be 
less than $500 million.

    Example 2.  (i) The facts are the same as Example 1, except that 
there are no reliable estimates of the value to P from the licensing 
alternative to the CSA. However, reasonably reliable estimates 
indicate that S can earn a 10% mark-up on total accounting costs 
related to its routine manufacturing and distribution activities.
    (ii) P undertakes an economic analysis that derives S's cost 
contributions under the CSA, based on reliable financial 
projections. Based on this and further economic analysis, P 
determines S's PCT Payment as a certain lump sum amount to be paid 
as of the date of the PCT.
    (iii) Based on reliable financial projections that include S's 
cost contributions and that incorporate S's PCT Payment, and using a 
discount rate of D%, appropriate for the riskiness of the CSA (see 
paragraph (g)(2)(vi) of this section), the anticipated net present 
value to S under the CSA (measured at the time of the PCT) is $800 
million. Of this amount, $100 million is the portion associated with 
the 10% markup on S's total accounting costs from its manufacturing 
and distribution activities, utilizing its existing investment in 
plant and equipment.
    (iv) In evaluating the PCT under the CSA, the Commissioner 
concludes that the respective activities undertaken by P and S would 
be identical regardless of whether the arrangement was undertaken as 
a CSA or as a licensing arrangement. That is, under either 
alternative, P would undertake all research activities and S would 
undertake routine manufacturing and distribution activities 
associated with its territory. Consequently, in every year the total 
anticipated combined nominal profits of P and S would be identical 
regardless of whether the arrangement was undertaken as a CSA or as 
a licensing arrangement. In addition, the Commissioner considers the 
fact that S's economic role in the CSA (beyond its routine 
activities) is merely that of an investor. A similarly situated 
investor would be willing to invest an amount in a similar R&D 
project such that it earns an anticipated return on that investment 
of D% and therefore has a net present value of $0 on the project 
(not taking into account any returns to routine activities). If S 
were to realize a D% return on its lump sum PCT Payment, then the 
anticipated net present value to S of the CSA would be $100 million, 
equal to the $100 million anticipated net present value related to 
S's manufacturing and distribution activities, utilizing its 
existing investment in plant and equipment, plus the $0 anticipated 
net present value from the investment in the form of the lump sum 
PCT Payment in the IDA of the CSA at a D% discount rate.
    (v) The lump sum PCT Payment computed by P results in S having 
significantly higher anticipated discounted profitability, and 
therefore, in this case, higher anticipated nominal profitability, 
than it could achieve under the licensing alternative. By 
implication, P must correspondingly earn lower nominal profits under 
the CSA than it would under the licensing alternative (that is, S's 
enhanced profitability under the CSA is matched dollar-for-dollar by 
P's reduced profitability under the CSA). Consequently, the 
Commissioner concludes that P is earning a lower anticipated return 
through the CSA than it could achieve under its realistic 
alternative to the CSA, and that consequently S's lump sum PCT 
Payment under-compensates P for its external contribution.

    Example 3.  (i) The facts are the same as Example 2 except as 
follows. Based on reliable financial projections that include S's 
cost contributions and S's PCT Payment, discounted at a rate of D% 
to reflect the riskiness of the CSA, the anticipated net present 
value to S under the CSA (measured as of the date of the PCT) is $50 
million. Instead of entering the CSA, S has the realistic 
alternative of investing in an R&D project with similar risk, at an 
anticipated return of D%, and manufacturing and distributing 
products unrelated to the gyroscopic personal transportation device 
to the same extent as its manufacturing and distribution under the 
CSA, with the same anticipated 10% mark-up on total costs.
    (ii) Under its realistic alternative, at a discount rate of D%, 
S anticipates a present value of $100 million from the routine 
manufacturing and distribution and $0 from the R&D investment, for a 
total of $100 million.
    (iii) Because the lump sum PCT Payment made by S results in S 
having a considerably lower anticipated net present value than S 
could achieve through an alternative arrangement realistically 
available to it, the Commissioner may conclude that the lump sum PCT 
Payment overcompensates P for its external contribution.
    (v) Aggregation of transactions. In some cases, controlled 
participants are required to determine arm's length payments for 
multiple PCTs covering various external contributions or, in addition 
to one or more PCTs, for transactions covering resources or 
capabilities that are not governed by this section, such as the 
transfer of make-or-sell rights as described in paragraph (c) of this 
section. Following the principles of aggregation described in Sec.  
1.482-1(f)(2)(i), a best method analysis under Sec.  1.482-1(c) may 
determine that the method that provides the most reliable measure of an 
arm's length charge for the multiple PCTs and other transactions not 
governed by this section, if any, is a method that determines the arm's 
length charge for the multiple transactions on an aggregate basis under 
this section. A section 482 adjustment may be made by comparing the 
aggregate arm's length charge so determined to the aggregate payments 
actually made for the multiple transactions. In such a case, it 
generally will not be necessary to allocate separately the aggregate 
arm's length charge as between various PCTs or as between PCTs and 
transactions governed by other regulations under section 482. However, 
such an allocation may be necessary for other purposes, such as 
applying paragraph (i)(6) (Periodic adjustments) of this section. An 
aggregate determination of the arm's length charge for multiple 
transactions will generally yield a payment for a controlled 
participant that is equal to the aggregate value of the external 
contributions and other resources and capabilities covered by the 
multiple transactions multiplied by that controlled participant's RAB 
share. Because RAB shares only include benefits from cost shared 
intangibles, the reliability of an aggregate determination of payments 
for multiple transactions may be reduced to the extent that it includes 
transactions not governed by this section covering resources and 
capabilities for which the controlled participants' expected benefit 
shares differ substantially from their RAB shares.
    (vi) Discount rate--(A) In general. Some calculations set forth in 
this paragraph (g) and elsewhere in this section require determining a 
rate of return which is used to convert a future or past monetary sum 
associated with a particular set of activities or transactions into a 
present value. For this purpose, a discount rate should be used that 
most reliably reflects the risk of the activities and the transactions 
based on all the information potentially available at the time for 
which the present value calculation is to be performed. Depending on 
the particular facts and circumstances, the risk involved and thus, the 
discount rate, may differ among a company's various activities or 
transactions. Normally, discount rates are most reliably determined by 
reference to market information. For example, the weighted average cost 
of capital (WACC) of the relevant activities and transactions derived 
using the capital asset pricing

[[Page 51144]]

model might provide the most reliable discount rate. In such cases, 
this WACC might most reliably be based on information from uncontrolled 
companies whose business activities as a whole constitute comparable 
uncontrolled transactions. Where a company is publicly traded and its 
CSA involves substantially the same risk as projects undertaken by the 
company as a whole, then the WACC of the relevant activities and 
transactions might most reliably be based on the company's own WACC. 
Depending on comparability and reliability considerations, including 
the extent to which the company's hurdle rate reflects market 
information and is used in a similar manner in the controlled and 
uncontrolled transactions, in some circumstances discount rates might 
be most reliably determined by reference to other data such as a 
company's internal hurdle rate for projects of comparable risk.
    (B) Examples. The following examples illustrate the principles of 
this paragraph (g)(2)(vi):

    Example 1. USPharm, a publicly traded U.S. pharmaceutical 
company, enters into a CSA with FPharm, its wholly-owned foreign 
subsidiary. Under the agreement both controlled participants agree 
to share the research costs of developing a specific drug compound 
called T. USPharm is also engaged in another development project for 
compounds U and V, which involves different risks than the T 
development project and which is not part of the CSA. However, there 
are a large number of uncontrolled publicly traded U.S. companies, 
for which information can be reliably derived, that are highly 
comparable to USPharm but that conduct research only on compounds 
similar to T involving risks similar to those of the T development 
project. At the commencement of the CSA (Year 1), USPharm and FPharm 
enter into a PCT with respect to external contributions owned by 
USPharm in the form of the RT Rights in its pre-existing drug 
research. As part of the method that USPharm determines will most 
reliably calculate PCT Payments, a discount rate is needed to 
convert future monetary sums into a present value. After analysis, 
USPharm concludes that the discount rate is most reliably determined 
by calculating a WACC based on the information relating to the 
comparable uncontrolled companies, with suitable adjustments for 
factors such as differences in capital structure between USPharm and 
the comparables, and for the stability and other statistical 
properties of the beta measurement of the comparables.

    Example 2. The facts are the same as in Example 1 except that 
the T development project is the only business activity of USPharm 
and FPharm and no reliable data exists on uncontrolled companies 
undertaking similar activities and risk as those associated with the 
CSA. After analysis, USPharm concludes that the discount rate is 
most reliably determined by reference to its own WACC. USPharm funds 
its operations with debt and common stock. Debt comprises 40% of its 
financing and USPharm's cost of debt is 6%. Equity comprises the 
remaining 60% of financing. USPharm is publicly traded and its 
equity beta is 1.25. Using third party information, USPharm 
concluded that the appropriate risk-free rate and equity risk 
premium are X% and Y%, respectively, implying a return on USPharm's 
equity of Z% [ X% + ( 1.25 x Y% )]. The weighted average cost of 
capital is calculated by blending and weighting the after-tax cost 
of debt and the cost of equity according to percentage of total 
financing. USPharm's weighted average cost of capital is W% [( 6% x 
0.4 ) + ( Z% x 0.6 )].

    Example 3. Use of a documented discount rate. The facts are the 
same as Example 1 except that no data exists on uncontrolled 
companies undertaking similar activities and risks as those 
associated with the CSA. USPharm has documented a hurdle rate of 12% 
that it uses as the minimum anticipated return for its business 
investments having a comparable risk profile. The Commissioner 
examines USPharm's documentation and concludes that the hurdle rate 
provides a reliable discount rate in this case.

    (vii) Accounting principles--(A) In general. Allocations or other 
valuations done for accounting purposes may provide a useful starting 
point but will not be conclusive for purposes of assessing or applying 
methods to evaluate the arm's length charge in a PCT, particularly 
where the accounting treatment of an asset is inconsistent with its 
economic value.
    (B) Examples. The following examples illustrate the principles of 
this paragraph (g)(2)(vii):

    Example 1. (i) USP, a U.S. corporation and FSub, a wholly-owned 
foreign subsidiary of USP, enter into a CSA in Year 1 to develop 
software programs with application in the medical field. Company X 
is an uncontrolled software company located in the United States 
that is engaged in developing software programs that could 
significantly enhance the programs being developed by USP and FSub. 
Company X is still in a startup phase, so it has no currently 
exploitable products or marketing intangibles and its workforce 
consists of a team of software developers. Company X has negligible 
liabilities and tangible property. In Year 2, USP purchases Company 
X as part of an uncontrolled transaction in order to acquire its in-
process technology and workforce for purposes of the development 
activities of the CSA. USP files a consolidated return that includes 
Company X. For accounting purposes, $50 million of the $100 million 
acquisition price is allocated to the in-process technology and 
workforce, and the residual $50 million is allocated to goodwill.
    (ii) The in-process technology and workforce of Company X 
acquired by USP are reasonably anticipated to contribute to 
developing cost shared intangibles and therefore the RT Rights in 
the in-process technology and workforce of Company X external 
contributions for which FSub must compensate USP as part of a PCT. 
In determining whether to apply the acquisition price or another 
method for purposes of evaluating the arm's length charge in the 
PCT, relevant comparability and reliability considerations must be 
weighed in light of the general principles of paragraph (g)(2) of 
this section. The allocation for accounting purposes raises an issue 
as to the reliability of using the acquisition price method in this 
case because it indicates that a significant portion of the value of 
Company X's assets is allocable to goodwill, which is often 
difficult to value reliably and which, depending on the facts and 
circumstances, might not be attributable to external contributions 
that are to be compensated by PCTs. See paragraph (g)(5)(iv(A) of 
this section.
    (iii) Paragraph (g)(2)(vii) of this section provides that 
accounting treatment may be a starting point, but is not 
determinative for purposes of assessing or applying methods to 
evaluate the arm's length charge in a PCT. The facts here reveal 
that Company X has nothing of economic value aside from its in-
process technology and assembled workforce. The $50 million of the 
acquisition price allocated to goodwill for accounting purposes, 
therefore, is economically attributable to either or both the in-
process technology and the workforce. That moots the potential issue 
under the acquisition price method of the reliability of valuation 
of assets not to be compensated by PCTs, since there are no such 
assets. Assuming the acquisition price method is otherwise the most 
reliable method, the aggregate value of Company X's in-process 
technology and workforce is the full acquisition price of $100 
million. Accordingly, the aggregate value of the arm's length PCT 
Payments due from FSub to USP for the external contributions 
consisting of the RT Rights in Company X's in-process technology and 
workforce will equal $100 million multiplied by FSub's RAB share.

    Example 2. (i) The facts are the same as in Example 1, except 
that Company X is a mature software business in the United States 
with a successful current generation of software that it markets 
under a recognized trademark, in addition to having the research 
team and new generation software in process that could significantly 
enhance the programs being developed under USP's and FSub's CSA. USP 
continues Company X's existing business and integrates the research 
team and the in-process technology into the efforts under its CSA 
with FSub. For accounting purposes, the $100 million acquisition 
price for acquiring Company X is allocated $50 million to existing 
software and trademark, $25 million to in-process technology and 
research workforce, and the residual $25 million to goodwill and 
going concern value.
    (ii) In this case an analysis of the facts indicates a 
likelihood, consistent with the allocation under the accounting 
treatment (although not necessarily in the same amount), of goodwill 
and going concern value economically attributable to the existing 
U.S. software business rather than to the external contributions 
consisting of the

[[Page 51145]]

RT Rights in the in-process technology and research workforce. 
Accordingly, further consideration must be given to the extent to 
which these circumstances reduce the relative reliability of the 
acquisition price method in comparison to other potentially 
applicable methods for evaluating the PCT Payment.
    Example 3. (i) USP, a U.S. corporation and FSub, a wholly-owned 
foreign subsidiary of USP, enter into a CSA in Year 1 to develop 
Product A. Company Y is an uncontrolled corporation that owns 
Technology X that is critical to the development of Product A. 
Company Y currently markets Product B, which is dependent on 
Technology X. USP is solely interested in acquiring Technology X, 
but is only able to do so through the acquisition of Company Y in 
its entirety for $200 million in an uncontrolled transaction in Year 
2. For accounting purposes, the acquisition price is allocated as 
follows: $120 million to Product B and the underlying Technology X, 
$30 million to trademark and other marketing intangibles, and the 
residual $50 million to goodwill and going concern. After the 
acquisition of Company Y, Technology X is used to develop Product A. 
No other part of Company Y is utilized in any manner. Product B is 
discontinued and accordingly, the accompanying marketing intangibles 
become worthless. None of the previous employees of Company Y are 
retained.
    (ii) The Technology X of Company Y acquired by USP is reasonably 
anticipated to contribute to developing cost shared intangibles and 
is therefore an external contribution for which FSub must compensate 
USP as part of a PCT. Although for accounting purposes a significant 
portion of the acquisition price of Company Y was allocated to items 
other than Technology X, the facts demonstrate that USP had no 
intention of using and therefore placed no economic value on any 
part of Company Y other than Technology X. If USP was willing to pay 
$200 million for Company Y solely for purposes of acquiring 
Technology X, then assuming the acquisition price method is 
otherwise the most reliable method, the value of Technology X is the 
full $200 million acquisition price. Accordingly, the value of the 
arm's length PCT Payment due from FSub to USP for the external 
contribution consisting of the RT Rights in Technology X will equal 
$200 million multiplied by FSub's RAB share.

