Cost Sharing and Cost Contribution Agreements

If there is a written agreement between controlled organizations to develop the intangible property and share in the resulting property, the arrangement is considered a cost-sharing arrangement (CSA). A CSA includes transactions in which the controlled participants share intangible development costs in proportion to their shares of reasonably anticipated benefits. If a controlled participant provides a resource, capability, or right that it acquired outside the CSA and that is reasonably anticipated to contribute to developing shared intangibles (a platform contribution) the participant must be paid the value of this contribution in a platform contribution transaction.

If the arrangement is not a CSA under the regulations, the IRS will analyze it as a transfer of intangible property under one of the methods discussed below. A CSA is not a partnership and participation in a CSA is not engaging in a U.S. trade or business.

An arrangement among controlled participants to share intangible development costs must satisfy the requirements listed below to qualify as a CSA:

It must satisfy the following three substantive requirements:

all controlled participants must make payments to each other cost-sharing transaction (CST Payments) so that in each tax year each controlled participant's IDC share (i.e., its share of the cost of developing the intangibles is in proportion to its reasonably anticipated benefits (RAB) share). RAB share is determined based on the most current information and is updated on a cumulative basis;
all controlled participants must commit to and engage in Platform Contribution Transactions (PCTs) to the extent that there are platform contributions (i.e., a controlled member's contribution of an external resource, capability, or right, see "Platform contribution" below). In a PCT, when a controlled participant (PCT Payee) provides a platform contribution, each other controlled participant must make arm's length payments to the PCT Payee; and
each controlled participant must receive a non-overlapping interest ("divisional interest") in the cost shared intangibles without further obligation to compensate another controlled participant for its interest.

It must satisfy administrative requirements, including contract, documentation, books and records, and reporting requirements; and
The controlled participants must enter into a PCT as of the earliest date, beginning with the date the CSA is entered into, on which a platform contribution is reasonably anticipated to contribute to the developing of intangibles.

Each controlled participant must receive a non-overlapping interest in the cost shared intangibles without further obligation to compensate another controlled participant for that interest and must be entitled to the perpetual and exclusive right to the profits from transactions of any member of the controlled group that includes the controlled participant with uncontrolled taxpayers to the extent the profits are attributable to that interest in cost-shared intangibles.

An arrangement may nevertheless be treated as a CSA under the regulations if all the regulations' requirements are not satisfied, if the administrative requirements are satisfied, and if (i) the controlled participants reasonably believed that the other requirements listed above were satisfied, or (ii) if IRS determines that the administrative requirements are satisfied and that treating the arrangement as a CSA will provide the most reliable measure of an arm's length result.

IRS may make allocations to adjust the results of a CST so that a controlled participant's share of the intangible development cost (IDC) contributions (IDC share) is equal to its reasonably anticipated benefit share. In this connection, the IRS may:

Re-determine IDCs by adding costs or by removing any costs that are not IDCs;
Reallocate costs between the CSA's intangible development activity and other business activities;
Revise the basis used to measure the RAB share;
Revise projections used to measure the RAB share; and
Allocate any unallocated interests in cost-shared intangibles.

The U.S. IRS has issued an international practice unit giving an overview of cost-sharing arrangements with stock-based compensation (SBC).

The U.S. IRS also published a memorandum dated 13 July 2021 concerning issues related to transfer pricing examinations involving cost-sharing agreements under which taxpayers did not contract to share SBC costs, i.e., non-SBC CSAs, and included so-called "reverse claw-back" provisions in their contracts. A reverse claw-back provision in a non-SBC contract requires a cost-sharing participant to make a true-up payment for the cumulative amount of unshared SBC costs from prior years upon a certain triggering event.

The memorandum provides the following legal advice in this regard:

If the IRS adjusts the results of a CST for a taxable year to account for SBC costs, that adjustment should be treated as reducing the amount of any reverse claw-back true-up obligation by a corresponding amount, thereby avoiding an overpayment of the SBC costs;
If allocations to adjust the results of a CST in the year the IDCs were incurred are not possible for certain years, the IRS may make other adjustments, if necessary, to reflect the contract or to ensure that the non-SBC CSA produces results that are consistent with an arm's length result; and
If a taxpayer disregards a reverse claw-back clause in a Non-SBC CS agreement (or modifies the clause to modify, defer, or remove the obligation to make a true-up payment in accordance with the contract), the IRS may make appropriate allocations in the year the true-up is or (but for the modification) would have been triggered to produce results consistent with the unmodified contract or otherwise to reflect an arm's length result.

