The Seemingly Strange Case of the Negative PCT Payment

Reproduced with permission from Tax Management Transfer Pricing Report, Vol. 24 No. 7, 8/6/2015. Copyright� 2015 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

The Seemingly Strange Case of the Negative PCT PaymentWhen Cost Sharing Under the Income Method

The authors offer a detailed analysis that shows how the income method in U.S. transfer

pricing regulations allows for the possibility that a U.S. multinational making platform con-

tributions to a controlled foreign corporation in the form of valuable intangible rights

would be required to compensate the foreign corporation to induce it to agree to enter into

the cost sharing arrangement.

BY MARCO FIACCADORI, JOSEPH L. TOBIN AND

PHILIPPE G. PENELLE, DELOITTE TAX LLP

T his article presents some important results in ap-plying the income method specified in the costsharing provisions under Regs. §1.482-7(g)(4).

These results are useful in understanding the relation-ship between the reasonably anticipated benefit (RAB)shares selected and the sign and magnitude of the plat-form contribution transaction (PCT) payment. In par-ticular, these results establish a necessary and sufficientcondition (an ‘‘if and only if’’ condition) such that proj-ects with strictly positive expected consolidated grossintangible income will result in a strictly positive PCTpayment. When that necessary and sufficient conditionis violated, a negative PCT payment is required because

the allocation of consolidated intangible developmentcosts (IDCs) to the controlled foreign participant (CFP)exceeds the gross intangible income it can reasonablyexpect from exploiting the cost shared intangibles (seethe discussion of the ‘‘FTP condition’’ below). As a cor-ollary to the main result, the ratio of the expected grossintangible income of the CFP to the expected consoli-dated gross intangible income always is equal to thesame ratio net of IDCs (see the discussion of FTPLemma). This result is important in applying the defini-tions in Regs. §1.482-7(j)(1)(i) and -7(e)(1)(i).

One of the most striking results is that one RABshare is not more reliable than any other in producingan arm’s-length result—defined in this context as the exante indifference of both participants between the li-censing alternative and the cost sharing alternative, asrequired under the realistic alternative concept in Regs.§§1.482-7(g)(2)(iii)(A) and (g)(4)(i)(A). In fact, the in-come method specified in the regulations will producean arm’s-length result for any RAB share 0 < α < 1, in-cluding randomly selected ones, as long as the PCTpayment is allowed to take any value on the real line(including negative values) to ensure achieving theregulatorily mandated indifference between the licens-ing alternative and the cost sharing alternative (see thediscussion of the IRS paradox below).

However, this article also will show (in Figure 4)that, under the requirements of Regs. §1.482-7(e)(1)(ii),the Fiaccadori-Tobin-Penelle (FTP) RAB share alwayswill be more reliable than any other RAB share that re-sults in a strictly negative PCT. Strictly negative PCTstherefore cannot be ruled out for violating the arm’s-length standard under Regs. §1.482-1(b)(1), but argu-ably they can be ruled out for violating Regs. §1.482-7(e)(1)(ii).

Marco Fiaccadori, Ph.D., and Joe Tobin aresenior managers, and Philippe Penelle, Ph.D.,is a principal, in Deloitte Tax LLP’s Wash-ington National Tax office. Tobin finalized thecost sharing regulations while at the InternalRevenue Service’s Office of Associate ChiefCounsel (Branch 6) in 2011. The authors aregrateful for feedback on a previous versionof this article received from Shanto Ghosh,Jay Das, Robin Hart and Juan Sebastian Lle-ras, and have benefited from discussions onthis and related topics over the years withAlan Shapiro, Arindam Mitra, Larry Powell,Larry Shanda, Mike Bowes, Sajeev Sidher andGretchen Sierra.

Copyright � 2015 Deloitte Development LLC

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Tax Management

Transfer Pricing Report™

ResultsThis section begins and ends with two fundamental

results. The first result establishes a necessary and suf-ficient condition for a PCT payment to be strictly posi-tive. The second result establishes that any RAB share,including randomly selected ones, produces an arm’s-length result. This leads to the legal discussion pre-sented in the next section, and the illustrative exampledeveloped in the third and last section.

Fiaccadori-Tobin-Penelle (FTP) Condition: Let the pres-ent value of the expected gross intangible income of theforeign participant in a cost sharing arrangement bestrictly positive. The platform contribution transactionpayment calculated under Regs. §1.482-7(g)(4)(2011) isstrictly positive if and only if the reasonably anticipatedbenefit share of the foreign participant is strictly lessthan the ratio of the present value of the expected grossintangible income of the foreign participant to the pres-ent value of the expected consolidated intangible devel-opment costs.

Proof:Let Rt denote the expected gross consolidated intan-

gible income at date t resulting from the intangible de-velopment activities under the cost sharing arrange-ment. Let Rt

FX > 0 and RtUS > 0 denote the CFP and

U.S. gross intangible income at date t resulting from theintangible development activities, respectively.1 It fol-lows that

Let IDCt denote the expected consolidated intangibledevelopment costs at date t. Let IDCt

FX denote the ex-pected intangible development costs allocated to theCFP at date t ε {1,2,. . .,T}.2 Following the definition ofthe platform contribution transaction payment underRegs. §1.482-7(g)(4)(i)(A)(2011), one has the equationbelow.

This formula to calculate the PCT payment alwaysholds true because the regulations mandate underRegs. §1.482-7(g)(4)(i)(C) that ‘‘the analysis under thelicensing alternative should assume a similar allocationof the risks of any existing resources, capabilities, orrights, as well as of the risks of developing other re-sources, capabilities, or rights that would be reasonably

anticipated to contribute to exploitation within the par-ties’ divisions, that is consistent with the actual alloca-tion of risks between the controlled participants as pro-vided in the CSA in accordance with this section.’’ Fur-thermore, Regs. §1.482-7(g)(4)(vi)(F)(1) provides that‘‘the financial projections associated with the licensingand cost sharing alternatives are the same, except forthe licensing payments to be made under the licensingalternative and the cost contributions and PCT Pay-ments to be made under the cost sharing alternative.’’This is one of the most commonly overlooked require-ments in the application of the income method underRegs. §1.482-7(g)(4), as it forces a structure such that,for example, any differences in discount rates betweenthe licensing and cost sharing alternative can only pos-sibly be driven by the operating leverage (the IDC in thecost sharing alternative being less variable than the roy-alty in the licensing alternative) of the IDC in this appli-cation of the income method.