    (viii) Valuation consistent with the investor model--(A) In 
general. The valuation of the amount charged in a PCT must be 
consistent with the assumption that, as of the date of the PCT, each 
controlled participant's aggregate net investment in developing cost 
shared intangibles pursuant to the CSA, attributable to both external 
contributions and cost contributions, is reasonably anticipated to earn 
a rate of return equal to the appropriate discount rate, determined 
following the principles set forth in paragraph (g)(2)(vi) of this 
section, over the entire period of developing and exploiting the cost 
shared intangibles. If the cost shared intangibles themselves are 
reasonably anticipated to contribute to developing other intangibles, 
then the period in the preceding sentence includes the period of 
developing and exploiting such indirectly benefited intangibles.
    (B) Example. The following example illustrates the principles of 
this paragraph (g)(2)(viii):

    Example. (i) P, a U.S. corporation, has developed a software 
program, DEF, which applies certain algorithms to reconstruct 
complete DNA sequences from partially-observed DNA sequences. S is a 
wholly-owned foreign subsidiary of P. P and S enter into a CSA to 
develop a new generation of genetic tests, GHI, based in part on the 
use of DEF which is therefore an external contribution of P for 
which compensation is due from S pursuant to a PCT. S makes no 
external contributions to the CSA. GHI sales are projected to 
commence two years after the inception of the CSA, which is on the 
first day of Year 1, and then to continue for eight more years. P 
and S project that GHI will be replaced by a new generation of 
genetic testing based on technology unrelated to DEF or GHI at the 
end of Year 10.
    (ii) For purposes of valuing the PCT for P's external 
contribution of DEF to the CSA, P and S apply a type of residual 
profit split method that is not described in paragraph (g)(7) of 
this section and which, accordingly, constitutes an unspecified 
method. See paragraph (g)(7)(i) (last sentence) of this section. The 
principles of this paragraph (g)(2) apply to any method for valuing 
a PCT, including the unspecified method used by P and S.
    (iii) Under the method employed by P and S, in each Year, a 
portion of the income from sales of GHI in S's territory is 
allocated to certain routine contributions made by S. The residual 
of the profit or loss from GHI sales in S's territory after the 
routine allocation step is divided between the controlled 
participants pro rata to their capital stocks allocable to S's 
territory. Each controlled participant's capital stock is computed 
by growing and amortizing (in the case of P) its historical 
expenditures regarding DEF allocable to S's territory and (in the 
case of S) its ongoing cost contributions towards developing GHI. 
The amortization of the capital stocks is effected on a straight-
line basis over an assumed four-year life for the relevant 
expenditures. The capital stocks are grown using an assumed growth 
factor which P and S consider to be appropriate. Thus, the residual 
profit or loss from sales of GHI in S's territory is divided between 
P and S pro rata to P's capital stock in DEF attributable to S's 
territory and to S's capital stock from its cost contributions.
    (iv) The assumption that all expenditures amortize on a 
straight-line basis over four years does not appropriately reflect 
the principle that as of the date of the PCT regarding DEF, every 
contribution to the development of GHI, including DEF is reasonably 
anticipated to have value throughout the entire period of 
exploitation of GHI as projected to continue through Year 10. Under 
this method as applied by P and S, P's capital stock in DEF, and 
therefore the amount of profit in S's territory allocated to P as a 
PCT Payment from S, will decrease every year. After Year 4, P's 
capital stock in DEF will necessarily be $0. Thus, under this 
method, P will receive none of the residual profit or loss from GHI 
sales in S's territory after Year 4 as a PCT Payment. As a result of 
this limitation of the PCT Payments to be made by S, the return to 
S's aggregate investment in the CSA is anticipated to be 
significantly higher than the appropriate discount rate for the CSA. 
This is not consistent with the investor model principle that S 
should anticipate a return to its aggregate investment in the CSA 
equal to the appropriate discount rate over the entire period of 
developing and exploiting GHI. The inconsistency of the method with 
the investor model materially lessens its reliability for purposes 
of a best method analysis. See Sec.  1.482-1(c)(2)(ii)(B).

    (ix) Coordination of best method rule and form of payment. A method 
described in paragraph (g)(1) of this section evaluates the arm's 
length amount charged in a PCT in terms of a form of payment (method 
payment form). For example, the method payment form for the income 
method described in paragraph (g)(4)(iii) or (iv) of this section is 
payment contingent on the exploitation of cost shared intangibles by 
the PCT Payor, and the method payment form for the market 
capitalization method is lump sum payment. The method payment form may 
not necessarily correspond to the form of payment specified pursuant to 
paragraphs (b)(3)(vi)(A) and (k)(2)(ii)(l) of this section (specified 
payment form). The determination under Sec.  1.482-1(c) of the method 
that provides the most reliable measure of an arm's length result is to 
be made without regard to whether the respective method payment forms 
under the competing methods correspond to the specified payment form. 
If the method payment form of the method determined under Sec.  1.482-
1(c) to provide the most reliable measure of an arm's length result 
differs from the specified payment form, then the conversion from such 
method payment form to such specified payment form will be made on a 
reasonable basis to the satisfaction of the Commissioner. For purposes 
of the preceding sentence, if the method described in the documentation 
by the controlled participants pursuant to paragraph (k)(2)(ii)(J) of 
this section is determined under Sec.  1.482-1(c) to provide the most 
reliable measure of an arm's length result, then the Commissioner will 
give due consideration whether the conversion from the method payment 
form to the specified payment form was made by the controlled 
participants on a reasonable basis.

[[Page 51146]]

    (x) Coordination of the valuations of prior and subsequent PCTs--
(A) In general. In cases where PCTs are required on different dates, 
coordination of the valuations of the prior and subsequent PCTs must be 
effected pursuant to a method that provides the most reliable measure 
of an arm's length result. Depending on the facts and circumstances, 
such as whether the external contributions that were the subject of the 
prior and subsequent PCTs were nonroutine contributions, an approach 
which may be appropriate would be to determine PCT Payments both for 
the prior and subsequent PCTs going forward from the date of the 
subsequent PCT pursuant to a residual profit split method, as described 
in paragraph (g)(7) of this section. Such application of the residual 
profit split method would include as nonroutine contributions all of 
the following: The external contribution(s) that were the subject of 
the prior PCT(s), the external contribution that is the subject of the 
subsequent PCT, and the interests of the controlled participants in the 
incremental cost shared intangible development resulting from the 
development activities under the CSA. Paragraph (g)(2)(x)(B) of this 
section specifies the appropriate coordination with a prior PCT in the 
case of a subsequent PCT the subject of which is a PFA.
    (B) Coordination with regard to PFAs. PCT Payments for a subsequent 
PCT that is derived from a PFA are determined independently of any 
prior PCTs. Such PCT Payments will be treated, for purposes of the 
application of the method used for evaluating a prior PCT, the same as 
IDCs, the actual amounts of which may not correspond to those projected 
on the date of the prior PCT. A divergence between actual and 
anticipated IDCs does not require alteration in the application of the 
method used to value PCT Payments. Similarly, a subsequent PCT derived 
from a PFA will not require alteration in the application of the method 
used to value PCT Payments for a prior PCT.
    (xi) Proration of PCT Payments to the extent allocable to other 
business activities. If a resource or capability that is the subject of 
a PCT is reasonably anticipated to contribute both to developing or 
exploiting cost shared intangibles and to other business activities of 
the PCT Payee (other than exploiting an existing intangible without 
further development), then to the extent it can be demonstrated that a 
portion of the value of the relevant PCT Payments otherwise determined 
under this section is attributable to such other business activities, 
the PCT Payments must be prorated. Such proration will be done on a 
reasonable basis in proportion to the relative economic value, as of 
the date of the PCT, reasonably anticipated to be derived from the 
resource or capability by the CSA Activity as compared to such other 
business activities of the PCT Payee. In the case of an aggregate 
valuation done under the principles of paragraph (g)(2)(v) of this 
section that includes payment for rights to exploit an existing 
intangible without further development, the prorated aggregate payments 
must take into account the economic value attributable to such 
exploitation rights as well. For purposes of the best method rule under 
Sec.  1.482-1(c), the reliability of the analysis under a method that 
requires proration pursuant to this paragraph is reduced relative to 
the reliability of an analysis under a method that does not require 
proration.
    (3) Comparable uncontrolled transaction method. The comparable 
uncontrolled transaction (CUT) method described in Sec.  1.482-4(c), 
and the arm's length charge described in Sec.  1.482-2(b)(3) (first 
sentence) based on a comparable uncontrolled transaction, may be 
applied to evaluate whether the amount charged in a PCT is arm's length 
by reference to the amount charged in a comparable uncontrolled 
transaction. When applied in the manner described in Sec.  1.482-4(c), 
or where a comparable uncontrolled transaction provides the most 
reliable measure of the arm's length charge described in Sec.  1.482-
2(b)(3) (first sentence), the CUT method, or the arm's length charge in 
the comparable uncontrolled transaction, will typically yield an arm's 
length total value for the external contribution that is the subject of 
the PCT. That value must then be multiplied by each PCT Payor's 
respective RAB share in order to determine the arm's length PCT Payment 
due from each PCT Payor. The reliability of a CUT that yields a value 
for the external contribution only in the PCT Payor's territory will be 
reduced to the extent that value is not consistent with the total 
worldwide value of the external contribution multiplied by the PCT 
Payor's RAB share.
    (4) Income method--(i) In general. The income method evaluates 
whether the amount charged in a PCT is arm's length by reference to the 
controlled participants' realistic alternatives to entering into a CSA.
    (ii) Determination of arm's length charge--(A) In general. Under 
this method, the arm's length charge for a PCT Payment will be an 
amount such that a controlled participant's present value, as of the 
date of the PCT, of entering into a CSA equals the present value of its 
best realistic alternative. Paragraphs (g)(4)(iii) and (iv) of this 
section describe two specific applications of the income method, but do 
not exclude other possible applications of this method.
    (B) Example. The following example illustrates the principles of 
this paragraph (g)(4)(ii):

    Example. (i) USP, a U.S. manufacturer, has developed a new, 
lightweight fabric for sleeping bags. In Year 1 USP enters into a 
CSA with its wholly-owned foreign subsidiary, FSub, to develop an 
improved version of this fabric. Under the CSA, USP will own the 
rights to exploit improved versions of the fabric in the United 
States and FSub will own the rights to exploit improvements in the 
rest of the world (ROW). The rights to further develop the fabric 
are reasonably anticipated to contribute to the development of 
future improved versions and therefore the RT Rights in the fabric 
are external contributions for which compensation is due pursuant to 
a PCT. USP does not transfer the right to exploit its current fabric 
to FSub. FSub does not furnish any external contributions. If USP 
did not participate in the CSA, its next best realistic alternative 
would be to develop future versions of the fabric on its own, 
exploit those versions in the United States and license such 
versions for exploitation outside the United States to FSub. In Year 
1, USP estimates that its present value of this alternative 
(including arm's length royalties on sales in the ROW) is $100 
million. Under the CSA, USP projects U.S. sleeping bag sales with 
improved versions of the fabric to amount to $80 million (present 
value in Year 1). The costs (other than IDCs) plus the routine 
return to such costs associated with the U.S. sales are anticipated 
to be $10 million. USP's anticipated cost contributions under the 
CSA are $10 million (present value in Year 1). FSub projects that in 
the ROW, future sales should amount to $100 million (present value 
in Year 1).
    (ii) An arm's length contingent PCT Payment under the income 
method is a sales-based royalty at a rate, p, such that the present 
value to USP of the next best realistic alternative is equal to the 
present value to USP of participating in the CSA. In other words, 
the rate is such that $100 million (value of licensing alternative) 
= $80 million (anticipated U.S. sales) - $10 million (anticipated 
costs, other than IDCs, plus routine return) - $10 million 
(anticipated cost contribution) + (p * $100 million (anticipated ROW 
sales)), or 40%. Accordingly, FSub should pay USP a royalty of 40% 
of actual ROW sales annually when the two begin to exploit future 
generations of the fabric.

    (iii) Application of income method using a CUT--(A) In general. 
This application of the income method is typically used in cases where 
only one controlled participant furnishes nonroutine contributions, as 
described in paragraph (g)(7)(iii)(C)(1) of this section. This 
application assumes that

[[Page 51147]]

the best reasonable alternative of the PCT Payee to entering into the 
CSA would be to develop the cost shared intangibles on its own, bearing 
all the IDCs itself, and then to license the cost shared intangibles to 
the other controlled participants.
    (B) Determination of arm's length charge--(1) In general. An arm's 
length PCT Payment under this application of the income method is 
represented as an applicable rate on sales from exploiting the cost 
shared intangibles, determined as of the date of the PCT.
    (2) Applicable rate. The applicable rate is equal to the 
alternative rate less the cost contribution adjustment.
    (3) Alternative rate. The alternative rate is the constant rate the 
PCT Payee would charge an uncontrolled licensee over the period the 
cost shared intangibles are anticipated to be exploited if the PCT 
Payee had developed the cost shared intangibles on its own and licensed 
them to the uncontrolled licensee. The alternative rate is determined 
using the comparable uncontrolled transaction method, as described in 
Sec.  1.482-4(c)(1) and (2).
    (4) Cost contribution adjustment. The cost contribution adjustment 
is equal to a fraction, the numerator of which is the present value of 
the PCT Payor's total anticipated cost contributions and the 
denominator of which is the present value of the PCT Payor's total 
anticipated sales from exploiting the cost shared intangibles.
    (C) Example. The following example illustrates the principles of 
this paragraph (g)(4)(iii):

    Example. (i) USP, a software company, has developed version 1.0 
of a new software application which it is currently marketing. In 
Year 1 USP enters into a CSA with its wholly-owned foreign 
subsidiary, FS, to develop future versions of the software 
application. Under the CSA, USP will have the rights to exploit the 
future versions in the United States, and FS will have the rights to 
exploit them in the rest of the world (ROW). The future rights in 
version 1.0, and USP's development team, are reasonably anticipated 
to contribute to the development of future versions and therefore 
the RT Rights in version 1.0 are external contributions for which 
compensation is due from FS as part of a PCT. USP does not transfer 
the current exploitation rights in version 1.0 to FS. FS does not 
furnish any external contributions. FS anticipates sales of $100 
million (present value in Year 1) in its territory and anticipates 
cost contributions of $40 million (present value in Year 1). The 
arm's length rate USP would have charged an uncontrolled licensee 
for a license of future versions of the software had USP further 
developed version 1.0 on its own is 60%, as determined under the 
comparable uncontrolled transaction method in Sec.  1.482-4(c).
    (ii) An arm's length contingent PCT Payment under the income 
method is an applicable rate equal to the alternative rate less the 
cost contribution adjustment. In this case the alternative rate is 
60%, the arm's length rate determined under Sec.  1.482-4(c). The 
cost contribution adjustment is 40%, the present value to FS of its 
anticipated cost contribution over the present value of its 
anticipated sales of future versions of the software, that is, $40 
million / $100 million. The applicable rate, which represents an 
arm's length contingent PCT Payment, payable by the FS to USP on all 
actual ROW sales of the future versions of the software therefore is 
20%, which is equal to the alternative rate of 60% less the cost 
contribution adjustment of 40%.

    (iv) Application of income method using CPM--(A) In general. This 
application of the income method is typically used in cases where only 
one controlled participant furnishes nonroutine contributions. Under 
this application, the present value of the anticipated PCT Payments is 
equal to the present value, as of the date of the PCT, of the PCT 
Payor's anticipated profit from developing and exploiting cost shared 
intangibles. This PCT Payment ensures that PCT Payors who do not 
furnish any external contributions subject to a PCT receive an 
appropriate ex ante risk adjusted return on their investment in the 
CSA.
    (B) Determination of arm's length charge based on sales--(1) In 
general. An arm's length PCT Payment under this application of the 
income method is represented as an applicable rate on sales from 
exploiting the cost shared intangibles, determined as of the date of 
the PCT.
    (2) Applicable rate. The applicable rate is equal to the 
alternative rate less the cost contribution adjustment.
    (3) Alternative rate. The alternative rate is determined using the 
comparable profits method described in Sec.  1.482-5 and is estimated 
as a fraction. The numerator of the fraction is the present value of 
the PCT Payor's total anticipated territorial operating profit, as 
defined in paragraph (j)(1)(vi) of this section, reduced by a market 
return for the routine contributions (other than cost contributions) to 
the relevant business activity in the relevant territory. The 
denominator of the fraction is the discounted present value of the PCT 
Payor's total anticipated sales from exploiting the cost shared 
intangibles.
    (4) Cost contribution adjustment. The cost contribution adjustment 
is equal to a fraction the numerator of which is the present value of 
the PCT Payor's total anticipated cost contributions and the 
denominator of which is the present value of the PCT Payor's total 
anticipated sales from exploiting the cost shared intangibles.
    (C) Determination of arm's length charge based on profit--(1) In 
general. An arm's length PCT Payment under this application of the 
income method may also be represented as an applicable rate on 
territorial operating profit, as defined in paragraph (j)(1)(vi) of 
this section, reduced by a market return for the routine contributions 
(other than cost contributions) to the relevant business activity in 
the relevant territory. This is done following the calculations 
described in paragraph (g)(4)(iv)(B) of this section, substituting 
anticipated territorial operating profit, reduced by a market return 
for the routine contributions (other than cost contributions) to the 
relevant business activity in the relevant territory, wherever 
anticipated sales appear in the calculations.
    (2) Alternative rate. Substituting territorial operating profits, 
reduced by a market return for the routine contributions (other than 
cost contributions) to the relevant business activity in the relevant 
territory, for sales in the calculation of the alternative rate results 
in a fraction with both a numerator and denominator equal to the 
present value of the PCT Payor's total anticipated territorial 
operating profit, as defined in paragraph (j)(1)(vi) of this section, 
reduced by a market return for the routine contributions (other than 
cost contributions) to the relevant business activity in the relevant 
territory. Therefore the alternative rate under this application is 1, 
or 100%.
    (3) Cost contribution adjustment. Substituting territorial 
operating profit, reduced by a market return for the routine 
contributions (other than cost contributions) to the relevant business 
activity in the relevant territory, for sales results in a cost 
contribution adjustment equal to a fraction the numerator of which is 
the present value of the PCT Payor's total anticipated cost 
contributions and the denominator of which is the present value of the 
PCT Payor's total anticipated territorial operating profit, as defined 
in paragraph (j)(1)(vi) of this section, reduced by a market return for 
the routine contributions (other than cost contributions) to the 
relevant business activity in the relevant territory.
    (D) Example. The following example illustrates the principles of 
this paragraph (g)(4)(iv):