The periodic adjustment will not be made under the above rules if the controlled participants establish to the IRS's satisfaction that all the conditions described in any of the following apply:

For transactions involving the same platform contribution as the trigger PCT:

the same platform contribution is furnished to an uncontrolled taxpayer under substantially the same circumstances and with a similar form of payment as those of the relevant trigger PCT;
this transaction serves as the basis for the application of the comparable uncontrolled transaction method (CUT) as described in the transfer pricing regulations in the first year and all later years in which substantial PCT payments relating to the trigger PCT were required to be paid; and
the amount of the PCT payments in that first year was arm's length;

The differential between the Actually Experienced Return Ratio (AERR) and the nearest bound of the Periodic Return Ratio Range (PRRR) is due to extraordinary events beyond the control of the controlled participants that could not reasonably have been anticipated as of the date of the trigger PCT; and
The Periodic Trigger would not have occurred if the PCT payor's divisional profits or losses used to calculate its Present Value of Total Profits (PVTP) excluded those profits or losses attributable to:

the PCT payor's routine contributions to its exploitation of cost-shared intangibles;
its operating cost contributions; and
its non-routine contributions to the CSA activity.

The Periodic trigger would not have occurred if the divisional profits or losses of the PCT payor used to calculate its PVTP included its reasonably anticipated divisional profits or losses after the adjustment year from the cost-sharing arrangement (CSA) activity, including from its routine contributions, its operating cost contributions, and its non-routine contributions to that activity, and had the PCT payor's cost contributions and PCT payments used to calculate its Present Value of Investment (PVI) included its reasonably anticipated cost contributions and PCT payments after the adjustment year.

A controlled participant meets the administrative requirements of the cost-sharing regulations if it substantially complies with the cost-sharing arrangement (CSA) contractual, documentation, accounting, and reporting requirements as follows:

Contractual Requirement

The CSA must be recorded in a written contract that is contemporaneous with the formation (and any revision) of the CSA and includes eleven specified provisions. To be contemporaneous, the CSA must be documented in a signed and dated contract no later than 60 days after the first occurrence of any intangible development cost. Contractual provisions will be interpreted by reference to the economic substance of the transaction and the actual conduct of the controlled participants, with the result that the IRS may impute contractual terms in a CSA consistent with the economic substance of the CSA and may disregard contractual terms that lack economic substance.

Documentation Requirement

The controlled participants must update and maintain documentation to establish that they satisfy the above contract requirement. They must also maintain documentation on the current scope and changes in the CSA covering ten specified categories of information, including the method used to estimate each participant's reasonably anticipated benefits for each year of the arrangement, and the costs incurred by each participant (including the cost of stock-based compensation) for each year.

Accounting Requirement

The controlled participants must maintain books and records (and underlying data and information) to establish that a consistent method of accounting has been used, permit verification that contingent payments have been properly determined, translate foreign currencies on a consistent basis, and explain material differences if the accounting method differs from U.S. GAAP.

Reporting Requirement

Each controlled participant must file with the IRS a "CSA Statement" covering five specified items within 90 days after the first occurrence of an intangible development cost to which the newly-formed CSA applies (or, if later, 90 days after the taxpayer became a controlled participant). Each controlled participant must attach to its U.S. income tax return for each tax year a copy of the original statement with a schedule that updates the information. If the controlled participant is not required to file a U.S. income tax return, the information must be attached to Schedule M of specified forms.

Transfer Pricing for Tangible Property

The arm's length price charged in a controlled transfer of tangible property must be determined under the best method rule using one of the following methods, discussed in detail below:

The comparable uncontrolled price (CUP) method;
The resale price method;
The cost-plus method;
The comparable profits method (CPM);
The profit split method; or
Other unspecified methods

Comparable Uncontrolled Price Method

The comparable uncontrolled price method (CUP) evaluates whether the amount charged in a controlled transaction is arm's length by reference to the amount charged in a comparable uncontrolled transaction.

