[Federal Register Volume 76, Number 247 (Friday, December 23, 2011)]
[Rules and Regulations]
[Pages 80249-80251]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-32728]



[[Page 80249]]

=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9569]
RIN 1545-BK72


Use of Differential Income Stream as a Consideration in Assessing 
the Best Method

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains temporary regulations that implement 
the use of the differential income stream as a consideration in 
assessing the best method in connection with a cost sharing 
arrangement. The text of these temporary regulations also serves as 
part of the text of proposed regulations contained in a cross-reference 
notice of proposed rulemaking (REG-145474-11) published in the Proposed 
Rules section in this issue of the Federal Register. This document also 
contains final regulations that provide cross-references in the final 
cost sharing regulations to relevant sections of these temporary 
regulations.

DATES: Effective Date: These regulations are effective December 19, 
2011.
    Applicability Dates: For dates of applicability, see Sec.  1.482-
7T(l).

FOR FURTHER INFORMATION CONTACT: Joseph L. Tobin or Mumal R. Hemrajani, 
(202) 435-5265 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Background

    A notice of proposed rulemaking and notice of public hearing 
regarding additional guidance to improve compliance with, and 
administration of, the rules in connection with a cost sharing 
arrangement (CSA) were published in the Federal Register (70 FR 51116) 
(REG-144615-02) on August 29, 2005 (2005 proposed regulations). A 
correction to the notice of proposed rulemaking and notice of public 
hearing was published in the Federal Register (70 FR 56611) on 
September 28, 2005. A public hearing was held on December 16, 2005.
    The Treasury Department and the IRS received numerous comments on a 
wide range of issues addressed in the 2005 proposed regulations. In 
response to these comments, temporary and proposed regulations were 
published in the Federal Register (74 FR 340-01 and 74 FR 236-01) (REG-
144615-02) on January 5, 2009 (2008 temporary regulations). Corrections 
to the 2008 temporary regulations were published in the Federal 
Register on February 27, 2009 (74 FR 8863-01), March 5, 2009 (74 FR 
9570-01, 74 FR 9570-02, and 74 FR 9577-01), and March 19, 2009 (74 FR 
11644-01). A public hearing was held on April 21, 2009.
    The Treasury Department and the IRS received comments on a range of 
issues addressed in the 2008 temporary regulations. Final regulations 
were issued in a previous issue of the Federal Register (REG-144615-02) 
(TD 9568) in December 2011 (``final regulations''). Certain guidance 
regarding discount rates was reserved in the final regulations because 
the Treasury Department and the IRS believe it is appropriate to 
solicit public comments on that subject matter. As explained herein, 
these temporary regulations provide a portion of that reserved guidance 
on discount rates. Simultaneous with these temporary regulations, the 
other portion of such reserved guidance concerning discount rates is 
being provided in proposed regulations elsewhere in this issue of the 
Federal Register (proposed regulations).

