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 §1.482-7 regulations and these proposed regulations provide rules governing cost sharing arrangements consistent with the commensurate with 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 §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 §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:

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 §1.482-7 relating to cost sharing arrangements. They revise §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, §§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 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 §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 §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.

Consistent with the rules governing other controlled transactions (for example, transfers of tangibles and intangibles under existing §§1.482-3 and 1.482-4), proposed §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 the 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 §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 §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 §§1.482-1 and 1.482-4 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 §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.

Under §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 §1.482-7(b) identifies two groups of transactions that are integral 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 arrangement 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:

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

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 §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.

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 §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 §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 limitations conform to economic substance and the parties’ conduct. See §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 §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 §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.

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 §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, 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.

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.

 Pursuant to proposed §1.482-7(b) (5)(i), as under the existing regulations, the Commissioner may, consistently with §1.482-1(d)(3)(ii)(B) (Identifying contractual terms), apply the §1.482-7 rules to any arrangement that in substance constitutes a CSA in accordance with the three substantive requirements enumerated in proposed §1.482-7(b)(1)(i) through (iii), notwithstanding a failure otherwise to meet the §1.482-7 requirements.

Provided a taxpayer has followed the formal requirements enumerated in proposed §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.

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 §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 §1.482-7(g)(2)(v).

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 §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 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 §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.

Proposed §1.482-7(e) restates existing §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 §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.

Proposed §1.482-7(f) replaces existing §1.482-7(g)(3) and (4), as well as the third and fourth sentences of existing §1.482-7(g)(1). This provision clarifies the application of the rules of §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 §§1.482-1 and 1.482-4 through 1.482-6.

Proposed §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 §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).

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 §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.

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 §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 §1.482-1(f)(2)(i) and proposed §1.482-7(g)(2)(v) regarding aggregation of transactions.

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 §1.482-1(b)(2)(ii), proposed §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 §§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 §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 §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 §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 §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 §1.482-7(g)(1) provides that each method must be applied in accordance with the provisions of §1.482-1, including the best method rule of §1.482-1(c), the comparability analysis of §1.482-1(d), and the arm’s length range of §1.482-1(e), except as those provisions are modified in §1.482-7(g).

The proposed regulations provide general principles for valuing PCT Payments, applicable for both specified and unspecified methods.

Existing §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 §1.482-7(b)(1)(ii), (b)(3), and (k)(1). Proposed §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 §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 §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 §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 §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.

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 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.

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 §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.

The proposed regulations provide that multiple PCTs, or one or more PCTs and one or more transactions not governed by proposed §1.482-7 (such as a make-or-sell license excluded from CSA coverage by proposed §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 §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 §1.482-7(i)(6).

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.

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.

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 of return equal to the appropriate discount rate for the CSA. If the anticipated rate of 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 diminishes the value of the buy-in payments, such that 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.

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 §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.

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 §1.482-7(g)(7). Such application of the residual profit split method wo