The CUP method generally will be the most direct and reliable measure of an arm's length price if an uncontrolled transaction has no differences with the controlled transaction that would affect the price, or if there are only minor differences that have a definite and reasonably ascertainable effect on price and for which appropriate adjustments are made.

Specific factors that may be particularly relevant include:

Quality of the product;
Contractual terms;
The level of the market (wholesale, retail, etc.);
The geographic market of the transaction;
Date of the transaction;
The alternatives realistically available;
Foreign currency risks; and
Intangible property associated with the sale.

A comparable uncontrolled price can be determined from data from public exchanges or quotation media, but only if the following requirements are met:

The data is used widely and routinely in the ordinary course of business in the industry to negotiate prices for uncontrolled sales;
The data from public exchanges or quotation media is used to set prices in the controlled transaction in the same way it is used by uncontrolled taxpayers in the industry; and
The amount charged in the controlled transaction is adjusted to reflect differences in product quality and quantity, contractual terms, transportation costs, market conditions, risks borne, and other factors affecting the price between uncontrolled taxpayers.

Resale Price Method

The resale price method is ordinarily used in cases involving the purchase and resale of tangible property in which the reseller does not add substantial value to the goods that are distributed by physically altering them before resale. Packaging, repackaging, labeling, or minor assembly are ordinarily not physical alteration. The resale price method tests the arm's length character of a controlled transaction by reference to the gross profit margin realized in comparable uncontrolled transactions and measures the value of functions performed. Ordinarily, the method should not be used if the controlled taxpayer uses its intangible property to add substantial value to the tangible goods.

An arm's length price is determined by subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction under review. The applicable resale price is equal to either the resale price of the particular item of the property involved or the price at which contemporaneous resales of the same property are made. The appropriate gross profit is computed by multiplying the applicable resale price by the gross profit margin earned in comparable uncontrolled transactions.

Comparability under the resale price method is less dependent on the close physical similarity of products transferred than it is under the CUP method. The controlled and uncontrolled transactions ordinarily should involve the distribution of products of the same general type. Significant differences in the value of the goods distributed due, for example, to the value of a trademark, can also affect the reliability of comparison, and reliability of profit measures based on gross profit can be adversely affected by factors that have less effect on prices (e.g., cost structures, business experience, or management efficiency).

Specific examples of factors that could be particularly relevant under the resale price method are:

Inventory levels and turnover rates, and corresponding risks;
Contractual terms;
Sales, marketing, advertising programs, and services;
The level of the market (wholesale, retail, etc.); and
Foreign currency risks.

A special rule applies if the controlled taxpayer is comparable to a sales agent who does not take title to goods or otherwise assume risks relating to ownership. The commission the agent earns, expressed as a percentage of the uncontrolled sales price of the goods, may be used as a comparable gross profit margin.

Cost Plus Method

The cost-plus method tests the arm's length character of a controlled transaction by reference to the gross profit mark-up realized in comparable uncontrolled transactions. The cost-plus method ordinarily will provide an accurate measure of an arm's length result if the controlled taxpayer manufactures or assembles goods that are sold to related parties. The determination of an arm's length result under the cost-plus method is made by adding the appropriate gross profit to the controlled taxpayer's costs of producing the property involved in the controlled transaction. The appropriate gross profit should be computed by multiplying the controlled taxpayer's cost of producing the property transferred by the gross profit mark-up earned in comparable uncontrolled transactions. The gross profit mark-up is expressed as a percentage of the cost. It ordinarily is expected under the cost-plus method that the controlled and uncontrolled transactions involve the production of goods in the same product categories. Significant differences in the value of the products due, for example, to the value of a trademark, may also affect the reliability of the comparison. The reliability of profit measures based on gross profit may be adversely affected by factors that have less effect on prices (such as cost structures, business experience, or management efficiency).

