Prior to the Tax Cuts and Jobs Act of 2017 ("TCJA"), the appeal of cost sharing was driven largely by the deferral of U.S. taxation on foreign earnings. Now that excess foreign returns are currently taxable as "global intangible low-taxed income" ("GILTI"), cost sharing is attractive mostly to corporate taxpayers that have decided to continue holding their intangible property ("IP") offshore and face GILTI tax, rather than bring the foreign-based IP back to the U.S. and enjoy the benefits of "foreign-derived intangible income." The cost sharing decision is further affected by TCJA's changes to Code Secs. 367, 482 and 936(h)(3)(B),1 which enhance the government's ability to increase the taxable amount of outbound transfers made in taxable years beginning after December 31, 2017.2

This article explores the impact of the TCJA on the issues typically arising in a common fact pattern targeted by the Internal Revenue Service.3 Assume a U.S. parent corporation ("USP") has maintained a cost sharing agreement ("CSA") with its controlled foreign subsidiary ("FSub") for many years. USP acquires a U.S. target corporation ("Target") and makes some of Target's resources, capabilities or rights available to the CSA. The purchase price allocation ("PPA") for financial accounting purposes allocates a portion of the price to identified tangible and intangible assets, with the majority allocated to goodwill.4 The PPA also includes a discounted cash flow calculation that incorporates USP-specific synergies, and is designed to equate the net present value to the price paid for Target stock. However, the purchase price significantly exceeds the present value of Target's cash flows when calculated without regard to USP-specific synergies. Target has generated net operating losses ("NOLs") from its research and development costs and is just beginning to turn a profit from its currently exploitable products. (This fact pattern is referred to herein as "our fact pattern.")

The IRS likely will assert that the acquisition price method ("APM") is the best method for valuing the platform contribution transaction ("PCT"), and that the entire net present value of Target's business, after adjusting for tangible assets and routine return, was made available to the CSA as a PCT. USP may have used a different method, and will assert that additional adjustments are necessary if APM is to be used. For purposes of this article, it is assumed that the use of APM will prevail, and the controversy centers on the adjustments to the stock purchase price.5 It is further assumed that the cost sharing regulations finalized in 2011, and made effective in 2009 (the "Final CSA Regulations"), are applicable.

We begin with a summary of key positions taken by taxpayers and the IRS under pre-TCJA law, and address PCTs both before and after the effective date of the temporary Code Sec. 482 regulations issued in September 2015 ("Temporary 482 Regulations"). Then we address how those positions are affected, if at all, by TCJA's changes to Code Secs. 367, 482 and 936(h)(3)(B), for PCTs arising both before and after the TCJA.

I. Pre-TCJA Key Positions of Taxpayer and IRS Regarding APM

A. Carveout for Goodwill Value

Any discussion of carveouts for goodwill, synergy value or control premium should begin with a focus on the definition of "platform contribution" in the Final CSA Regulations.6 There are three key components. First, the controlled participant (USP) must be contributing a "resource, capability, or right" to the CSA. Second, the "resource, capability or right" must have been "developed, maintained, or acquired externally" by the controlled participant (USP). Third, the resource, capability, or right must be "reasonably anticipated to contribute to developing cost shared intangibles."

In our fact pattern we know that the discounted cash flows incorporate a unique synergy value contributed by USP that goes beyond what a normal market participant would provide. We also know that from an accounting standpoint, a majority of the stock purchase price is attributable to a residual value, or goodwill. The issue is to what extent, if any, this excess or residual value, which represents the excess of the purchase price over the value of the identified tangible and intangible assets, should be part of the platform contribution.

The IRS approaches the issue from several angles. The first focuses on the legal question of whether the acquisition premium represented by the excess or residual value—whether you call it goodwill or synergy value—is a "resource, capability, or right." The second focuses on the economic question of the extent to which the excess or residual value should be attributed to the identified intangible assets. These two issues are inter-related and often blur together.