 Explanation of Provisions

    The Treasury Department and the IRS are aware that some taxpayers 
are taking unreasonable positions in applying the income method by 
using relatively low licensing discount rates, and relatively high cost 
sharing discount rates, without sufficiently considering the 
appropriate interrelationship of the discount rates and financial 
projections, thus deriving PCT Payments that are not in accordance with 
the arm's length standard.
    In light of these concerns, the Treasury Department and the IRS are 
providing additional guidance as follows: (1) In the final regulations, 
further guidance on comparing the financial projections associated with 
the cost sharing alternative discounted at the rate appropriate for the 
cost sharing alternative with the financial projections associated with 
the licensing alternative discounted at the rate appropriate for the 
licensing alternative, and evaluating reliability considerations 
associated with such a comparison (Sec.  1.482-7(g)(4)(vi)(F)(1) 
(Reflection of similar risk profiles in cost sharing alternative and 
licensing alternative)); (2) in these temporary regulations, further 
guidance on evaluating results of application of the income method 
(Sec.  1.482-7T(g)(2)(v)(B)(2) (Implied discount rates) and 
(4)(vi)(F)(2) (Use of differential income stream as a consideration in 
assessing the best method)); and (3) in proposed regulations, a new 
specified application of the income method for directly determining the 
arm's length charge for PCT Payments (Sec.  1.482-7(g)(4)(v) 
(Application of income method using differential income stream)).
    As discussed in the Preamble to the final regulations, any 
difference, if any, in market-correlated risks between the licensing 
and cost sharing alternatives is due solely to the different effects on 
risks of the PCT Payor's making licensing payments under the licensing 
alternative on the one hand, and the PCT Payor's making cost 
contributions and PCT Payments under the cost sharing alternative on 
the other hand. Thus, the difference in risk between the two scenarios 
should reflect solely (1) the incremental risk, if any, associated with 
the cost contributions taken on by the PCT Payor in developing cost 
shared intangibles under the cost sharing alternative, and (2) any 
difference in risk associated with the particular payment forms of the 
licensing payments and the PCT Payments, in light of the fact that the 
licensing payments in the licensing alternative are partially replaced 
by cost contributions and partially replaced by PCT Payments in the 
cost sharing alternative, each with its own payment form. Accordingly, 
the final regulations added Sec.  1.482-7(g)(4)(vi)(F)(1) (Reflection 
of similar risk profiles in cost sharing alternative and licensing 
alternative), which provides that an analysis under the income method 
that uses a different discount rate for the cost sharing alternative 
than the licensing alternative will be more reliable the greater the 
extent to which any difference between the two discount rates reflects 
solely those differences in risk profiles of these two alternatives.
    These temporary regulations build upon Sec.  1.482-
7(g)(4)(vi)(F)(1) of the final regulations by providing additional 
guidance relating to analysis of the interrelationship between the 
discount rate for the cost sharing alternative and the discount rate 
for the licensing alternative, and evaluation of the reasonableness of 
the implied discount rate that may be derived from the differential 
income stream between the licensing alternative and the cost sharing 
alternative. The differential income stream is the difference between 
the PCT Payor's undiscounted operating income under the cost sharing 
alternative (before PCT Payments) and the PCT Payor's undiscounted 
operating income under the licensing alternative. This difference 
equals the licensing payments to be made under the licensing 
alternative minus the PCT

[[Page 80250]]

Payor's cost contributions to be made under the cost sharing 
alternative. The differential income stream should be discounted at an 
appropriate rate in order to evaluate the reliability of a 
determination of the arm's length charge for the PCT Payment. 
Accordingly, these temporary regulations add Sec.  1.482-
7T(g)(4)(vi)(F)(2), which provides that an analysis under the income 
method that uses a different discount rate for the cost sharing 
alternative than for the licensing alternative will be more reliable 
the greater the extent to which the implied discount rate for the 
projected present value of the differential income stream is consistent 
with reliable direct evidence of the appropriate discount rate 
applicable for activities reasonably anticipated to generate an income 
stream with a similar risk profile to the differential income stream 
(such as those of the uncontrolled companies described in Sec.  1.482-
7T(g)(4)(viii) Example 8). The Treasury Department and the IRS have 
added Sec.  1.482-7T(g)(4)(viii) Example 8 to illustrate how Sec.  
1.482-7T(g)(4)(vi)(F)(2) may be used to evaluate the reliability of a 
particular application of the income method.
    The Treasury Department and the IRS are also proposing a new 
specified application of the income method in Sec.  1.482-7(g)(4)(v), 
which provides that the determination of the arm's length charge for 
the PCT Payment can be derived by discounting the differential income 
stream at an appropriate rate. The differential income stream approach 
to determining PCT Payments depends on reliably determining the 
discount rate associated with the differential income stream. This, in 
turn, requires an understanding of the economic meaning of the 
differential income stream. For example, assume a CSA in which the PCT 
Payor does not contribute any platform or operating contributions, and 
undertakes only routine exploitation activities for which it 
anticipates a routine return. In such case, the total undiscounted 
anticipated profits (before PCT Payments) to the CSA in the PCT Payor's 
territory can be thought of as comprising the anticipated routine 
exploitation profits plus the anticipated profits associated with the 
development of the cost shared intangibles in the PCT Payor's 
territory. Under the licensing alternative, on the other hand, the PCT 
Payor's total undiscounted anticipated profits consist solely of the 
anticipated routine exploitation profits. Thus, the differential income 
stream conceptually corresponds to the anticipated development profits 
of the cost shared intangibles. For these reasons, an appropriate 
discount rate for the differential income stream might be determined 
based, for example, on the weighted average cost of capital of 
uncontrolled companies whose activities consist primarily of developing 
intangibles similar to the cost shared intangibles, and whose 
resources, capabilities, or rights are similar to the platform 
contributions and cost shared intangibles under the CSA. The proposed 
regulations also add Sec.  1.482-7(g)(4)(viii) Example 9 to illustrate 
this newly specified application of the income method.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to this regulation, and because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, these 
regulations have been submitted to the Chief Counsel for Advocacy of 
the Small Business Administration (CCASBA) for comment on their impact 
on small business. CCASBA had no comments.