Specific examples of factors that could be particularly relevant under the cost-plus method are:

The complexity of manufacturing or assembly;
Manufacturing, production, and process engineering;
Procurement, purchasing, and inventory control activities;
Testing functions;
Selling, general, and administrative expenses;
Foreign currency risks; and
Contractual terms.

Unspecified Methods for Tangible Property

Methods not specified under the above rules may be used in determining whether the charge in a controlled transaction is at arm's length. These methods must consider the general rule that uncontrolled taxpayers must evaluate the terms of the transaction by considering realistic alternatives to it and must only enter a transaction if none of the alternatives is preferable. For example, the CUP method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price to which the parties would have agreed if they had used a market alternative to the controlled transaction. Therefore, in showing whether a controlled transaction reached an arm's length result, an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction.

Coordination Rules

The value of an item of tangible property may be affected by the value of the intangible property, such as a trademark affixed to tangible property (embedded intangible). Ordinarily, the transfer of tangible property with an embedded intangible will not be treated as a transfer of the embedded intangible if the controlled buyer does not acquire any rights to exploit the intangible other than rights relating to the resale of the tangible property under normal commercial practices. However, the embedded intangible must be accounted for in evaluating the comparability of the controlled transaction and uncontrolled comparables.

Transfer Pricing for Services

The original IRS regulations on transfer pricing date back to 1968 and originally covered many different types of transactions, including sales of tangible property and transfers of intangible property. When the IRS updated the transfer pricing regulations, they did not comprehensively address "controlled services transactions," i.e., the provision of services by one member of a controlled group to another.

After issuing temporary and proposed regulations in 2003 and 2006, the IRS in July 2009 promulgated final regulations covering controlled services transactions. As with all the IRS transfer pricing regulations, their purpose is to ensure that taxpayers clearly reflect income attributable to controlled services transactions and to prevent avoidance of U.S. taxes. In so doing, controlled taxpayers must use the best method to reach an arm’s length result (i.e., the result unrelated taxpayers would have reached in the transaction under the same circumstances).

The controlled services transactions regulations provide that, in determining the arm’s length amount uncontrolled parties would charge for services, the taxpayers must use one of seven methods set forth below, applied in accordance with the general transfer pricing rules.

The methods that may be used to determine the arm’s length amount to be charged in a controlled services transaction are as follows:

The services cost method;
The comparable uncontrolled services price method;
The gross services margin method;
The cost of services plus method;
The comparable profits method;
The profit split method; or
An unspecified method, if none of the preceding specific methods produce an arm's length amount determined under the best method rule.
Each of these methods is briefly described below.

The Services Cost Method

The services cost method (SCM) evaluates whether the amount charged for certain services (covered services) is at arm’s length by reference only to the total services costs with no mark-up. If the taxpayer applies the SCM, then the IRS’s authority is limited to adjusting only the amount charged for such reimbursed service amounts based on the properly computed amount of total services costs.

To apply the SCM, all of the following requirements must be met:

The service is a "covered service";
The service is not an "excluded activity";
The service is not precluded from constituting a covered service under the business judgment rule; and
The taxpayer must maintain adequate books and records.

A covered service is either specified in an IRS revenue procedure or constitutes a low margin covered service. IRS revenue procedures will identify certain specified covered services which are support services common among taxpayers across industry sectors, and generally do not involve a significant median comparable mark-up on total services costs. IRS Rev. Proc. 2007-13 is the first such revenue procedure and identifies about 100 activities in 20 categories as constituting specified covered services potentially eligible for the SCM.

SCM also applies to low margin covered services, which are controlled services transactions for which the median comparable mark-up on total services costs is less than or equal to seven percent (7%). The median comparable mark-up on total services costs mean the excess of the arm’s length price of the controlled services transaction using the interquartile (25% - 75% range) range over total services costs, expressed as a percentage of total services costs.

High-value services, which would not be either of the above two categories are not eligible for the SCM and require a formal transfer pricing analysis to determine the appropriate pricing. The following types of activities are high value and excluded from the SCM:

Manufacturing,
Production;
Extraction, exploration, or processing of natural resources;
Construction;
Reselling, distributing, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement;
Research, development, or experimentation;
Engineering or scientific;
Financial transactions; and
Insurance or reinsurance.