In the following equation, rL denotes the licensing al-ternative discount rate, and rIDC denotes the intangibledevelopment cost discount rate. Note that rIDC < rL.4

Let 0 < α < 1 denote the share of IDC allocated to theforeign participant.5 It follows that

Substituting this equation in the definition of theplatform contribution transaction payment, one obtainsthe equation below.6

It follows that

1 Under Regs. §1.482-7(g)(4)(iii), RtFX and Rt

US are esti-mated using a comparable uncontrolled transaction (CUT) ora comparable profits method (CPM).

2 Where T can be a natural number or ∞.

4 See Philippe G. Penelle, ‘‘The Mathematics of Cost Shar-ing under the Income Method,’’ 21 Transfer Pricing Report665, 11/1/12. The discount rates are assumed to be those ofmarket participants (this is an application of the arm’s-lengthstandard) and, without loss of generality, constant over time.

5 Because α measures the expected reasonably anticipatedbenefit share of the CFP over the period of cost sharing activ-ity calculated at date t=1, the strict inequality is required to en-sure that the cost sharing arrangement satisfies the require-ments of Regs. §1.482-7(b) (2011). Because the valuation of thePCT occurs at the inception of the cost sharing, α is not carry-ing a time index.

6 This formula confirms the following statement attributedto Daniel J. Frisch by Paul Shukovsky: ‘‘In testimony, Frischalso made a point of saying that proper intangible develop-ment costs affect the buy-in; the larger the IDC, the smaller thebuy-in value.’’ Shukovsky, ‘‘As Amazon Trial Closes, TaxCourt Judge Alludes to One Conclusion About Cost Pool,’’ 23Transfer Pricing Report 1087, 1/8/15.

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This concludes the proof of the FTP condition. Itshould be noted and understood that the way the PCTpayment is defined and calculated in the Treasury regu-lations is a ‘‘plug’’ that forces two discounted streams ofcash flows to have the same present value. Whether thediscounted stream of cost sharing alternative cash flowsbefore the PCT payment is greater or smaller than thediscounted stream of licensing alternative cash flowsentirely depends on the selected α. For some (low) val-ues of α it could be the case that the discounted streamof cost sharing alternative cash flows is greater thanthat of licensing alternative cash flows and vice versafor some (high) other values of α. This result is a directconsequence of the tightly specified structure of the in-come method in Regs. §1.482-7(g)(4).

Before graphically illustrating the FTP condition, theFTP RAB share for the CFP shall be defined as:

αFTP is named the FTP RAB share because when theCFP is allocated IDC based on αFTP, the resulting PCTpayment is by definition always exactly zero. Any RABshare for the CFP lower than αFTP results in a strictlypositive PCT (that is the FTP condition) and any RABshare greater than αFTP results in a strictly negativePCT (because the FTP condition is an ‘‘if and only ifcondition’’).

With a few substitutions, the PCT formula can be re-written as:

This formula for the PCT makes clear when and whya PCT may be negative, as summarized in Figure 1. Adirect graph of the size of the PCT is provided later inFigure 4.

In the previous graph, α* denotes the RAB share forthe CFP consisting in the ratio of the present value ofthe expected gross intangible income of the CFP to thepresent value of the expected consolidated gross intan-gible income. This graphic illustration of the FTP condi-

tion underscores the critical importance of the FTP RABshare—RAB shares lower than the FTP RAB share re-sult in a positive PCT, while RAB shares greater thanthe FTP RAB share result in a negative PCT.

Thus, for a project with positive expected consoli-dated value under the discounted cash flow method(DCF), one has the following (assuming without loss of

generality that the consolidated IDCs are in excess ofthe expected gross intangible income of the CFP):

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Similarly, for a project with negative expected con-solidated value under DCF, one has the following:

For example, consider a project with positive ex-pected consolidated value under DCF. Suppose that theRAB share selected is net sales, where:

Since the RAB share of the foreign participant α isstrictly greater than the ratio of the present value of theexpected gross intangible income of the foreign partici-pant to the present value of the expected consolidatedintangible development costs, the resulting PCT pay-ment is negative—despite the project having strictlypositive expected value under DCF.

This establishes that projects with strictly positiveexpected value under DCF will result in a negative PCTpayment under Regs. §1.482-7(g)(4) when the FTP con-dition is violated. In the previous example, the negativePCT payment rebalances in present value the over-allocation of IDC. The over-allocation of IDC is the re-sult of using a RAB share for the CFP based on salesrather than expected gross (or net—see FTP Lemma be-low) intangible income. The RAB share based on salesoverestimates the relative benefit of the CFP from thecost sharing arrangement. The rebalancing is requiredby law to achieve indifference between the licensingand the cost sharing alternatives.

As another example, consider a project with negativeconsolidated expected value under DCF. Suppose thatthe RAB share selected for the CFP is expected gross in-tangible income, where:

Because the RAB share of the CFP α is strictlygreater than the ratio of the present value of the ex-pected gross intangible income of the CFP to the pres-ent value of the expected consolidated intangible devel-opment costs, the resulting PCT payment is negative.

This establishes that projects with strictly negativeexpected value under DCF will result in a negative PCTpayment under Regs. §1.482-7(g)(4) if the RAB shareselected for the CFP is the ratio of the expected gross(or net—see FTP Lemma below) intangible income ofthe CFP in the expected gross (or net) consolidated in-tangible income.

Corollary 1: If the RAB share of the CFP is calculatedusing the present value of expected gross intangible in-come of the CFP in the expected gross consolidated in-tangible income, the PCT payment is strictly positive ifand only if the intangible development activity hasstrictly positive expected consolidated net present valueunder DCF.

Proof:

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Let

Using the FTP condition, one knows that

Furthermore:

Therefore,

Corollary 2: If the present value of the expected grossintangible income of the CFP is strictly greater than thepresent value of the expected consolidated intangibledevelopment costs, the platform contribution transac-tion payment is always strictly positive.

