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The IRS has issued temporary cost-sharing regulations pursuant to Treas. Reg. § 1.482-7T (Temporary Regulations).

The Temporary Regulations were issued December 31, 2008. This summary provides a high-level overview of the Temporary Regulations’ transition rules for existing cost-sharing arrangements (CSAs).

I. General

1. What is the effective date of the new Temporary Regulations?

The effective date is January 5, 2009, the date on which the Temporary Regulations were published in the Federal Register.

The former regulations under Treas. Reg. § 1.482-7 relating to CSAs were adopted in 1995 (Former Regulations). In August 2005, the IRS and Treasury published proposed cost-sharing regulations. These 2005 proposed regulations have now been modified and adopted as temporary regulations, effective January 5, 2009, under Treas. Reg. § 1.482-7T. Accordingly, all CSAs entered into on or after January 5, 2009 are subject to the new Temporary Regulations. It should be noted that the Temporary Regulations will expire on or before December 30, 2011, although Treasury and the IRS are likely to finalize the regulations prior to that time.

For qualified CSAs existing prior to January 5, 2009, the Temporary Regulations provide transition rules that permit these CSAs to be grandfathered under the Former Regulations and remain subject, in substantial part, to the rules under the Former Regulations (grandfathered CSAs). As described below, however, the Temporary Regulations do require that some modifications be made to these grandfathered CSAs.

2. Does the effective date apply to Buy-In Transactions as well as to Cost-Sharing Transactions?

Yes.

Under Treas. Reg. § 1.482-7T(m)(2)(i), cost-sharing transactions (CSTs) and platform contribution transactions (PCTs, formerly known as buy-in transactions), occurring prior to January 5, 2009, are generally subject to the provisions of former Treas. Reg. § 1.482-7. Therefore, even if buy-in license royalty payments are received by one CSA party in 2009 or thereafter, as long as the buy-in license was in place prior to January 5, 2009, the Former Regulations’ rules on valuation and transfer pricing methodologies should apply.

II. Revisions to Existing CSAs

1. Must a grandfathered CSA be amended to comply with the Temporary Regulations' requirements?

Yes.

The Temporary Regulations provide that a written CSA must include certain specific contractual provisions. See Treas. Reg. § 1.482-7T(k)(1)(ii). Some of the provisions are new and different from the original list of contractual requirements in the Former Regulations under Treas. Reg. § 1.482-7(b)(4).

Under Treas. Reg. § 1.482-7T(m)(1), a qualified CSA in existence on January 5, 2009 will continue to be respected as a CSA only if the written CSA is amended to conform, and if the activities of the controlled participants substantially comply, with the new Temporary Regulations, subject to certain exceptions and modifications. All required amendments to existing written CSAs must be made by July 6, 2009. See Treas. Reg. § 1.482-7T(m)(2)(vi).

The following is a list of new contractual provisions required for grandfathered CSAs under the Temporary Regulations that either were not included as part of the Former Regulations or are substantially different than the provisions required under the Former Regulations. Any grandfathered CSA existing on January 5, 2009 should be amended by July 6, 2009 to include the following provisions to ensure conformity with the requirements under the Temporary Regulations.

a. The address of each domestic entity that is a participant in the CSA or a member of the controlled group that is reasonably anticipated to benefit from the use of the cost shared intangibles.

Previously, there was no requirement to list the address of each domestic entity as former Treas. Reg. § 1.482-7(b)(4) required only a list of the participants. It is likely, however, that most taxpayers have included the address of each participant in their existing CSAs.

b. The country of incorporation¹ of each foreign entity that is a participant in the CSA or a member of the controlled group that is reasonably anticipated to benefit from the use of the cost shared intangibles.

Previously, there was no requirement to list the country of incorporation of the foreign entities as former Treas. Reg. § 1.482-7(b)(4) required only a list of the participants. It is likely, however, that most taxpayers have included the country of incorporation of each foreign entity in their existing CSAs.

c. Specification of the functions and risks that each controlled participant will undertake in connection with the CSA.

Previously, there was no requirement to list the functions and risks of each entity as former Treas. Reg. § 1.482-7(b)(4) required only a list of each participant’s interest in the covered intangibles. It is possible that many taxpayers have included the functions and risks of each party, but a careful review of the existing CSA should be undertaken to ensure compliance with this provision.

d. Specification that the controlled participant must use a consistent method of accounting to determine intangible development costs (“IDCs”) and reasonably anticipated benefits (“RAB”) shares and must translate foreign currencies on a consistent basis.

Former Treas. Reg. § 1.482-7(b)(4) did not have any such requirement. Therefore, most taxpayers will likely need to make amendments to their grandfathered CSAs in order to comply with this requirement.

e. Specification of the date on which the CSA was entered into.