Similar issues were decided in favor of taxpayers in Veritas7 and Amazon8 under the prior cost sharing regulations, which required a buy-in payment for the value of pre-existing intangibles, defined as those intangible assets listed in former Code Sec. 936(h)(3)(B). The IRS attempted in each case to value the buy-in as if it were a geographic sale of part of the U.S. participant's business. The Tax Court rejected the Service's "all value" or "enterprise value" approach to value a buy-in payment on separate but related grounds. First, the enterprise value was substantially attributable to goodwill, and goodwill was not listed in former Code Sec. 936(h)(3)(B). Second, any attempt to associate the enterprise value with the value of identified, pre-existing intangibles would inappropriately tax the value of intangibles outside the scope of former Code Sec. 936(h)(3)(B).

As for the legal question of whether goodwill value is part of a platform contribution, the IRS believes that the Final CSA Regulations have made that clear due to the broad definition of "platform contribution." Admittedly the term "platform contribution" was intended to be broader than the term "pre-existing intangibles" used in the old regulations. But the breadth of "platform contribution" is far from certain. In the 75 pages of the Final CSA Regulations, the only references to "goodwill" are in three examples (discussed later) whose meaning is subject to intense debate. There is no reference anywhere in the Final CSA Regulations to former Code Sec. 936(h) (3)(B). Specifically, the term "platform contribution" is entirely silent on whether it is or is not limited to former Code Sec. 936(h)(3)(B) assets.9

The IRS's main authority for the legal question is the preamble to the Final CSA Regulations, which states: "These regulations do not turn on whether a given transaction in connection with a CSA involves intangible property within the meaning of section 936(h)(3) (B) ...."10 The preamble says that platform contribution includes a controlled participant's commitment of "a particular research team's experience and expertise," or its contribution of "core entrepreneurial functions such as product selection, market positioning, research strategy, and risk determinations and management."

One has to wonder why these statements were not built into the Final CSA Regulations themselves. Was it because of lack of authority, due to Code Sec. 482's reference to intangible property defined in former Code Sec. 936(h)(3)(B)? In six budgets starting in 2010, the Obama Administration tried to amend former Code Sec. 936(h)(3)(B) to incorporate the IRS's litigating position in Veritas, but those efforts failed. Beginning in 2018, former Code Sec. 936(h)(3)(B) assets, now Code Sec. 367(d)(4) assets, include goodwill, but (as discussed later) Congress said that "[n]o inference is intended with respect to the application of section 936(h)(3)(B) or the authority of the Secretary to provide by regulation for such application with taxable years beginning before January 1, 2018." Essentially, the IRS is interpreting the Final CSA Regulations to mean something that Congress felt compelled to address by statute. Suffice it to say that the legal debate over whether the term "platform contribution" includes goodwill will continue for pre-TCJA years.

The goodwill debate is further complicated by three examples in the Final CSA Regulations, which involve the use of APM where a PPA has allocated a portion of the stock purchase price to goodwill.11 While these examples are focused on whether APM is the best method, the lessons provided cross over to the issue of whether a carveout is appropriate even if APM is the best method.

In Example 1, the PPA made a 50% purchase price allocation to goodwill, but the target company "has nothing of economic value aside from the in-process technology and assembled workforce." Target "is still in a startup phase" and "has no currently exploitable products or marketing intangibles." The example recognizes that, according to the PPA, a significant portion of the target's nonroutine contributions to USP's business activities is goodwill, which "might not be attributable to platform contributions that are to be compensated by PCTs." However, because it is clear under the facts that Target has no goodwill value, the 50% purchase price allocation to goodwill is considered "economically attributable to either of, or both, the in-process technology and the workforce."

The IRS certainly likes the result from Example 1, and will assert that the same result—applicability of APM with no goodwill carveout—should apply to our fact pattern, even though our Target is generating revenue from currently exploitable products and likely has some valuable goodwill apart from the value of its identified intangible assets. There is unlikely to be a clear winner on this debate given the limited facts and analysis in Example 1. Nevertheless, it is undeniable that Example 1 suggests that if the target had goodwill value, "it might not be attributable to platform contributions that are to be compensated by PCTs." That statement would seem to contradict any IRS position that goodwill is always part of the platform or, alternatively, that all the enterprise value should be attributable to the identified intangible assets. If the IRS positions are correct, one has to question why Example 1 was included in the regulations. Thus, Example 1 fuels the taxpayer's argument as much as the IRS's argument.

