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Cost sharing has been a part of IRS regulations since 1994, but only this summer has the IRS developed an audit program for its international examiners and field specialists.  In August, the IRS issued its first checklist for use by   international examiners and field specialists (both to be referred to herein as IEs) to use in examining cost sharing arrangements (CSA).  IEs will use the document to assess the taxpayer's treatment of the issue and as a guide in determining whether the cost sharing documentation submitted by the taxpayer complies with the contemporaneous documentation requirements of Treas. Reg. Sec. 1.482-7(j)(2) and the IRC 6662(e) penalty regulations. 

The checklist consists of eight sections or "sets." Each set corresponds to one of the stated requirements as set forth in the regulations in 1.482-7.    (The IRS also issued proposed changes to the cost sharing regulations on August 22, 2005.  Those proposed regulations will be the subject of a forthcoming newsletter.)

Checklist Will Reveal Essentials of Potential Audits

The checklist allows the IRS to conduct a focused analysis that will indicate the essential points that will be involved in potential future audits.  In that regard, as discussed below, taxpayers will want to be certain that they have addressed certain specific issues on a timely basis, and documented every issue in writing.  A CSA that fails to meet the requirements of 1.482-7(b) and 1.482-7(c) will not be a qualified CSA.  The IRS may apply the 1.482-7 rules to any arrangement that in substance constitutes a CSA. 

As discussed below, each set is divided into three parts: Part A states the applicable requirement of the regulations; Part B lists the suggested documentation to meet the requirements; and Part C provides information to assist the IE in determining whether there has been compliance. 

Document Set One: Time Limit for Documentation

Document Set One addresses the 30-day time limit for providing documentation, CSA document requirements, and CSA participant requirements. In essence this part reminds the IE that a controlled participant in a CSA must maintain sufficient documentation to meet the requirements of Sections 1.482-7 (b)(4) and (c)(1) and that such documentation must be provided within 30 days of a request by the IRS, unless an extension is granted by the director of field operations. 

Key among the CSA requirements are that there be two or more participants, that a method be provided to determine each participant's share of the intangible development costs (IDC), that such shares may be adjusted   in light of changed conditions, and that a CSA is recorded contemporaneously with the commencement of the transaction.  The checklist states that a CSA may "NOT"  be modified retroactively.

Document Set Two: Determination of Costs

Document Set Two concerns the determination of costs subject to the CSA.  (Stock compensation issues are discussed in Document Set Seven.)  The checklist reminds the IE that intangible development costs (IDC) must include all such costs in determining the cost sharing pool.  The checklist directs the examiner to obtain source documents that the taxpayer used in determining the pool and reminds the IE that indirect costs must also be included.  The compliance section states that the definition of research expenses is not limited by IRC 41 (research tax credit) nor by IRC 174 (research expenses).    (However, taxpayers that “stretch” the definition of research for Section 41 purposes should consider the impact of such a position on cost sharing calculations.)  IDC must include all costs undertaken in the development of the intangible or class of intangible to be developed.  The checklist warns the IE that taxpayers may seek to limit such costs by taking a narrow definition of the operations needed for the development or to allocate such costs to intangibles outside the CSA. 

Document Set Three: Participants Share in Costs Based on RAB

Document Set Three addresses the requirement that each participant shares in the costs based on their "reasonably anticipated benefits" (RAB).  The checklist reminds the IE that the RAB should be based on the most reliable method.  Such measurement is on a direct basis and by reference to estimated additional income or the costs to be saved by the use of the CSA intangibles.  RABs are not product specific, but are broadly related to all intangibles developed under the CSA or made available via the buy-in payment.