Former Treas. Reg. § 1.482-7(b)(4) did not have any such requirement. It is likely, however, that most taxpayers have included the date on which the CSA was entered into and/or the effective date in their existing CSAs.

f. Specification of the consequences of a change in participation under a CSA when there is either a controlled transfer of interest or a capability variation within the meaning of Treas. Reg. § 1.482-7T(f).

Former Treas. Reg. § 1.482-7(b)(4) did not have any such specific requirement. It is likely, however, that many taxpayers have included provisions in their existing CSAs to deal with changes of interest or capabilities.

g. Method for calculating each participant’s share of costs based on factors that can reasonably be expected to reflect the RAB and required updates to the RAB.

While this requirement is substantially similar to that included in former Treas. Reg. § 1.482-7(b)(4), the determination of RAB and any updates thereto must be determined under the Temporary Regulations, rather than the Former Regulations. Details of the differences between these provisions will be published in a forthcoming DLA Piper article.

h. Specification of the form of payment due under each PCT (or group of PCTs) in existence at the formation (and any revision) of the CSA, including information and explanation that reasonably supports an analysis of applicable provisions of the new form of payment rules under Treas. Reg. § 1.482-7T(h).

Although former Treas. Reg. § 1.482-7(b)(4) did not contain this requirement, it is likely that many taxpayers have included form of payment provisions in their grandfathered CSAs or in a separate buy-in license agreement. Given that the Temporary Regulations do not apply to PCTs occurring before January 5, 2009, taxpayers with grandfathered CSAs with PCTs (formerly buy-in transactions) prior to this date may be able to satisfy this requirement by a cross-reference to an existing buy-in transaction.

In addition to the above requirements, the Temporary Regulations require all new written CSAs entered into on or after January 5, 2009 (or transactions occurring on or after January 5, 2009 as noted below) to also include the following provisions, none of which is required for grandfathered CSAs.

a. Divisional Interest - A provision that divides among the controlled participants all divisional interests (as described under the Temporary Regulations at Treas. Reg. § 1.482-7T(b)(1)(iii) and (b)(4)) in cost shared intangibles and specifies each controlled participant’s divisional interest. A divisional interest is a non-overlapping interest in the cost shared intangibles without further obligation to compensate another controlled participant for such interest and each controlled participant must be entitled to the perpetual and exclusive right to the profits from such divisional interest attributable to the cost shared intangibles. Examples of permitted divisional interests include territorial based divisional interests or field of use divisional interests. See Treas. Reg. § 1.482-7T(b)(4).

The requirement that participants in the CSA must receive divisional interests does not apply to grandfathered CSAs.

b. IDCs – With respect to transactions occurring on or after January 5, 2009, a provision requiring that the controlled participants enter into CSTs covering all IDCs, as described under the Temporary Regulations at Treas. Reg. § 1.482-7T(b)(1)(i), in connection with the CSA.

Although former Treas. Reg. § 1.482-7(b)(4) did not contain any such specific requirement, it is likely that most grandfathered CSAs already include such a provision (or substantially similar provision).

c. PCTs – With respect to transactions occurring on or after January 5, 2009, a provision requiring that the controlled participants enter into PCTs covering all platform contributions, as described under the Temporary Regulations at Treas. Reg. § 1.482-7T(b)(1)(ii), in connection with the CSA. This is a new requirement mandating that provisions relating to PCTs entered into on or after January 5, 2009 be included as part of the written CSA agreement itself.

Although former Treas. Reg. § 1.482-7(b)(4) did not contain any such requirement, it is likely that many taxpayers with grandfathered CSAs have included provisions relating to PCTs (formerly buy-in transactions ) in a separate agreement.

2. Must a taxpayer with a grandfathered CSA file any CSA Statements with the IRS?

Yes.

The Temporary Regulations at Treas. Reg. § 1.482-7T(k)(4) require each controlled participant to file a “CSA Statement” containing the information described therein no later than the due date specified in the Temporary Regulations. With respect to grandfathered CSAs required to be amended by July 6, 2009, each controlled participant must file a CSA Statement with respect to the amended grandfathered CSA with the IRS Ogden Campus Service Center no later than September 2, 2009. Thereafter, each controlled participant generally must attach its original CSA Statement along with a schedule documenting any changes to the information in the CSA statement to its federal income tax return for each taxable year during which the CSA is in effect. If the controlled participant is not required to file a federal income tax return, it must attach the CSA Statement to a Form 5471, Form 5472 or Form 8865, as applicable.

The CSA Statements for grandfathered CSAs are not required to include certain information described under the Temporary Regulations that applies only to PCTs occurring on or after January 5, 2009.

III. “Material Change in Scope” of a Grandfathered CSA

1. What is a “Material Change in Scope”?

Material Change in Scope is defined as expanded lines of research and development beyond the scope of the intangible development area.