Example 2 involves facts closer to our fact pattern. The target has a "mature software business ... with a successful generation of software that it markets under a recognized trademark" in addition to a "research term and new generation software in process that could significantly enhance" the existing CSA between USP and its foreign subsidiary. The PPA allocates the purchase price 50% to the existing software and trademark, 25% to in process technology and research workforce, and 25% to goodwill. The make-or-sell rights under the existing software and trademark were not contributed to the CSA and, therefore, were not considered part of the platform contribution. The example concludes that APM may not be the best method due to the goodwill being economically attributable to the existing U.S. software business rather than to the platform contributions, and the resulting difficulty in valuing the platform contribution.

In the context of our fact pattern, Example 2 is probably a draw for the IRS and taxpayers. It doesn't address what should happen when goodwill is made available to the foreign cost sharing participant as part of the transferred make-sell rights, including when make-sell rights and the PCT are valued in the aggregate. IRS likely will assert that Example 2 provides no authority for carving out goodwill from the aggregate valuation of make-sell rights and PCT, when the goodwill is made available to the foreign cost sharing participant as part of the transferred make-sell rights. While that may be true, nor does the example preclude taxpayer from asserting a goodwill carveout is necessary in those circumstances, particularly given the implication from Example 2 that goodwill might not be part of a compensable platform contribution.

Example 3 is basically the same as Example 1, except in Example 3 there are other assets (trademark, marketing intangibles and goodwill) on which the acquiring company places no value because it has no intention of continuing to produce and market the target company's existing product. Consequently, the acquisition price was paid for no assets other than the identifiable intangible property. Nevertheless, Example 3, like Example 1, is instructive as to the process when there is an allocation of the purchase price for accounting purposes. Specifically, it is necessary to look closer at the assets of the target company and determine if the accounting allocation lines up with the economic value of the target's assets. Only after that first step has been taken can the accounting allocations be regarded as not relevant.

B. Carveout for Synergy Value

Synergy is a form of acquisition premium, like control premium, except it represents the additional value arising from integrating the target with acquirer. Often the buyer will share the synergy value with the seller in arriving at a purchase price.

The carveout issue for synergy value is slightly different than the carveout issue for goodwill. Compared to goodwill, synergy value is more easily seen as an asset contributed by both the United States and foreign cost sharing participant, as opposed to being an asset that is acquired by the U.S. participant from the target and then made available to the foreign participant. This difference goes to a key component of the platform contribution definition in the acquisition context, that is, the "resource, capability, or right" must be "acquired externally" from the target. In other words, if the synergy value has been developed by the cost sharing participants, how can it be "acquired externally" from the target?

While the term synergy (unlike goodwill) cannot be found in the Final CSA Regulations, Treasury recognized in the preamble of those regulations that the acquiring controlled group may obtain benefits beyond cost-shared intangibles: "Comments were received that, with some acquisitions, there may be benefits to the controlled group whose scope extends beyond the development of cost shared intangibles. The Treasury Department and the IRS agree that these facts and circumstances should be taken into account in the appropriate application of the acquisition price method and any other methods for purposes of determining the best method ...."12 It is believed that Treasury was thinking of synergy value when it said that. Specifically, Treasury treated an article by Clark Chandler and Sean Foley,13 written after the 2009 temporary regulations were issued but before the Final CSA Regulations, as a comment and this statement was a response to that comment.

The gist of the Chandler-Foley article is that the APM results in double counting (compared to the income method) in situations whereby the PCT Payor has already paid for certain items, such as a trademark royalty or routine operating costs, and thus owns the synergies attributable to those items. Synergy value contributed by buyer—at least the buyer-specific synergy value that is beyond what a normal market participant would provide— generally would not be factored into the cash flows under the income method. This is because, under the income method: (1) you need to determine a useful life for the assets (you cannot assume they are perpetual) and (2) the cash flow projections are specific to the target business, that is, they are done on a standalone basis. And, unless synergy value is carved out from the acquisition price, the APM will result in a much higher PCT payment than the income method.