In addition, a service cannot constitute a covered service unless the taxpayer reasonably concludes in its business judgment that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the controlled group. Even if the taxpayer believes it has reached such a reasonable business judgment, the IRS of course can challenge such judgment on the audit. Permanent books of account must be maintained for as long as the costs with respect to the covered services are incurred by the service provider. Such books and records must include a statement evidencing the taxpayer’s intention to apply the SCM to evaluate the arm’s length charge for such services and must be adequate to permit the IRS to verify the total services costs incurred, including a description of the services, the identification of the service provider and service recipient, and sufficient documentation to allow IRS verification of the methods used to allocate and apportion such costs to the services in question, where necessary.

Comparable Uncontrolled Services Price Method

In general, the comparable uncontrolled services price method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the amount charged in a comparable uncontrolled services transaction. This determination is based on the factors described under the best method rules and comparability rules set forth in the regulations. This method generally is applicable where the comparable uncontrolled services are substantially similar, or where adjustments can reliably be made to any material differences.

Gross Services Margin Method

In general, the gross services margin method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the gross profits margin realized in a comparable uncontrolled transaction. This method is ordinarily used in cases where a controlled taxpayer performs services or functions in connection with an uncontrolled transaction between a member of the controlled group and an uncontrolled taxpayer. This method may be used where a controlled taxpayer renders services to another member of the controlled group in connection with a transaction between that other member and an uncontrolled taxpayer.

Cost of Services Plus Method

In general, the cost of services plus method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the gross services profits mark-up realized in comparable uncontrolled transactions. The cost of services plus method is ordinarily used in cases where the controlled service provider provides the same or similar services to both controlled and uncontrolled parties. This method is ordinarily not used in controlled services transactions involving a contingent payment arrangement.

Comparable Profits Method

The comparable profits method evaluates whether the amount charged in a controlled transaction is arm’s length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances. A profit level indicator that may provide a reliable basis for comparing operating cost profits of the tested party involved in a controlled services transaction and uncontrolled comparable is the ratio of operating profits and total services costs.

Profits Split Method

The profits split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The relative value of each controlled taxpayer’s contribution is determined in a manner that reflects the functions performed, risks assumed, and resources employed by such controlled taxpayer in the relevant business activity. There are two types of profits split methods that may be used: the comparable profits split and residual profits split, as more fully described in the regulations. The residual profits split method may not be used where only one controlled taxpayer makes significant non-routine contributions.

Unspecified Methods

Methods not specified above may be used to evaluate whether the amount charged in a controlled services transaction produces an arm’s length result. However, any method used under this unspecified method provision must take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, including economically similar transactions structured as other than services transactions, and only enter into a particular transaction if none of the alternatives is preferable to it. As with any of the above-specified methods, an unspecified method cannot be applied unless it provides the most reliable measure of an arm’s length result under the best method rule.

Transfer Pricing for Interest

There are no specified methods of transfer pricing to determine the arm’s length rate of interest.

According to Code Sec 482, the rate of interest that would have been charged in independent transactions between unrelated parties under identical circumstances at the time indebtedness arose is considered as the arm’s length rate of interest. All relevant factors of comparability must be considered, including the principal amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties.

Inter-Group Loans

For inter-group loans or advances where no interest is charged, or the interest charged is at a rate which is not equal to an arm's length rate of interest, the district director can make appropriate adjustments to determine the arm's length rate of interest.

Intra-Group Loans

For intra-group loans, as per non-taxpayer-specific legal advice released on 29 December 2023, the IRS may consider group membership in determining the arm's length rate of interest chargeable for intragroup loans and making adjustments under Code Sec 482. Thus, an arm's length rate of interest for intra-group loans shall be that which would have been charged in independent transactions between unrelated parties under similar circumstances, taking into account all relevant factors such as the borrower's credit standing, the credit rating of specific debt issuance, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties.