    Example. (i) USP, a U.S. pharmaceutical company, invests in 
research and development to begin developing a vaccine for disease 
K. In Year 1, USP enters into a CSA with its wholly-owned foreign 
subsidiary, FS, to complete the development

[[Page 51148]]

of the vaccine. Under the CSA, USP will have the rights to exploit 
the vaccine in the United States, and FS will have the rights to 
exploit it in the rest of the world. The partially developed vaccine 
owned by USP, and USP's development team, are reasonably anticipated 
to contribute to the development of the final vaccine and therefore 
the RT Rights in the vaccine and the development team are external 
contributions for which compensation is due from FS as part of a 
PCT. FS does not furnish any external contributions. The total 
anticipated IDCs under the CSA are $100 million (in Year 1 dollars). 
USP and FS each have total projected sales of $100 million (in Year 
1 dollars) of the vaccine, which they use as the basis for 
determining RAB shares. Accordingly, they divide the development 
costs based on 50/50 RAB shares, $50 million (in Year 1 dollars) 
paid by each participant. Based on an analysis under the comparable 
profits method under Sec.  1.482-5, FS's anticipated territorial 
operating profit, as reduced by a market return for its routine 
contributions to exploiting the vaccine in its territory, is $80 
million (in Year 1 dollars).
    (ii) An arm's length contingent PCT Payment under the income 
method is an applicable rate equal to the alternative rate less the 
cost contribution adjustment. In this case the alternative rate is 
80% (($80 million territorial operating profit/$100 million sales). 
The cost contribution adjustment is 50%, the present value to FS of 
its anticipated cost contributions over the present value of its 
anticipated sales of the vaccine, that is, $50 million/$100 million. 
The applicable rate, which represents an arm's length contingent PCT 
Payment, payable by the FS to the USP over the period the vaccine is 
exploited therefore is 30%, which is equal to the alternative rate 
of 80% less the cost contribution adjustment of 50%.
    (iii) An arm's length contingent PCT Payment based on 
territorial operating profits under the income method is an 
applicable rate equal to the alternative rate less the cost 
contribution adjustment. In this case the alternative rate is 100% 
(($80 million territorial operating profit /$80 million territorial 
operating profit). The cost contribution adjustment is 62.5%, the 
present value to FS of its anticipated cost contributions over the 
present value of its anticipated territorial profits from sales of 
the vaccine, that is, $50 million/$80 million. The applicable rate 
on territorial operating profit, which represents an arm's length 
contingent PCT Payment, payable by the FS to the USP over the period 
the vaccine is exploited therefore is 37.5%, which is equal to the 
alternative rate of 100% less the cost contribution adjustment of 
62.5%.

    (v) Routine external contributions. For purposes of this paragraph 
(g)(4), any routine contributions that are external contributions 
(routine external contributions), the valuation and PCT Payments for 
which are determined and made independently of the income method, are 
treated similarly to cost contributions. Accordingly, wherever the term 
cost contributions appears in this paragraph (g)(4) it shall be read to 
include net routine external contributions. Net routine external 
contributions are defined as a controlled participant's total 
anticipated routine external contributions, plus its anticipated PCT 
Payments to other controlled participants in respect of their routine 
external contributions, minus the anticipated PCT Payments it is to 
receive from other controlled participants in respect of its routine 
external contributions.
    (vi) Comparability and reliability considerations--(A) In general. 
Whether results derived from this method are the most reliable measure 
of the arm's length result is determined using the factors described 
under the best method rule in Sec.  1.482-1(c). Thus, comparability and 
the quality of data and assumptions must be considered in determining 
whether this method provides the most reliable measure of an arm's 
length result. Consistent with those considerations, the reliability of 
applying the income method as a measure of the arm's length charge for 
a PCT Payment is typically less reliable to the extent that more than 
one controlled participant furnishes nonroutine contributions.
    (B) Application of the income method using a CUT. If the income 
method is applied using a CUT, as described in paragraph (g)(4)(iii) of 
this section, any additional comparability and reliability 
considerations stated in Sec.  1.482-4(c)(2) may apply.
    (C) Application of the income method using CPM. If the income 
method is applied using CPM, as described in paragraph (g)(4)(iv) of 
this section, any additional comparability and reliability 
considerations stated in Sec.  1.482-5(c) apply.
    (5) Acquisition price method--(i) In general. The acquisition price 
method applies the comparable uncontrolled transaction method of Sec.  
1.482-4(c), or the arm's length charge described in Sec.  1.482-
2(b)(3)(first sentence) based on a comparable uncontrolled transaction, 
to evaluate whether the amount charged in a PCT, or group of PCTs, is 
arm's length by reference to the amount charged (the acquisition price) 
for the stock or asset purchase of an entire organization or portion 
thereof (the target) in an uncontrolled transaction. The acquisition 
price method is ordinarily used only where substantially all the 
target's nonroutine contributions (as described in paragraph 
(g)(7)(iii)(C)(1) of this section) to the PCT Payee's business 
activities are covered by a PCT or group of PCTs.
    (ii) Determination of arm's length charge. Under this method, the 
arm's length charge for a PCT or group of PCTs covering resources and 
capabilities of the target is equal to the adjusted acquisition price, 
as divided among the controlled participants according to their 
respective RAB shares.
    (iii) Adjusted acquisition price. The adjusted acquisition price is 
the acquisition price of the target increased by the value of the 
target's liabilities on the date of the acquisition, other than 
liabilities not assumed in the case of an asset purchase, and decreased 
by the value of the target's tangible property on that date and by the 
value on that date of any other resources and capabilities not covered 
by a PCT or group of PCTs.
    (iv) Reliability and comparability considerations. The 
comparability and reliability considerations stated in Sec.  1.482-
4(c)(2) apply. Consistent with those considerations, the reliability of 
applying the acquisition price method as a measure of the arm's length 
charge for the PCT Payment normally is reduced if--
    (A) A substantial portion of the target's nonroutine contributions 
to the PCT Payee's business activities is not required to be covered by 
a PCT or group of PCTs, and that portion of the nonroutine 
contributions cannot reliably be valued; or
    (B) A substantial portion of the target's assets consists of 
tangible property that cannot reliably be valued.
    (v) Example. The following example illustrates the principles of 
this paragraph (g)(5):

    Example. USP, a U.S. corporation, and its newly incorporated, 
wholly-owned foreign subsidiary (FS) enter into a CSA in Year 1 to 
develop Group Z products. Under the CSA, USP and FS will have the 
exclusive rights to exploit the Group Z products in the U.S. and the 
rest of the world, respectively. Based on RAB shares, USP will bear 
60% and FS will bear 40% of the costs incurred during the term of 
the agreement. USP acquires Company X in Year 2 for cash 
consideration worth $110 million. Company X joins in the filing of a 
U.S. consolidated income tax return with USP. Under paragraph 
(j)(2)(i) of this section, Company X and USP are treated as one 
taxpayer. Accordingly, the RT Rights in any of Company X's resources 
and capabilities that are reasonably anticipated to contribute to 
the development activities of the CSA will be considered external 
contributions furnished by USP. Company X's resources and 
capabilities consist of its workforce, certain technology 
intangibles, $15 million of tangible property and other assets and 
$5 million in liabilities. The technology intangibles, as well as 
Company X's workforce, are reasonably anticipated to contribute to 
the development of the Group Z products under the CSA and therefore 
the RT Rights in the technology intangibles and the workforce are 
external contributions by way of a PFA for which FS must make a PCT

[[Page 51149]]

Payment to USP. None of Company X's existing intangible assets or 
any of its workforce are anticipated to contribute to activities 
outside the CSA. Applying the acquisition price method, the value of 
USP's external contributions is the adjusted acquisition price $100 
million ($110 million acquisition price plus $5 million liabilities 
less $15 million tangible property and other assets). FS must make a 
PCT Payment to USP for these external contributions in an amount of 
$40 million, which is the product of $100 million (the value of the 
external contributions) and 40% (FS's RAB share).

    (6) Market capitalization method--(i) In general. The market 
capitalization method applies the comparable uncontrolled transaction 
method of Sec.  1.482-4(c), or the arm's length charge described in 
Sec.  1.482-2(b)(3)(first sentence) based on a comparable uncontrolled 
transaction, to evaluate whether the amount charged in a PCT, or group 
of PCTs, is arm's length by reference to the average market 
capitalization of a controlled participant (PCT Payee) whose stock is 
regularly traded on an established securities market. The market 
capitalization method is ordinarily used only where substantially all 
of the PCT Payee's nonroutine contributions (as described in paragraph 
(g)(7)(iii)(C)(1) of this section) to the PCT Payee's business are 
covered by a PCT or group of PCTs.
    (ii) Determination of arm's length charge. Under the market 
capitalization method, the arm's length charge for a PCT or group of 
PCTs covering resources and capabilities of the PCT Payee is equal to 
the adjusted average market capitalization, as divided among the 
controlled participants according to their respective RAB shares.
    (iii) Average market capitalization. The average market 
capitalization is the average of the daily market capitalizations of 
the PCT Payee over a period of time beginning 60 days before the date 
of the PCT and ending on the date of the PCT. The daily market 
capitalization of the PCT Payee is calculated on each day its stock is 
actively traded as the total number of shares outstanding multiplied by 
the adjusted closing price of the stock on that day. The adjusted 
closing price is the daily closing price of the stock, after 
adjustments for stock-based transactions (dividends and stock splits) 
and other pending corporate (combination and spin-off) restructuring 
transactions for which reliable arm's length adjustments can be made.
    (iv) Adjusted average market capitalization. The adjusted average 
market capitalization is the average market capitalization of the PCT 
Payee increased by the value of the PCT Payee's liabilities on the date 
of the PCT and decreased by the value on such date of the PCT Payee's 
tangible property and of any other resources and capabilities of the 
PCT Payee not covered by a PCT or group of PCTs.
    (v) Reliability and comparability considerations. The comparability 
and reliability considerations stated in Sec.  1.482-4(c)(2) apply. 
Consistent with those considerations, the reliability of applying the 
comparable uncontrolled transaction method using the adjusted market 
capitalization of a company as a measure of the arm's length charge for 
the PCT Payment normally is reduced if--
    (A) A substantial portion of the PCT Payee's nonroutine 
contributions to its business activities is not required to be covered 
by a PCT or group of PCTs, and that portion of the nonroutine 
contributions cannot reliably be valued;
    (B) A substantial portion of the PCT Payee's assets consists of 
tangible property that cannot reliably be valued; or
    (C) Facts and circumstances demonstrate the likelihood of a 
material divergence between the average market capitalization of the 
PCT Payee and the value of its resources and capabilities for which 
reliable adjustments cannot be made.
    (vi) Examples. The following examples illustrate the principles of 
this paragraph (g)(6):

    Example 1. (i) USP, a publicly traded U.S. company, and its 
newly incorporated wholly-owned foreign subsidiary (FS) enter into a 
CSA on Date 1 to develop software. Under the CSA, USP and FS will 
have the exclusive rights to exploit all future generations of the 
software in the United States and the rest of the world, 
respectively. Based on RAB shares, USP will bear 70% and FS will 
bear 30% of the costs incurred during the term of the CSA. USP's 
assembled team of researchers and its entire existing and in-process 
software are reasonably anticipated to contribute to the development 
of the software under the CSA and the RT Rights in the research team 
and existing and in-process software are therefore external 
contributions for which compensation is due from FS. USP separately 
enters into a license agreement with FS for make-and-sell rights for 
all existing software in the rest of the world. This license of 
current make-and-sell rights is a transaction that is governed by 
Sec.  1.482-4. However, after analysis, it is determined that the 
PCT Payments and the arm's length payments for the make-and-sell 
license may be most reliably determined in the aggregate using the 
market capitalization method, under principles described in 
paragraph (g)(2)(v) of this section.
    (ii) On Date 1, USP had an average market capitalization of $205 
million, tangible property and other assets that can be reliably 
valued worth $5 million and no liabilities. Applying the market 
capitalization method, the aggregate value of USP's external 
contributions and the make-and-sell rights in its existing software 
is $200 million ($205 million average market capitalization of USP 
less $5 million of tangible property and other assets). The total 
arm's length value of the PCT Payments and license payments FS must 
make to USP for the external contributions and current make-and-sell 
rights is $60 million, which is the product of $200 million (the 
value of the external contributions and the make-and-sell rights) 
and 30% (FS's share of anticipated benefits of 30%).
    Example 2. The facts are the same as Example 1 except that USP 
also makes significant nonroutine contributions that are difficult 
to value to several other mature business divisions it operates that 
are not reasonably anticipated to contribute software development 
that is the subject of the CSA and are therefore not external 
contributions and accordingly not required to be covered by a PCT. 
The reliability of using the market capitalization method to 
determine the value of USP's external contributions to the CSA is 
significantly reduced in this case because it would require 
adjusting USP's average market capitalization to account for the 
significant nonroutine contributions that are not required to be 
covered by a PCT.

    (7) Residual profit split method--(i) In general. The residual 
profit split method evaluates whether the allocation of combined 
operating profit or loss attributable to one or more external 
contributions subject to a PCT is arm's length by reference to the 
relative value of each controlled participant's contribution to that 
combined operating profit or loss. The combined operating profit or 
loss must be derived from the most narrowly identifiable business 
activity of the controlled participants for which data are available 
that include the developing and exploiting of cost shared intangibles 
(relevant business activity). The residual profit split method may not 
be used where only one controlled participant makes significant 
nonroutine contributions to the development and exploitation of the 
cost shared intangibles. The provisions of Sec.  1.482-6 shall apply to 
CSAs only to the extent provided and as modified in this paragraph 
(g)(7). Any other application to a CSA of a residual profit method not 
described below will constitute an unspecified method for purposes of 
sections 482 and 6662(e) and the regulations thereunder.
    (ii) Appropriate share of profits and losses. The relative value of 
each controlled participant's contribution to the success of the 
relevant business activity must be determined in a manner that reflects 
the functions performed, risks assumed, and resources employed by each 
participant in the relevant business activity, consistent with the 
comparability provisions of Sec.  1.482-1(d)(3). Such an allocation is 
intended to correspond to the division of profit or

