Daily Tax Update - August 24, 2005

IRS and Treasury Issue Proposed Cost-Sharing Regulations:
On August 22nd, the IRS and Treasury issued proposed regulations that provide guidance on cost-sharing arrangements between related parties and how to determine taxable income under section 482 in connection with such cost sharing arrangements. A cost sharing arrangement is a method by which related parties agree to share the costs and risks of the development of intangible property in proportion to the benefits they expect to receive from the developed intangibles. Comprehensive regulations under section 482 were issued in 1968. The guidance regarding the sharing of costs and risks in the 1968 regulations was replaced in 1996 by the existing §  1.482_7 regulations. The existing § 1.482-7 regulations would be replaced by the proposed regulations. The proposed regulations include many of the same concepts in the existing regulations, but include new terminology and provide additional guidance.

  • The preamble states that the goal of the proposed regulations is to provided guidance relative to cost sharing arrangements regarding "the results that would have been realized if uncontrolled taxpayers had engaged in the same transactions under the same circumstances."
  • The proposed regulations would adopt an "investor model" as a fundamental concept for evaluating cost sharing arrangements (CSAs). The proposed regulations integrate into the definition of a CSA both "cost sharing transactions" (CSTs), regarding the ongoing sharing of intangible development costs, and "preliminary or contemporaneous transactions" (PCTs), by which the controlled participants compensate each other for their external contributions (PCTs are currently referred to as "buy-ins" in the existing regulations).
  • The preamble states that the proposed regulations were issued to respond to a need for additional guidance regarding "preliminary or contemporaneous transactions" and the methods for valuing these external contributions.
  • The proposed regulations include additional methods for sharing costs. In addition to the comparable uncontrolled transaction, residual profit split, and rules for unspecified methods provided in the existing regulations, the proposed regulations would allow taxpayers to use: (i) the income method; (ii) the acquisition price method; and (iii) the market capitalization method.
  • The preamble states that Treasury 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. Therefore, the proposed regulations provide that the arm’s length compensation for PCTs, and the applicable method used to determine that compensation, must reflect the type of transaction and contractual terms of a "reference transaction" (RT). The required RT must be 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.
  • The proposed regulations provide guidance on the periodic adjustments the IRS may make when the actual experience under the cost sharing arrangement is "widely divergent from reasonable expectations at the time of the investment." The proposed regulations provide that such periodic adjustments may only be made by the IRS, and may not be made by taxpayers.
  • The proposed regulations are proposed to be effective on the date of publication as final regulations in the Federal Register. CSAs commencing on or after such date, and cost sharing transactions occurring after such date with respect to CSAs existing as of the effective date, will be subject to the then final regulations. The proposed regulations include transition rules under which an existing arrangement that constituted a qualified cost sharing arrangement under the existing regulations will be considered a CSA and will be allowed an additional period to conform to the new rules with certain modifications.

IRS and Treasury Issue final and proposed Regulations on section 951 pro rata allocations:
Today, the IRS and Treasury issued final and proposed regulations under section 951. The final regulations adopt, with certain modifications, the regulations proposed by the IRS and Treasury on August 6, 2004. The final regulations address a U.S. shareholder’s pro rata share of a controlled foreign corporation’s subpart F income, previously excluded subpart F income withdrawn from investment in less developed countries, and previously excluded subpart F income withdrawn from foreign base company shipping operations.

  • In addition, the IRS and Treasury issued proposed regulations that would amend the final regulations to address certain transactions that the IRS and Treasury view as inappropriately deflecting subpart F income inclusions with respect to a U.S. shareholder’s stock in a controlled foreign corporation.
  • The specific transactions addressed in the proposed regulations involve the issuance to foreign persons of mandatorily redeemable preferred stock with cumulative dividend rights. The parties in these transactions provide a relatively high dividend rate on such stock, but forego compounding on the accrued but unpaid dividends.
  • The proposed regulations address these transactions by providing a special allocation rule for such stock to appropriately discount the amount of earnings and profits allocated to the preferred stock in annual hypothetical distributions.
  • The final regulations are effective for taxable years of a CFC beginning on or after January 1, 2005. However, the regulations include a transitional rule for cases in which the application of the pro rata rules for purposes of applying a related Code section would result in an allocation to the stock of the CFC of earnings and profits that have already been allocated to the stock for an earlier year under the prior rules. In that case, the prior rules will continue to apply for purposes of applying the related Code section.

For additional information, contact Philip R. West, Stanley Smilack, John J. Giles, or Gregory N. Kidder.

As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

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