Transfer Pricing for Intangible Property

An intangible is defined as an asset that has substantial value independent of the services of any individual, and that comprises any of the following items:

Patents, inventions, formulae, processes, designs, patterns, or know-how;
Copyrights and literary, musical or artistic compositions;
Trademarks, trade names, or brand names;
Franchises, licenses, or contracts;
Methods, programs, systems, procedures, campaigns, surveys. studies, forecasts, estimates, customer lists, or technical data; and
Other similar items (that is, items deriving their value not from physical attributes but from intellectual content or other intangible properties).

Form of Consideration

If the transferee of the intangible pays nominal consideration or no consideration at all, and the transferor has kept a substantial interest in the property, the arm's length consideration must be in the form of a royalty unless a different form is demonstrably more appropriate. In a transfer for a lump sum, the sum must be commensurate with the income from the intangible. It is commensurate with income in a tax year if the equivalent royalty amount for that year is equal to an arm's length royalty. The equivalent royalty amount for a tax year is defined as the amount determined by treating the lump sum as an advance payment of a stream of royalties over the intangible's useful life (or the period of the agreement, if shorter) taking into account the projected sales of the licensee as of the transfer date. Thus, finding the equivalent royalty amount requires a present value calculation based on the lump sum, an appropriate discount rate, and the projected sales over the relevant period. The equivalent royalty amount is subject to periodic adjustments to the same extent as an actual royalty payment.

Periodic Adjustments

If an intangible is transferred under an arrangement covering more than one year, the consideration charged in each tax year can be adjusted to make sure that it is commensurate with the income from the intangible. In deciding whether to make such adjustments in a tax year under examination, the IRS can consider all facts and circumstances relevant throughout the intangible's period of use, and a determination in an earlier year that a charge was arm's length will not preclude a later year adjustment to the amount charged for the intangible in the later year. A periodic adjustment under the Code Sec. 482 "commensurate with income" standard can be made in a later tax year regardless of whether the tax year of the original transfer remains open.

The periodic adjustment rule above will not apply to require a later year allocation for a controlled transfer of intangible property.

If the same intangible was transferred to an uncontrolled taxpayer under substantially the same circumstances as the controlled transaction,
If this transfer to an uncontrolled taxpayer is the basis for applying the CUT method in the first tax year in which substantial consideration had to be paid; and
The amount paid in that year was an arm's length amount.

The facts which must be shown include the fact that a percentage test was met. Under this test, the aggregate profits actually earned or aggregate cost savings by the controlled taxpayer from using the intangible in the examination year and all past years must not be less than 80% nor over 120% of the prospective profits or cost savings foreseeable when the comparability of the uncontrolled agreement was established.

If an arm's length amount was determined under a method other than the CUT method, no allocation can be made under the periodic adjustments rule if the following facts are shown:

The controlled taxpayers entered a written "controlled agreement" providing for a consideration amount for each tax year covered, and the agreement stayed in effect for the year under review;
The controlled agreement consideration was arm's length for the first tax year in which substantial periodic consideration had to be paid, and relevant supporting documentation was prepared along with the execution of the agreement;
There have been no substantial changes in the transferee's functions since the execution of the agreement, except changes from unforeseeable events; and
Total profits actually earned or total cost savings by the controlled transferee from using the intangible in the examination year and all past years meet a percentage test.

If the requirements of either of the 80% through 120% exceptions are met for each year of the five-year period beginning with the first tax year, substantial periodic consideration has to be paid, no periodic adjustment will be made in any later year. Moreover, if the requirements of either of these exceptions are otherwise met, no periodic adjustment is necessary if the aggregate cost savings or aggregate actual profits realized by the taxpayer are less than 80% or more than 120% of the prospective profits or cost savings due to extraordinary events that were beyond the controlled taxpayers' control and that could not reasonably have been anticipated at the time of the controlled agreement.

Ownership

The legal owner of intangible property under the intellectual property laws of the relevant jurisdiction, or the holder of rights constituting an intangible property under a contract (e.g., a license) or other legal provision, is considered the sole owner of the intangible for transfer pricing purposes unless this ownership is inconsistent with the economic substance of the underlying transactions.

The arm's length amount charged in a controlled transfer of intangible property must be determined under one of the following methods discussed in further detail below:

The comparable uncontrolled transaction;
The comparable profits method;
The profit split method; or
Unspecified methods explained.