Proof:Using the FTP condition, one knows that Furthermore,

Since α < 1, it follows that j 0 < α < 1

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Lemma (Fiaccadori-Tobin-Penelle): RAB shares calcu-lated as the ratio of the present value of the expectedgross intangible income of the CFP to the expected con-solidated gross intangible income are equal to thosecalculated as the ratio of the present value of the ex-pected net intangible income of the CFP to the expectedconsolidated net intangible income.

Proof:

Let h denote a fixed point of the following mapping:

That is,

Solving for h

Simplifying,

h is therefore given by

Furthermore, h is unique by the intermediate valuetheorem as Map is a continuous and strictly decreasingin the compact domain 0 ≤ α ≤ 1 with Map(0) > 0 andMap(1) < 1.

One may now prove the striking result that any RABshare (for the CFP) such that 0 < α < 1, including ran-domly selected ones, produces an arm’s length result.Again, this property is a direct consequence of the waythe income method under Regs. §1.482-7(g)(4) is speci-fied and implemented; it is not a universal property ofthe application of other specifications of the income

method. This result is, however, critically important asthe Irrelevance of the RAB Share Paradox below (IRSParadox in short) shows that controversy on the rea-sonableness of specific RAB shares appears to be some-what meaningless—at least insofar as the arm’s lengthnature of the result is not at stake. Taxpayers are re-quired by the Treasury regulations under Internal Rev-enue Code Section 482 to achieve an arm’s length resultin their controlled dealings. That overarching require-ment of Regs. §1.482-7(b)(1) tends to trump any otherrequirements under Section 482. In the next section of

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this article, the reader will be engaged in a more granu-lar legal discussion of the results outlined herein, in-cluding a discussion of how Regs. §1.482-7(e)(1)(ii) af-fects the selection of RAB shares.

Irrelevance of RAB Share Paradox (IRS Paradox): Letthe present value of the expected gross intangible in-come of the controlled foreign participant in a CSA bestrictly positive. The platform contribution transactionpayment calculated under Regs. §1.482-7(g)(4)(2011) isarm’s length for all RAB shares for the CFP 0 < α < 1.

Proof:Consider the proof of the FTP condition up until

Recall that this formula is satisfied for all 0 < α < 1.Let WCSA and WLicense denote the non-routine value ofthe cost sharing alternative and of the licensing alterna-tive to the CFP, respectively. It should be clear that onecan always normalize WLicense = 0 because the CFPdoes not contribute any valuable intangible assets to theCSA, and to the extent the CFP exploits non-cost-shared intangibles in the cost sharing alternative, it alsodoes in the licensing alternative. This is a direct conse-

quence of Regs. §1.482-7(g)(4)(i)(C) and Regs. §1.482-7(g)(4)(vi)(F)(1).

An arm’s length result is defined as a result such thatfor 0 < α < 1 one has WCSA(α) = WLicense = 0. This is adirect application of the realistic alternative concept ofRegs. §1.482-7(g)(2)(iii)(A) and Regs. §1.482-7(g)(4)(i)(A).7

Substituting the formula for the PCT above into WCSA (α), one obtains, for all 0 < α < 1:

Notice how the function WCSA(α) reduces to WLicense

regardless of the particular value of α (the CFP RABshare) selected.

Legal DiscussionThe most interesting case to discuss is that of a proj-

ect with positive (consolidated) value under DCF, andnot enough expected gross intangible income in the for-eign divisional interest to justify incurring the expectedconsolidated intangible development costs. These twoconditions are written below:

Applying the FTP condition, one concludes thatsince:

A strictly negative PCT payment will occur when theCFP RAB shares are such that

7 Regs. §1.482-7(g)(4)(i)(A) reads: ‘‘The income methodevaluates whether the amount charged in a PCT is arm’slength by reference to a controlled participant’s best realisticalternative to entering into a CSA. Under this method, thearm’s length charge for a PCT Payment will be an amount suchthat a controlled participant’s present value, as of the date ofthe PCT, of its cost sharing alternative of entering into a CSAequals the present value of its best realistic alternative. In gen-eral, the best realistic alternative of the PCT Payor to enteringinto the CSA would be to license intangibles to be developedby an uncontrolled licensor that undertakes the commitmentto bear the entire risk of intangible development that wouldotherwise have been shared under the CSA. Similarly, the bestrealistic alternative of the PCT Payee to entering into the CSAwould be to undertake the commitment to bear the entire riskof intangible development that would otherwise have beenshared under the CSA and license the resulting intangibles toan uncontrolled licensee. Paragraphs (g)(4)(i)(B) through (vi)of this section describe specific applications of the incomemethod, but do not exclude other possible applications of thismethod.’’

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From a legal standpoint, it is interesting to explorewhether anything in the Treasury Regulations could, orwould, prevent the CFP RAB share α to satisfy the lastinequality above and result in a negative PCT payment.

At this stage of the discussion, it becomes particu-larly important to distinguish the definition of variousconcepts in the Treasury Regulations from the mea-surement thereof, and the guidance provided in theTreasury Regulations about the measurement thereof.Regs. §1.482-7(j)(1)(i) provides the following importantdefinitions:

s Benefit: ‘‘Benefits mean the sum of additional rev-enue generated, plus cost savings, minus any cost in-creases from exploiting cost shared intangibles.’’ MainCross References §1.482-7(e)(1)(i);

s Reasonably Anticipated Benefits: ‘‘A controlledparticipant’s reasonably anticipated benefits mean thebenefits that reasonably may be anticipated to be de-rived from exploiting cost shared intangibles. For pur-poses of this definition, benefits mean the sum of addi-tional revenue generated, plus cost savings, minus anycost increases from exploiting cost shared intangibles.’’Main Cross References §1.482-7(e)(1).

In addition, Regs. §1.482-7(e)(1)(i) provides that ‘‘Acontrolled participant’s share of reasonably anticipatedbenefits is equal to its reasonably anticipated benefitsdivided by the sum of the reasonably anticipated ben-efits, as defined in paragraph (j)(1)(i) of this section, ofall the controlled participants.’’ These provisions com-bine to precisely define the ‘‘true’’ RAB share for theCFP as being the ratio of present value of the expectednet intangible income of the CFP to the present value ofthe expected consolidated net intangible income (attrib-utable to the cost shared intangibles). The FTP Lemmademonstrated that the aforementioned ratio is equal toα*, the ratio of the present value of the expected grossintangible income of the CFP to the present value of theexpected consolidated gross intangible income (attrib-utable to the cost shared intangibles).