[[Page 51150]]

loss that would result from an arrangement between uncontrolled 
taxpayers, each performing functions similar to those of the various 
controlled participants engaged in the relevant business activity. The 
profit allocated to any particular controlled participant is not 
necessarily limited to the total operating profit of the group from the 
relevant business activity. For example, in a given year, one 
controlled participant may earn a profit while another controlled 
participant incurs a loss. In addition, it may not be assumed that the 
combined operating profit or loss from the relevant business activity 
should be shared equally, or in any other arbitrary proportion.
    (iii) Profit split--(A) In general. Under the residual profit split 
method, each controlled participant's territorial operating profit or 
loss, as defined in paragraph (j)(1)(vi) of this section, is allocated 
between the controlled participants that each furnish significant 
nonroutine contributions to the relevant business activity in that 
territory following the three step process set forth in paragraphs 
(g)(7)(iii)(B) and (C) of this section.
    (B) Allocate income to routine contributions other than cost 
contributions. The first step allocates an amount of income to each 
controlled participant that is subtracted from its territorial 
operating profit or loss to provide a market return for the controlled 
participant's routine contributions (other than cost contributions) to 
the relevant business activity in its territory. Routine contributions 
are contributions of the same or a similar kind to those made by 
uncontrolled taxpayers involved in similar business activities for 
which it is possible to identify market returns. Routine contributions 
ordinarily include contributions of tangible property, services and 
intangibles that are generally owned or provided by uncontrolled 
taxpayers engaged in similar activities. A functional analysis is 
required to identify these contributions according to the functions 
performed, risks assumed, and resources employed by each of the 
controlled participants. Market returns for the routine contributions 
should be determined by reference to the returns achieved by 
uncontrolled taxpayers engaged in similar activities, consistent with 
the methods described in Sec. Sec.  1.482-3, 1.482-4, and1.482-5, or 
with the arm's length charge described in Sec.  1.482-2(b)(3) (first 
sentence) based on a comparable uncontrolled transaction.
    (C) Allocate residual profit--(1) In general. The allocation of 
income to each controlled participant's routine contributions in the 
first step will not reflect profit or loss attributable to that 
controlled participant's cost contributions, nor reflect the profit or 
loss attributable to any controlled participant's nonroutine 
contributions to the relevant business activity. Nonroutine 
contributions include nonroutine external contributions, and other 
nonroutine contributions, to the relevant business activity in the 
relevant territory. The residual territorial profit or loss after the 
allocation of income in the first step in paragraph (g)(7)(iii)(B) of 
this section is further allocated under the second and third steps in 
paragraphs (g)(7)(iii)(C)(2) and (3) of this section.
    (2) Cost contribution share of residual profit or loss. Under the 
second step, a portion of each controlled participant's residual 
territorial profit or loss after the first step allocation is allocated 
to that controlled participant's cost contributions (cost contribution 
share). A controlled participant's cost contribution share is equal to 
the following fraction of such residual territorial profit or loss. The 
numerator is the present value, determined as of the relevant date, of 
the summation, over the entire period of developing and exploiting cost 
shared intangibles, of the total value of such controlled participant's 
total anticipated cost contributions. The denominator is the present 
value, determined as of the relevant date, of the summation, over the 
same period, of such controlled participant's total anticipated 
territorial operating profits, as defined in paragraph (j)(1)(vi) of 
this section, reduced by a market return for the routine contributions 
(other than cost contributions) to the relevant business activity in 
the relevant territory. For these purposes, the relevant date is the 
date of the PCTs.
    (3) Nonroutine contribution share of residual profit or loss. Under 
the third step, the remaining share of each controlled participant's 
residual territorial profit or loss after the first and second step 
allocations generally should be divided among all of the controlled 
participants based upon the relative value, determined as of the date 
of the PCTs, of their nonroutine contributions to the relevant business 
activity in the relevant territory. The relative value of the 
nonroutine contributions of each controlled participant may be measured 
by external market benchmarks that reflect the fair market value of 
such nonroutine contributions. Alternatively, the relative value of 
nonroutine contributions may be estimated by the capitalized cost of 
developing the nonroutine contributions and updates, as appropriately 
grown or discounted so that all contributions may be valued on a 
comparable dollar basis as of the same date. If the nonroutine 
contributions by a controlled participant are also used in other 
business activities (such as the exploitation of make-or-sell rights 
described in paragraph (c) of this section), an allocation of the value 
of the nonroutine contributions must be made on a reasonable basis 
among all the business activities in which they are used in proportion 
to the relative economic value that the relevant business activity and 
such other business activities are anticipated to derive over time as 
the result of such nonroutine contributions.
    (4) Determination of PCT Payments. Any amount of a controlled 
participant's territorial operating profit or loss that is allocated to 
another controlled participant's external contributions to the relevant 
business activity in the relevant territory under the third step 
represents the amount of the PCT Payment due to that other controlled 
participant for its such external contributions.
    (5) Routine external contributions. For purposes of this paragraph 
(g)(7), routine external contributions, the valuation and PCT Payments 
for which are determined and made independently of the residual profit 
split method, are treated similarly to cost contributions. Accordingly, 
wherever used in this paragraph (g)(7), the term routine contribution 
shall not be read to include routine external contributions and the 
term cost contribution shall be read to include net routine external 
contributions, as defined in paragraph (g)(4)(v) of this section.
    (iv) Comparability and reliability considerations--(A) In general. 
Whether results derived from this method are the most reliable measure 
of the arm's length result is determined using the factors described 
under the best method rule in Sec.  1.482-1(c). Thus, comparability and 
the quality of data and assumptions must be considered in determining 
whether this method provides the most reliable measure of an arm's 
length result. The application of these factors to the residual profit 
split in the context of the relevant business activity of developing 
and exploiting cost shared intangibles is discussed in paragraphs 
(g)(7)(iv)(B), (C), and (D) of this section.
    (B) Comparability. The first step of the residual profit split 
relies on market benchmarks of profitability. Thus, the comparability 
considerations that are relevant for the first step of the residual 
profit split are those that are relevant for the methods that are used 
to determine

[[Page 51151]]

market returns for the routine contributions.
    (C) Data and assumptions. The reliability of the results derived 
from the residual profit split is affected by the quality of the data 
and assumptions used to apply this method. In particular, the following 
factors must be considered--
    (1) The reliability of the allocation of costs, income, and assets 
between the relevant business activity and the controlled participants' 
other activities will affect the reliability of the determination of 
the territorial operating profit and its allocation among the 
controlled participants. See Sec.  1.482-6(c)(2)(ii)(C)(1);
    (2) The degree of consistency between the controlled participants 
and uncontrolled taxpayers in accounting practices that materially 
affect the items that determine the amount and allocation of operating 
profit affects the reliability of the result. See Sec.  1.482-
6(c)(2)(ii)(C)(2); and
    (3) The reliability of the data used and the assumptions made in 
valuing the nonroutine contributions by the controlled participants. In 
particular, if capitalized costs of development are used to estimate 
the value of intangible property, the reliability of the results is 
reduced relative to the reliability of other methods that do not 
require such an estimate, for the following reasons. In any given case, 
the costs of developing the intangible may not be related to its market 
value. In addition, the calculation of the capitalized costs of 
development may require the allocation of indirect costs between the 
relevant business activity and the controlled participant's other 
activities, which may affect the reliability of the analysis.
    (D) Other factors affecting reliability. Like the methods described 
in Sec. Sec.  1.482-3, 1.482-4, and 1.482-5, or with the arm's length 
charge described in Sec.  1.482-2(b)(3) (first sentence) based on a 
comparable uncontrolled transaction, the first step of the residual 
profit split relies exclusively on external market benchmarks. As 
indicated in Sec.  1.482-1(c)(2)(i), as the degree of comparability 
between the controlled participants and uncontrolled transactions 
increases, the relative weight accorded the analysis under this method 
will increase. In addition, to the extent the allocation of profits in 
the third step is not based on external market benchmarks, the 
reliability of the analysis will be decreased in relation to an 
analysis under a method that relies on market benchmarks. Finally, the 
reliability of the analysis under this method may be enhanced by the 
fact that all the controlled participants are evaluated under the 
residual profit split. However, the reliability of the results of an 
analysis based on information from all the controlled participants is 
affected by the reliability of the data and the assumptions pertaining 
to each controlled participant. Thus, if the data and assumptions are 
significantly more reliable with respect to one of the controlled 
participants than with respect to the others, a different method, 
focusing solely on the results of that party, may yield more reliable 
results.
    (v) Example. The following example illustrates the principles of 
this paragraph (g)(7):

    Example. (i) USP, a U.S. nanotech company, has partially 
developed technology for nanomotors which are used to provide 
mobility for nanodevices. At the same time, USP's wholly-owned 
subsidiary, FS, a foreign nanotech company, has partially developed 
technology for nanosensors which provide sensing capabilities for 
nanodevices. At the beginning of Year 1, USP enters into a CSA with 
FS to develop NanoBuild, a technology which will be used to build a 
wide range of fully functioning nanodevices. The partially developed 
nanomotor and nanosensor technologies owned by USP and FS, 
respectively, are reasonably anticipated to contribute to the 
development of NanoBuild and therefore the RT Rights in the 
nanomotor and nanosensor technologies constitute external 
contributions of USP and FS for which compensation is due under 
PCTs. Under the CSA, USP will have the right to exploit NanoBuild in 
the United States, while FS will have the right to exploit NanoBuild 
in the rest of the world. USP's and FS's RAB shares are 40% and 60% 
respectively.
    (ii) The present value of the total projected IDCs for the CSA 
is $10 billion (as of the date of the PCTs). Based on RAB shares, 
USP expects to bear 40%, or $4 billion, of these IDCS and FS expects 
to bear 60%, or $6 billion. For accounting purposes, USP and FS 
project a combined operating profit from exploitation of the 
NanoBuild of $11 billion (in Year 1 dollars), taking into account 
the $10 billion of projected IDCs. However, for purposes of applying 
the residual profit split method, combined operating profit is 
determined without taking into account IDCs. Therefore, USP and FS 
redetermine their combined operating profits for purposes of the 
residual profit split method to equal $21 billion (adding $10 
billion of IDCs back to the accounting profit of $11 billion). Of 
this amount, 40% or $8.4 billion is expected to be generated by USP 
in the U.S. and 60% or $12.6 billion is expected to be generated by 
FS in the rest of the world.
    (iii) USP and FS each undertake routine distribution activities 
in their respective markets that constitute routine contributions to 
the relevant business activity of exploiting NanoBuild. They 
estimate that the total market return (costs plus a market return on 
those costs) on these routine contributions will amount to $1 
billion, (in Year 1 dollars). Of this amount, USP's anticipated 
routine return is $400 million and FS's anticipated routine return 
is $600 million. After deducting the routine return, USP's total 
anticipated residual operating profit is $8 billion ($8.4 billion-
$0.4 billion) and FS's total anticipated residual operating profit 
equals $12 billion ($12.6 billion-$0.6 billion).
    (iv) After analysis, USP and FS determine that the relative 
values of the nanomotor and nanosensor technologies are most 
reliably measured by their respective capitalized costs of 
development. Some of the factors considered in this analysis include 
the similar nature and success, and the relatively contemporaneous 
timing, of the nanoengineering research done to develop both the 
nanomoter and nanosensor technologies and the lack of external 
market benchmarks. The capitalized costs of the nanomotor and 
nonsensor technologies are $3 billion and $5 billion, respectively.
    (v) Under the residual profit split method, in each taxable year 
USP and FS will allocate the operating income they each separately 
report in their territory (territorial operating income) between 
their routine contributions, their cost contribution share and their 
nonroutine contributions, in this case the nanomotor and nanosensor 
technologies.
    (vi) In step one of the residual profit split, USP and FS each 
allocate an amount of income that is subtracted from their actual 
territorial operating income for the taxable year to provide a 
market return for their actual routine contributions in that year.
    (vii) In step two, a portion of residual territorial operating 
profit or loss after accounting for the allocation of income to 
routine contributions in step one, will be allocated by USP and FS 
to their cost contribution shares. The percentage allocable to the 
cost contribution share in this case is equal to the each 
participant's share of total anticipated IDCs divided by the 
difference between its total anticipated operating profits in its 
territory and the total anticipated routine return in its territory. 
It follows that the cost contribution shares of USP and FS are as 
follows: USP = 50% ($4 billion/$8 billion) and FS = 50% ($6 billion/
$12 billion).
    (viii) In step three, USP and FS each allocate a portion of 
their residual territorial operating income remaining after 
application of steps one and two between their respective nonroutine 
contributions. USP and FS have estimated relative values for USP's 
nanomotor technology at $3 billion and FS's nanosensor technology at 
$5 billion. The percentage of each participant's residual 
territorial operating income that is allocated to the nanomotor 
technology is therefore 37.5% ($3 billion/($3 billion + $5 billion)) 
and the percentage allocated to the nanosensor technology is 62.5% 
($5 billion/($3 billion + $5 billion)).
    (ix) USP will owe a PCT Payment to FS equal to the amount of its 
territorial operating profit or loss that is allocated in step three 
to FS's nanosensor technology and FS will owe a PCT Payment to USP 
equal to the amount of its territorial operating iprofit or loss 
that is allocated in step three to USP's nanomotor technology. The 
PCT Payments owed each year by USP and FS, respectively, will be 
netted against each other, so that only

[[Page 51152]]

one participant will make a net PCT Payment.

    (8) Unspecified methods. Methods not specified in paragraphs (g)(3) 
through (7) of this section may be used to evaluate whether the amount 
charged for a PCT is arm's length. Any method used under this paragraph 
(g)(8) must be applied in accordance with the provisions of Sec.  
1.482-1 and of paragraph (g)(2) of this section. Consistent with the 
specified methods, an unspecified method should take into account the 
general principle that uncontrolled taxpayers evaluate the terms of a 
transaction by considering the realistic alternatives to that 
transaction, and only enter into a particular transaction if none of 
the alternatives is preferable to it. Therefore, in establishing 
whether a PCT achieved an arm's length result, an unspecified method 
should provide information on the prices or profits that the controlled 
participant could have realized by choosing a realistic alternative to 
the CSA. As with any method, an unspecified method will not be applied 
unless it provides the most reliable measure of an arm's length result 
under the principles of the best method rule. See Sec.  1.482-1(c). In 
accordance with Sec.  1.482-1(d) (Comparability), to the extent that an 
unspecified method relies on internal data rather than uncontrolled 
comparables, its reliability will be reduced. Similarly, the 
reliability of a method will be affected by the reliability of the data 
and assumptions used to apply the method, including any projections 
used.
    (h) Coordination with the arm's length standard. A CSA produces 
results that are consistent with an arm's length result within the 
meaning of Sec.  1.482-1(b)(1) if, and only if, each controlled 
participant's IDC share (as determined under paragraph (d)(4) of this 
section) equals its RAB share (as required by paragraph (a)(1) of this 
section), and all other requirements of this section are satisfied.
    (i) Allocations by the Commissioner in connection with a CSA--(1) 
In general. The Commissioner may make allocations to adjust the results 
of a controlled transaction in connection with a CSA so that the 
results are consistent with an arm's length result, in accordance with 
the provisions of this paragraph (i).
    (2) CST allocations--(i) In general. The Commissioner may make 
allocations to adjust the results of a CST so that the results are 
consistent with an arm's length result, including any allocations to 
make each controlled participant's IDC share, as determined under 
paragraph (d)(4) of this section, equal to that participant's RAB 
share, as determined under paragraph (e)(1) of this section. Such 
allocations may result from, for purposes of CST determinations, 
adjustments to--
    (A) Redetermine IDCs by adding any costs (or cost categories) that 
are directly identified with, or are reasonably allocable to, the IDA, 
or by removing any costs (or cost categories) that are not IDCs;
    (B) Reallocate costs between the IDA and other business activities;
    (C) Improve the reliability of the selection or application of the 
basis used for measuring benefits for purposes of estimating a 
controlled participant's RAB share;
    (D) Improve the reliability of the projections used to estimate RAB 
shares, including adjustments described in paragraph (i)(2)(ii) of this 
section; and
    (E) Allocate among the controlled participants any unallocated 
interests in cost shared intangibles.
    (ii) Adjustments to improve the reliability of projections used to 
estimate RAB shares--(A) Unreliable projections. A significant 
divergence between projected benefit shares and benefit shares adjusted 
to take into account any available actual benefits to date (adjusted 
benefit shares) may indicate that the projections were not reliable for 
purposes of estimating RAB shares. In such a case, the Commissioner may 
use adjusted benefit shares as the most reliable measure of RAB shares 
and adjust IDC shares accordingly. The projected benefit shares will 
not be considered unreliable, as applied in a given taxable year, based 
on a divergence from adjusted benefit shares for every controlled 
participant that is less than or equal to 20% of the participant's 
projected benefits share. Further, the Commissioner will not make an 
allocation based on such divergence if the difference is due to an 
extraordinary event, beyond the control of the controlled participants, 
which could not reasonably have been anticipated at the time that costs 
were shared. The Commissioner generally may adjust projections of 
benefits used to calculate benefit shares in accordance with the 
provisions of Sec.  1.482-1. In particular, if benefits are projected 
over a period of years, and the projections for initial years of the 
period prove to be unreliable, this may indicate that the projections 
for the remaining years of the period are also unreliable and thus 
should be adjusted. For purposes of this paragraph, all controlled 
participants that are not U.S. persons are treated as a single 
controlled participant. Therefore, an adjustment based on an unreliable 
projection of RAB shares will be made to the IDC shares of foreign 
controlled participants only if there is a matching adjustment to the 
IDC shares of controlled participants that are U.S. persons. Nothing in 
this paragraph (i)(2)(ii)(A) prevents the Commissioner from making an 
allocation if taxpayer did not use the most reliable basis for 
measuring anticipated benefits. For example, if the taxpayer measures 
its anticipated benefits based on units sold, and the Commissioner 
determines that another basis is more reliable for measuring 
anticipated benefits, then the fact that actual units sold were within 
20% of the projected unit sales will not preclude an allocation under 
this section.
    (B) Foreign-to-foreign adjustments. Adjustments to IDC shares based 
on an unreliable projection also may be made solely among foreign 
controlled participants if the variation between actual and projected 
benefits has the effect of substantially reducing U.S. tax.
    (C) Correlative adjustments to PCTs. Correlative adjustments will 
be made to any PCT Payments of a fixed amount that were determined 
based on RAB shares which are subsequently adjusted on a finding that 
they were based on unreliable projections. No correlative adjustments 
will be made to contingent PCT Payments regardless of whether RAB 
shares were used as a parameter in the valuation of those payments.
    (D) Examples. The following examples illustrate the principles of 
this paragraph (i)(2)(ii):

    Example 1. U.S. Parent (USP) and Foreign Subsidiary (FS) enter 
into a CSA to develop new food products, dividing costs on the basis 
of projected sales two years in the future. In Year 1, USP and FS 
project that their sales in Year 3 will be equal, and they divide 
costs accordingly. In Year 3, the Commissioner examines the 
controlled participants' method for dividing costs. USP and FS 
actually accounted for 42% and 58% of total sales, respectively. The 
Commissioner agrees that sales two years in the future provide a 
reliable basis for estimating benefit shares. Because the 
differences between USP's and FS's adjusted and projected benefit 
shares are less than 20% of their projected benefit shares, the 
projection of future benefits for Year 3 is reliable.