A material change in scope is defined to include any material expansion into one or more lines of research and development beyond the scope of the intangible development area, as described in former Treas. Reg. § 1.482-7(b)(4)(iv). Such analysis of material expansion is determined on a cumulative basis, even if individually an expansion is not material. As discussed below, it is unclear how broadly this definition will be interpreted.

A contraction of activity under the CSA will not constitute a material change in scope.

2. What is the impact to a grandfathered CSA if a material change in scope occurs?

If a material change in scope occurs, new PCTs are subject to the periodic adjustment rules under the Temporary Regulations, rather than under the Former Regulations.

Unlike the proposed regulations, the Temporary Regulations do not require a termination of a CSA if certain changes or events occur, such as a material change in scope to a grandfathered CSA. Instead, the Temporary Regulations provide a targeted transition rule for grandfathered CSAs under which the new periodic adjustment rules apply to PCTs that occur on or after the date of a material change in scope of the grandfathered CSA. The periodic adjustment rules under the Temporary Regulations require adjustments to be made to the PCT if certain requirements are met.

It should be noted that the periodic adjustment rules under the Former Regulations will continue to apply to PCTs under grandfathered CSAs where such PCT either occurred before January 5, 2009 or where there has been no material change in scope and the PCT occurred on or after January 5, 2009.

3. Are acquisitions made on or after January 5, 2009 and made available to a grandfathered CSA, subject to the Temporary Regulations?

Yes, the PCT for the acquired IP will be subject to the valuation and transfer pricing methodologies under the Temporary Regulations, but it appears that the periodic adjustment rules under the Former Regulations will apply to the PCT relating to the acquired IP to the extent there has been no material change in scope of the grandfathered CSA.

If the US entity that is party to the grandfathered CSA makes an acquisition and then makes the acquired IP available to the grandfathered CSA through a PCT occurring on or after January 5, 2009, such PCT will be subject to the valuation methodologies set forth by the Temporary Regulations. It appears, however, that this PCT will remain subject to the periodic adjustment rules under the Former Regulations to the extent there has been no material change in scope of the grandfathered CSA. This interpretation is supported by the Preamble to the Temporary Regulations, which provides that the transition rules adopt “a targeted provision that applies the [new] periodic adjustment rules to PCTs that occur on or after the date of a material change in the scope of the grandfathered CSA” (emphasis added). It is not entirely clear that the intended result was to treat periodic adjustments for PCTs occurring on or after January 5, 2009 differently based on whether there has been a material change in scope, but Treasury and the IRS are expected to provide insight on this issue in the coming weeks.

If the PCT relating to the acquired IP does result in a material change in scope of the grandfathered CSA, the Temporary Regulations would subject the PCT to the new periodic adjustment rules. There is a risk that the Service may view any acquisition as a material change in scope, thus triggering application of the new periodic adjustment rules to the related PCT. Therefore, the main issue for taxpayers to analyze will be whether a subsequent acquisition of IP made available to the grandfathered CSA constitutes a material change in the scope of the grandfathered CSA.

4. If a taxpayer’s grandfathered CSA is applicable to Product A and taxpayer expands its research and development to include development of Product B, will the development of Product B be treated as a material change in scope?

Presumably no, provided the development of Product B is within the scope of the intangible development area as defined in the grandfathered CSA.

If a taxpayer chooses to pursue development of Product B and such development does not require any additional PCT, then any development costs for Product B will be shared pursuant to the grandfathered CSA. As a result, provided the activities undertaken in the development of Product B are not beyond the scope of the intangible development area of the grandfathered CSA, this should not constitute a material change in scope of the grandfathered CSA.

5. Are all changes made to grandfathered CSAs, including those changes required under the transition rules, subject to the material change in scope provisions?

No.

It appears that a taxpayer may make amendments to its grandfathered CSAs, provided such amendments are only related to items that do not materially expand the scope of the research and development beyond the intangible development area. For example, a taxpayer may wish to redefine net revenues in order to clarify whether maintenance is included in such calculation. Presumably, such an amendment would not be considered a material change in scope as it does not constitute a change to the activities undertaken by the taxpayer beyond the scope of the intangible development area and does not require an additional PCT. Similarly, any amendments made to a grandfathered CSA required by the transition rules appear to not constitute a material change in scope as these items are primarily administrative changes.

6. Will a CSA that was entered into during 2008 and is not yet fully operational as of January 5, 2009 be grandfathered?

Yes, assuming it was a qualified CSA under former Treas. Reg. § 1.482-7 and is amended in accordance with the transition rules of the Temporary Regulations.

Provided the taxpayer had a qualified CSA as of January 5, 2009 and complies with the Temporary Regulations’ requirements to amend its existing CSA, the CSA should be treated as a grandfathered CSA under the Temporary Regulations. Therefore, the main issue for taxpayers to analyze will be whether they had a qualified CSA under the Former Regulations.