That ‘‘true’’ RAB share α*, however, is neitherknown nor directly observable ex ante nor ex post.Regs. §1.482-7(e)(1)(ii) thus provides taxpayers withguidance on how to estimate the ‘‘true’’ RAB share α* :‘‘A controlled participant’s RAB share must be deter-mined by using the most reliable estimate. In determin-ing which of two or more available estimates is most re-

liable, the quality of the data and assumptions used inthe analysis must be taken into account, consistent with§1.482-1(c)(2)(ii) (Data and assumptions). Thus, the re-liability of an estimate will depend largely on the com-pleteness and accuracy of the data, the soundness of theassumptions, and the relative effects of particular defi-ciencies in data or assumptions on different estimates.’’

Let 0 < i* < 1 denote the most reliable estimate ofα* based on the data available. Applying the IRS Para-dox, it is known that any CFP RAB share, including i*and any other strictly greater than zero and strictlylower than one, results in an arm’s length allocation ofincome between participants. This property of the CFPRAB shares addresses the overarching principle of Sec-tion 482—as memorialized in the affirmation of thearm’s length standard under Regs. §1.482-1(b)(1) as be-ing the universal burden placed on taxpayers. However,only one RAB share meets the requirement of Regs.§1.482-7(e)(1)(ii).

Regs. §1.482-7(a)(1) directs readers to ‘‘See para-graph (b)(1)(i) of this section regarding the require-ment that controlled participants, as defined in section(j)(1)(i) of this section, share intangible developmentcosts (IDCs) in proportion to their shares of reasonablyanticipated benefits (RAB shares) by entering into costsharing transactions (CSTs).’’ Furthermore, Regs.§1.482-7(e)(1)(ii) provides that ‘‘[a] controlled partici-pant’s RAB share must be determined by using the mostreliable estimate.’’

First note that Regs. §1.482-7(a)(1) states merely that

This provision, however, does not provide any guid-ance as to how α must be estimated. That piece of guid-ance is provided in Regs. §1.482-7(e)(1)(ii) by the re-quirement that i* must be the most reliable estimate ofthe α* . In other words:

For taxpayers who (i) have reliable projections de-veloped for both controlled participants down to the op-erating income line; (ii) can reliably estimate for bothcontrolled participants the routine returns; and (iii) canreliably bifurcate the estimated gross intangible incomeof the U.S. participant to isolate the contribution of thecost shared intangibles (RUS) from the contribution ofnon-cost-shared intangibles to that gross residual, itcould be the case that

It should be clear that this strategy requires a largenumber of data, parameters, and assumptions com-pared to an indirect base of measurement such as aRAB share based on net revenue, for example. The

mere fact that a taxpayer has developed full financialprojections for both participants down to the operatingincome line does not mean that a direct measurementof α* is more reliable than an indirect measurement

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thereof. The Treasury regulations are very clear on thatpoint.

Should reliable estimates of RFX and RUS not exist,one obvious alternative would be to use the presentvalue of projected operating income as a proxy of eachRX , provided reliable projections down to the operatingincome line exist for both participants.8

However, guidance in Regs. §1.482-7(e)(2)(ii)(C) in-dicates that operating profit is likely to be the most reli-able method only in certain limited circumstances:‘‘This basis of measurement will more reliably deter-mine RAB shares to the extent that such profit is largelyattributable to the use of cost shared intangibles, or ifthe share of profits attributable to the use of cost sharedintangibles is expected to be similar for each controlledparticipant. This circumstance is most likely to arisewhen cost shared intangibles are closely associatedwith the activity that generates the profit and the activ-ity could not be carried on or would generate little profitwithout use of those intangibles.’’

In other circumstances, a different measurementmetric would arguably have to be used, such as unitssold (allowed under Regs. §1.482-7(e)(2)(ii)(A)), orsales (allowed under Regs. §1.482-7(e)(2)(ii)(B)), or an-other base (allowed under Regs. §1.482-7(e)(2)(ii)(D)).While the direct basis for measuring RAB shares is a netconcept, the regulations do not indicate any preferencefor the direct basis for measuring RAB shares; instead,the regulations simply indicate that the most reliablebasis for measurement must be used.

Note that two of the three specified indirect bases formeasuring RAB shares – sales and units sold — aregross concepts. The other base method for determiningRAB share under Regs. §1.482-7(e)(2)(ii)(D) indicatesthat the general criteria of acceptability for such otherbase would be the extent to which ‘‘there is expected tobe a reasonably identifiable relationship between thebasis of measurement used and additional revenue gen-erated or net costs saved by the use of the cost sharedintangibles.’’ When none of the specified bases work,the regulations sanction the use of a gross concept asthe basis of measurement. Thus, three of the four indi-rect bases of measurement of RAB share are gross con-cepts rather than net concepts. It follows that the regu-lations contemplate that a gross basis for measuringbenefits may be the most reliable measurement metricin many circumstances.

The conclusion of this legal analysis is that out of allthe RAB shares examples contained in the cost sharingregulations only one example—Regs. §1.482-7(e)(2)(ii)(E) (Example 5) — uses a ratio that may en-sure that a PCT payment will not be negative for a proj-ect with positive expected value under DCF (see Corol-lary 1). The word ‘‘may’’ is used because the ratio usedis expected operating income, not expected gross intan-gible income—the words ‘‘shall’’ or ‘‘will’’ would havebeen chosen had the ratio used been expected gross in-tangible income. However, since in that example mostof the expected operating income comes from the costshared intangibles, it is likely (albeit not guaranteed)that the two ratios will be very close to each other.

For projects that have expected consolidated grossintangible values fairly close to the expected consoli-dated discounted IDC, it is very likely that even smalldeviations of i* from the ‘‘true’’ α* will result in a nega-tive PCT payment.

Mathematically:

And using the FTP condition, one has:

So, for example, if the first ratio above is 50 percentand the second ratio is 52 percent, then a selection of aRAB share strictly greater than 52 percent (for instance,53 percent) results in a negative PCT payment. This cor-responds to a 1.5 percent deviation (not basis points)from the target ratio that ensures a non-negative PCT.Since RAB shares have to be estimated, the level ofmeasurement accuracy required in such cases to ensurea non-negative PCT is substantially greater than canpossibly be realistically achieved or required of taxpay-

ers. For example, suppose the CFP RAB share based onsales is 55 percent. It follows that using a CFP RABshare of 55 percent (instead of 50 percent) makes a dif-ference between a strictly negative and a positive PCTpayment.