    Example 2. The facts are the same as in Example 1, except that 
in Year 3 USP and FS actually accounted for 35% and 65% of total 
sales, respectively. The divergence between USP's projected and 
adjusted benefit shares is greater than 20% of USP's projected 
benefit share and is not due to an extraordinary event beyond the 
control of the controlled participants. The Commissioner concludes 
that the projected benefit shares were unreliable, and uses adjusted 
benefit shares as the basis for an adjustment to the cost shares 
borne by USP and FS.


[[Page 51153]]


    Example 3. U.S. Parent (USP), a U.S. corporation, and its 
foreign subsidiary (FS) enter a CSA in Year 1. They project that 
they will begin to receive benefits from covered intangibles in 
Years 4 through 6, and that USP will receive 60% of total benefits 
and FS 40% of total benefits. In Years 4 through 6, USP and FS 
actually receive 50% each of the total benefits. In evaluating the 
reliability of the controlled participants' projections, the 
Commissioner compares the adjusted benefit shares to the projected 
benefit shares. Although USP's adjusted benefit share (50%) is 
within 20% of its projected benefit share (60%), FS's adjusted 
benefit share (50%) is not within 20% of its projected benefit share 
(40%). Based on this discrepancy, the Commissioner may conclude that 
the controlled participants' projections were not reliable and may 
use adjusted benefit shares as the basis for an adjustment to the 
cost shares borne by USP and FS.

    Example 4. Three controlled taxpayers, USP, FS1 and FS2 enter 
into a CSA. FS1 and FS2 are foreign. USP is a United States 
corporation that controls all the stock of FS1 and FS2. The 
controlled participants project that they will share the total 
benefits of the covered intangibles in the following percentages: 
USP 50%; FS1 30%; and FS2 20%. Adjusted benefit shares are as 
follows: USP 45%; FS1 25%; and FS2 30%. In evaluating the 
reliability of the controlled participants' projections, the 
Commissioner compares these adjusted benefit shares to the projected 
benefit shares. For this purpose, FS1 and FS2 are treated as a 
single controlled participant. The adjusted benefit share received 
by USP (45%) is within 20% of its projected benefit share (50%). In 
addition, the non-US controlled participants' adjusted benefit share 
(55%) is also within 20% of their projected benefit share (50%). 
Therefore, the Commissioner concludes that the controlled 
participants' projections of future benefits were reliable, despite 
the fact that FS2's adjusted benefit share (30%) is not within 20% 
of its projected benefit share (20%).

    Example 5. The facts are the same as in Example 4. In addition, 
the Commissioner determines that FS2 has significant operating 
losses and has no earnings and profits, and that FS1 is profitable 
and has earnings and profits. Based on all the evidence, the 
Commissioner concludes that the controlled participants arranged 
that FS1 would bear a larger cost share than appropriate in order to 
reduce FS1's earnings and profits and thereby reduce inclusions USP 
otherwise would be deemed to have on account of FS1 under subpart F. 
Pursuant to paragraph (i)(2)(ii)(B) of this section, the 
Commissioner may make an adjustment solely to the cost shares borne 
by FS1 and FS2 because FS2's projection of future benefits was 
unreliable and the variation between adjusted and projected benefits 
had the effect of substantially reducing USP's U.S. income tax 
liability (on account of FS1 subpart F income).

    Example 6. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS) 
enter into a CSA in 1996 to develop a new treatment for baldness. 
USS's interest in any treatment developed is the right to produce 
and sell the treatment in the U.S. market while FP retains rights to 
produce and sell the treatment in the rest of the world. USS and FP 
measure their anticipated benefits from the cost sharing arrangement 
based on their respective projected future sales of the baldness 
treatment. The following sales projections are used:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                     Year                           USS           FP
------------------------------------------------------------------------
1.............................................            5           10
2.............................................           20           20
3.............................................           30           30
4.............................................           40           40
5.............................................           40           40
6.............................................           40           40
7.............................................           40           40
8.............................................           20           20
9.............................................           10           10
10............................................            5            5
------------------------------------------------------------------------

    (B) In Year 1, the first year of sales, USS is projected to have 
lower sales than FP due to lags in U.S. regulatory approval for the 
baldness treatment. In each subsequent year USS and FP are projected to 
have equal sales. Sales are projected to build over the first three 
years of the period, level off for several years, and then decline over 
the final years of the period as new and improved baldness treatments 
reach the market.
    (ii) To account for USS's lag in sales in the Year 1, the present 
discounted value of sales over the period is used as the basis for 
measuring benefits. Based on the risk associated with this venture, a 
discount rate of 10 percent is selected. The present discounted value 
of projected sales is determined to be approximately $154.4 million for 
USS and $158.9 million for FP. On this basis USS and FP are projected 
to obtain approximately 49.3% and 50.7% of the benefit, respectively, 
and the costs of developing the baldness treatment are shared 
accordingly.
    (iii) (A) In Year 6 the Commissioner examines the cost sharing 
arrangement. USS and FP have obtained the following sales results 
through the Year 5:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                     Year                           USS           FP
------------------------------------------------------------------------
1.............................................            0           17
2.............................................           17           35
3.............................................           25           41
4.............................................           38           41
5.............................................           39           41
------------------------------------------------------------------------

    (B) USS's sales initially grew more slowly than projected while 
FP's sales grew more quickly. In each of the first three years of the 
period the share of total sales of at least one of the parties diverged 
by over 20% from its projected share of sales. However, by Year 5 both 
parties' sales had leveled off at approximately their projected values. 
Taking into account this leveling off of sales and all the facts and 
circumstances, the Commissioner determines that it is appropriate to 
use the original projections for the remaining years of sales. 
Combining the actual results through Year 5 with the projections for 
subsequent years, and using a discount rate of 10%, the present 
discounted value of sales is approximately $141.6 million for USS and 
$187.3 million for FP. This result implies that USS and FP obtain 
approximately 43.1% and 56.9%, respectively, of the anticipated 
benefits from the baldness treatment. Because these adjusted benefit 
shares are within 20% of the benefit shares calculated based on the 
original sales projections, the Commissioner determines that, based on 
the difference between adjusted and projected benefit shares, the 
original projections were not unreliable. No adjustment is made based 
on the difference between adjusted and projected benefit shares.

    Example 7. (i) The facts are the same as in Example 6, except 
that the actual sales results through Year 5 are as follows:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                     Year                           USS           FP
------------------------------------------------------------------------
1.............................................            0           17
2.............................................           17           35
3.............................................           25           44
4.............................................           34           54
5.............................................           36           55
------------------------------------------------------------------------

    (ii) Based on the discrepancy between the projections and the 
actual results and on consideration of all the facts, the 
Commissioner determines that for the remaining years the following 
sales projections are more reliable than the original projections:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                     Year                           USS           FP
------------------------------------------------------------------------
6.............................................           36           55
7.............................................           36           55
8.............................................           18           28
9.............................................            9           14
10............................................          4.5            7
------------------------------------------------------------------------

    (iii) Combining the actual results through Year 5 with the 
projections for subsequent years, and using a discount rate of 10%, 
the present discounted value of sales is approximately $131.2 
million for USS and

[[Page 51154]]

$229.4 million for FP. This result implies that USS and FP obtain 
approximately 35.4% and 63.6%, respectively, of the anticipated 
benefits from the baldness treatment. These adjusted benefit shares 
diverge by greater than 20% from the benefit shares calculated based 
on the original sales projections, and the Commissioner determines 
that, based on the difference between adjusted and projected benefit 
shares, the original projections were unreliable. The Commissioner 
adjusts costs shares for each of the taxable years under examination 
to conform them to the recalculated shares of anticipated benefits.

    (iii) Timing of CST allocations. If the Commissioner makes an 
allocation to adjust the results of a CST, the allocation must be 
reflected for tax purposes in the year in which the IDCs were incurred. 
When a cost sharing payment is owed by one controlled participant to 
another controlled participant, the Commissioner may make appropriate 
allocations to reflect an arm's length rate of interest for the time 
value of money, consistent with the provisions of Sec.  1.482-2(a) 
(Loans or advances).
    (3) PCT allocations. The Commissioner may make allocations to 
adjust the results of a PCT so that the results are consistent with an 
arm's length result in accordance with the provisions of the applicable 
sections of the section 482 regulations, as determined pursuant to 
paragraph (a)(2) of this section.
    (4) Allocations regarding changes in participation under a CSA. The 
Commissioner may make allocations to adjust the results of any 
controlled transaction described in paragraph (f) of this section, if 
the controlled participants do not reflect arm's length results in 
relation to any such transaction.
    (5) Allocations when CSTs are consistently and materially 
disproportionate to RAB shares. If a controlled participant bears IDC 
shares that are consistently and materially greater or lesser than its 
RAB share, then the Commissioner may conclude that the economic 
substance of the arrangement between the controlled participants is 
inconsistent with the terms of the CSA. In such a case, the 
Commissioner may disregard such terms and impute an agreement that is 
consistent with the controlled participants' course of conduct, under 
which a controlled participant that bore a disproportionately greater 
IDC share received additional interests in the cost shared intangibles. 
See Sec.  1.482-1(d)(3)(ii)(B) (Identifying contractual terms) and 
Sec.  1.482-4(f)(3)(ii) (Identification of owner). Such additional 
interests will consist of partial undivided interests in another 
controlled participant's territory. Accordingly, that controlled 
participant must receive arm's length consideration from any controlled 
participant whose IDC share is less than its RAB share over time, under 
the provisions of Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6.
    (6) Periodic adjustments--(i) In general. Subject to the exceptions 
in paragraph (i)(6)(vi) of this section, the Commissioner may make 
periodic adjustments with respect to all PCT Payments for an open 
taxable year (the Adjustment Year), and for all subsequent taxable 
years for the duration of the CSA Activity, if the Commissioner 
determines that, for a particular PCT (the Trigger PCT), a particular 
controlled participant that owes or owed a PCT Payment relating to that 
PCT (the PCT Payor) has realized an Actually Experienced Return Ratio 
(AERR) that is outside the Periodic Return Ratio Range (PRRR). The 
satisfaction of the condition stated in the preceding sentence is 
referred to as a Periodic Trigger. See paragraph (i)(6)(ii) through 
(vi) of this section regarding the PRRR, the AERR, and periodic 
adjustments. In determining whether to make such adjustments, the 
Commissioner may consider whether the outcome as adjusted more reliably 
reflects an arm's length result under all the relevant facts and 
circumstances, including any information known as of the Determination 
Date. The Determination Date is the date of the relevant determination 
by the Commissioner. The failure of the Commissioner to determine for 
an earlier taxable year that a PCT Payment was not arm's length will 
not preclude the Commissioner from making a periodic adjustment for a 
subsequent year. A periodic adjustment under this paragraph may be made 
without regard to whether the taxable year of the Trigger PCT or any 
other PCT remains open for statute of limitations purposes.
    (ii) PRRR. Except as provided in the next sentence, the PRRR will 
consist of return ratios that are not less than \1/2\ nor more than 2. 
Alternatively, if the controlled participants have not substantially 
complied with the documentation requirements referenced in paragraph 
(k) of this section, as modified, if applicable, by paragraph (m)(3) of 
this section, the PRRR will consist of the return ratios that are not 
less than .67 nor more than 1.5.
    (iii) AERR. (A) In general. The AERR is the Present Value of Total 
Profits (PVTP) divided by the Present Value of Investment (PVI). In 
computing PVTP and PVI, present values are computed using the 
Applicable Discount Rate (ADR), and all information available as of the 
Determination Date is taken into account.
    (B) PVTP. The PVTP is the present value, as of the earliest date 
that any IDC described in paragraph (d)(1) of this section occurred 
(the CSA Start Date), of the PCT Payor's actually experienced 
territorial operating profits, as defined in paragraph (j)(1)(vi) of 
this section, from the CSA Start Date through the end of the Adjustment 
Year.
    (C) PVI. The PVI is the present value, as of the CSA Start Date, of 
the PCT Payor's investment associated with the CSA Activity, defined as 
the sum of its cost contributions and its PCT Payments, from the CSA 
Start Date through the end of the Adjustment Year. For purposes of 
computing the PVI, PCT Payments means all PCT Payments due from a PCT 
Payor before netting against PCT Payments due from other controlled 
participants.
    (iv) ADR--(A) In general. Except as provided in paragraph 
(i)(6)(iv)(B) of this section, the ADR is the discount rate pursuant to 
paragraph (g)(2)(vi) of this section, subject to such adjustments as 
the Commissioner determines appropriate.
    (B) Publicly traded companies. If the PCT Payor meets the 
conditions of paragraph (i)(6)(iv)(C) of this section, the ADR is the 
PCT Payor WACC as of the date of the trigger PCT. However, if the 
Commissioner determines, or the controlled participants establish to 
the Commissioner's satisfaction, that a discount rate other than the 
PCT Payor WACC better reflects the degree of risk of the CSA Activity 
as of such date, the ADR is such other discount rate.
    (C) Publicly traded. A PCT Payor meets the conditions of this 
paragraph (i)(6)(iv)(C) if--
    (1) Stock of the PCT Payor is publicly traded; or
    (2) Stock of the PCT Payor is not publicly traded, provided--
    (i) The PCT Payor is included in a group of companies for which 
consolidated financial statements are prepared; and
    (ii) A publicly traded company in such group owns, directly or 
indirectly, stock in PCT Payor. Stock of a company is publicly traded 
within the meaning of this paragraph (i)(6)(iv)(C) if such stock is 
regularly traded on an established United States securities market and 
the company issues financial statements prepared in accordance with 
United States generally accepted accounting principles for the taxable 
year.
    (D) PCT Payor WACC. The PCT Payor WACC is the WACC of the PCT Payor 
or the publicly traded company

[[Page 51155]]

