Cost Sharing

Note:  This user guide is intended to help clarify the concepts and identify issues in the application of the U.S. regulations. It does not constitute legal advice, and should not be relied on as such.

A. Application/Timing
For all cases in which two or more related parties agree to jointly develop an intangible and both expect to derive an economic benefit once the intangible is developed, the "cost sharing" section of the 482 regulations must be considered. These regulations apply to all agreements signed after January 1, 1996, and offer a one year "Grace Period" for all agreements signed before January 1, 1996.

B. Structure
The 482 regulations specify the structure for cost sharing agreements, including the payments, expected benefits, and covered intangibles. Payments (and time of payments) by each party must be defined, and the regulations classify two types of payments: R&D operating expenses and an arm’s length price for necessary tangible property.

Expected benefits (and time receiving benefits) by each party must be defined. Such expected benefits might include additional units sold, additional revenue generated, or additional operating profit received.

In calculating benefits and accounting for payments, it is necessary to define which intangibles are to be included as a part of the cost sharing agreement. In this sense, benefits are calculated based upon any monetary benefit earned from the exploitation of any intangibles developed as a result of the cost sharing arrangement.

C. Regulatory Use of Cost vs. Benefit Analysis
Each party’s share of costs (discounted present value) should equal its share of expected benefits (discounted present value). The agreement must be designed so that "cost share equals expected benefit share." No adjustment is made if the actual benefit share is within 20% of the expected benefit share (i.e., if expected share is 50%, actual may be anywhere from 40-60%).

D. Buy-in/Buy-out/Transfer
In addition to the actual cost share arrangement, the regulations cover buy-ins, buy-outs, and transfers within the cost sharing arrangement. In a buy-in, an entity wants to join a cost sharing relationship with another entity(ies) that have already done some intangible development. The entering entity pays its expected share of the current value of the intangible to the entity(ies) that will lose that share of the intangible. After the initial buy-in, the future development costs are split according to the new split of expected benefit shares.

In a buy-out, an entity wants to exit a cost sharing relationship that has already performed some intangible development. The exiting entity receives its share of the current value of the intangible from the entity(ies) that will gain its share of the intangible. After the buy-out, the future development costs are split according to the new split of expected benefit shares.

In a transfer, an entity wants to receive more (less) of a share in the benefits or an entity realizes that it is receiving a larger (smaller) share of the benefits than intended. The entity that is increasing (or has increased) its benefit share must pay the entity that is losing (or has lost) its benefit share an amount equal to: (current intangible value) * (share being transferred). After the transfer, the future development costs are split according to the new split of expected benefit shares.

E. IRS Regulations
The IRS regulations are contained in Section 1.482-7.

F. Examples

Agreement

In 2004, NI and NL enter into a cost sharing arrangement to develop widget technology. Both parties agree to pay 50 percent of the development costs, as each expects to earn 50 percent of the benefits generated by the covered intangibles. NI will have the rights to exploit the covered intangibles in North and South America, while NL will have rights to the rest of the world. Benefits are defined as additional operating profit (in comparison to what NI and NL would have earned without the covered intangibles) in the following manner:

NI’s benefits will equal: NI’s annual operating profits minus $100 million
NL’s benefits will equal: NL’s annual operating profits minus $150 million

Safe Harbor (Expected vs. Actual Shares)

The widget technology developed from this arrangement was only able to be exploited for 1 year. In that year, NI’s operating profits were $125 million, while NL’s were $225 million. Thus, this technology provided $100 million in additional profit, divided 25/75 between NI and NL. Since 25 percent (and 75 percent) is more than 20 percent lower (higher) than the expected 50 percent share, a $25 million adjustment would be imposed to provide a 50/50 split.

Buy-in

In 2005, NS, another related party, wanted to "buy-in" to the project and take over half of North and South America from NI. Thus, post buy-in, the shares will be 25/50/25 for NI/NL/NS. Since the intangibles that have been developed by this time are valued at $10 million, NS must pay NI a $2.5 million (25 percent*$10 million) buy-in payment. After this payment, the 3 entities share the future costs 25/50/25.

Buy-out

Assume first that NS has already bought in and the shares are 25/50/75 for NI/NL/NS. In 2006, NL wants to be bought out by NS. Thus, post buy-out, the shares will be 25/0/75 for NI/NL/NS. Since the intangibles that have been developed by this time are valued at $15 million, NS must pay NL a $7.5 million (50 percent*$15 million) buy-out payment. After this payment, the 2 entities (NI and NS) share the future costs 25/75.