International Tax

Update: Transfer Pricing Developments

By Mary Richter
April 17, 2009

New Regulations for Cost Sharing Arrangements Are Now Effective

 

Cost sharing arrangements (“CSA’s”) are agreements among related parties to share the costs of developing intangible property (trademarks, know-how, patents, or similar items) in proportion to their shares of reasonably anticipated benefits from the use of the intangible. As with all related party transactions, the rules require “arm’s length pricing”- what unrelated parties would pay under the same circumstances. In addition, for transfers of intangible property, the payment for the property or the right to use the property must be “commensurate with income” derived from its use. 

 

In keeping with the recent flurry of transfer pricing guidance, new rules are now effective for CSA’s entered into after January 5, 2009. Some of the new rules also apply to previously existing arrangements. Agreements which meet the definition of “qualified” CSA’s will reduce the risk of IRS adjustment upon audit. Generally, these rules require that the cost sharing arrangement include a formal written document that provides a method to calculate each participant’s share of reasonably anticipated benefits. When related parties enter into a CSA, there must be an appropriate “buy-in” payment for the interest acquired in any intangibles. Keep in mind that the IRS can apply these rules to any arrangement that, in substance, constitutes a CSA, even if no written agreement exists. 

 

What does this mean to your company?

 

Companies frequently develop new products to remain competitive or increase market share. In closely held organizations, these development costs are often shared among entities in the group. Many times, no formal written agreement exists to document the intercompany activities and charges. While the transfer pricing rules apply to all related taxpayers, to the extent that foreign entities are involved, inadvertent noncompliance can cause painful audit results.

 

Let’s look at an example. A US based manufacturer of machinery recently acquired a foreign manufacturing facility. The US company has a large engineering group in the US which focuses on development of new products and product improvements. The parent company decides to allocate the engineering and R&D departmental costs among all of its manufacturing facilities, both US and foreign, based on revenue, although there is no formal written agreement among the parties. The foreign entity has the rights to manufacture and sell the products, including all US group-created products throughout its geographical region. Some of these products were developed prior to the foreign entity’s entry into the group.

 

It seems on the surface that the costs are being shared among group members appropriately, based on revenues derived from product sales. That seems fair. Well, it’s not that simple. In this case, the foreign entity did not make any “buy in” payments. That is, the foreign entity did not “pay” for its share of the development which occurred prior to joining the group. The tax rules require that, if the company can utilize the technology, it should “pay” for the privilege of doing so. In this case, the IRS (or other taxing authority) could require additional income recognition from the sale or license of intangible property, creating more tax. On the other side, the foreign county tax authority may not allow a corresponding adjustment, particularly if it occurs after local country tax returns have been filed and audited. 

The regulations establish several compliance criteria: contractual, documentation, accounting and reporting.    For CSA’s entered into after January 5, 2009, an original CSA statement must be filed with the IRS no later than 90 days after the first costs are incurred which are covered by the agreement. The reporting rules also require that taxpayers include an annual disclosure statement with the return which outlines the terms of the CSA. Agreements existing prior to January 5, 2009 will need to comply only with previous regulations, but, once revised, these agreements become subject to the new reporting rules.

 

In order to avoid tax adjustments and penalties, you should review intercompany charges for intangibles (as well as any other intercompany transactions), document the policy and maintain compliance with both the US and foreign reporting requirements.