described in paragraph (i)(6)(iv)(C)(2) of this section, as the case 
may be.
    (E) Generally accepted accounting principles. For purposes of 
paragraph (i)(6)(iv)(C) of this section, a financial statement prepared 
in accordance with a comprehensive body of generally accepted 
accounting principles other than United States generally accepted 
accounting principles is considered to be prepared in accordance with 
United States generally accepted accounting principles provided that 
the amounts of debt, equity and interest expense are reflected in the 
reconciliation between such other accounting principles and United 
States generally accepted accounting principles required to be 
incorporated into the financial statement by the securities laws 
governing companies whose stock is regularly traded on United States 
securities markets.
    (v) Determination of periodic adjustments. In the event of a 
Periodic Trigger, subject to paragraph (i)(6)(vi) of this section, the 
Commissioner may make periodic adjustments with respect to all PCT 
Payments between all PCT Payors and PCT Payees for the Adjustment Year 
and all subsequent years for the duration of the CSA Activity pursuant 
to the residual profit split method as provided in paragraph (g)(7) of 
this section, subject to the further modifications in this paragraph 
(i)(6)(v).
    (A) If the AERR is less than the PRRR, then the cost contribution 
share of residual profit or loss under paragraph (g)(7)(iii)(C)(2) of 
this section is determined as follows:
    (1) The relevant date specified in that paragraph is the CSA Start 
Date. However, the effect of using such relevant date is modified as 
specified in paragraphs (i)(6)(vi)(A)(2) and (i)(6)(vi)(A)(3) of this 
section.
    (2) The discount rate to be used in paragraph (g)(7)(iii)(C)(2) of 
this section is determined as of the relevant date, but taking into 
account any data relevant to such determination that may become 
available up through the Determination Date.
    (3) The present values of the summations described in paragraph 
(g)(7)(iii)(C)(2) of this section are determined by substituting actual 
results up through the Determination Date, and future results 
anticipated on that date, for the results anticipated on the relevant 
date. It is possible that, because of these substitutions, the 
resulting fraction determined in that paragraph will be greater than 
one.
    (B) If the AERR is greater than the PRRR, then the cost 
contribution share of residual profit or loss under paragraph 
(g)(7)(iii)(C)(2) of this section is determined as follows:
    (1) The relevant date specified in that paragraph is the first day 
of the Adjustment Year. However, the effect of using such relevant date 
is modified as specified in paragraphs (i)(6)(vi)(B)(2) and 
(i)(6)(vi)(B)(3) of this section.
    (2) The discount rate to be used in paragraph (g)(7)(iii)(C)(2) of 
this section is determined as of the relevant date, but taking into 
account any data relevant to such determination that may become 
available up through the Determination Date.
    (3) In computing the fraction described in paragraph 
(g)(7)(iii)(C)(2) of this section, the summation period described in 
that paragraph is modified to start on the first day of the Adjustment 
Year; thus, the summations described in that paragraph that are used to 
determine that fraction will not include any items relating to periods 
before the first day of the Adjustment Year.
    (C) The relative value of nonroutine contributions in paragraph 
(g)(7)(iii)(C)(3) of this section are determined as described in that 
paragraph, but taking into account any data relevant to such 
determination that may become available up through the Determination 
Date.
    (D) For these purposes, the residual profit split method may be 
used even where only one controlled participant makes significant 
nonroutine contributions to the CSA Activity. If only one controlled 
participant provides all the external contributions and other 
nonroutine contributions, then the third step residual profit or loss 
belongs entirely to such controlled participant.
    (vi) Exceptions to periodic adjustments--(A) Transactions involving 
the same external contribution as in the PCT. If--
    (1) The same external contribution is furnished to an uncontrolled 
taxpayer under substantially the same circumstances as those of the 
relevant RT (as defined in paragraph (b)(3)(iii) of this section) and 
with a similar form of payment as the PCT;
    (2) This transaction serves as the basis for the application of the 
comparable uncontrolled transaction method described in Sec.  1.482-
4(c), or the arm's length charge described in Sec.  1.482-2(b)(3)(first 
sentence) based on a comparable uncontrolled transaction, in the first 
year in which substantial PCT Payments relating to this PCT were 
required to be paid; and
    (3) The amount of those PCT Payments in that year was arm's length; 
then no periodic adjustment that uses that PCT as the Trigger PCT will 
be made under paragraphs (i)(6)(i) and (i)(6)(v) of this section.
    (B) Results not reasonably anticipated. If the controlled 
participants establish to the satisfaction of the Commissioner that the 
differential between the AERR and the nearest bound of the PRRR is due 
to extraordinary events beyond its control and that could not 
reasonably have been anticipated at the time of the Trigger PCT, then 
no periodic adjustment will be made under paragraphs (i)(6)(i) and 
(i)(6)(v) of this section.
    (C) Reduced AERR does not cause Periodic Trigger. If the controlled 
participants establish to the satisfaction of the Commissioner that the 
Periodic Trigger would not have occurred had the PCT Payor's operating 
profits used to calculate its PVTP excluded those operating profits 
attributable to the PCT Payor's routine contributions to its 
exploitation of cost shared intangibles, and nonroutine contributions 
to the CSA Activity, then no periodic adjustment will be made under 
paragraphs (i)(6)(i) and (i)(6)(v) of this section.
    (D) Increased AERR does not cause Periodic Trigger--(1) If the 
controlled participants establish to the satisfaction of the 
Commissioner that the Periodic Trigger would not have occurred had the 
operating profits of the PCT Payor used to calculate its PVTP included 
its reasonably anticipated operating profits after the Adjustment Year 
from the CSA Activity, including from routine contributions to that 
activity, and had the cost contributions and PCT Payments of the PCT 
Payor used to calculate its PVI included its reasonably anticipated 
cost contributions and PCT Payments after the Adjustment Year, then no 
periodic adjustment will be made under paragraphs (i)(6)(i) and 
(i)(6)(v) of this section. The reasonably anticipated amounts in the 
previous sentence are determined based on all information available as 
of the Determination Date.
    (2) For purposes of this paragraph (i)(6)(vii)(D) of this section, 
the controlled participants may, if they wish, assume that the average 
yearly operating profits for all taxable years prior to and including 
the Adjustment Year, in which there has been substantial exploitation 
of cost shared intangibles resulting from the CSA (exploitation years), 
will continue to be earned in each year over a period of years equal to 
15 minus the number of exploitation years prior to and including the 
Determination Date.
    (E) 10-year period. If the AERR determined is within the PRRR for 
each year of the 10-year period beginning

[[Page 51156]]

with the first taxable year in which there is substantial exploitation 
of cost shared intangibles resulting from the CSA is, then no periodic 
adjustment in a subsequent year will be made under paragraphs (i)(6)(i) 
and (i)(6)(v) of this section.
    (F) 5-year period. For any year of the 5-year period beginning with 
the first taxable year in which there is substantial exploitation of 
cost shared intangibles resulting from the CSA, no Periodic Trigger 
will be considered to occur as a result of a determination that the 
AERR falls below the lower bound of the PRRR.
    (vii) Examples. The following examples illustrates the principles 
of this paragraph (i)(6):

    Example 1. (i) At the beginning of Year 1, USP, a publicly 
traded U.S. company, and FS, its wholly-owned foreign subsidiary, 
enter into a CSA to develop new technology for wireless cell phones. 
As part of a PCT, USP furnishes an external contribution, the RT 
Rights for an in-process technology that when developed will improve 
the clarity of cell to cell calls, for which compensation is due 
from FS. FS furnishes no external contributions to the CSA. The 
weighted average cost of capital of the controlled group that 
includes USP and FS in Year 1 is 15%. In Year 10, the Commissioner 
audits Years 1 through 8 of the CSA to determine whether or not any 
periodic adjustments should be made. USP and FS have substantially 
complied with the documentation requirements of this section.
    (ii) FS derives the following actual cash flow from its 
participation in the CSA. The cash flows include the lump sum PCT of 
$100 million made by FS to USP. The derivation of such PCT Payment 
was based on financial projections undertaken in Year 1 (not shown). 
(All amounts in this table and the tables that follow are in 
millions.)

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                  Operating
                  Year                        Sales        Non-IDC        IDCs           PCT       Total inv.      profits    Exploitation      AERR
                                                            costs                     payments        costs     (accounting)     profits
--------------------------------------------------------------------------------------------------------------------------------------------------------
1.......................................             0             0            15           100           115          -115             0
2.......................................             0             0            17             0            17           -17             0
3.......................................             0             0            18             0            18           -18             0
4.......................................           780           562            20             0            20           198           218
5.......................................           936           618            22             0            22           296           318
6.......................................         1,123           680            24             0            24           420           444
7.......................................         1,179           747            27             0            27           405           432
8.......................................         1,238           822            29             0            29           387           416
NPV through Year 5......................         1,048           722            69           100           169           157           326           1.9
NPV through Year 6......................         1,606         1,060            81           100           181           365           546           3.0
NPV through Year 7......................         2,116         1,383            92           100           192           541           733           3.8
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (iii) Because USP is publicly traded in the United States and is 
a member of the controlled group to which the PCT Payor, FS, 
belongs, for purposes of calculating the AERR for FS, the present 
values of its PVTP and PVI are determined using an ADR of 15%, the 
weighted average cost of capital of the controlled group. At a 15% 
discount rate, the PVTP, calculated in Year 8 as of Year 1, and 
based on actual profits realized by FS through Year 7 from 
exploiting the new wireless cell phone technology developed by the 
CSA, is $733 million. The PVI, based on FS's IDCs and its 
compensation expenditures pursuant to the PCT, is $192 million. The 
AERR for FS is equal to its PVTP divided by its PVI, $733 million/
$192 million, or 3.8. There is a Periodic Trigger because FS's AERR 
of 3.8 falls outside the PRRR of \1/2\ to 2, the applicable PRRR for 
controlled participants complying with the documentation 
requirements of this section.
    (iv) At the time of the Determination Date, it is determined 
that the first Adjustment Year in which a Periodic Trigger occurred 
was Year 6, when the AERR of FS was determined to be 3.0. It is also 
determined that none of the exceptions to periodic adjustments 
described in paragraph (i)(6)(vi) of this section applies. It 
follows that the arm's length PCT Payments made by FS from Year 6 
forward shall be determined each taxable year using the residual 
profit split method described in paragraph (g)(7) of this section as 
modified by paragraph (i)(6)(v) of this section. Periodic 
adjustments will be made to the extent the PCT Payments actually 
made by FS differ from the PCT Payment calculation under the 
residual profit split.
    (v) Actual and projected IDCs, territorial operating profits and 
returns to routine contributions for the remainder of the 
exploitation of the cost shared intangibles, determined as of the 
beginning of Year 6 are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                        Territorial    Return to    Profits less
                          Year                               IDCs        operating      routine        routine
                                                                          profits    contributions     return
----------------------------------------------------------------------------------------------------------------
6......................................................            24           444             68           376
7......................................................            27           432             75           357
8......................................................            29           416             82           334
9 (Projected)..........................................            32           396             90           305
10 (Projected).........................................            35           370             99           271
                                                        ---------------
    Total PV as of Year 6..............................           116          1666            326          1340
----------------------------------------------------------------------------------------------------------------

    (vi) Under step one of the residual profit split method, for 
each taxable year, FS will be allocated a portion of its actual 
territorial operating income for the taxable year to provide a 
market return for its actual routine contributions in that year. As 
a result of a transfer pricing analysis, the Commissioner determines 
that the return to FS's routine activities, based on the return for 
comparable routine functions undertaken by comparable unrelated 
companies, is 10% of non-IDC costs. The allocations of actual 
territorial profits in Years 6 through 8 are as follows:

[[Page 51157]]



------------------------------------------------------------------------
                                Territorial    Return to      Residual
             Year                operating      routine        profits
                                  profits    contributions  after step 1
------------------------------------------------------------------------
6............................           444             68           376
7............................           432             75           357
8............................           416             82           334
------------------------------------------------------------------------

    (vii) Under step two, a portion of the residual territorial 
operating profit or loss after the allocation of profit to routine 
contributions in step one will be allocated by FS to its cost 
contribution share. The percentage allocable to the cost 
contribution share is equal to FS's share of the total anticipated 
IDCs divided by its total anticipated territorial operating profits 
reduced by total expected return to its routine contributions to the 
exploitation of the cost shared technology in its territory. All 
amounts are determined as present values as of the first day of Year 
6, using an appropriate discount rate on that date, and do not 
include any amounts relating to periods before the first day of Year 
6. Following these rules, it is determined that the present value of 
FS's share of the total anticipated IDCs after the first day of Year 
6 is $116 million and its total anticipated territorial operating 
profits reduced by the return to its routine contributions is $1,340 
million. It follows that the percentage of residual territorial 
operating profit or loss allocated to FS's cost contribution share 
is 8.6% ($116/$1,340). The allocation of actual residual profits 
after Step 1 in Years 6 through 8 is as follows:

------------------------------------------------------------------------
                                                 Step 2
                                  Residual       profits      Residual
             Year                  profits    allocated to     profits
                                after step 1       FS       after step 2
------------------------------------------------------------------------
6.............................           376            32           344
7.............................           357            31           327
8.............................           334            29           305
------------------------------------------------------------------------

    (viii) In step three, because USP provided the only nonroutine 
contributions to the CSA Activity, 100% of FS's residual operating 
income after steps one and two is allocated to USP's external 
contributions and therefore represents the amount of the PCT Payment 
due from FS to USP for the particular taxable year. Also because USP 
provided the only nonroutine contributions to the CSA Activity, none 
of its residual territorial operating profit or loss is attributable 
to FS, therefore no offsetting PCT Payment is due from USP to FS. 
The PCT Payments due and adjustments made in Years 6 through 8 are 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                            Residual     PCT payment
                          Year                               profits     due from FS   Actual PCT    Adjustment
                                                          after step 2     to USP     payment made
----------------------------------------------------------------------------------------------------------------
6.......................................................           344           344             0           344
7.......................................................           327           327             0           327
8.......................................................           305           305             0           305
----------------------------------------------------------------------------------------------------------------


    Example 2. The facts are the same as Example 1 paragraphs (i) 
through (iii). At the time of the Determination Date, it is 
determined that the first Adjustment Year in which a Periodic 
Trigger occurred was Year 6, when the AERR of FS was determined to 
be 3.0. Upon further investigation as to what may have caused the 
high return in FS's market, the Commissioner learns that, in Year 4, 
significant health risks were linked to the use of wireless cell 
phones of USP's leading competitors. No such health risk was linked 
to the cell phones developed by USP and FS under the CSA. This 
resulted in a significant increase in USP's and FS's market share 
for cellular phones. Further analysis determines that it was this 
unforeseen occurrence that was primarily responsible for the AERR 
trigger. Based on paragraph (i)(6)(vi)(B) of this section, the 
Commissioner concludes that no adjustments are warranted, as FS 
simply has earned the premium return that any such investor would 
earn under the circumstances.

    (j) Definitions and special rules--(1) Definitions. For purposes of 
this section:
    (i) Controlled participant means a controlled taxpayer, as defined 
under Sec.  1.482-1(i)(5), that is a party to the contractual agreement 
that underlies the CSA, and that reasonably anticipates that it will 
derive benefits, as defined in paragraph (j)(1)(iv) of this section, 
from exploiting one or more cost shared intangibles.
    (ii) Cost shared intangible means any intangible, within the 
meaning of Sec.  1.482-4(b), developed or to be developed as a result 
of the IDA, as described in paragraph (d)(1) of this section, including 
any portion of such intangible that reflects an external contribution, 
as described in paragraph (b)(3)(ii) of this section.
    (iii) An interest in an intangible includes any commercially 
transferable interest, the benefits of which are susceptible of 
valuation.
    (iv) Benefits mean the sum of additional revenue generated, plus 
cost savings, minus any cost increases from exploiting cost shared 
intangibles.
    (v) A controlled participant's reasonably anticipated benefits mean 
the aggregate benefits that reasonably may be anticipated to be derived 
from exploiting cost shared intangibles.
    (vi) Territorial operating profit or loss means the operating 
profit or loss as separately earned by each controlled participant in 
its geographic territory, described in paragraph (b)(4) of this 
section, from the CSA activity, determined before any expense 
(including amortization) on account of IDCs, routine external 
contributions, and nonroutine contributions.
    (vii) The CSA Activity is the activity of developing and exploiting 
cost shared intangibles.
    (viii) Examples. The following examples illustrate the principles 
of this paragraph (j)(1):

    Example 1. Controlled participant. Foreign Parent (FP) is a 
foreign corporation engaged in the extraction of a natural resource. 
FP has a U.S. subsidiary (USS) to which FP sells supplies of this 
resource for sale in the United States. FP enters into a CSA with 
USS to develop a new machine to extract the natural resource. The 
machine uses a new extraction process that will be patented in the 
United States and in other countries. The CSA provides that USS will 
receive the rights to exploit the machine in the extraction of the 
natural resource in the United States, and

[[Page 51158]]

FP will receive the rights in the rest of the world. This resource 
does not, however, exist in the United States. Despite the fact that 
USS has received the right to exploit this process in the United 
States, USS is not a controlled participant because it will not 
derive a benefit from the exploiting the intangible developed under 
the CSA.

    Example 2. Controlled participants. (i) U.S. Parent (USP), one 
foreign subsidiary (FS), and a second foreign subsidiary 
constituting the group's research arm (R+D) enter into a CSA to 
develop manufacturing intangibles for a new product line A. USP and 
FS are assigned the exclusive rights to exploit the intangibles 
respectively in the United States and the rest of the world, where 
each presently manufactures and sells various existing product 
lines. R+D is not assigned any rights to exploit the intangibles. 
R+D's activity consists solely in carrying out research for the 
group. It is reliably projected that the RAB shares of USP and FS 
will be 66\2/3\% and 33\1/3\%, respectively, and the parties' 
agreement provides that USP and FS will reimburse 66\2/3\% and 33\1/
3\%, respectively, of the IDCs incurred by R+D with respect to the 
new intangible.
    (ii) R+D does not qualify as a controlled participant within the 
meaning of paragraph (j)(1)(i) of this section, because it will not 
derive any benefits from exploiting cost shared intangibles. 
Therefore, R+D is treated as a service provider for purposes of this 
section and must receive arm's length consideration for the 
assistance it is deemed to provide to USP and FS, under the rules of 
paragraph (a)(3) of this section and Sec.  1.482-4(f)(3)(iii). Such 
consideration must be treated as IDCs incurred by USP and FS in 
proportion to their RAB shares (i.e., 66\2/3\% and 33\1/3\%, 
respectively). R+D will not be considered to bear any share of the 
IDCs under the arrangement.

    Example 3. Cost shared intangible. U.S. Parent (USP) has 
developed and currently exploits an antihistamine, XY, which is 
manufactured in tablet form. USP enters into a CSA with its wholly-
owned foreign subsidiary (FS) to develop XYZ, a new improved version 
of XY that will be manufactured as a nasal spray. XYZ is a cost 
shared intangible under the CSA.

    Example 4. Cost shared intangible. The facts are the same as in 
Example 3, except that instead of developing XYZ, the controlled 
participants develop ABC, a cure for the common cold. ABC is a cost 
shared intangible under the CSA.

