Cost-Sharing Agreements

These tax consequences arise because of the differences in tax rates across the jurisdictions in which the various divisions of the company do business. Most managers also know that choosing transfer prices in a way that both minimizes a firm’s tax liability and receives the approval of tax authorities is among the most important tax issues that their firms face. While transfer pricing regulations (e.g., §1.482 of the U.S. Treasury regulations) try to restrict firms’ choices by requiring that the prices charged for the transfers of internal products or services occur at “arm’s length” or market prices, firms often have discretion in selecting transfer prices because these internally transferred products or services have no identical external, or market, counterparts.

However, many managers may be less familiar with how they can sometimes reduce their tax bill by implementing a “cost-sharing agreement” among those divisions that engage in the internal transfer of intangible products or services. As its name would suggest, a cost-sharing agreement between, say, a U.S.-based parent division and a foreign-based subsidiary division specifies how the costs of intangible assets developed by the parent and the sub are to be allocated between them. Typical examples of such intangible assets include a company’s specialized methods of production, the licensing rights for producing products, and marketing techniques.

The fundamental tax advantage associated with cost-sharing agreements is that (estimated) market prices get replaced by incurred costs. To expand on this point, suppose a company consists of two divisions, a parent and its sub, and that these two divisions construct a cost-sharing agreement. The parent then develops an intangible asset — let’s say, a patent on some product that can be sold by both divisions. Given the cost-sharing agreement, the sub must pay the parent a fraction of the cost of developing the patent, with the fraction determined by the patent’s relative benefits to the parent and sub. In contrast, if no cost-sharing agreement had been constructed, the sub would have to make a royalty payment to the parent for each unit of the patented product the sub sells, with the royalty equaling the estimated market value of the license to sell the patented product. Both the sub’s royalty payments to the parent (under the transfer pricing agreement) and the sub’s cost-sharing payment to the parent (under the cost-sharing agreement) constitute taxable income to the parent, and are tax deductible for the sub. So, if the parent operates in a higher tax jurisdiction than does the sub, and the cost of developing the patent is less than the market-based royalty payments, the firm could reduce its worldwide tax liability by implementing a cost-sharing agreement instead of adopting royalty-based transfer prices.

Let’s consider an explicit example. Suppose the parent is located in the United States, where the corporate tax rate is 35%, and the sub is located in some tax haven where the corporate tax rate is, say, 10%. On January 1, 2008, the parent and sub construct a cost-sharing agreement that stipulates that any future intangibles developed by the parent that can be used by both the parent and the sub are to be shared based on the relative earnings of any future patented products.1 Suppose that later in 2008, the parent spends $100m to develop a new patented product that increases the parent’s earnings by $30m and the sub’s earnings by $20m. To keep the analysis simple, I will also suppose that these increases in earnings are perpetuities, i.e., last forever.2 Finally, suppose interest rates are 10%.

Under the cost-sharing agreement, the sub will have to pay the parent $40m, as the sub’s fraction of benefits from the patent are 40% = 2/5ths of the company’s total benefits from the patent and the parent’s total cost of developing the patent was $100m. Had no cost-sharing agreement been constructed, the sub would have had to pay the parent $200m in present value terms, which is the present market value ($20m/0.10) of the sub’s future earnings generated by the patent.

The worldwide tax benefits of the cost-sharing agreement can be determined as follows. The sub’s $40m payment to the parent will result in the parent paying an additional 0.35 x $40m = $14m in taxes in the United States, which will be offset by a 0.1 x $40m = $4m tax reduction for the sub, yielding $10m = $14m — $4m of worldwide tax payments. Compare that to what would have happened had no cost-sharing agreement been in effect prior to the patent’s invention. The sub would have had to pay, in present value terms, $200m to the parent, since this is the present value of the sub’s future earnings attributable to the patent. The parent would owe the IRS 35% x $200 = $70m on the sub’s payments, which would be offset by the sub’s reduced tax bill of 0.1 x $200m = $20m. Consequently, the company’s worldwide taxes would increase by $50m = $70m — $20m.

While people naturally tend to be bored by tax-related issues and, in particular, transfer prices, when a firm can shrink its worldwide tax payments by 80% ($10m vs. $50m) by substituting a cost-sharing scheme for a traditional transfer pricing policy, this is something to get excited about!