It would be erroneous to assume that this case is far-fetched. Remember that the discount rate used to dis-count the expected IDC is lower than the discount rateused to discount expected gross intangible income. Aninvestment that requires high levels of IDC upfront (be-

8 This would be an unreliable strategy if the U.S. participantexploits non-cost-shared intangibles in connection with the ex-ploitation of cost shared intangibles, which is often the case.See Regs. §1.482-7(e)(2)(ii)(C).

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fore any expectation of revenue) for a long period be-fore any revenue is expected will therefore tend to re-sult easily in a violation of the FTP condition. This, inturn, will result in a strictly negative PCT payment, de-spite the choice of an otherwise reliable measurementof the CFP RAB share.

The use of differential discount rates is not necessaryto cause the PCT to be negative—the numerical ex-ample in the next section clearly illustrates that. The

real factor that causes a PCT to be negative under Regs.§1.482-7(g)(4) is the RAB share selected relative to theexpected gross intangible income in the foreign divi-sional interest. The use of differential discount rates ex-acerbates the issue and makes the likelihood of a nega-tive PCT greater for any given RAB share.

It was mentioned earlier that the FTP RAB share isof great importance. One of the reasons is illustrated inFigure 4.

Figure 4 illustrates the decrease in PCT as the CFPRAB share increases. Notice that when the CFP RABshare equals the FTP RAB share, the PCT is exactlyzero. Figure 4 is thus the same as Figure 1 with the ad-dition of a y-axis tracking the value of the PCT as theRAB share selected varies. Assume that a taxpayertakes the position that, based on data availability, andassumptions and parameters required, the most reliableRAB share is based on net revenue. Further assume thati* > αFTP. The ‘‘true’’ RAB share α* is always to the leftof the FTP RAB share for projects with positive valueunder DCF, as shown in Figure 4 (also see Figure 2). In

this case, i* cannot possibly satisfy Regs. §1.482-7(e)(1)(ii) and be the most reliable. The reason for thatimpossibility should be clear from Figure 4; althoughnobody knows where α* really is, it is certain that α* ≤αFTP. It follows that it is more reliable to use the FTPRAB share in this case than it is to use the RAB sharesbased on net revenue—it gets you closer to the ‘‘true’’(but unknown and unobservable) PCT.

This is the reason why the application of Regs.§1.482-7(e)(1)(ii) allows a rewrite of the general for-mula for the PCT:

As:

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With:

The article will now turn to a more developed ex-ample that will illustrate the ideas developed conceptu-ally in this article.

ExampleThe example discussed in this section demonstrates

numerically the existence of the inverse relationship be-tween RAB shares and PCT payment calculated underRegs. §1.482-7(g)(4). Recall from our previous discus-sion that a larger allocation of IDC to the CFP by choiceof a greater RAB share will translate into a lower, pos-sibly negative PCT payment (see the FTP condition)that always satisfies the arm’s length standard (see theIRS Paradox). These properties were discussed in theResults section of this article.

Table I summarizes the results of the numerical ex-ample developed and discussed in this section. Not onlydoes Table I illustrate the impact of the selection of RABshares on the sign of the PCT payment, it also illustratesthe sensitivity of the magnitude of the PCT payment tothe RAB shares selected.

Table 1

RAB Shares SelectedBased On

RABShares

Lump-Sum PCTPayment (NPV)

Cumulative Sales(undiscounted)

50% -$2.2 million

FTP RAB share 49% $0.0Pre-IDC Operating

Profits (discounted)42% +$15.5 million

The various RAB shares considered in Table 1 have amathematical expression that were presented in the Re-sults section of this article. In particular, the FTP RABshare was defined as the RAB share that resulted in azero PCT payment. It was the pivotal RAB share thatswung the PCT from being positive to becoming nega-tive in the FTP condition. It was also shown to be amore reliable RAB share under Regs. §1.482-7(e)(1)(ii)than any RAB share that results in a negative PCT.

To eliminate any doubt as to what causes the possi-bility of a negative PCT under Regs. §1.482-7(g)(4), thisexample will be developed using the same discountrates to discount the cash flows in the cost sharing al-ternative and in the licensing alternative. It should beobvious that a negative PCT cannot possibly be causedby differential discount rates in an example in whichsaid discount rates are forced (unrealistically) to beidentical.9 Every other assumption made will serve the

same purpose, that is, rule out causality between eachspecific potential cause of a negative PCT other thanthat memorialized in the FTP condition—a RAB sharein excess of a specific ratio of discounted values. In thisexample, only timing differences will cause the negativePCT for the RAB shares that are being analyzed.10

Assumptions

1. Differential discount rates do not cause negativePCT: all streams are discounted at the same rate (15percent per annum);

2. Tax rates and tax arbitrage do not cause negativePCT: all relevant tax rates are assumed to be zero;

3. Long valuation horizons do not cause negativePCT: the CSA is expected to last for five years (2015-19)with no terminal value;

4. Only timing differences across divisional interestscause negative PCT:

a. The expected operating margin before IDC is 55percent per annum in each divisional interest;

b. Routine returns are 5 percent of sales in each di-visional interest;

c. Cumulative sales are the same in each divisionalinterest;

d. Cumulative cost of goods sold are the same ineach divisional interest;

e. Cumulative operating income are the same ineach divisional interest; and

f. The only difference between the divisional inter-ests is the timing of exploitation of the cost sharedintangibles (see Tables 3 and 4 below).

5. Other assumptions:

a. The income method is applied to the expected op-erating income streams (not cash flows) of the li-censing and cost sharing alternatives, respectively;

b. The PCT payment shall be paid in a lump sum;and

c. The project has positive expected consolidatedvalue.

9 The use of differential discount rates can exacerbate themagnitude of a negative PCT, but it does not cause it per se.

Note that in a legitimate CSA involving legitimate IDC, it is al-ways the case that the cost sharing alternative and the licens-ing alternative discount rates are different in an application ofRegs. §1.482-7(g)(4). This is another consequence of the pre-scriptions of Regs. §1.482-7(g)(4)(i)(C) and -7(g)(4)(vi)(F)(1).