    Example 5. Reasonably anticipated benefits. Controlled parties A 
and B enter into a cost sharing arrangement to develop product and 
process intangibles for an already existing Product P. Without such 
intangibles, A and B would each reasonably anticipate revenue, in 
present value terms, of $100M from sales of Product P until it 
became obsolete. With the intangibles, A and B each reasonably 
anticipate selling the same number of units each year, but 
reasonably anticipate that the price will be higher. Because the 
particular product intangible is more highly regarded in A's market, 
A reasonably anticipates an increase of $20M in present value 
revenue from the product intangible, while B reasonably anticipates 
only an increase of $10M. Further, A and B each reasonably 
anticipate spending an extra $5M present value in production costs 
to include the feature embodying the product intangible. Finally, A 
and B each reasonably anticipate saving $2M present value in 
production costs by using the process intangible. A and B reasonably 
anticipate no other economic effects from exploiting the cost shared 
intangibles. A's reasonably anticipated benefits from exploiting the 
cost shared intangibles equal its reasonably anticipated increase in 
revenue ($20M) plus its reasonably anticipated cost savings ($2M) 
minus its reasonably anticipated increased costs ($5M), which equals 
$17M. Similarly, B's reasonably anticipated benefits from exploiting 
the cost shared intangibles equal its reasonably anticipated 
increase in revenue ($10M) plus its reasonably anticipated cost 
savings ($2M) minus its reasonably anticipated increased costs 
($5M), which equals $7M. Thus A's reasonably anticipated benefits 
are $17M and B's reasonably anticipated benefits are $7M.

    (2) Special rules--(i) Consolidated group. For purposes of this 
section, all members of the same consolidated group shall be treated as 
one taxpayer. For purposes of this paragraph (j)(2)(i), the term 
consolidated group means all members of a group of controlled entities 
created or organized within a single country and subjected to an income 
tax by such country on the basis of their combined income.
    (ii) Trade or business. A participant that is a foreign corporation 
or nonresident alien individual will not be treated as engaged in a 
trade or business within the United States solely by reason of its 
participation in a CSA described in paragraph (b)(1) of this section. 
See generally Sec.  1.864-2(a).
    (iii) Partnership. A CSA, or an arrangement to which the 
Commissioner applies the rules of this section, will not be treated as 
a partnership to which the rules of subchapter K of the Internal 
Revenue Code apply. See Sec.  301.7701-1(c) of this chapter.
    (3) Character--(i) In general. CST payments generally will be 
considered costs of developing intangibles of the payor and 
reimbursements of the same kind of costs of developing intangibles of 
the payee. For purposes of this paragraph (j)(3), a controlled 
participant's payment required under a CSA is deemed to be reduced to 
the extent of any payments owed to it under the CSA from other 
controlled participants. Each payment received by a payee will be 
treated as coming pro rata from payments made by all payors. Such 
payments will be applied pro rata against deductions for the taxable 
year that the payee is allowed in connection with the CSA. Payments 
received in excess of such deductions will be treated as in 
consideration for use of the land and tangible property furnished for 
purposes of the CSA by the payee. For purposes of the research credit 
determined under section 41, cost sharing payments among controlled 
participants will be treated as provided for intra-group transactions 
in Sec.  1.41-6(e). Any payment made or received by a taxpayer pursuant 
to an arrangement that the Commissioner determines not to be a CSA will 
be subject to the provisions of Sec. Sec.  1.482-1 and 1.482-4 through 
1.482-6. Any payment that in substance constitutes a cost sharing 
payment will be treated as such for purposes of this section, 
regardless of its characterization under foreign law.
    (ii) PCT Payments. A PCT Payor's payment required under paragraphs 
(b)(1)(ii) and (b)(3) of this section is deemed to be reduced to the 
extent of any payments owed to it under such paragraphs from other 
controlled participants. Each PCT Payment received by a PCT Payee will 
be treated as coming pro rata out of payments made by all PCT Payors. 
PCT Payments will be characterized consistently with the designation of 
the type of transaction involved in the RT pursuant to paragraph 
(b)(iv) of this section. Depending on such designation, such payments 
will be treated as either consideration for a transfer of an interest 
in intangible property or for services.
    (iii) Examples. The following examples illustrate this paragraph 
(j)(3):

    Example 1. U.S. Parent (USP) and its wholly owned Foreign 
Subsidiary (FS) form a CSA to develop a miniature widget, the Small 
R. Based on RAB shares, USP agrees to bear 40% and FS to bear 60% of 
the costs incurred during the term of the agreement. The principal 
IDCs are operating costs incurred by FS in Country Z of 100X 
annually, and costs incurred by USP in the United States also of 
100X annually. Of the total costs of 200X, USP's share is 80X and 
FS's share is 120X. The payment will be treated as a reimbursement 
of 20X of USP's costs in the United States. Accordingly, USP's Form 
1120 will reflect an 80X deduction on account of activities 
performed in the United States for purposes of allocation and 
apportionment of the deduction to source. The Form 5471 for FS will 
reflect a 100X deduction on account of activities performed in 
Country Z, and a 20X deduction on account of activities performed in 
the United States.

    Example 2. The facts are the same as in Example 1, except that 
the 100X of costs borne by USP consist of 5X of costs incurred by 
USP in the United States and 95X of arm's length rental charge, as 
described in paragraph (d)(1) of this section, for the use of a 
facility in the United States. The depreciation deduction 
attributable to the U.S. facility is 7X. The 20X net payment by FS 
to USP will first be applied in reduction

[[Page 51159]]

pro rata of the 5X deduction for costs and the 7X depreciation 
deduction attributable to the U.S. facility. The 8X remainder will 
be treated as rent for the U.S. facility.

    Example 3. (i) Four members A, B, C, and D of a controlled group 
form a CSA to develop the next generation technology for their 
business. Based on RAB shares, the participants agree to bear shares 
of the costs incurred during the term of the agreement in the 
following percentages: A 40%; B 15%; C 25%; and D 20%. The arm's 
length values of the external contributions they respectively own 
are in the following amounts for the taxable year: A 80X; B 40X; C 
30X; and D 30X. The provisional (before offsets) and final PCT 
Payments among A, B, C, and D are shown in the table as follows:

                       [All amounts stated in X's]
------------------------------------------------------------------------
                                      A         B         C         D
------------------------------------------------------------------------
Payments........................      <40>      <21>    <37.5>      <30>
Receipts........................        48        34      22.5        24
                                 -----------
    Final.......................         8        13      <15>       <6>
------------------------------------------------------------------------

    (ii) The first row/first column shows A's provisional PCT 
Payment equal to the product of 100X (sum of 40X, 30X, and 30X) and 
A's RAB share of 40%. The second row/first column shows A's 
provisional PCT receipts equal to the sum of the products of 80X and 
B's, C's, and D's RAB shares (15%, 25%, and 20%, respectively). The 
other entries in the first two rows of the table are similarly 
computed. The last row shows the final PCT receipts/payments after 
offsets. Thus, for the taxable year, A and B are treated as 
receiving the 8X and 13X, respectively, pro rata out of payments by 
C and D of 15X and 6X, respectively.

    (k) CSA contractual, documentation, accounting, and reporting 
requirements--(1) CSA contractual requirements--(i) In general. A CSA 
that is described in paragraph (b)(1) of this section must be recorded 
in writing in a contract that is contemporaneous with the formation 
(and any revision) of the CSA and that includes the contractual 
provisions described in this paragraph (k)(1).
    (ii) Contractual provisions. The written contract described in this 
paragraph (k)(1) must include provisions that--
    (A) List the controlled participants and any other members of the 
controlled group that are reasonably anticipated to benefit from the 
use of the cost shared intangibles, including the address of each 
domestic entity and the country of organization of each foreign entity;
    (B) Describe the scope of the IDA to be undertaken, including each 
cost shared intangible or class of cost shared intangibles that the 
controlled participants intend to develop under the CSA;
    (C) Specify the functions and risks that each controlled 
participant will undertake in connection with the CSA;
    (D) Divide among the controlled participants all interests in cost 
shared intangibles and specify each controlled participant's 
territorial interest in the cost shared intangibles, as described in 
paragraph (b)(4) of this section, that it will own and exploit without 
any further obligation to compensate any other controlled participant 
for such interest;
    (E) Provide a method to calculate the controlled participants' RAB 
shares, based on factors that can reasonably be expected to reflect the 
participants' shares of anticipated benefits, and require that such RAB 
shares must be updated, as described in paragraph (e)(1) of this 
section (see also paragraph (k)(2)(ii)(F) of this section);
    (F) Enumerate all categories of IDCs to be shared under the CSA;
    (G) Specify that the controlled participants must use a consistent 
method of accounting to determine IDCs and RAB shares, as described in 
paragraphs (d) and (e) of this section, respectively, and must 
translate foreign currencies on a consistent basis;
    (H) Require the controlled participants to enter into CSTs covering 
all IDCs, as described in paragraph (b)(2) of this section, in 
connection with the CSA;
    (I) Require the controlled participants to enter into PCTs covering 
all external contributions, as described in paragraph (b)(3) of this 
section, in connection with the CSA; and
    (J) Specify the duration of the CSA, the conditions under which the 
CSA may be modified or terminated, and the consequences of a 
modification or termination (including consequences described under the 
rules of paragraph (f) of this section).
    (iii) Meaning of contemporaneous--(A) In general. For purposes of 
this paragraph (k)(1), a written contractual agreement is 
contemporaneous with the formation (or revision) of a CSA if, and only 
if, the controlled participants record the CSA, in its entirety, in a 
document that they sign and date no later than 60 days after the first 
occurrence of any IDC described in paragraph (d) of this section to 
which such agreement (or revision) is to apply.
    (B) Example. The following example illustrates the principles of 
this paragraph (k)(1)(iii):

    Example. Companies A and B, both of which are members of the 
same controlled group, commence an IDA on March 1, Year 1. Company A 
pays the first IDCs in relation to the IDA, as cash salaries to A's 
research staff, for the staff's work during the first week of March, 
Year 1. A and B, however, do not sign and date any written 
contractual agreement until August 1, Year 1, whereupon they execute 
a ``Cost Sharing Agreement'' that purports to be ``effective as of'' 
March 1 of Year 1. The arrangement fails the requirement that the 
participants record their arrangement in a written contractual 
agreement that is contemporaneous with the formation of a CSA.

    (2) CSA documentation requirements--(i) In general. The controlled 
participants must timely update and maintain sufficient documentation 
to establish that the participants have met the CSA contractual 
requirements of paragraph (k)(1) of this section and the additional CSA 
documentation requirements of this paragraph (k)(2).
    (ii) Additional CSA documentation requirements. The controlled 
participants to a CSA must timely update and maintain documentation 
sufficient to--
    (A) Identify the cost shared intangibles that the controlled 
participants have developed or intend to develop under the CSA, 
together with each controlled participant's interest therein;
    (B) Establish that each controlled participant reasonably 
anticipates that it will derive benefits from exploiting cost shared 
intangibles;
    (C) Describe the functions and risks that each controlled 
participant has undertaken during the term of the CSA;
    (D) Provide an overview of each controlled participant's business 
segments, including an analysis of the economic and legal factors that 
affect CST and PCT pricing;
    (E) Establish the amount of each controlled participant's IDCs for 
each taxable year under the CSA, including all IDCs attributable to 
stock-based compensation, as described in

[[Page 51160]]

paragraph (d)(3) of this section (including the method of measurement 
and timing used in determining such IDCs, and the data, as of the date 
of grant, used to identify stock-based compensation with the IDA);
    (F) Describe the method used to estimate each controlled 
participant's RAB share for each year during the course of the CSA, 
including--
    (1) All projections used to estimate benefits;
    (2) All updates of the RAB shares in accordance with paragraph 
(e)(1) of this section; and
    (3) An explanation of why that method was selected and why the 
method provides the most reliable measure for estimating RAB shares;
    (G) Describe all external contributions, as described in paragraph 
(b)(3)(ii) of this section;
    (H) Describe the RT for each PCT or group of PCTs;
    (I) Specify the form of payment due under each PCT or group of 
PCTs;
    (J) Describe and explain the method selected to determine the arm's 
length payment due under each PCT, including--
    (1) An explanation of why the method selected constitutes the best 
method, as described in Sec.  1.482-1(c)(2), for measuring an arm's 
length result;
    (2) The economic analyses, data, and projections relied upon in 
developing and selecting the best method, including the source of the 
data and projections use;
    (3) Each alternative method that was considered, and the reason or 
reasons that the alternative method was not selected;
    (4) Any data that the controlled participant obtains, after the CSA 
takes effect, that would help determine if the controlled participant 
method selected has been applied in a reasonable manner;
    (5) The discount rate, where applicable, used to value each payment 
due under a PCT, and a demonstration that the discount rate used is 
consistent with the principles of paragraph (g)(2)(vi) of this section;
    (6) The estimated arm's length values of any external contributions 
as of the dates of the relevant PCTs, in accordance with paragraph 
(g)(2)(ii) of this section;
    (7) A discussion, where applicable, of why transactions were or 
were not aggregated under the principles of paragraph (g)(2)(v) of this 
section;
    (8) The method payment form and any conversion made from the method 
payment form to the specified payment form, as described in paragraph 
(g)(2)(ix) of this section; and
    (9) If applicable under paragraph (i)(6)(iv) of this section, the 
WACC of the controlled group that includes the controlled participants.
    (iii) Coordination rules and production of documents--(A) 
Coordination with penalty regulations. See Sec.  1.6662-6(d)(2)(iii)(D) 
regarding coordination of the rules of this paragraph (k) with the 
documentation requirements for purposes of the accuracy-related penalty 
under section 6662(e) and (h).
    (B) Production of documentation. Each controlled participant must 
provide to the Commissioner, within 30 days of a request, the items 
described in paragraphs (k)(2) and (3) of this section. The time for 
compliance described in this paragraph (k)(2)(iii)(B) may be extended 
at the discretion of the Commissioner.
    (3) CSA accounting requirements--(i) In general. The controlled 
participants must maintain books and records (and related or underlying 
data and information) that are sufficient to--
    (A) Establish that the controlled participants have used (and are 
using) a consistent method of accounting to measure costs and benefits;
    (B) Translate foreign currencies on a consistent basis; and
    (C) To the extent that the method materially differs from U.S. 
generally accepted accounting principles, explain any such material 
differences.
    (ii) Reliance on financial accounting. For purposes of this 
section, the controlled participants may not rely solely upon financial 
accounting to establish satisfaction of the accounting requirements of 
this paragraph (k)(3). Rather, the method of accounting must clearly 
reflect income. Thor Power Tools Co. v. Commissioner, 439 U.S. 522 
(1979).
    (4) CSA reporting requirements--(i) CSA Statement. Each controlled 
participant must file with the Internal Revenue Service, in the manner 
described in this paragraph (k)(4), a ``Statement of Controlled 
Participant to Sec.  1.482-7 Cost Sharing Arrangement'' (CSA Statement) 
that complies with the requirements of this paragraph (k)(4).
    (ii) Content of CSA Statement. The CSA Statement of each controlled 
participant must--
    (A) State that the participant is a controlled participant in a 
CSA;
    (B) Provide the controlled participant's taxpayer identification 
number;
    (C) List the other controlled participants in the CSA, the country 
of organization of each such participant, and the taxpayer 
identification number of each such participant;
    (D) Specify the earliest date that any IDC described in paragraph 
(d)(1) of this section occurred; and
    (E) Indicate the date on which the controlled participants formed 
(or revised) the CSA and, if different from such date, the date on 
which the controlled participants recorded the CSA (or any revision) 
contemporaneously in accordance with paragraphs (k)(1)(i) and (iii) of 
this section.
    (iii) Time for filing CSA Statement--(A) 90-day rule. Each 
controlled participant must file its original CSA Statement with the 
Internal Revenue Service Ogden Campus, no later than 90 days after the 
first occurrence of an IDC to which the newly-formed CSA applies, as 
described in paragraph (k)(1)(iii)(A) of this section, or, in the case 
of a taxpayer that became a controlled participant after the formation 
of the CSA, no later than 90 days after such taxpayer became a 
controlled participant. A CSA Statement filed in accordance with this 
paragraph (k)(4)(iii)(A) must be dated and signed, under penalties of 
perjury, by an officer of the controlled participant who is duly 
authorized (under local law) to sign the statement on behalf of the 
controlled participant.
    (B) Annual return requirement--(1) In general. Each controlled 
participant must attach to its U.S. income tax return, for each taxable 
year for the duration of the CSA, a copy of the original CSA Statement 
that the controlled participant filed in accordance with the 90-day 
rule of paragraph (k)(4)(iii)(A) of this section. In addition, the 
controlled participant must update the information reflected on the 
original CSA Statement annually by attaching a schedule that documents 
changes in such information over time.
    (2) Special filing rule for annual return requirement. If a 
controlled participant is not required to file a U.S. income tax 
return, the participant must ensure that the copy or copies of the CSA 
Statement and any updates are attached to Schedule M of any Form 5471, 
any Form 5472, or any Form 8865, filed with respect to that 
participant.
    (iv) Examples. The following examples illustrate this paragraph 
(k)(4). In each example, Companies A and B are members of the same 
controlled group. The examples are as follows:

    Example 1. A and B, both of which file U.S. tax returns, agree 
to share the costs of developing a new chemical formula in 
accordance with the provisions of this section. On March 30, Year 1, 
A and B record their agreement in a written contract styled, ``Cost 
Sharing Agreement.'' The contract applies by its terms to IDCs 
occurring after

[[Page 51161]]

March 1, Year 1. The first IDCs to which the CSA applies occurred on 
March 15, Year 1. To comply with paragraph (k)(4)(iii)(A) of this 
section, A and B individually must file separate CSA Statements no 
later than 90 days after March 15, Year 1 (June 13, Year 1). 
Further, to comply with paragraph (k)(4)(iii)(B) of this section, A 
and B must attach copies of their respective CSA Statements to their 
respective Year 1 U.S. income tax returns.