Comparable Uncontrolled Transaction Method

The comparable uncontrolled transaction (CUT) method evaluates whether the amount charged for a controlled transfer of intangible property was arm's length by reference to the amount charged in a comparable uncontrolled transaction.

If an uncontrolled transaction involves the transfer of the same intangible under the same, or substantially the same, circumstances as the controlled transaction, the results from applying the comparable uncontrolled transaction method, generally will be the most direct and reliable measure of an arm's length result for the controlled transfer of an intangible. Between the controlled and uncontrolled transactions, circumstances will be considered substantially the same if there are, at most, only minor differences that have a definite and reasonably ascertainable effect on the amount charged. Appropriate adjustments for the differences must be made.

In order for the intangible property in an uncontrolled transaction to be considered comparable to the intangible property in a controlled transaction, both intangibles must have similar profit potential and be used in connection with similar products or processes within the same general industry or market.

The profit potential of an intangible is measured by the net present value of the benefits to be realized through the use or subsequent transfer of the intangible taking into consideration the capital investment and start-up expenses required, the risks to be assumed, and other relevant considerations.

In evaluating the comparability of circumstances, specific factors that may be particularly relevant to the comparable uncontrolled transaction method include:

The terms of the transfer;
The stage of development of the intangible;
Any rights to receive periodic updates or modifications to the intangible;
The uniqueness of the property and the period for which it stays unique;
The duration of the license, contract, or other agreement, and any termination or renegotiation rights;
Any economic or product liability risks to be assumed by the transferee;
The existence and extent of any collateral transactions and ongoing business relationships between the transferor and the transferee; and
The functions to be performed by the transferor and transferee, including any ancillary or subsidiary services.

Comparable Profits Method

The comparable profits method relies on the general principle that similarly situated taxpayers will tend to earn similar returns over a reasonable period of time. The method is included in the methods available for both tangible and intangible property.

The CPM determines the arm's length consideration for a controlled transfer of property by referring to objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities with other uncontrolled taxpayers under comparable circumstances. An arm's length result is determined based on the amount of operating profit the tested party would have earned on related party transactions if its profit level indicator were equal to that of an uncontrolled comparable (comparable operating profit). Comparable operating profit is determined by finding a profit level indicator for an uncontrolled comparable and applying the profit level indicator to the financial data related to the tested party's most narrowly identifiable business activity for which data incorporating the controlled transaction is available (relevant business activity). Profit level indicators should, to the extent possible, be applied only to the tested party's data that is related to controlled transactions. The tested party's reported operating profit is compared to the comparable operating profits from the profit level indicators of uncontrolled comparable to find if the reported operating profit is an arm's length result. The tested party generally will be the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data on uncontrolled comparable can be found. Thus, the tested party will usually be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets distinguishing it from potential uncontrolled comparable. Profit level indicators are ratios measuring relationships between profits and costs incurred or resources employed. They include two specified types of indicators: the rate of return on capital employed and financial ratios. Other profit level indicators not described specifically in the regulations can be used if they satisfy the best method rule, but profit level indicators based solely on internal data cannot be used because they are not objective measures of profitability derived from operations of uncontrolled taxpayers in similar business activities under similar circumstances.

Reliability under the CPM is not as dependent on product similarity as the resale price or cost-plus method. But, the reliability of profitability measures based on operating profit may be adversely affected by factors that have less effect on results under the CUP, resale price and, cost-plus methods. For example, operating profit may be affected by varying cost structures, differences in business experience, or differences in management efficiency.

Profit Split Method

Profit split methods are for both tangible and intangible property. Two profit split methods can be used: the residual profit split method and the comparable profit split method. The basic approach of the methods is to estimate an arm's length return by comparing the relative economic contributions of the parties to the venture and dividing the returns between them on the basis of the contributions.

Specifically, the methods evaluate whether the allocation of the combined operating profit or loss from one or more controlled transactions is arm's length by reference to the relative value of each controlled taxpayer's contribution to that combined operating profit. The combined operating profit or loss must be derived from the most narrowly identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions.