If the APM result exceeds the income method result, there could be a violation of Reg. §1.482-7(g)(1), which requires that any of the listed methods must "yield results consistent with measuring the value of a platform contribution by reference to the future income anticipated to be generated by the resulting cost shared intangibles." Practitioners have interpreted this regulation to mean that all reliable methods including APM must yield a result similar to the income method. That is why economists often corroborate their choice to use APM by comparing the APM results to the results under the income method.

IRS likely will assert that no carveout for synergy is permitted since it is not specifically provided for in the Final CSA Regulations. Another likely assertion is that USP paid for the synergy value when it purchased the target stock despite whether or not it was brought to the table by the cost sharing participants, and the arm's length standard requires that the foreign participant share in that cost. The IRS also asserts that the arm's length standard requires that the specific attributes of the buyer and seller be taken into account.

This debate over what the arm length standard requires has been litigated in other contexts. In Xilinx,14 the regulation at issue required that "all costs" be shared. IRS argued that this regulation required that the cost of stock compensation be shared. The Tax Court and Ninth Circuit rejected that argument, holding that the "all cost" regulation was subject to the overall arm's length standard, which requires an examination of what uncontrolled parties would do by looking at comparable transactions. Since unrelated parties would not share the cost of stock compensation, it was not required among related parties.

Taxpayers can argue that, based on the teaching of Xilinx, the arm's length standard requires that no more than synergies of a normal market participant be taken into account.15 That is, the Tax Court and Ninth Circuit adopted the so-called "behavioral" rule, meaning that the arm's length standard looks to the behavior of uncontrolled taxpayers to test the controlled transaction.16 Here, instead of an "all cost" regulation, IRS is asserting an "all value" theory, but the issue is similar. We have to ask what an uncontrolled buyer in the foreign participant's circumstances would pay for the platform.

If the arm's length standard requires that the uncontrolled buyer should be viewed as having the exact same assets and capabilities as the actual foreign participant, it would seem impossible to determine an arm's length price by reference to comparable transactions. That is, no third party could be comparable if all the unique characteristics of the actual buyer have to be taken into account. That is why the arm's length standard, in order to be consistent with the holding in Xilinx, should look to what a normal market participant would pay.17 In other words, the PCT payment should be based on the inherent value of the intangibles rather than the unique ability of any specific PCT payor or PCT payee to enhance the value of the intangibles.

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Originally published by International Tax Journal.


* The author appreciates the valuable contributions from his colleagues, Jason Osborn and Elena Khripounova, also members of the firm's Tax Controversy and Transfer Pricing practice.

1. All section references are to the Internal Revenue Code of 1986, as amended, or the Treasury regulations promulgated thereunder, unless otherwise indicated.

2. The TCJA amended Code Sec. 936(h)(3)(B) to drop former clause (vi) and add new clauses (vi) and (vii). On March 23, 2018, the Consolidated Appropriations Act of 2018 (P.L. 115-141), §§401(d)(1)(C) and (D) repealed Code Sec. 936 as deadwood, added Code Sec. 367(d)(4)(A) through (G) to reflect the TCJA version of Code Sec. 936(h)(3)(B)(i) through (vii), and modify Code Sec. 482 to add a reference to Code Sec. 367(d)(4) and strike the reference to Code Sec. 936(h)(3)(B). These changes are effective as if they were included in the TCJA, that is, for taxable years beginning after December 31, 2017.

