June 5, 2009
Re: Proposed Regulations on Methods to Determine Taxable Income in connection with a Cost Sharing Arrangement (REG-144615-02)
Dear Messrs. Mundaca and Musher:
This letter follows up on two questions posed to Tax Executives Institute during the April 21 IRS hearing on the proposed cost sharing regulations. The questions related to the definition of variable input parameters and the methodology for reflecting risks. Dorothy C. Chao, a member of TEI’s International Tax Committee, represented the Institute at the hearing.
I. Variable Input Parameters
In the preamble to the regulations, the Treasury Department and IRS solicited comments on “the limitation of variable input parameters to market-based parameters.” At the hearing, TEI was asked whether the definition of variable input parameters should be broadened to include projections to take into account the probability of different outcomes. TEI believes the answer is no.
Temp. Reg. § 1.482-7T(g)(2)(ix)(B) states:
An applicable method may determine [platform cost transaction] PCT Payments based on calculations involving two or more parameters whose values depend on the facts and circumstances of the case (input parameters). For some input parameters (market-based input parameters), the value is most reliably determined by reference to data that derive from uncontrolled transactions (market data).
The regulation provides two examples. First, the profit level of a comparable company may be used to determine the value of the return to a controlled participant’s routine contributions. Second, the stock beta of a comparable company may be used to determine the value for the discount rate that reflects the riskiness of a controlled participant’s role in the CSA.
Temp. Reg. § 1.482-7T(g)(2)(ix)(C) provides that “[f]or some market-based input parameters (variable input parameters), the parameter’s value is most reliably determined by considering two or more observations of market data that have, or with adjustment can be brought to, a similar reliability and comparability . . . (for example, profit levels or stock betas of two or more companies).” Clause (D)(2) provides that if there is only one variable input parameter, the arm’s-length range of PCT Payments is the interquartile range calculated iteratively by varying the value of the variable input parameter each time. Clause (D)(3) further provides that if there are two or more variable input parameters, the arm’s-length range of PCT Payments is the interquartile range calculated iteratively by using every possible combination of permitted choices of values for the input parameters. An example of this methodology is found in Temp. Reg. § 1.482-7T(g)(4)(vii), Example 2.
TEI believes it is not feasible to expand the iterative interquartile range methodology mandated by Temp. Reg. § 1.482-7T(g)(2)(ix)(D) for variable input parameters beyond market-based input parameters. Applying this methodology to risk-based projections regarding sales, intangible development costs (IDCs), costs of developing operating contributions, routine operating expenses, costs of sales, the effect of delays, probabilities of R&D success, etc., would be difficult because each possible value for a given projection parameter will most likely not have an equal weight. For example, the probability of sales being, say, $200 may differ from the probability that sales will be either $100 or $300 in a given year.
TEI believes that the methodology for two or more variable input parameters described in Temp. Reg. § 1.482-7T(g)(2)(ix)(D)(3) and § 1.482-7T(g)(4)(vii), Example 2 could break down when dealing with, say, six or ten variable input parameters, each with its own probability distribution. In other words, a computation that must take into account “every possible combination of permitted choices of values for the input parameters” is not likely to yield a meaningful or reliable outcome. Accordingly, the definition of variable input parameters should not be broadened to include projections to take into account the probability of different outcomes. Rather, the probability of different outcomes should be incorporated into taxpayer projections and be addressed in the regulations as described in the next section.
II. Methodology for Reflecting Risks
In its April 14 written comments, TEI recommended adding an example explicitly incorporating a probability-of-success factor ― in lieu of different discount rates ― to illustrate that the other methodologies may be used to reflect risk in a valuation model. This is because the probability of different outcomes and the effect of various risks are part of the taxpayer’s projections.
During the IRS hearing, TEI was asked whether the guidance in the proposed regulations concerning how projections should reflect the probability-weighted average of possible outcomes addressed TEI’s concerns. Specifically, Temp. Reg. § 1.482-7T(g)(2)(vi) provides:
The reliability of an estimate of the value of a platform or operating contribution in connection with a PCT will often depend upon the reliability of projections used in making the estimate. Such projections should reflect the best estimates of the items projected (normally reflecting a probability weighted average of possible outcomes). Projections necessary for this purpose may include a projection of sales, IDCs, costs of developing operating contributions, routine operating expenses, and costs of sales. (Emphasis added.)
Although the language in the italicized language in the regulation is helpful, it does not go far enough. Take, for example, two hypothetical investments. The first is a safe and stable investment in government bonds that pays a return of $100 million. The second is a risky R&D opportunity that has a 10-percent probability of generating a $1 billion profit, and a 90-percent probability of being a total loss. Both investments have the same probability-weighted average of possible outcomes, namely, $100 million. Yet, they have completely different risk profiles and should not be valued using the same discount rate based on the taxpayer’s cost of capital.