Drafting Information

    The principal authors of these regulations are Joseph L. Tobin and 
Mumal R. Hemrajani, Office of the Associate Chief Counsel 
(International). However, other personnel from the Internal Revenue 
Service and the Treasury Department participated in the development of 
the regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *
    Sections 1.482-7 and 1.482-7T also issued under 26 U.S.C. 482. * 
* *


0
Par. 2. Section 1.482-7 is amended by revising paragraphs 
(g)(2)(v)(B)(2) and (g)(4)(vi)(F)(2), and adding Example 8 to paragraph 
(g)(4)(viii), to read as follows:


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

* * * * *
    (g) * * *
    (2) * * *
    (v) * * *
    (B) * * *
    (2) [Reserved]. For further guidance, see Sec.  1.482-
7T(g)(2)(v)(B)(2).
* * * * *
    (4) * * *
    (vi) * * *
    (F) * * *
    (2) [Reserved]. For further guidance, see Sec.  1.482-
7T(g)(4)(vi)(F)(2).
* * * * *
    (viii) * * *
    Example 8. [Reserved]. For further guidance, see Sec.  1.482-
7T(g)(4)(viii), Example 8.
* * * * *

0
Par. 3. Section 1.482-7T is added to read as follows:


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

    (a) through (g)(2)(v)(B)(1) [Reserved]. For further guidance, see 
Sec.  1.482-7(a) through (g)(2)(v)(B)(1).
    (2) Implied discount rates. In some circumstances, the particular 
discount rate or rates used for certain activities or transactions 
logically imply that certain other activities will have a particular 
discount rate or set of rates (implied discount rates). To the extent 
that an implied discount rate is inappropriate in light of the facts 
and circumstances, which may include reliable direct evidence of the 
appropriate discount rate applicable for such other activities, the 
reliability of any method is reduced where such method is based on the 
discount rates from which such an inappropriate implied discount rate 
is derived. See paragraphs (g)(4)(vi)(F)(2) and (g)(4)(viii), Example 8 
of this section.
    (g)(2)(v)(B)(3) through (g)(4)(vi)(F)(1) [Reserved]. For further 
guidance, see Sec.  1.482-7(g)(2)(v)(B)(3) through (g)(4)(vi)(F)(1).
    (2) Use of differential income stream as a consideration in 
assessing the best method. An analysis under the income method that 
uses a different discount rate for the cost sharing alternative than 
for the licensing alternative will be more reliable the greater the 
extent to which the implied discount rate for the projected present 
value of the differential income stream is consistent with reliable 
direct evidence of the appropriate discount rate applicable for 
activities reasonably anticipated to generate an income stream with a