3. LB&I International Practice Service Transaction Unit, DCN ISO/9411.01_02 (2013) (updated Dec. 23, 2015).

4. Compare Reg. §1.482-7(g)(2)(vii) ("Allocations or other valuations done for accounting purposes may provide a useful starting point but will not be conclusive for purposes of the best method analysis in evaluating the arm's length charge in a PCT, particularly where the accounting treatment is inconsistent with its economic value") with LB&I International Practice Service Transaction Unit, DCN ISO/9411.01_02 (2013) ("Many taxpayers compute the subsequent acquisition PCT payment focusing solely on limited IP for example per the purchase price allocation ('PPA') ... ignoring other platform contributions—resources, capabilities and rights acquired from Target that require compensation").

5. Another issue that typically arises is the reasonably anticipated benefits (RAB) share that should be used in calculating a PCT payment under APM. That issue is not addressed in this article. See LB&I Directive 04-0118-004 (Jan. 12, 2018), in which LB&I directed its agents to stop developing adjustments based on changing the taxpayer's RAB shares to a single RAB share when PCTs are added to an existing CSA, at least until an IRS-wide position is finalized. In CCM 2018-003 (July 26, 2018), the National Office of IRS Chief Counsel concluded that it may be appropriate for cost sharing participants to use a separate RAB share to determine PCT payments with respect to a subsequent PCT.

6. Reg. §1.482-7(c)(1).

7. Veritas, 133 TC 297, Dec. 58,016 (2009), nonacq. 2010-49 IRB.

8. Amazon, 148 TC 108 (2017), appeal pending in 9th Circuit (No. 17-72922).

9. Note, however, that Reg. §1.482-7(j)(3) of the Final CSA Regulations defines a platform contribution to be either a transfer of an intangible under Reg. §1.482-4 or a provision of a service under Reg. §1.482-9, that Reg. §1.482-4(b) has for many years (that is, both before and after the issuance of the Final CSA Regulations) defined intangible property as property defined in former Code Sec. 936(h)(3) (B), and that the Tax Court has held that intangible property under Reg. §1.482-4(b) does not include goodwill, going concern value or workforce in place. See infra discussion accompanying footnote 53.

10. T.D. 9568 (Dec. 22, 2011), preamble.

11. Reg. §1.482-7(g)(2)(vii)(B), Examples 1, 2 and 3.

12. T.D. 9568, Federal Register, Vol. 76, No. 246 (Dec. 22, 2011), at 80085.

13. Chandler and Foley, Why the Acquisition Price Method and Income Method Give Different Answers Under the Same Set of Facts, 19 Transfer Pricing Report 861 (BNA, Dec. 2, 2010).

14. Xilinx, CA-9, 2010-1 ustc ¶50,302, 598 F3d 1191.

15. Buyer-specific synergies are synergies over and above the market participant synergies that are created by the specific buyer. Such synergies exist when one specific buyer can make more efficient use of the assets of target than a typical market participant. For financial accounting purposes, if buyer-specific synergies are part of the purchase price, they are removed in carrying out the purchase price allocation.

16. The IRS disagrees with this holding in Xilinx, stating that the court "mistakenly interprets the arm's length standard to limit the behavior of controlled taxpayers, or the transactions into which they enter, based on the behavior or transactions into which uncontrolled taxpayers may or may not enter." AOD 201003 (July 16, 2010).

17. There is nothing explicit in the Code Sec. 482 regulations requiring that arm's length be determined by reference to the hypothetical market participant, rather than the specific attributes of the individual buyer and seller. The regulations do refer to an uncontrolled party involved in the "same transaction" under the "same circumstances." Reg. §1.482- 1(b)(1). The issue of course is what is meant by "same." This regulation then acknowledges that "because identical transactions can rarely be located, whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances" (emphasis added). If there were truly a requirement to take the unique characteristics of the buyer and seller into account, it would make no sense for the regulation to acknowledge that it is difficult to find comparable parties with those same characteristics, and then direct you to look for "comparable" situations, which suggests that you should look for "market participant" situations. Indeed, in the concurring opinion in the 9th Circuit's opinion in Xilinx, the judge notes that taxpayer argued that the regulation requires an examination of "comparable circumstances," whereas the IRS argued that regulation forces you to view the unrelated parties under the "same circumstances" and that analyzing comparable transactions is not dispositive.

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