TEI believes the example provided in its written comments (attached as Appendix A) should be added to the final regulations to illustrate that methodologies other than discount rates may be used to reflect risk in a valuation model. Otherwise, field agents may feel constrained to apply different discount rates as the only method of reflecting risk since this is the only method used in all of the examples in the cost sharing regulations.
If TEI’s suggested example is not included, then TEI recommends that language similar to the following be added to each example: “These numbers reflect the best available estimates of the items projected, which may include a probability weighted assessment of possible outcomes as contemplated in Temp Reg. § 1.482-7T(g)(2)(vi) or other methods of taking risks and probabilities into account.”
III. Conclusion
Tax Executives Institute thanks the U.S. Department of Treasury and the Internal Revenue Service for their willingness to consider changes to the proposed cost sharing regulations. If you have any questions, please do not hesitate to call Brian C. Ugai, chair of TEI’s International Tax Committee, at 206.318.6313, or bugai@starbucks.com; or Mary L. Fahey of the Institute’s professional staff at 202.638.5601; mfahey@tei.org.
Respectfully submitted,
TAX EXECUTIVES INSTITUTE, INC.
Vincent Alicandri
International President
APPENDIX A
TEI recommends adding an example explicitly applying a probability-of-success factor in lieu of different discount rates, as follows:
(i) USP, a pharmaceutical company, has developed a new drug that it is currently marketing. In Year 1, USP enters into a CSA with its wholly-owned foreign subsidiary, FS, to develop an improved
version of the drug. Under the CSA, USP will have the rights to exploit the improved version in the United States, and FS will have such rights in the rest of the world. The current version of the drug and USP’s development team are reasonably anticipated to contribute to the development of future versions and therefore the rights in the current version are platform contributions for which compensation is due from FS as part of a PCT. USP does not transfer the current exploitation rights in the current version to FS. FS does not furnish any platform contributions nor does it control any operating intangibles at the inception of the CSA that would be relevant to the exploitation of the current or future versions of the drug. FS agrees to make PCT payments in the form of a single lump sum payment as of the date of the PCT.
(ii) In evaluating the CSA, the Commissioner concludes that the cost sharing alternative represents a riskier alternative for FS than the licensing alternative because, in cost sharing, FS will take on the additional risks associated with CST Payments and making the PCT payments as a single lump sum. Consequently, the Commissioner accepts the taxpayer’s projections, based on the industry’s and taxpayer’s own experiences, that the probability of successfully developing an improved version of the drug is 50%. The Commissioner also concludes that the appropriate discount rate to apply in assessing the licensing alternative, based on the discount rates of comparable uncontrolled companies undertaking comparable licensing transactions, would be 13% per year. FS undertakes financial projections and anticipates making no sales during the first two years of the CSA in its territory, with sales in Years 3 through Year 8 rapidly increasing to $200 million, $400 million, $600 million, $650 million, $700 million and $750 million, respectively. After year 8, sales in the rest of the world are expected to remain at $750 million per year for the foreseeable future. Costs ― including routine costs and operating cost contributions ― are anticipated to equal 60% of gross sales from Year 3 onwards. FS anticipates its cost contributions will equal $50 million per year for the first four years of the CSA and equal 10% of gross sales in each year, thereafter. The Commissioner accepts the financial projections undertaken by FS and determines that the arm’s-length rate USP would have charged an uncontrolled licensee for a license of an improved version of the drug (had USP further developed the original version on its own) is 35% of the sales price, as determined under the comparable uncontrolled transaction method in §1.482-4(c). FS also determines that the tax rate applicable to it will be the same in the licensing alternative as in the CSA.
(iii) Based on these projections and applying the same 13% discount rate to both the licensing and cost sharing alternatives, the Commissioner determines that under the cost sharing alternative, the present value of its divisional profits (after subtracting the present value of the anticipated operating cost contributions and cost contributions) would be $488 million.1
Under the licensing alternative, the present value of the divisional profits and losses minus the operating cost contributions would be $1.592 billion, and the present value of the licensing payments would be $1.393 billion.
Therefore, the total value of the licensing alternative would be $199 million.
In order for the present value of the cost sharing alternative to equal the present value of the licensing alternative, the present value of the PCT payments must equal $288 million; the arm’s-length lump sum PCT payment therefore equals $288 million.
1 For simplicity, all financial flows are assumed to occur at the beginning of each period and the
numbers are rounded. Some numbers may be rounded.