10 To be more specific, differences in the timing of recogni-tion of expected costs and revenues for the two divisional in-terests will dictate what the CFP FTP RAB share is, which inturn will determine whether any candidate RAB share resultsin a positive or negative PCT payment.

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The following will now explain step by step the rea-sons why this numerical example results in a negativePCT.

Step 1: Check that the project has positiveexpected consolidated value

An important purpose of this example is to demon-strate that a cost sharing agreement? that has positiveexpected consolidated value under the DCF method canhave at arm’s length negative PCT payments associatedwith it under Regs. §1.482-7(g)(4). The first step in es-tablishing this conclusion numerically is thus to con-struct an example of a cost sharing arrangement withpositive expected consolidated value.

Table 2 presents the consolidated financial projec-tions of the cost sharing alternative. Note that consis-tent with the Treasury regulations, these financial pro-jections are assumed to be probability weighted aver-ages of possible outcomes. Notice that the firstexpected operating income and operating margin pre-sented in Table 2 are pre-IDC. After presenting the ex-pected value of each of the financial projection items foreach year 2015-19, the present value of these items, dis-counted at 15 percent (see assumptions) is calculatedand presented in the far-right column of Table 2.

All values in Table 2 are assumed to be in millions ofcurrent dollars.

Table 2

CONSOLIDATED (WW)(In millions)

2015 2016 2017 2018 2019 2015-2019(PV)

Revenue $50.0 $250.0 $100.0 $100.0 $300.0 a $504.59CoGS $7.5 $37.5 $15.0 $15.0 $45.0 b $75.69Operating Expenses $15.0 $75.0 $30.0 $30.0 $90.0 c $151.38

Op. Income (pre-IDC) $27.5 $137.5 $55.0 $55.0 $165.0 d $277.53Op. Margin (pre-IDC) 55% 55% 55% 55% 55% e 55%

Routine Profits $2.5 $12.5 $5.0 $5.0 $15.0 f $25.23

Gross Intangible Income $25 $125 $50.0 $50.0 $150.0 g $252.30IDC $150.0 $75.0 $30.0 $10.0 $5.0 h $215.07Net Intangible Income -$125 $50 $20 $40 $145 i $37.22

Note: a, b, c, and h are assumed. d=a-b-c; e=d/a; f=5%×a; g=d-f; i=g-h

The expected net present value (consolidated) of theintangible development activity of the cost sharing al-

ternative is positive $37.22 million. In the notation usedthroughout the article, one has:

By assumption, one has rL = rIDC = 15 percent (seeassumptions). Having a project subject to a cost sharingarrangement with positive expected net present value(consolidated), the next step is to show how the ex-pected costs and revenues are expected to be recog-nized by both participants in the cost sharing alterna-tive; timing is going to be of the essence, because it willbe the only difference between the expected results ofthe cost sharing for the two divisional interests. In fact,cumulatively (undiscounted) over the period of costsharing activity, the two divisional interests are undis-tinguishable.

Step 2: Show the financial projections of thedivisional interest of each participant

The financial projections for the divisional interest ofeach participant obviously reconcile with the consoli-dated financial projections in Table 2. The reader willrecognize in Table 3 and Table 4 that the only differ-ence in the financial projections of the divisional inter-est of each participant is the timing of recognition of ex-pected costs and revenues; everything else is assumedto be exactly the same (see assumptions). As a reminderto the reader, this is done to isolate the cause of nega-tive PCT, not to isolate factors that exacerbate negativePCT.

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Table 3

U.S. Participant(In millions)

2015 2016 2017 2018 2019 2015-2019(PV)


Op. Income (pre-IDC) $27.5 $137.5 $27.5 $27.5 $0.0 d $161.69Op. Margin (pre-IDC) 55% 55% 55% 55% NA e 55%


Gross Intangible Income $25 $125 $25.0 $25.0 $0.0 g $146.99

Note: a, b, and c are assumed. d=a−b−c; e=d/a; f=5%×a; g=d−f

Table 4

CF Participant(In millions)

2015 2016 2017 2018 2019 2015-2019(PV)


Op. Income (pre-IDC) $0.0 $0.0 $27.5 $27.5 $165.0 d $115.84Op. Margin (pre-IDC) NA NA 55% 55% 55% e 55%


Gross Intangible Income $0.0 $0.0 $25.0 $25.0 $150.0 g $105.31

Note: a, b, and c are assumed. d=a−b−c; e=d/a; f=5%×a; g=d−f

Using the notation used throughout this article, onecan write the expected gross intangible income of theCFP as:

Recall from Step 1 that the expected net presentvalue of the IDC (consolidated) was given by:

One is now in position to analyze in the next stepvarious RAB shares that could reasonably allocate aportion of the consolidated IDC of $270 million to eachparticipant.

Step 3: RAB share allocation of consolidatedIDC to each participant

The Treasury regulations provide that a RAB must beselected, and consolidated IDC must be shared betweenparticipants to a cost sharing in proportion to their re-spective reasonably anticipated benefit share.

Cumulative Revenue-Based RAB SharesConsider an allocation of consolidated IDC based on

the cumulative revenue reasonably anticipated by eachcost sharing participant in its respective divisional in-terests. Revenue is one of the most frequently used RABshare alternatives used by practitioners, because it isfairly reliably estimated and it is simple to administer.Based on the assumptions, this is equivalent to a 50-50split of IDCs as each cost sharing participant expectscumulative revenues of $400 million during the courseof the cost sharing arrangement. Table 5 summarizesthe data used to calculate the RAB shares using cumu-lative revenue.

Table 5

Cumulative Revenue (inmillions)

2015 2016 2017 2018 2019 2015-2019

U.S. Participant $50.0 $250.0 $50.0 $50.0 $0.0 $400CF Participant $0.0 $0.0 $50.0 $50.0 $300.0 $400

α is denoted as the RAB share of the CFP. Keeping that notation, it follows that

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Therefore, the CFP will be allocated half of the cu-mulative IDC. Table 6 shows the yearly expected IDCand the allocation of half to each participant.