[[Page 80251]]

similar risk profile to the differential income stream. Such 
differential income stream is defined as the stream of the reasonably 
anticipated residuals of the PCT Payor's licensing payments to be made 
under the licensing alternative, minus the PCT Payor's cost 
contributions to be made under the cost sharing alternative. See, for 
example, Example 8 of this paragraph (g)(4)(viii).
    (g)(4)(vii) through (viii) (Example 7) [Reserved]. For further 
guidance, see Sec.  1.482-7(g)(4)(vii) through (g)(4)(viii) (Example 
7).

    (viii) Example 8. (i) The facts are the same as in Example 1, 
except that the taxpayer determines that the appropriate discount 
rate for the cost sharing alternative is 20%. In addition, the 
taxpayer determines that the appropriate discount rate for the 
licensing alternative is 10%. Accordingly, the taxpayer determines 
that the appropriate present value of the PCT Payment is $146 
million.
    (ii) Based on the best method analysis described in Example 2, 
the Commissioner determines that the taxpayer's calculation of the 
present value of the PCT Payments is outside of the interquartile 
range (as shown in the sixth column of Example 2), and thus warrants 
an adjustment. Furthermore, in evaluating the taxpayer's analysis, 
the Commissioner undertakes an analysis based on the difference in 
the financial projections between the cost sharing and licensing 
alternatives (as shown in column 11 of Example 1). This column shows 
the anticipated differential income stream of additional positive or 
negative income for FS over the duration of the CSA Activity that 
would result from undertaking the cost sharing alternative (before 
any PCT Payments) rather than the licensing alternative. This 
anticipated differential income stream thus reflects the anticipated 
incremental undiscounted profits to FS from the incremental activity 
of undertaking the risk of developing the cost shared intangibles 
and enjoying the value of its divisional interests. Taxpayer's 
analysis logically implies that the present value of this stream 
must be $146 million, since only then would FS have the same 
anticipated value in both the cost sharing and licensing 
alternatives. A present value of $146 million implies that the 
discount rate applicable to this stream is 34.4%. Based on a 
reliable calculation of discount rates applicable to the anticipated 
income streams of uncontrolled companies whose resources, 
capabilities, and rights consist primarily of software applications 
intangibles and research and development teams similar to USP's 
platform contributions to the CSA, and which income streams, 
accordingly, may be reasonably anticipated to reflect a similar risk 
profile to the differential income stream, the Commissioner 
concludes that an appropriate discount rate for the anticipated 
income stream associated with USP's platform contributions (that is, 
the additional positive or negative income over the duration of the 
CSA Activity that would result, before PCT Payments, from switching 
from the licensing alternative to the cost sharing alternative) is 
16%, which is significantly less than 34.4%. This conclusion further 
suggests that Taxpayer's analysis is unreliable. See paragraphs 
(g)(2)(v)(B)(2) and (4)(vi)(F)(1) and (2) of this section.
    (iii) The Commissioner makes an adjustment of $296 million, so 
that the present value of the PCT Payments is $442 million (the 
median results as shown in column 6 of Example 2).
    (g)(5) through (k) [Reserved]. For further guidance, see Sec.  
1.482-7(g)(5) through (k).

    (l) Effective/Applicability Date. Treas. Reg. Sec.  1.482-
7T(g)(2)(v)(B)(2), (g)(4)(vi)(F)(2) and (g)(4)(viii), Example 8 apply 
to taxable years beginning on or after December 19, 2011.
    (m) [Reserved]. For further guidance, see Sec.  1.482-7(m).
    (n) Expiration date. The applicability of this section expires on 
December 19, 2014.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: December 8, 2011.
Emily S. McMahon,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2011-32728 Filed 12-19-11; 11:15 am]
BILLING CODE 4830-01-P