When a group decides to form a cost-sharing arrangement to fund the development phase, as opposed to the research phase of R&D, an important issue arises: whether a payment should be made by a company entering into a cost-sharing arrangement with the owner of existing technology. This concept, known as “buy-in”, has been under debate for some time but came under widespread review following the publication of a white paper by the Internal Revenue Service (IRS) in the US in 1988. This white paper interpreted the transfer pricing proposals contained in the Tax Reform Act of 1986 in the US, which obtained widespread publicity. Most tax authorities are now aware of the concept of buy-in and are in the process of considering the issues raised by this concept.
The concept of buy-in is based on the view that when a new member joins a cost-sharing arrangement, the benefits emerging from research typically not only build on current R&D costs but also capitalise on past experience, know-how and the prior investment of those involved in the earlier cost-sharing arrangement. Consequently, the new member receives benefits from the historical expenditure of the earlier participants, although it did not contribute to those costs. In the international context, the US has made the point very strongly that it is inappropriate for a new member to receive these benefits free of charge.
While the need for a buy-in payment is well-established, the required computation may be controversial. The IRS has advocated that a valuation be carried out to determine an amount that would be appropriate to be paid to the original cost-sharers by the new member, reflecting the fact that the latter has obtained access to know-how and other valuable intangible property, which it will not be paying for through its proportionate share of future R&D expenditure.
The 1988 white paper indicated that the buy-in valuation should encompass all pre-existing, partially developed intangibles, which would become subject to the new cost-sharing arrangements, all basic R&D not directly associated with any existing product, and the going-concern value of the R&D department, the costs of which are to be shared.
The 1995 US final cost-sharing regulations provide that buy-in payment is the arm’s-length consideration that would be paid if the transfer of the intangible was to, or from, an unrelated party. The arm’s-length charge is determined under the pertinent part of the US regulations, multiplied by the controlled participant’s share of reasonable anticipated benefits.
The 2008 US temporary cost-sharing regulations refer to buy-in payments as platform contribution transactions (PCTs) and expand the definition of intangible property subject to a PCT payment as any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to contribute to developing cost-shared intangibles. Under this new definition, the contribution of an experienced research team in place would require adequate consideration in the PCT payment. Such a team would represent a PCT for which a payment is required over and above the team’s costs included in the cost-sharing pool.
The 2008 US temporary cost-sharing regulations also make an important change to the requirements under which reasonably anticipated benefit ratios are calculated for PCTs and cost-sharing arrangements. There is now an explicit requirement that reasonably anticipated benefit ratios be computed using the entire period of exploitation of the cost-shared intangibles.
Furthermore, the 2008 US temporary cost-sharing regulations reiterate that the rights required to be transferred in order to eliminate a perceived abuse where the transfer of limited rights could result in lower PCT payments. Therefore, under these 2008 US temporary cost-sharing regulations, the PCT payment must account for the transfer of exclusive, non-overlapping, perpetual and territorial rights to the intangible property.
The 2008 US temporary cost-sharing regulations also consider other divisional bases in addition to territorial basis, including field of use.
Similar to the 2005 US proposed cost-sharing regulations, the 2008 US temporary cost-sharing regulations do not allow a reduction in the PCT for the transfer of existing
“make or sell” rights by any participant that has already paid for these rights.
Another significant change in the 2008 US temporary cost-sharing regulations is the so-called “periodic adjustment” rule, which allows the IRS (but not the taxpayer) to adjust the payment for the PCT, based on actual results. Unlike the “commensurate with income” rules, the temporary regulations provide a cap on the licensee’s profits (calculated before cost-sharing or PCT payments) equal to 1.5 times its “investment”.
(For this purpose, both the profits and “investment” are calculated on a present value basis.) Notably, this periodic adjustment is waived if the taxpayer concludes an Advance Pricing Agreement with the IRS on the PCT payment. There is also an exception for “grandfathered” CSAs, whereby the periodic adjustment rule is applied only to PCTs occurring on or after the date of a “material change” in scope of the intangible development area. The 2008 US temporary regulations also provide
exceptions to the periodic adjustment rule in cases where the PCT is valued under a CUT method involving the same intangible and in situations where results exceed the periodic adjustment cap due to extraordinary events beyond control of the parties.
In addition, the 2005 US proposed cost-sharing regulations introduced the “investor model” approach, which provides that the amount charged in a PCT must be consistent with the assumption that, as of the date of the PCT, each controlled participants’
aggregate net investment in developing cost-shared intangibles pursuant to a CCA, attributable to external contributions and cost contributions, is reasonably anticipated to earn a rate of return, equal to the appropriate discount rate. The 2008 US temporary cost-sharing regulations significantly change the application of the investor model. This model indicates that the present value of the income attributable to the CSA for both the licensor and licensee must not exceed the present value of income associated with the best realistic alternative to the CSA. In the case of a CSA, the 2008 US temporary cost-sharing regulations indicate that such an alternative is likely to be a licensing arrangement with appropriate adjustments for the different levels of risk assumed in such arrangements. The 2008 US temporary cost-sharing regulations also recognise that discount rates used in the present value calculation of PCTs can vary among different types of transactions and forms of payment. These new proposed rules are discussed in more detail in the US chapter. Furthermore, the requirements under the Temporary Regulations for application of the Residual Profit Split Method will likely restrict the use of this method to certain cases where the licensee brings pre-existing intangibles to the CSA. In cases where the licensee does not possess pre-existing intangibles, the Income Method, Market Capitalization Method and Acquisition Price Method are likely to predominate.
Chapter VIII of the OECD Guidelines supports the use of buy-in payments as the incoming entity becomes entitled to a beneficial interest in intangibles (regardless of whether fully developed), which it had no rights in before. As such, the buy-in would represent the purchase of a bundle of intangibles and would need to be valued in that way (i.e. by applying the provisions of the Guidelines for determining an arm’s-length consideration for the transfers of intangible property).
Note that the terminology employed in Chapter VIII of the Guidelines, the 1995 US final cost-sharing regulations and the 2008 US temporary cost-sharing regulations with respect to this concept is somewhat different. Under Chapter VIII, a buy-in is limited to a payment made by a new entrant to an existing cost-sharing arrangement for acquiring an interest in the results of prior activities of the cost-sharing arrangement.
Similarly, a buyout refers only to a payment made to a departing member of an existing cost-sharing arrangement. Chapter VIII refers to any payment that does not qualify as a buy-in or a buyout payment (e.g. a payment made to adjust participants’ proportionate shares of contributions in an existing cost-sharing arrangement) as a “balancing payment”. In contrast, the 1995 US final cost-sharing regulations use the terms more broadly. Buy-in and buyout payments refer to payments made in the context of new as well as existing cost-sharing arrangements under these regulations. There is no such thing as a balancing payment in the 1995 US final cost-sharing regulations. In further contrast, the 2008 US temporary cost-sharing regulations refer to buy-in payments as PCTs for which the controlled participants compensate one another for their external contributions to the CCA. In addition, post-formation acquisitions (PFAs) occur after the formation of a CCA and include external contributions representing resources or capabilities acquired by a controlled participant in an uncontrolled transaction.
If payments are to be made to another participant in the cost-sharing arrangement (regardless of whether the payment is characterised a buy-in, a buyout or a balancing payment), consideration must be given to the tax deductibility of such payments made by the paying entity and their accounting treatment. Unless there is symmetry between their treatment as income in the recipient country and deductible expenditure in paying countries, a related group might well face significant double taxation as a result of the buy-in payment. The buy-in payment issue must be addressed on each occasion a new company becomes involved in the cost-sharing arrangement.