[Federal Register Volume 78, Number 166 (Tuesday, August 27, 2013)]
[Rules and Regulations]
[Pages 52854-52856]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-20786]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9630 ]
RIN 1545-BK71


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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SUMMARY: This document contains final 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 and as a 
specified application of the income method.

DATES: Effective Date: These regulations are effective on August 27, 
2013.
    Applicability Dates: For dates of applicability, see Sec.  1.482-
7(l).

FOR FURTHER INFORMATION CONTACT: Mumal R. Hemrajani, (202) 622-3800 
(not a toll-free call).

SUPPLEMENTARY INFORMATION: 

Background

    Final cost sharing regulations were published in the Federal 
Register (76 FR 80082) (REG-144615-02) (TD 9568) on December 22, 2011 
(``final cost sharing regulations''). Corrections to the final cost 
sharing regulations were published in the Federal Register (77 FR 3606, 
77 FR 8143, and 77 FR 8144) on January 25, 2012, and February 14, 2012. 
Certain guidance regarding application of the differential income 
stream approach was reserved in the final cost sharing regulations 
because the Treasury Department and the IRS believed it was appropriate 
to solicit public comments on that subject matter.
    Temporary cost sharing regulations and a notice of proposed rule 
making on application of the differential income stream approach were 
published in the Federal Register (76 FR 80249 and 76 FR 80309) (REG-
145474-11) (TD 9569) on December 23, 2011 (``temporary and proposed 
regulations''). Comments were submitted, which we address in this 
Preamble. No request for a public hearing was received. The Treasury 
Department and the IRS are finalizing the proposed regulations without 
change.

Explanation of Provisions

    The Treasury Department and the IRS were aware that some taxpayers 
were 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. This practice gave rise to material distortions and the 
potential for PCT Payments not in accordance with the arm's length 
standard. To address these problems, the temporary and proposed 
regulations provided additional guidance on evaluating the results of 
an application of the income method (Sec.  1.482-7T(g)(2)(v)(B)(2) 
(Implied discount rates) and (g)(4)(vi)(F)(2) (Use of differential 
income stream as a consideration in assessing the best method)), and

[[Page 52855]]

provided 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)).
    Comments noted that Sec.  1.482-7T(g)(4)(vi)(F)(2) explicitly 
provides that the implied discount rate may be used to evaluate the 
reliability of the corresponding actual discount rates associated with 
the licensing and cost sharing alternatives, but no similar explicit 
provision is contained in Sec.  1.482-7(g)(4)(v) regarding the use of 
actual discount rates to evaluate the reliability of the corresponding 
implied discount rate. Thus, the comments suggested that such an 
explicit provision be adopted. The Treasury Department and the IRS 
agree that, depending on facts and circumstances, separately derived 
discount rates pursuant to a general application of the income method 
may yield a more reliable measure of an arm's length result than a 
proffered discount rate pursuant to a differential income stream 
application of the income method in a particular case. In such a case, 
however, the best method rule already would require a determination of 
PCT Payments under the method, and the application of such method, 
that, under the facts and circumstances, provides the most reliable 
measure of an arm's length result. See, for example, Sec. Sec.  1.482-
1(c)(1) and 1.482-7(g)(4)(vi)(A). Accordingly, the suggested change was 
not adopted.

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 author of these regulations is 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 continues to read in 
part as follows:

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

0
Par. 2. Section 1.482-7 is amended by revising paragraph 
(g)(2)(v)(B)(2), adding paragraph (g)(4)(v), revising paragraphs 
(g)(4)(vi)(F)(2), (g)(4)(viii) Example 8, adding Example 9, and 
revising paragraph (l).


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

* * * * *
    (g) * * *
    (2) * * *
    (v) * * *
    (B) * * *
    (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.
* * * * *
    (4) * * *
    (v) Application of income method using differential income stream. 
In some cases, the present value of an arm's length PCT Payment may be 
determined as the present value, discounted at the appropriate rate, of 
the PCT Payor's reasonably anticipated stream of additional positive or 
negative income over the duration of the CSA Activity that would result 
(before PCT Payments) from undertaking the cost sharing alternative 
rather than the licensing alternative (differential income stream). See 
Example 9 of paragraph (g)(4)(viii) of this section.
* * * * *
    (vi) * * *
    (F) * * *
    (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 
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).
* * * * *
    (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

[[Page 52856]]

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 (g)(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).
    Example 9. The facts are the same as in Example 1, except that 
additional data on discount rates are available that were not 
available in Example 1. The Commissioner determines the arm's length 
charge for the PCT Payment by discounting at an appropriate rate the 
differential income stream associated with the rights contributed by 
USP in the PCT (that is, the stream of income in column (11) of 
Example 1). Based on an analysis of a set of public companies whose 
resources, capabilities, and rights consist primarily of resources, 
capabilities, and rights similar to those contributed by USP in the 
PCT, the Commissioner determines that 15% to 17% is an appropriate 
range of discount rates to use to assess the value of the 
differential income stream associated with the rights contributed by 
USP in the PCT. The Commissioner determines that applying a discount 
rate of 17% to the differential income stream associated with the 
rights contributed by USP in the PCT yields a present value of $446 
million, while applying a discount rate of 15% to the differential 
income stream associated with the rights contributed by USP in the 
PCT yields a present value of $510 million. Because the taxpayer's 
result, $464 million, is within the interquartile range determined 
by the Commissioner, no adjustments are warranted. See paragraphs 
(g)(2)(v)(B)(2), (g)(4)(v), and (g)(4)(vi)(F)(1) of this section.
* * * * *
    (l) Effective/applicability dates. Except as otherwise provided in 
this paragraph (l), this section applies on December 16, 2011. 
Paragraphs (g)(2)(v)(B)(2), (g)(4)(vi)(F)(2), and (g)(4)(viii), Example 
8 of this section apply to taxable years beginning on or after December 
19, 2011. Paragraphs (g)(4)(v) and (g)(4)(viii), Example 9 apply to 
taxable years beginning on or after August 27, 2013.
* * * * *


Sec.  1.482-7T  [Removed]

0
Par. 3. Section 1.482-7T is removed.

Beth Tucker,
Deputy Commissioner for Operations Support.
    Approved: August 15, 2013.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2013-20786 Filed 8-26-13; 8:45 am]
BILLING CODE 4830-01-P