Document Set Four: Determining Participants’ Share of IDC

Document Set Four addresses the issue of the methodology that will determine the participant's share of IDCs.  The checklist reminds the IE that the taxpayer must describe the method used to determine each participant's share of IDC, including the projections used to estimate benefits, and an explanation of why that method was selected.  Thus, the IE will request an explanation as to reasons for the selected method.  In addition, most methods will rely on projections; thus, the checklist instructs the IE   to determine if the projections are reliable.  The checklist then reminds the IE   that Examples 10 and 11 in 1.482-7(f)(3)(iv) state that a projection is unreliable if the projections, when compared to actual results, vary by more than 20 percent.  The IE is also reminded that while sales are the most often used measure of   RABs, sales may not be the most reliable method (such as where the sales price is controlled in certain jurisdictions). 

Document Set Five: Accounting Method

Document Set Five addresses the accounting method the taxpayer used to determine IDCs and RABs.  Issues may arise when a taxpayer uses an accrual method for one participant and a cash or modified cash method for another participant.  The checklist reminds the IE to determine that a consistent method has been used to measure both IDC and RAB.  If there is divergence from GAAP, the taxpayer must explain it.   In addition, the checklist directs the IE to the financial statements to compare the R&D on the financials versus the CSA.  Taxpayers that are aware of a difference should have a reconciliation prepared to explain the adjustments made from the financials.  This divergence can occur based on an industry-specific driven definition and/or due to the differences in allocation of direct and indirect costs under GAAP.

Document Set Six: Prior Research and Other Property Used in CSA

Document Set Six addresses the issue of prior research and other property used in the CSA. This set acknowledges that complicated issues revolve around base technology and that these issues may affect the development stage of the intended intangibles under the CSA.

Taxpayers please note: Caution should be used in drafting the intended intangible section of the CSA, since that declaration is the basis for determining the intangible rights to be shared.  Taxpayers should work closely with their advisors to state clearly what is intended to be shared since base technology will be examined to determine whether a buy-in payment should have been made.  Thus, if such an intangible is intended to be excluded, taxpayers should so state the exclusion.  This has been an area of disagreement between taxpayers and the IRS.

Buy-in and buy-out payments must be determined under the regulations under IRC Section 482.  Such payments may take the form of a lump sum payment, a series of payments, or a royalty or contingency arrangement.  The checklist alerts the IE that it may be necessary to convert one method selected appropriately by the taxpayer into another method.  In addition, the IE is reminded that the buy-in or buy-out may be substantiated in documentation pursuant to Treas. Reg 1.6662 (e).  Furthermore, the checklist directs the IE to examine acquisitions where intangibles may have been acquired by the acquisition of a company.  Finally, buy-ins, like other intangibles, are subject to periodic adjustments, and such adjustments are the prerogative of the IRS.

 

Document Set Seven: Stock Based Compensation

Document Set Seven addresses stock based compensation.  The checklist reminds the IE that such compensation is includable for tax years on or after August 26, 2003.  The key point is that the IE is cautioned that only stock options that are related to the intangible development area and that are granted after the formation of the CSA are to be considered.  The checklist directs the IE to request the work papers that calculated the tax deduction for tax purposes as well as those used for the financial statements.

Document Set Eight: Reporting Requirements

Document Set Eight addresses reporting requirements.  The checklist reminds the IE of the IRS's position that a controlled participant must attach to its U.S. tax return, including forms 5471 or 5472 with regard to a participant not filing its own return, a statement indicating that it is a participant in a qualified CSA and listing the other controlled participants in the CSA.  If a taxpayer fails to meet this requirement, the   checklist states that the IRS may not accept the CSA as a qualified CSA.  In general, when a U.S. taxpayer fails to meet the qualified CSA standard, the most likely result will be to incur additional taxable income under Section 482. 

What Taxpayers Should Do

Tthe new audit checklist is a useful tool for IRS examiners and field specialists and one that benefits taxpayers by clarifying the IRS position on cost sharing arrangements.   

Now that this new checklist is in use by the IRS, taxpayers should review their cost sharing arrangements and ensure that they have proper, appropriate documentation to meet its criteria and that they are able to provide the documentation in the required time limit.   We recommend that you review your CSA in light of the audit checklist that the IRS examiners will be using in future audits.