If one has never heard of cost-sharing schemes before, this seems almost too good to be true. You might think there is a catch that wasn’t mentioned in the example that, in practice, would reduce the value firms get from adopting cost-sharing schemes. There is indeed an element left out of the preceding discussion — the “buy-in payment” but it will not dissuade firms from adopting cost-sharing agreements. In a typical relationship between a parent and a sub, where the parent is developing most of the intangibles used by both entities, it is unlikely that the parent will start developing intangibles only after entering into a cost-sharing agreement with the sub. Instead, the parent will have supplied intangibles to the sub — such as use of the parent’s brand name, marketing know-how, and production technology — throughout the sub’s existence. Those intangibles that the parent supplied to its sub prior to constructing a cost-sharing agreement are referred to as its pre-buy-in intangibles. In the typical situation where a parent has developed these pre-buy-in intangibles on behalf of the sub, in order to implement a cost-sharing agreement, the sub has to make a one-time payment to the parent — the buy-in payment — equal to the estimated market value to the sub of the pre-buy-in intangibles (calculated as of the date the cost-sharing agreement becomes effective). This buy-in payment is taxable income to the parent and is tax deductible to the sub.

To account for the effects of the buy-in payment, let’s modify the preceding example by supposing that the parent and sub were both incorporated on January 1, 2007, so they had been together for one year before constructing the cost-sharing agreement. Suppose also that during 2007, the parent spent $400m developing intangibles, and that each of the parent’s and sub’s earnings attributable to these 2007 intangibles are $30m/year.3 With this additional detail, now when the parent and sub write a cost-sharing agreement on January 1, 2008, both entities will continue to share the costs of intangibles developed after January 1, 2008, but in addition the sub will be obliged to make a one-time payment to the parent for the present value of the pre-buy-in intangibles.4 Given the same data as before, that payment will be $300m, the present value ($30m/10%) to the sub of the pre-buy-in intangibles.

The critical point to note is that this required buy-in payment does nothing to reduce the desirability of the cost-sharing agreement. Without a cost-sharing agreement, the sub would be obliged to make an annual payment to the parent of $30m for the sub’s earnings generated by the parent’s pre-buy-in intangibles. Since the present value of these payments is $300m, which is the same amount as the buy-in payment, the total (present value of the) payments the sub makes related to these pre-buy-in intangibles is unaffected by whether or not the parent and sub entered into a cost-sharing agreement. Because it reduces the sub’s post-buy-in payments to the parent, notwithstanding the sub’s obligation to make the buy-in payment, the attractiveness of the cost-sharing agreement persists.

To sum up, cost-sharing agreements have the potential to significantly reduce a taxpayer’s tax liabilities. Are there any situations that reduce their desirability? If the returns to developing the intangibles are uncertain — and the market value of the intangibles turns out to be below their development costs — then entering into a cost-sharing agreement is undesirable. Cost-sharing agreements also could be unattractive if most of a company’s intangibles are developed by a subsidiary operating in a low tax jurisdiction. In that case, the U.S. parent would be required to make a payment to the sub for the parent’s share of the cost of intangibles developed by the sub. This is less desirable than using (typically higher) market-based transfer prices because — in this case — market-based transfer prices would have the advantage of shifting more of the taxpayer’s worldwide income to the sub’s lower tax jurisdiction than would a cost-sharing agreement.

Finally, it must be mentioned that cost-sharing agreements can result in additional disputes between a taxpayer and the IRS. In the illustrative example above, there is a clear delineation between the earnings the parent and sub generate from the pre-buy-in intangibles and the earnings the parent and sub generate from expenditures on intangibles after the cost-sharing agreement becomes effective. In practice, the earnings from these time-dated intangibles are often not easily distinguished. In that case, there are potentially difficult allocation issues involved in determining, for example, how much of the sub’s post-buy-in earnings are attributable to the parent’s pre-buy-in intangibles. This is somewhat ironic: based on conversations I have had with IRS personnel, one of the reasons the Treasury regulations were modified to include cost-sharing agreements was to eliminate disagreements between the IRS and taxpayers over what constitutes a reasonable assessment of the market value of royalty payments for transferred intangibles. Although cost-sharing agreements succeed in eliminating many disputes with the tax authority regarding intangibles developed after the agreements become effective, they also create new disputes over the size of the buy-in payments. And since (1) the buy-in payments are potentially very large — and are supposed to be based on the present value of all pre-buy-in intangibles, and (2) the buy-in payments force the taxpayer to address potentially contentious questions about what fraction of a sub’s post-buy-in profits are attributable to intangibles developed up to the buy-in date, cost-sharing agreements have replaced one source of disagreements over intangibles with another source of disagreement over intangibles.