Apr 1, 2008

Cost-Shar­ing Agreements

A tax-sav­ing device for multi-nationals

Most man­agers who work in inter­na­tion­al busi­ness­es are aware that trans­fer prices — that is, the prices one divi­sion of their busi­ness pays or receives for prod­ucts and/​or ser­vices sup­plied to or acquired from its oth­er divi­sions — can have a large effect on their total tax bill and their over­all cor­po­rate-wide profitability. 

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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.

In some cas­es, a firm can reduce its world­wide tax lia­bil­i­ty by imple­ment­ing a cost-shar­ing agree­ment instead of adopt­ing roy­al­ty-based trans­fer prices.

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.

If one has nev­er heard of cost-shar­ing schemes before, this seems almost too good to be true.”

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.

Featured Faculty

Ronald A. Dye

Leonard Spacek Professor of Accounting Information & Management; Director, Accounting Research Center

About the Research

Ronald Dye, R#8220;Valuation Issues for Buy-In Payments Associated with Cost-Sharing Agreements,” working paper, Kellogg School of Management, 2008.

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