Table 6

IDC Allocation(In millions)

2015 2016 2017 2018 2019 2015-2019(PV)

Consolidated $150.0 $75.0 $30.0 $10.0 $5.0 $215.07Allocated U.S. Participant $75.0 $37.5 $15.0 $5.0 $2.5 $107.6Allocated CF Participant $75.0 $37.5 $15.0 $5.0 $2.5 $107.6

Since the CFP gets allocated $107.6 million of IDCbut only expects million of gross intangible income, one

can calculate the PCT as:

The negative PCT is required to make the CFP indif-ferent between licensing and cost sharing pursuant toRegs. 1.482-7(g)(4)(i)(A). The intuition is simpleenough: in this example, RAB shares based on cumula-tive revenue allocate more IDC to the CFP than it rea-sonably expects in gross intangible income (both in

present values), despite the positive expected value ofthe (consolidated) project.

FTP RAB ShareThe FTP RAB share is (by definition) the RAB share

that results in a zero PCT.Remember that the FTP RAB share was defined as

(see Results section):

To verify that an allocation of 49 percent of consoli-dated IDC to the CFP results in a zero PCT, considerTable 6.

Table 7

IDC Allocation(In millions) 2015 2016 2017 2018 2019

2015-2019(PV)

Consolidated $150.0 $75.0 $30.0 $10.0 $5.0 $215.07

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Table 7 − Continued

IDC Allocation(In millions) 2015 2016 2017 2018 2019

2015-2019(PV)

Allocated U.S. Participant $76.6 $38.3 $15.3 $5.1 $2.6 $109.8

Allocated CF Participant $73.4 $36.7 $14.7 $4.9 $2.4 $105.3

Since the CFP gets allocated $105.31 million of IDCand reasonably expects million of gross intangible in-

come, one can calculate the PCT as:

The allocation of IDC to the CFP exactly wipes out inpresent value the entire gross intangible income ex-pected by the CFP, resulting in indifference between li-censing and cost sharing at a zero PCT.

Discounted Pre-IDC OperatingProfit RAB Share

Finally, consider a RAB share based on the expecteddiscounted pre-IDC operating profits of the partici-pants. Note that this is different from the use of cumu-lative pre-IDC operating profits, which would give the

same negative PCT result as cumulative sales, becausethe RAB share based on cumulative pre-IDC operatingprofits would be 50 percent as well.

From Tables 3 and 4, one calculates the RAB shareof the CFP as:

Table 7 summarizes the resulting allocation of IDCto both participants.

Table 8

IDC Allocation(In millions)

2015 2016 2017 2018 2019 2015-2019(PV)


Because the CFP gets allocated $89.77 million of IDCand reasonably expects million of gross intangible in-

come, one can calculate the PCT as:

The allocation of IDC to the CFP leaves $15.54 mil-lion of net intangible income in the cost sharing alter-native that the CFP does not have in the licensing alter-native. A PCT of $15.54 million is thus necessary toachieve the regulatory mandate under Regs. 1.482-7(g)(4)(i)(A) of indifference between the two options.

Applying the FTP Condition

As a practical matter, the easiest way to understandthe impact of the RAB shares on the sign of the PCT isto apply the FTP condition directly. Having verified thatthe expected gross intangible income of the CFP isstrictly positive (as per Table 4, it is $105.31 million),one knows that

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The FTP condition says that the PCT will be strictlypositive if and only if the selected RAB share for theCFP is strictly less than 49 percent. The PCT will bezero when the selected RAB share of the CFP is exactly49 percent, and it will be strictly negative when the RABshare of the CFP is strictly greater than 49 percent.Armed with this important result, it is clear that RABshares based on cumulative sales that result in an allo-

cation of 50 percent of the consolidated IDC to the CFPwill result in a strictly negative PCT.

Applying the IRS Paradox

The IRS paradox states that any RAB share strictlygreater than zero and strictly less than one results in anarm’s length outcome. To illustrate the application ofthat result, a random number generator is used to picka random number strictly between zero and one. Theresult of that random experiment was 0.62, which thenwas selected as the RAB share for the CFP:

α = 0.62

Table 9 summarizes the resulting allocation of IDCto both participants.

Table 9

Cumulative IDC(In millions)

2015 2016 2017 2018 2019 2015-2019(PV)


Since the CFP gets allocated $133.35 million of IDCand reasonably expects millions of dollars of gross in-

tangible income, one can calculate the PCT as:

To prove that allocating $133.35 million of IDC to theCFP and having the U.S. participant pay the CFP alump-sum amount of $28.04 million is an arm’s-lengthresult, one must show that the realistic alternative con-dition of the realistic alternative concept of Regs.§1.482-7(g)(2)(iii)(A) and Regs. §1.482-7(g)(4)(i)(A) is

satisfied, namely, that the CFP is indifferent between li-censing the intangibles and cost sharing them.

Normalize, as was done earlier, the value of the li-censing alternative to the CFP to be zero—WLicense = 0.One thus needs to show that WCSA(α = 0.62) = 0.

The application of the IRS Paradox (see Results sec-tion) to this particular example illustrates the trade-offthat is implicit in the income method specified underRegs. §1.482-7(g)(4) between allocating a certainamount of present value of consolidated IDC to the CFPand the sign and magnitude of the PCT. Because thePCT is constructed to ensure indifference between li-censing and cost sharing, any increase in IDC allocatedto the CFP will result in a one-for-one (in present value)decrease of PCT to ensure WCSA = WLicense at the par-

ticular RAB share α selected. Since IDC allocations andRAB shares increase and decrease together proportion-ally, it follows that PCTs and both RAB shares and IDCallocations will move in opposite directions: an increasein RAB share results in a proportional decrease in PCT,and a decrease in RAB share results in a proportionalincrease in PCT. These movements in opposite direc-tions are such that the net impact on the expected valueof the cost sharing to the CFP is left unchanged at theexpected value of the licensing alternative to the CFP.

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Applying Regs. §1.482-7(e)(1)(ii)

Nowhere in this example was it indicated what the‘‘true’’ CFP RAB share is. It is generally unobservableand unknown and must be estimated based on the mostreliable measure of the ‘‘true’’ RAB share. The standardof reliability to be used is that of Regs. §1.482-7(e)(1)(ii). As discussed in the Legal Discussion sectionof this article, the RAB share based on cumulative salesof 50 percent is strictly less reliable than the FTP RABshare of 49 percent. This is because for projects withpositive expected value under DCF, the ‘‘true’’ RABshare α* is always to the left of the FTP RAB share,which itself is always to the left of any and all RABshares that result in a negative PCT. It follows that theFTP RAB share is more reliable in estimating the ‘‘true’’RAB share than is the RAB share based on cumulativesales.

