April 21, 2009
Oral Testimony of
DOROTHY C. CHAO, Senior Tax Counsel
Baxter International Inc.
on behalf of
TAX EXECUTIVES INSTITUTE, INC.
on
Proposed Regulations on Methods to Determine Taxable Income in Connection with a Cost Sharing Arrangement
Public Hearing before the Internal Revenue Service
Good morning. I am Dorothy Chao, Senior Tax Counsel for Baxter International Inc. in Deerfield, Illinois. I am here today as a member of the International Tax Committee of Tax Executives Institute. TEI is a professional association with 7,000 members who work for 3,200 of the largest companies in the world.
At the outset, TEI commends the government for responding positively to comments on the workability of the earlier regulations, which were proposed in 2005. The new regulations are an improvement, especially in regard to the transition and grandfather rules.
In particular, we note: (i) the elimination of the references to the weighted average cost of capital and discount rates; (ii) the elimination of the requirement that the consideration for platform contributions acquired in a post-formation acquisition be in the same form as the third-party transaction in which the platform contribution was acquired; and (iii) elimination of the termination triggers for existing cost sharing arrangements.
TEI’s written comments on the proposed regulations cover a multitude of issues. My remarks today will focus on just a few of them:
- The contemporaneous documentation requirement;
- The maintenance of documents;
- The requirements for CSA Statements;
- The division of interests;
- The risk exposure of licensing versus cost sharing; and
- The limited life of certain contributed technology.
Under the 2008 regulations, a CSA must be recorded in a written contract that is “contemporaneous” with the CSA’s formation. The “contemporaneous” contract must be signed by all controlled participants within 60 days of the first occurrence of an intangible development cost.
The extensive contractual requirements in the regulations make it extremely difficult to satisfy the 60-day rule. Compliance requires not only extensive fact gathering, but also forecasting and valuation. Since the contemporaneous documentation requirement is intended to ensure that allocations among controlled participants are determined before the time that outcomes materially affecting the PCT pricing or determination of RAB shares are known, we think the 60-day rule is too strict. We propose that taxpayers be allowed to enter into or revise a CSA contract within 8½ months from the earlier of (i) the date of the first occurrence of an IDC, or (ii) the date when the tax return for the applicable year is filed. Such a rule would be consistent with the deadline for specifying the form of the PCT payment.
The 60-day requirement presents particular challenges in the context of acquisitions. It may well take more than 60 days to determine which of the acquired members will enter into existing CSAs and the amount, if any, of each PCT required. The tax rules recognize elsewhere that acquisitions require complex analysis, for example, in the case of an acquisition involving a section 338 election. An 8½-month deadline should apply to revisions of CSAs.
The 2008 regulations require controlled participants to update and maintain documentation regarding the scope of the intangible development activity and other requirements.
Given the substantial documentation required, TEI recommends that the final regulations expressly permit the documentation to be maintained at a central place by one U.S. participant on behalf of all controlled participants. The final regulations should also provide that the information need only be updated annually.
Under the 2008 regulations, participants in CSAs must file a statement with the IRS within 90 days after the first occurrence of an IDC to which the newly formed CSA applies. The statement must be signed under penalties of perjury by an officer of each controlled participant who is authorized by local law to sign, and a taxpayer identification number must be provided for each participant.
TEI recommends that the government abandon the requirement of physically obtaining signatures and TINs from all participants. Satisfying such requirements will be a time-consuming and cumbersome task. It should be sufficient that the U.S. taxpayer charged with filing the CSA statement sign a statement on behalf of all CSA participants under penalties of perjury.
Unlike the 2005 regulations, the 2008 regulations permit the division of rights in the cost-shared intangibles among the participants not only on a geographic basis but on the basis of field of use and other arrangements (such as place of manufacture). Example 3 in this section discusses the ability to shift production and concludes that the division of interests does not meet the requirements of the temporary regulations because P’s and S’s “relative shares of benefits are not predictable with reasonable reliability.”
In TEI’s view, the ability to shift production should not disqualify an arrangement from being a CSA where the parties do not intend to ― and do not in fact ― shift production. The Institute recommends that Example 3 be revised to reach the same conclusion as Example 2, so long as P and S do not, in fact, shift production of product Z. P’s and S’s qualification under this section can be conditioned on their ability to satisfy the Commissioner that production of Product Z has not shifted between sites owned by P and sites owned by S.
TEI commends the IRS and Treasury for recognizing that risk exposures for licensing and cost sharing may vary, but suggests that the concept be expanded to enumerate common risk factors.
An example in the regulations uses a discount rate of 13 percent for the licensing alternative and 15 percent for cost sharing. In TEI’s view, the difference of two percentage points is unlikely to be sufficient to compensate for the additional risks that FS faces under cost sharing. For example, FS’s actual cost contributions may be greater than projected, perhaps because of budget overruns, or the timetable may be delayed. This is on top of the fundamental and significant risk ― not shared by a licensee ― that the research will fail.
TEI recommends adding an additional example explicitly incorporating a probability-of-success factor ― in lieu of different discount rates ― to illustrate that other methodologies may be used to reflect risk in a valuation model. Appendix B in our written comments illustrates some of these risks. In addition, we have provided an example ― explicitly applying a probability-of-success factor in lieu of different discount rates ― and recommend that it be included in the final regulations.
In the preamble to the new regulations, the IRS and Treasury Department recognize that contributed technology may be expected to achieve incremental improvement in results for only a finite period. While the first example in section (g)(4)(vii) of the proposed regulations appears to involve an infinite life for a PCT, Example 3 involves a software application with a five-year life, after which, version 1.0 will become “obsolete and unmarketable by the obsolescence of the storage medium technology to which it relates.
TEI commends the government for recognizing that some technology may have a finite life. Just because subsequent versions build on the original version 1.0, however, does not necessarily give version 1.0 an infinite useful life. At some point, the value of subsequent versions may be attributable solely to CST payments made by the participants under the cost sharing arrangement. TEI therefore recommends adding a fourth example under which version 1.0 of the software becomes obsolete even in the absence of obsolete storage medium technology.
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Our written comments include several examples relating to the effects of being first to market a product, as well as recommendations concerning the application of these regulations in the context of the Compliance Assurance Process and the application of certain documentation requirements to grandfathered CSAs.
Thank you for the opportunity to present TEI’s views. I would be glad to respond to any questions you may have.