29 March 2011
In a chief counsel advice memorandum released March 18, 2011 (CCA 201111013 of June 25, 2010, (the CCA)), the IRS draws directly from the temporary cost sharing regulations in calling for “a new approach” to valuing intangible property transferred outside of a cost sharing arrangement (CSA) when that property must be further developed by the recipient before it can be fully exploited. Though thin on specifics, the CCA’s comment that this “new approach” should rely “less on comparables and more on fundamental financial principles” is enough to put taxpayers on notice of the potential for valuation controversies.
Scenario Considered. The CCA focuses on a transaction in which a US parent corporation (Parent) provided “valuable initial services (with embedded intangibles)” to its controlled foreign corporation (CFC). These services, the CCA says, resulted in the CFC’s owning rights in an intangible asset that could not be exploited without the CFC incurring its own costs of further development. The question posed by the CCA is how much the CFC must pay Parent for the transfer of this asset.
Analogy to Cost Sharing. According to the CCA, this transaction presents questions similar to those that arise with CSAs. A participant in a CSA who receives rights in “preexisting intangible property” (under the 1995 cost sharing regulations) or a “platform contribution” (under the 2009 temporary cost sharing regulations) must compensate the donor of such rights at arm’s length. In this respect, the CCA claims, the CFC is similarly situated because it receives rights in an intangible that will require further development. Further, a CSA participant and the CFC both bear all of the costs allocable to the territory in which they intend to exploit the intangible—the CSA participant with respect to its territory defined in the CSA, and the CFC with respect to the worldwide market.
The Need for “A New Approach to Valuation.” Treas. Reg. § 1.482-4 and Treas. Reg. § 1.482-6 set forth general methods for valuing intercompany transfers of intangible property. However, the CCA concludes that none of these methods “works well” for cases involving intangible property of the type conveyed by Parent to the CFC. According to the CCA, the shortcoming of the “traditional” methods under Treas. Reg. § 1.482-4 is that they address rights to exploit intangible property “as is,” not property whose anticipated value will be realized only through further development. The residual profit split method of Treas. Reg. § 1.482-6 addresses this problem “to some extent,” the CCA says, but it “tends to be unreliable” when, as in this case, one party’s investment in intangible property significantly precedes the other party’s investment—a criticism of this method raised in the 2007 Coordinated Issue Paper (CIP).
In light of these perceived limitations of the standard methods, the CCA concludes that a “new approach to valuation” (rather than “other methods”) is needed to analyze transactions involving property of the type conveyed by Parent to the CFC, “relying less on comparables and more on fundamental financial principles.” For background on this approach, the CCA refers to the CIP, as well as to an exhibit to the APA Study Guide and papers written by several practitioners. The CCA suggests that the position the IRS draws drawn from these sources is that “the economic result should control: there is in general no legal loophole to avoid full economic compensation, and methods that deny full compensation should be rejected,” whether in cases involving CSAs or in the kinds of transaction examined in the CCA.
Three Key Takeaways from the CCA
First, the IRS is actively seeking to extend the reach of the valuation principles of Treas. Reg. § 1.482-7T beyond CSAs. It is important to keep track of these efforts, which were foreshadowed by Treas. Reg. § 1.482-4T(g): “consideration of the principles, methods, comparability, and reliability considerations set forth in § 1.482-7T” is relevant to selecting the best method under Treas. Reg. §1.482-4 (and thus, by implication, Treas. Reg. § 1.482-6) for evaluating the arm’s-length value of property transferred in an arrangement involving costs and risks of the development of intangibles that is not a CSA.1
Second, it is clear that the IRS will vigorously pursue cases where it believes a CFC has received preexisting intangibles that give it a “headstart” on intangible development, making good on an implicit promise in its Action on Decision (AOD) in Veritas.2 Indeed, the CCA’s parting remark echoes one of the IRS’s main contentions in the AOD—the “full” economic value of preexisting intangibles comprises not only the right to make and sell current products, but also the right to conduct further research and development on such intangibles and incur the costs of doing so.
And third, taxpayers should be concerned by the CCA’s sweeping statement that a “new valuation approach” is required in these cases, “relying less on comparables and more on fundamental financial principles.” Such a position seems directly contrary to the approach taken by the court in Veritas, which determined that the better assessment of the arm’s length price was found in the taxpayer’s comparables-based analysis (with some adjustments), rather than in the IRS’s “akin to a sale theory” and the controversial financial and economic analysis upon which it was based. More broadly, such a new approach creates significant application concerns in that it prescribes arguably ambiguous valuation principles (aimed at determining the undefined concept of “full economic compensation”) that are likely to create uncertainties for taxpayers and potential controversies with our trading partners.
To discuss issues raised by the CCA, including transactions to which its reasoning might be applied and the ways the IRS might seek to capture the “full value” of transferred intangibles, please contact your regular Mayer Brown lawyer or
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1. See also Treas. Reg. § 1.482-7T(b)(5) (noting that Treas. Reg. § 1.482-7T can be applied even when an arrangement does not meet the technical requirements of a cost sharing arrangement).
2. Doc 2010-24215, 2010 TNT 218-15.