    Example 2. The facts are the same as in Example 1, except that a 
year has passed and C, which files a U.S. tax return, joined the CSA 
on May 9, Year 2. To comply with the annual filing requirement 
described in paragraph (k)(4)(iii)(B) of this section, A and B must 
each attach copies of their respective CSA Statements (as filed for 
Year 1) to their respective Year 2 income tax returns, along with a 
schedule updated appropriately to reflect the changes in information 
described in paragraph (k)(4)(ii) of this section resulting from the 
addition of C to the CSA. To comply with both the 90-day rule 
described in paragraph (k)(4)(iii)(A) of this section and the annual 
filing requirement described in paragraph (k)(4)(iii)(B) of this 
section, C must file a CSA Statement no later than 90 days after May 
9, Year 2 (August 7, Year 2), and must attach a copy of such CSA 
Statement to its Year 2 income tax return.

    (l) Effective date. This section applies on the date of publication 
of this document as a final regulation in the Federal Register.
    (m) Transition rule--(1) In general. Subject to paragraph (m)(2) of 
this section, an arrangement in existence before the date of 
publication of this document as a final regulation in the Federal 
Register will be considered a CSA, as described under paragraph (b) of 
this section, if, prior to such date, it was a qualified cost sharing 
arrangement under the provisions of Sec.  1.482-7 (as contained in the 
26 CFR part 1 edition revised as of January 1, 1996, hereafter in this 
section referred to as ``former Sec.  1.482-7''), but only if the 
written contract, as described in paragraph (k)(1) of this section, is 
amended, if necessary, to conform with the provisions of this section, 
as modified by paragraph (m)(3) of this section, by the close of the 
120th day after the date of publication of this document as a final 
regulation in the Federal Register.
    (2) Termination of grandfather status. Notwithstanding paragraph 
(m)(1) of this section, an arrangement otherwise therein described will 
not be considered a CSA from the earliest of--
    (i) A failure of the controlled participants to substantially 
comply with the provisions of this section, as modified by paragraph 
(m)(3) of this section;
    (ii) A material change in the scope of the arrangement, such as a 
material expansion of the activities undertaken beyond the scope of the 
intangible development area, as described in former Sec.  1.482-
7(b)(4)(iv), as of the date of publication of this document as a final 
regulation in the Federal Register; or
    (iii) The date 50 percent or more of the value of the interests in 
cost shared intangibles are owned directly or indirectly by a person or 
persons that were not direct or indirect owners of such interests as of 
the date of publication of this document as a final regulation in the 
Federal Register.
    (3) Transitional modification of applicable provisions. For 
purposes of this paragraph (m), conformity and substantial compliance 
with the provisions of this section shall be determined with the 
following modifications:
    (i) CSTs and PCTs occurring prior to the date of publication of 
this document as a final regulation in the Federal Register shall be 
subject to the provisions of former Sec.  1.482-7 rather than this 
section. Notwithstanding the foregoing, PCTs of a CSA will be subject 
to the provisions of this section if there is a Periodic Trigger for 
such CSA for which a subsequent PCT, occurring on or after the date of 
publication of this document as a final regulation in the Federal 
Register, is the Trigger PCT.
    (ii) Paragraph (b)(1)(i) and paragraph (b)(4) of this section shall 
not apply.
    (iii) Paragraph (k)(1)(ii)(D) of this section shall not apply.
    (iv) Paragraph (k)(1)(ii)(H) and paragraph (k)(1)(ii)(I) of this 
section shall be construed as applying only to transactions entered 
into on or after the date of publication of this document as a final 
regulation in the Federal Register.
    (v) The deadline for recordation of the revised written contractual 
agreement pursuant to paragraph (k)(1)(iii) of this section shall be no 
later than the 120th day after the date of publication of this document 
as a final regulation in the Federal Register.
    (vi) Paragraphs (k)(2)(ii)(G) through (J) of this section shall be 
construed as applying only with reference to PCTs entered into on or 
after the date of publication of this document as a final regulation in 
the Federal Register.
    (vii) Paragraph (k)(4)(iii)(A) shall be construed as requiring a 
CSA Statement with respect to the revised written contractual agreement 
described in paragraph (m)(3)(iv) of this section no later than the 
180th day after the date of publication of this document as a final 
regulation in the Federal Register.
    (viii) Paragraph (k)(4)(iii)(B) shall be construed as only applying 
for taxable years ending after the filing of the CSA Statement 
described in paragraph (m)(3)(vii) of this section.
    Par. 9. Section 1.482-8 is amended by adding Examples 10 through 15 
at the end of the section to read as follows:


Sec.  1.482-8  Examples of the best method rule.

* * * * *
    Example 10. Preference for acquisition price method. (i) USP 
develops, manufacturers, and distributes ethical pharmaceutical 
products. USP and FS, USP's wholly-owned subsidiary, enter into a 
CSA to develop a new oncological drug, Oncol. Immediately prior to 
entering into the CSA, USP acquires Company X, an unrelated U.S. 
pharmaceutical company. Company X is solely engaged in oncological 
pharmaceutical research, and its only significant resources and 
capabilities are its workforce and its sole patent, which is 
associated with Compound Y, a promising molecular compound derived 
from a rare plant, which USP reasonably anticipates will contribute 
to developing Oncol. All of Company X researchers will be engaged 
solely in research that is reasonably anticipated to contribute to 
developing Oncol as well. The RT Rights in the Compound X and the 
commitment of Company X's researchers to the development of Oncol 
are external contributions for which compensation is due from FS as 
part of a PCT. Under the terms of the CSA, USP is to be compensated 
for its external contributions on a lump sum basis.
    (ii) In this case, the acquisition price method, based on the 
lump sum price paid by USP for Company X, is likely to provide a 
more reliable measure of an arm's length PCT Payment due to USP than 
the application of any other method.

    Example 11. Preference for market capitalization method. (i) 
Company X is a publicly traded U.S. company solely engaged in 
oncological pharmaceutical research and its only significant 
resources and capabilities are its workforce and the its sole 
patent, which is associated with Compound Y, a promising molecular 
compound derived from a rare plant. Company X has no marketable 
products. Company X enters into a CSA with FS, a newly-formed 
foreign subsidiary, to develop a new oncological drug, Oncol, 
derived from Compound Y. Compound X is reasonably anticipated to 
contribute to developing Oncol. All of Company X researchers will be 
engaged solely in research that is reasonably anticipated to 
contribute to the developing Oncol under the CSA. The RT Rights in 
Compound Y and the commitment of Company X's researchers are 
external contributions for which compensation is due from FS as part 
of a PCT. Under the terms of the CSA, Company X is to be compensated 
for its external contributions on a lump sum basis.
    (ii) In this case, given that Company X's external contributions 
covered by PCTs relate to its entire economic value, the application 
of the market capitalization method, based on the market 
capitalization of Company X, is likely to provide a more reliable 
measure of an arm's length result for Company X's PCTs

[[Page 51162]]

to the CSA than the application of any other method.

    Example 12. Preference for market capitalization method. (i) 
MicroDent, Inc. (MDI) is a publicly traded company that developed a 
new dental surgical microscope ScopeX-1, which drastically shortens 
many surgical procedures. On January 1 of Year 1, MDI entered into a 
CSA with a wholly-owned foreign subsidiary (FS) to develop ScopeX-2, 
the next generation of ScopeX-1. The RT Rights associated with 
ScopeX-1, as well as MDI's research capabilities are reasonably 
anticipated to contribute to the development of ScopeX-2 and are 
therefore external contributions for which compensation is due from 
FS as part of a PCT. Under the terms of the CSA, MDI is to be 
compensated for its external contributions on a lump sum basis. At 
the time of the PCT, MDI's only product was the ScopeX-I microscope, 
although MDI was in the process of developing ScopeX-2. Concurrent 
with the CSA, MDI separately transfers exclusive and perpetual 
exploitation rights associated with ScopeX-1 to FS in the same 
specified geographic area as assigned to FS in the CSA.
    (ii) Although the transactions between MDI and FS under the CSA 
are distinct from the transactions between MDI and FS relating to 
the exploitation rights for ScopeX-1, it is likely to be more 
reliable to evaluate the combined effect of the transactions than to 
evaluate them in isolation. This is because the combined 
transactions between MDI and FS relate to all of the economic value 
of MDI (that is, the exploitation rights and research rights 
associated with ScopeX-1, as well as the research capabilities of 
MDI). In this case, application of the market capitalization method, 
based on the enterprise value of MDI on January 1 of Year 1, is 
likely to provide a more reliable measure of an arm's length payment 
for the aggregated transactions than the application of any other 
method.
    (iii) Notwithstanding that the market capitalization method 
provides the most reliable measure of the aggregated transactions 
between MDI and FS, see paragraph (g)(2)(v) of this section for 
further considerations of when further analysis may be required to 
distinguish between the remuneration to MDI associated with PCTs 
under the CSA (for research rights and capabilities associated with 
ScopeX-1) and the remuneration to MDI for the exploitation rights 
associated with ScopeX-1.

    Example 13. Income method (CPM-based) preferred to acquisition 
price method. The facts are the same as Example 10, except that the 
acquisition occurred significantly in advance of formation of the 
CSA, and reliable adjustments cannot be made for this time 
difference. In addition, Company X has other valuable molecular 
patents and associated research capabilities, apart from Compound Y, 
that are not reasonably anticipated to contribute to the development 
of Oncol and that cannot be reliably valued. Under the terms of the 
CSA, USP will undertake all R&D (consisting of laboratory research 
and clinical testing) and manufacturing associated with Oncol, as 
well as the distribution activities for its assigned area (the 
United States). FS will distribute Oncol in its assigned area (the 
rest of the world). FS's distribution activities are routine in 
nature, and the profitability from its activities may be reliably 
determined from third-party comparables. FS does not furnish any 
external contributions. At the time of the PCT, reliable (ex ante) 
financial projections associated with the development of Oncol and 
its separate exploitation in each of USP's and FSub's assigned 
geographical territories are undertaken. In this case, application 
of the income method is likely to provide a more reliable measure of 
an arm's length result than application of the acquisition price 
method based on the price paid by USP for Company X.

    Example 14. Evaluation of alternative methods. (i) The facts are 
the same as Example 10, except that the acquisition occurred 
sometime prior to the CSA, and Company X has some areas of promising 
research that are not reasonably anticipated to contribute to 
developing Oncol. In general, the Commissioner determines that the 
acquisition price data is useful in informing the arm's length 
price, but not necessarily determinative. Under the terms of the 
CSA, USP will undertake all R&D (consisting of laboratory research 
and clinical testing) and manufacturing associated with Oncol, as 
well as the distribution activities for its assigned area (the 
United States). FS will distribute Oncol in its assigned area (the 
rest of the world). FS's distribution activities are routine in 
nature, and the profitability from its activities may be reliably 
determined from third-party comparables. At the time of the PCT, 
financial projections associated with the development of Oncol and 
its separate exploitation in each of USP's and FSub's assigned 
geographical territories are undertaken.
    (ii) Under the facts, it is possible that the acquisition price 
method or the CPM-based income method might reasonably be applied. 
Whether the acquisition price method or the income method provides 
the most reliable evidence of the arm's length price of USP' 
contributions depends on a number of factors, including the 
reliability of the financial projections, the reliability of the 
discount rate chosen, and the extent to which the acquisition price 
of Company X can be reliably adjusted to account for changes in 
value over the time period between the acquisition and the formation 
of the CSA and to account for the value of the in-process research 
done by Company X that does not constitute external contributions to 
the CSA.

    Example 15. Evaluation of alternative methods. (i) The facts are 
the same as Example 14, except that FS has a patent on Compound Y, 
which the parties reasonably anticipate will be useful in mitigating 
potential side effects associated with Compound X and thereby 
contribute to the development of Oncol. The RT Rights in Compound Y 
constitute an external contribution for which compensation is due 
from USP as part of a PCT. The value of FS's external contribution 
cannot be reliably measured by market benchmarks.
    (ii) Under the facts, it is possible that either the acquisition 
price method and the income method together or the residual profit 
split method might reasonably be applied to determine the arm's 
length PCT Payments due between USP and FS. Under the first option 
the PCT Payment for the external contributions related to Company 
X's workforce and Compound X would be determined using the 
acquisition price method referring to the lump sum price paid by USP 
for Company X. Because the value of these external contributions can 
be determined by reference to a market benchmark they are considered 
routine external contributions. Accordingly, under this option, the 
external contribution related to Compound Y would be the only 
nonroutine external contribution and the relevant PCT Payment is 
determined using the income method. Under the second option, rather 
than looking to the acquisition price for Company X, all the 
external contributions are considered nonroutine and the RPSM is 
applied to determine the PCT Payments for each external 
contribution. Under either option, the PCT Payments will be netted 
against each other.
    (iii) Whether the acquisition price method together with the 
income method or the residual profit split method provides the most 
reliable evidence of the arm's length price of the external 
contributions of USP and FS depends on a number of factors, 
including the reliability of the determination of the relative 
values of the external contributions for purposes of the RPSM, and 
the extent to which the acquisition price of Company X can be 
reliably adjusted to account for changes in value over the time 
period between the acquisition and the formation of the CSA and to 
account for the value of the RT Rights in the in-process research 
done by Company X that does not constitute external contributions to 
the CSA. In these circumstances, it is also relevant to consider 
whether the results of each method are consistent with each other, 
or whether one or both methods are consistent with other potential 
methods that could be applied.

    Par. 10. Section 1.861-17 is amended by revising paragraph 
(c)(3)(iv) to read as follows:


Sec.  1.861-17  Allocation and apportionment of research and 
experimental expenditures.

* * * * *
    (c) * * *
    (3) * * *
    (iv) Effect of cost sharing arrangements. If the corporation 
controlled by the taxpayer has entered into a cost sharing arrangement, 
in accordance with the provisions of Sec.  1.482-7, with the taxpayer 
for the purpose of developing intangible property, then that 
corporation shall not reasonably be expected to benefit from the 
taxpayer's share of the research expense.
* * * * *
    Par. 11. Section 1.6662-6 is amended by:
    1. Removing the third and fourth sentence of paragraph (d)(2)(i).
    2. Adding paragraph (d)(2)(iii)(D).
    The addition reads as follows:

[[Page 51163]]

Sec.  1.6662-6  Transaction between persons described in section 482 
and net section 482 transfer price adjustments.

* * * * *
    (d) * * *
    (2) * * *
    (iii) * * *
    (D) Satisfaction of the documentation requirements described in 
Sec.  1.482-7(k)(2) for the purpose of complying with the rules for 
CSAs under Sec.  1.482-7 also satisfies all of the documentation 
requirements listed in paragraph (d)(2)(iii)(B) of this section, except 
the requirements listed in paragraphs (2) and (10) of such paragraph, 
with respect to CSTs and PCTs described in Sec.  1.482-7(b)(2) and (3), 
provided that the documentation also satisfies the requirements of 
paragraph (d)(2)(iii)(A) of this section.
* * * * *

PART 301--PROCEDURE AND ADMINISTRATION

    Par. 12. The authority for part 301 continues to read, in part, as 
follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 13. Section 301.7701-1 is amended by revising paragraph (c) to 
read as follows:


Sec.  301.7701-1  Classification of organizations for federal tax 
purposes.

* * * * *
    (c) Cost sharing arrangements. A cost sharing arrangement that is 
described in Sec.  1.482-7 of this chapter, including any arrangement 
that the Commissioner treats as a CSA under Sec.  1.482-7(b)(5) of this 
chapter, is not recognized as a separate entity for purposes of the 
Internal Revenue Code. See Sec.  1.482-7 of this chapter for the rules 
regarding CSAs.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-16626 Filed 8-22-05; 2:48 pm]
BILLING CODE 4830-01-P