A cost sharing arrangement (CSA) is an agreement between related companies to work together on developing intellectual property, like patents, software, trademarks, or technology.
Instead of one company handling all the development, each participating company shares the costs based on the benefits it expects to receive in the future.
For example, if a U.S. parent company and its European subsidiary are developing new software together, they might split the development costs 60% to 40%. This split matches the share of future benefits each company expects to receive.
Each company then has the right to use the IP in its own agreed territory or business area. Because each company owns its share of the IP, it usually does not have to pay royalties to the other.
The primary aim of a CSA is to enable related companies to develop valuable intellectual property jointly, with both the costs and the anticipated benefits being shared on an arm’s length basis.
The U.S. transfer pricing rules allow related companies to jointly develop intellectual property while ensuring that each participant pays only its fair share of the development costs. This helps prevent multinational groups from shifting profits to low-tax countries by allocating too much or too little of the development costs to a related company.
Next, let’s understand how a cost-sharing arrangement qualifies under the U.S. transfer pricing rules.
The IRS will accept a Cost Sharing Arrangement if it meets the requirements in the U.S. transfer pricing rules. The IRS recognizes a Cost Sharing Arrangement only if it meets the requirements under the U.S. transfer pricing regulations. If the arrangement does not qualify, the IRS may disregard it and recalculate the transactions, which can increase a company’s U.S. taxable income and tax liability.
The following are the conditions for a qualified CSA:
If the conditions in question are not fulfilled, the IRS might ignore the CSA and instead treat the arrangement as a licensing or service transaction, which could lead to further transfer pricing adjustments.
Next, let’s understand the intangible development costs that are used to develop the intellectual property under a CSA. These costs should be identified and shared correctly amongst participants so that the related companies pay their fair share of the costs. This helps avoid any IRS adjustment of the cost allocation between related companies.
When related companies enter into a Cost Sharing Arrangement (CSA), they work together to develop intellectual property such as software, patents, trademarks, or technology. The costs incurred to develop this intellectual property are called Intangible Development Costs (IDCs).
These costs generally include:
The U.S. transfer pricing rules require all these development costs to be identified and shared correctly among the participants. This ensures that each participant pays only its fair share of the costs and prevents multinational groups from shifting profits by allocating too much or too little development cost to a related company.
However, the costs are not shared equally. Instead, each participant pays a share of the costs based on the future benefits it expects to receive from the intellectual property being developed.
For example, if one participant expects to receive 70% of the future benefits from the intellectual property, while another expects to receive only 30%, they should generally bear 70% and 30% of the development costs, respectively.
These expected future benefits are called Reasonably Anticipated Benefits (RAB). Therefore, estimating these benefits accurately is essential because they determine how the development costs are allocated among the participants under the arm’s length principle.
Let’s now understand Reasonably Anticipated Benefits (RAB) in more detail.
Reasonably Anticipated Benefits (RAB) are the future economic benefits that each participant expects to receive from the intellectual property developed under the Cost Sharing Arrangement.
The U.S. transfer pricing rules use these expected benefits to determine how the development costs should be shared. In simple terms, a participant that expects to receive a larger share of the future benefits should also pay a larger share of the development costs.
Expected benefits may be estimated using factors such as:
For example, if a U.S. parent company expects to earn 80% of the future profits from a new software platform and its foreign subsidiary expects to earn 20%. Therefore, they would generally share the development costs in the same 80:20 ratio.
Because business conditions, market demand, and expected profits may change over time, participants should review and update their RAB estimates whenever necessary. If the IRS believes the estimates are unreasonable or do not reflect the expected economic benefits, it may adjust the allocation of the development costs to ensure they satisfy the arm’s length principle.
However, Cost Sharing Arrangements do not always begin with a clean slate. In many cases, one of the participants already owns valuable intellectual property, technology, or know-how before the arrangement starts. Since this existing intellectual property helps develop the new intellectual property under the CSA, the other participants should compensate the owner for using it.
This type of contribution is called a Platform Contribution Transaction (PCT), and the payment made to the contributing participant is commonly known as a buy-in payment. Therefore, the U.S. transfer pricing rules also ensure that participants pay a fair, arm’s length amount for any valuable intellectual property contributed at the beginning of the arrangement. Next, let’s understand Platform Contribution Transactions (PCTs) and buy-in payments in more detail.
Sometimes, before a Cost Sharing Arrangement (CSA) begins, one of the participants already owns valuable intellectual property, technology, software, patents, or other know-how. If that existing intellectual property is used in the CSA to help develop new intellectual property, it is called a Platform Contribution Transaction (PCT).
Because the existing intellectual property already has value, the other participants cannot use it for free. They should compensate the contributing participant by making a buy-in payment at an arm’s-length price.
For example, suppose a U.S. company has already developed patented software before entering into a CSA with its subsidiary in Germany. The U.S. company allows the German subsidiary to use that existing software to develop a new product. Since the German subsidiary benefits from technology that already existed, it should make a buy-in payment to the U.S. company based on the fair market value of that technology.
The IRS allows several valuation methods to determine the appropriate buy-in payment. This rule ensures that valuable pre-existing intellectual property is properly compensated and is not transferred between related companies at an unfair price.
Once the participants have agreed on how the development costs will be shared, they should make cost-sharing payments each year so that each participant pays its correct share of the Intangible Development Costs (IDCs).
Sometimes, the amount initially paid may not match the participant’s share of the expected future benefits. In such cases, adjustments are made so that each participant ultimately bears the correct portion of the development costs.
The U.S. transfer pricing rules require these payments to be reviewed regularly to ensure they remain consistent with the arm’s length principle. This helps ensure that no participant pays too much or too little compared to the benefits it expects to receive.
If the IRS determines that the cost-sharing payments are not at arm’s length, it may adjust the transfer prices, require additional payments between the participants, and charge interest where appropriate. These adjustments help ensure that the profits reported by each participant accurately reflect the economic value of their contributions.
A Cost Sharing Arrangement (CSA) should be supported by proper documentation. Maintaining accurate records helps demonstrate that the arrangement complies with the U.S. transfer pricing rules and that the development costs have been allocated fairly.
The documentation generally includes:
Companies should also maintain records supporting their cost calculations, expected benefit projections, and valuation methods. In addition, certain information and disclosures must be filed with the IRS.
Proper documentation is important because it provides evidence that the CSA follows the U.S. transfer pricing regulations. During an IRS audit, well-prepared documentation can help support the company’s transfer pricing position and may reduce the risk of adjustments and penalties.
The IRS carefully reviews Cost Sharing Arrangements because they often involve valuable intellectual property and significant cross-border transactions. Its objective is to ensure that related companies allocate costs and profits in the same way that independent businesses would under similar circumstances.
If a CSA does not comply with the U.S. transfer pricing rules, the IRS may:
In addition to these adjustments, significant transfer pricing or valuation errors may result in accuracy-related penalties of 20% or even 40% of the additional tax owed.
Some of the most common issues identified during IRS audits include:
Following the U.S. transfer pricing rules and maintaining proper documentation can help reduce the risk of IRS adjustments, additional taxes, interest, and penalties.