ConclusionThe concept of a U.S. multinational making platform

contributions to a CFP in the form of valuable intan-gible rights and required to compensate the CFP to in-duce it to agree to enter into the cost sharing arrange-ment may appear to many as egregious. How can thatpossibly happen? This article provided a clear and defi-nite answer as to why that can happen under the in-come method specified in Regs. §1.482-7(g)(4). If theselection of RAB share allocates more IDC to the CFPthan there is reasonably expected gross intangible in-come in the foreign divisional interest, a negative PCTis required under the law to ensure indifference of theCFP between licensing and cost sharing.

Note once again that many of the properties of theincome method specified under Regs. §1.482-7(g)(4) de-rive directly from Regs. §1.482-7(g)(4)(i)(C) and Regs.§1.482-7(g)(4)(vi)(F)(1). These two provisions requirethe financial projections used to value the cost sharingalternative and the licensing alternative to be exactlyidentical other than (i) the payment of a royalty in thelicensing alternative, (ii) the payment of IDC in the costsharing alternative, and (iii) the payment of a PCT inthe cost sharing alternative. In addition, all risks otherthan those deriving directly from the differences notedabove are the same in both alternatives. Whether or notthese requirements are economically realistic in everysingle scenario, or whether or not arm’s length partieswould make these two strong assumptions is irrelevant;a taxpayer asserting treatment under Regs. §1.482-7(g)(4) is bound by them. In that sense, although Regs.§1.482-7(g)(4) does not provide taxpayers with a safeharbor, when combined with new language that seemsto require results consistent with the results of incomemethod approaches in Regs. §1.482-7(g)(1),11 and theIRS’s historical preference for the income method,12 it

creates something that provides taxpayers with a sig-nificant level of predictability in outcome. Should a tax-payer not be willing to accept Regs. §1.482-7(g)(4)(i)(C)and -7(g)(4)(vi)(F)(1) in a particular fact pattern, andthus decline the level of predictability offered by Regs.§1.482-7(g)(4), other flavors of the income method canbe used as unspecified methods.

This article presents a view of the possible legal ba-sis the government might have to shut down a negativePCT resulting from the selection of a RAB share that ex-ceeds the FTP RAB share. That basis is Regs. §1.482-7(e)(1)(ii). The government could argue that the FTPRAB share always is more reliable than the RAB shareselected by the taxpayer since it always is closer to the‘‘true’’ (yet unknown and unobservable) RAB share de-fined in Regs. §1.482-7(j)(1)(i) and Regs. §1.482-7(e)(1)(i) for projects with positive value under DCF.Taxpayers, however, likely will counter that they havemet the overarching burden of achieving an arm’s-length result because all RAB shares strictly betweenzero and one produce arm’s-length results (see IRSParadox). This article demonstrated that property ofRAB shares.

Additionally, the IRS might have a difficult time con-vincing the courts that an unknown and unobservableRAB share was more reliable than the RAB share thecontrolled parties selected ex ante with the then-available information, because the courts have rejectedthe IRS’s theoretical approach to the arm’s length stan-dard in favor of a practical approach that looks for con-crete facts, rather than rely on theoretical econometricanalysis.13 Accordingly, it is possible that negative PCTpayments might be upheld by courts under certain factpatterns discussed in this article.

The arguments for and against transactions valuedunder Regs. §1.482-7(g)(4) with reasonable assump-tions, data and parameters, carried out with negativePCT payments, have now been set forth. The argumentin favor is that such transactions achieve an arm’s-length result; the argument against is that they can beconsidered to violate Regs. §1.482-7(e)(1)(ii) andshould be valued at a zero PCT payment.

Going forward, it will be up to taxpayers, the IRS andthe courts to resolve the inevitable resulting controver-sies.

The opinions expressed in this article are those ofthe authors and should not be construed in any way asrepresenting the opinions of Deloitte Tax LLP or any of

11 The 2011 final cost sharing regulations added the follow-ing sentence to the regulations: ‘‘Each method must yield re-sults consistent with measuring the value of a platform contri-bution by reference to the future income anticipated to be gen-erated by the resulting cost shared intangibles.’’ Regs. §1.482-7(g)(1) (emphasis added). Thus, while any method can beselected (consistent with the best method rule), that methodmust yield results consistent with the results the incomemethod would generate.

12 See, for example, IRS Coordinated Issue Paper on CostSharing Buy-ins favoring the application of the income method

as an unspecified method (16 Transfer Pricing Report 386,10/4/07), withdrawn in 2012 (20 Transfer Pricing Report 812,1/26/12); Veritas Software Corp. v. Comr., 133 T.C. No. 14(2010), rejecting the IRS’s application of income method to acost sharing buy-in (18 Transfer Pricing Report 890, 12/17/09);A.O.D. 2010-05, the IRS’s statement that it will not follow thedecision Veritas, rejecting the court’s results, reasoning andfactual conclusions, and asserting the IRS will continue to usethe income method for cost sharing buy-in disputes (19 Trans-fer Pricing Report 808, 11/18/10); Amazon.com Inc. v. Comr.,T.C., Docket No. 031197-12, the cost sharing buy-in dispute inwhich the taxpayer is contesting the IRS’s application of theDCF method to the buy-in payment (23 Transfer Pricing Re-port 1087, 1/8/15).

13 See Xilinx Inc. v. Comr., 598 F.3d 1191 (9th Cir. 2010),which rejected the IRS’s theoretical econometric interpretationof the arm’s-length standard in Regs. §1.482-1(b)(1), indicatingthat an arm’s-length analysis must be based on concrete facts(18 Transfer Pricing Report 1171, 3/25/10).

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its affiliated legal entities. This article does not consti-tute tax, legal, or other advice from Deloitte Tax LLP,which assumes no responsibility with respect to assess-

ing or advising the reader as to tax, legal, or other con-sequences arising from the reader’s particular situa-tion.

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The Seemingly Strange Case of the Negative PCT Payment