The Evolution of the Use of Cost Sharing Arrangements in International Income Tax Planning and New Indications for Valuing Intellectual Property

• Author: Keith Reams, Alan Shapiro, Laura Clauser, Jon Hakken, Ahmad Keshk, & Mark Klitgaard
• Pages: 401-422

401

Chapter 16

The Evolution of the Use of Cost Sharing

Arrangements in International Income

Tax Planning and New Indications for

Valuing Intellectual Property

keith reams, alan shapiro, laura clauser,

jon hakken, ahmad keshk, & mark klitgaard

A. BACKGROUND

There have long been a wide variety of income tax plan ning tools generally

available to sophisticated multinational companies (MNCs), all designed to

enable such companies to optimize the amount of income taxes they have

to pay in different tax jurisdict ions a round t he world. Over t he past two

decades the cost sharing arrangement (CSA) has emerged as an important

and integral tool of income tax planning, especially for an MNC, whose

continuing success and viability often depends on the company’s ability to

innovate and exploit valuable intellectual property (IP).

In t he ear ly year s, IP d evelop ment ef fort s tende d to be under tak en clo se to

home, which in most cases meant at company headquarters, usua lly located

in the United States, Japan, or Europe. This tendency was largely driven by

the avail abili ty of s kill ed ind ividu als an d fami liar resou rces, of ten fo und cl ose

to centres for basic research, such as universities and government agencies.

As comp anies g rew, so did their ac cess to mu ltiple so urces of i ntellec tual f‌i re-

power. By the mid-1980s, it became commonplace for companies to conduct

important research and development (R&D) in multiple locations, although

these effor ts generally continue d to be clustered in t he developed economies.

Starting in the mid-1990s, and accelerating recently, the trend has been for

MNCs to set up and rely on R&D c entre s in em ergi ng eco nomies , par ticu larl y

in Chin a and India, as well as in other countr ies that have invested he avily in

advanced science and technology education for their citizenry.

402 keith reams, et al.

Reliance on expanded R&D resources outside the home country has

brought with it the complexity of establishing IP ownership, as well as the

problems associated with the related accounting and reporting of the f‌inan-

cial be nef‌its and burdens of such ownership. More p roblematic, MNCs have

often become entangled in a web of confusing and conf‌lict ing legal and tax

rules associated with operating in sometimes far-f‌lung locations. Initial ly,

most MNCs relied on a patchwork of sometimes formal, but more often than

not informal, royalty-bearing intercompany licensing arrangements, de-

signed generally to deal with legal and regulatory complexity. While licens-

ing did address some important aspects of these issues, it often introduced

a large degree of inf‌le xibility into organizational str uctures that conf‌licted

with the long-term commercial goals and objectives of many MNCs.

Over time, MNCs have increasingly turned to CSAs in an effort to cope

more effectively with complexity by c larifying issues of IP ow nership, the

allocation of economic benef‌its and burdens among related aff‌iliates, and,

consequently, the location of income taxation. The benef‌it of the CSA is its

commercial agility and structural f‌lexibility. Under the typical CSA, the cost

and risks of R &D are shared among related aff‌iliates according to a legally

specif‌ied set of rules, in exchange for a specif‌ied dist ribution of ownership

interests in the IP that is developed. Each CSA participant is given specif‌ied

benef‌icial r ights to the IP developed under the arrangement, usually on a

territorial basis, thus avoiding the need for royalty payments and/or asset

transfers among aff‌iliates.

In an effort to keep up with and, in some cases, even encourage the use

of CSAs by MNCs, governments and their respective tax authorities around

the world have adopted an array of relevant measures. As early as 1966, the

U.S. Department of Treasury proposed a n extensive set of r ules governing

the u se of CSAs.1 The 1966 proposed regulations allowed any aff‌iliate to

participate in the CSA, provided that the IP created under the CSA was in-

tended for use in connect ion with the active conduct of the aff‌iliate’s trade

or business. The 1966 proposed regulations introduced t he idea that the

sharing of costs and risks be proportional to the anticipated benef‌its to each

participant in the CSA, which meant that cost sharing should be based on

some measure of economic benef‌it, such as relative sales, prof‌its, or other

f‌inancial criteria. The 1966 proposed regulations required that CSAs allow

for the payment of an arm’s-length amount to any aff‌iliate that provided IP

that substantially contributed to the development of future IP under the ar-

rangement. The costs incurred by non-CSA participating aff‌iliates in con-

1 Proposed U.S. Treasury Re gulations, § 1.482-2(d)(4), published on 2 August 1966.