US multi-nationals have long enjoyed the simplicity and tax certainty afforded by Cost Sharing Arrangements (CSA). In a CSA, participants share in the development of valuable intangibles in exchange for the right to exploit the resulting intangible. The cost of the development activity is allocated to the participants based on each participant’s expected benefit. (To the extent that a participant contributes a resource, capability or right that was developed outside of the CSA, that resource, capability or right must be valued at arm’s length. Each participant is then allocated their share of that arm’s length value.)
October 2015 saw the release of the Final Report OECD/G20 Base Erosion and Profit Shifting Project. There were few surprises in the Final Report. Much of the content had been previously released in discussion drafts and had been commented on by interested parties. However, certain comments within the report on Actions 8-10 Aligning Transfer Pricing Outcomes with Value Creation may surprise taxpayers and service providers.
In Action 8, the OECD Transfer Pricing guidelines were modified to include the following language regarding Cost Contribution Arrangements (CCA, the OECD equivalent of the CSA):
“For development CCAs, the measurement of current contributions at cost will generally not provide a reliable basis for the application of the arm’s length principle.”
Rather, the value of the current contributions must be determined under the arm’s length principles. This change from cost to value represents a significant shift and should cause all multi-nationals currently in or contemplating CCAs or CSAs to reevaluate the costs and benefits.
US Tax Law versus OECD Guidelines
To the extent that the US multi-national has entered into a CSA with an entity with a tax home in a country that has adopted the OECD Transfer Pricing guidelines, a conflict will arise with respect to the allocation of development costs. The OECD country tax authority will potentially look to value the contributions of each participant at some amount greater than cost.
Impact on Simplicity
Capturing the costs of development activities incurred within a CCA or CSA is generally a straightforward exercise. To the extent that each contribution now must be evaluated under the arm’s length principle, multi-nationals will now need to perform an economic analysis of each contribution, thus eliminating one of the major advantages of the CCA or CSA.
When allocating the CCA or CSA development cost and the method for calculating contributions made to development activities is based on cost, the only variable that exists is the anticipated benefits of each participant. However, if each contribution must be valued, a plethora of new variables (and hence, uncertainty) are created. At the extreme, the value placed upon the contribution of one participant could be so great that it renders the CSA or CCA worthless. That is to say, the allocation of development cost would equate to the arm’s length royalty that would be charged in the event of a successful development effort.
All multi-nationals should evaluate the consequences of valuing contributions to CSAs and CCAs at an amount in excess of cost.