The relative value of each controlled taxpayer's contribution to the success of the relevant business activity is determined in a way reflecting the functions performed, risks assumed, and resources employed by each in the activity. The profit allocated to any particular member of a controlled group is not necessarily limited to the total operating profit of the group from the relevant business activity. Thus, in a given year, one member may incur a loss while another member has a profit. It cannot be assumed that the combined operating profit or loss from the activity should be shared equally or in any other arbitrary proportion.

Residual Profit Split

Under the residual profit split rule, the combined profit and loss from the relevant business activity is allocated between the controlled taxpayers using a two-step process. The first step allocates operating income to each party to the controlled transactions to provide a market return for its routine contributions. Routine contributions are contributions of the same kind or of a similar kind to those by uncontrolled taxpayers involved in similar business activities for which it is possible to identify market returns. They ordinarily include contributions of tangible property, services, and intangibles that are generally owned by uncontrolled taxpayers engaged in similar activities. A functional analysis is needed to identify these contributions according to the functions performed, resources employed, and risks assumed by each of the controlled taxpayers. The allocation of income to the controlled taxpayer's routine contributions will not reflect profits attributable to non-routine contributions. A non-routine contribution is any contribution that is not a routine contribution.

The second step allocates the residual profit among the controlled taxpayers based upon the relative value of their non-routine contributions to the relevant business activity. The relative value of the non-routine contributions of each taxpayer should be measured in a manner that most reliably reflects each non-routine contribution made to the controlled transaction and each controlled taxpayer's role in the non-routine contributions. If the non-routine contribution by one of the controlled taxpayers is also used in other business activities (e.g., transactions with other controlled taxpayers), an appropriate allocation of the value of the non-routine contribution must be made among all the business activities in which it is used.

Non-routine contributions of a taxpayer to the relevant business activity may be contributions of intangible property. The relative value of non-routine intangible property contributed by taxpayers may be measured by external market benchmarks that reflect the fair market value of such intangible property. Alternatively, the relative value of non-routine intangible property contributions may be estimated by the capitalized cost of developing the intangible property and all related improvements and updates, less an appropriate amount of amortization based on the useful life of each intangible. Finally, if the intangible development expenditures of the parties are relatively constant over time and the useful life of the intangible property contributed by all parties is approximately the same, the amount of actual expenditures in recent years may be used to estimate the relative value of non-routine intangible property contributions.

The reliability of the results from the residual profit split is affected by the quality of the data and assumptions used to apply it. The following factors are particularly important:

The reliability of the allocation of costs, income, and assets relating to the comparable profit split;
Accounting relating to the comparable profit split; and
The reliability of the data used and assumptions made in valuing the intangibles contributed by participants.

Comparable Profit Split

A comparable profit split is derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayer in the relevant business activity. Each uncontrolled taxpayer's percentage of the combined operating profit or loss is used to allocate the combined profit or loss of the relevant business activity. The method compares the division of operating profits among the controlled taxpayers to the division of operating profits among uncontrolled taxpayers engaged in similar activities in similar circumstances. The degree of similarity of the contractual terms of the controlled and uncontrolled taxpayers is also particularly important. The comparable profit split cannot be used if the combined operating profit of the uncontrolled comparable as a percentage of combined assets varies significantly from that earned by the controlled taxpayers.

Unspecified Methods for Intangible Property

Methods not specified under the above rules may be used in determining whether the charge in a controlled transaction is at arm's length. These methods must consider the general rule that uncontrolled taxpayers must evaluate the terms of the transaction by considering realistic alternatives to it, and must only enter a transaction if none of the alternatives is preferable. For example, the CUT method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price to which the parties would have agreed if they had used a market alternative to the controlled transaction. Therefore, in showing whether a controlled transaction reached an arm's length result, an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction.

Permanent Establishment (‘AOA Approach’)

Under the Authorized OECD Approach (AOA), the OECD has published guidelines for the allocation of profits to permanent establishments. Currently, there are seven U.S. tax treaties that have incorporated the latest Authorized OECD Approach (AOA), which is based on Article 7 of the OECD Model Tax Convention as amended in 2010. The remaining treaties continue to use the pre-existing version.

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