What a cost sharing agreement is
Although cost sharing arrangements may take many forms, at their core, a cost sharing arrangement is a contractual mechanism intended to ensure the sharing of the costs and risks of operating a business between related parties. Cost sharing arrangements between entities that do not file a consolidated tax return will generally need to be documented in order to help support such arrangements with the IRS. Depending upon the facts, a cost sharing arrangement can be useful in situations involving activities such as research and development, distribution and, marketing and sales .
Common characteristics of cost sharing arrangements tend to include the following:
In the U.S., a cost sharing agreement may be entered into between parties if one party will perform significant services and bear significant risks in connection with the development of products or performance of services. The parties typically share the financial burden of the costs associated with developing products or providing services. In addition, costs will typically be shared among the parties based on their expected use of the product or services once developed.
The essentials of a cost sharing agreement
The scope of costs to be shared. This section outlines the areas and types of costs that will be shared among the authorized participants. It can be as broad or narrow as the parties require, but we always recommend using objective cost categories and descriptions so that you don’t spend unnecessary time determining whether a certain expense is covered.
The method for allocating costs among the participants. For example, if the agreement is between the members of a consolidated group, the allocation may be similar to the consolidated return. If the members are not in common parent / subsidiary relationships, it may be allocated in a manner that is consistent with the law or the method the parties believe to be the most fair.
The method of determining adjustments to shared costs. This section is similar to the method of allocating costs among the participants, but rather than being applied to the specific costs to be shared, it’s for any related costs that are not covered by the specific costs under the agreement. It’s also used for costs that one party has covered but then later believes is subject to the cost sharing agreement.
The mechanics of accounting for shared costs. The accounting methods or templates used to keep track of the shared costs and how each participant will be credited is very important. Proper consideration should be given to the accounting, billing, and payment procedures for the shared costs.
The applicable law or regulations that are relevant. Within this section, identify the applicable U.S. Treasury regulations. If there’s no relevant laws or regulations (new regulations have not yet been proposed), you can use IRC Section 482 as your legal basis for the cost sharing agreement.
Advantages of a cost sharing agreement
Entering into a CFS agreement can also increase co-development efficiency. In certain situations, the parties may share the same drug assets, thus reducing the time, resources and overall cost spent on development. In addition, sometimes an asset enters an unexpected, critical clinical trial. The cost of the trial may amount to millions of dollars, and costs may be difficult to predict. A cost sharing agreement may allocate jurisdiction over such trial on a party-to-party basis, in order to share the risk that it is not properly designed or well executed.
The Collaboration may increase markets and reduce competition. A CFS agreement provides a framework for the sharing of knowledge and revenue between competitors. This may foster goodwill between the parties that may lead to future collaboration opportunities or mergers. Moreover, once the CFS agreement is signed, the parties may be less likely to compete for the same customers. In some markets, this is a significant driver. For example, in the pharmaceutical industry, there are many players who are looking for niche products to support and add to their primary offerings. By entering into a CFS agreement with a local collaborator, the parties may divide target markets, rather than compete for them.
Typical challenges associated with cost sharing agreements
Cost sharing agreements are not without pitfalls. Parties may have disputes not only over the allocation of costs among them post-arrangement but also concerning the proper amount and character of costs charged among them under the arrangement, particularly when the parties each have their own tax advisors. The business circumstances or even the players involved in a cost sharing arrangement may change. And parties can have non-compliance issues (including in the event that one party undertakes an internal inquiry concerning potential disallowed payments to avoid possible understatement penalties).
The IRS released a consultation paper in 2012 in which it weighed in on its concerns with cost sharing arrangements, particularly with respect to the potential overreach by one party or another. For example, the IRS is concerned that a paying party may "undervalue the work performed by the receiving party under the CSA" or otherwise not value the activities in the correct manner, which could result in an understatement in the amount of the payment under the CSA to its detriment. The IRS is also concerned that the parties may fail to properly share the costs according to the methodology set forth in the CSA and as required under the regulations.
In response to these and other concerns, the IRS’s current guidance requires that the payment to the receiving party under a CSA be made only pursuant to a written CSA that is part of the controlled group’s transfer pricing documentation. The CSA must specify the methods that are used to determine the costs shared between the parties. It must also specify how the CSA will be adjusted over time to reflect changes in the underlying arrangements, methodologies, business circumstances, or other matters. The published guidance places the IRS on record as to its concerns as well as its intention to examine CSAs in the future.
Examples of cost sharing agreements
It is not possible to definitively say whether a cost sharing arrangement exists based on a brief description of an asserted "cost sharing agreement". Distilling the cases into a dozen categories is neither possible nor would it make for a very interesting example section. However, the following are several examples of case law or agency guidance in which a cost sharing agreement was at issue.
In Revenue Ruling 65-56, the IRS ruled that licensees of a patented dyeing method that paid a fee to the patent holder for dye and auxiliary materials received under a cost sharing agreement with the patent holder were entitled to deduct the payments as patent inputs. The licensee engaged in dyeing that required the use of twelve named dyes. To obtain the dyes, the licensee agreed with the patent holder to a profit sharing formula based on the final product produced (i.e., fabric ready for sale). Under the formula, the licensee paid fifty percent of profits under $16,000 and paid more than fifty percent of profits over that amount. The Court held that the agreement was not a profit-sharing arrangement; it was merely a cost-sharing agreement where the licensee paid a fee to receive the patented dyes for using in its manufacturing process. The ruling is a single-payor agreement. The licensee that uses the patented goods must pay the patent holder for the patented material.
In PLRs 200925027, 201106047 and 201113007 , the IRS addresses a cost sharing agreement in which there is no third party payor. The arrangement at issue involved both a licensee of a patent and a joint venture component. The taxpayer was a participant in the cost sharing regimes for the license agreement and joint venture discussed above. For each type of agreement, the licensee was obligated to pay its LP’s proportionate share of R&D expenses but was not entitled to any profits from the license or the joint venture. Further, the venture was a service provider to the R&D agreement. Because the service provided by the codevelopers did not constitute substantially all of the activities, the expenses were service costs.
In a simple example of a cost sharing agreement, two companies, X Corporation and Y Corporation, enter into an agreement in which X agrees to develop a new software application. X is responsible for covering its own costs. Under the agreement, Y agrees to pay X a portion of the costs of development in exchange for not less than thirty percent of the intellectual property. As the software application is developed, X and Y agree to share the intellectual property rights on a proportional basis. In addition, Company A will contribute to the development of the software by making its facilities and employees available for use in the project. The key in this transaction is that Y is not paying 50% (or other majority share) of the development costs.
Legal considerations and best practices
When preparing a cost sharing agreement, the terms between the parties should be precisely defined and presented in clear, specific language. The parties should be careful to cover a number of important elements, including payment terms, obligations, contributions, and how intellectual property created pursuant to the agreement will be managed and treated in the future. These items are necessary to avoid misunderstandings in the future, practicing what the lawyers often say, namely that the only good contract is the one that discusses every conceivable circumstance in the parties’ relationship.
One of the more important issues to consider in a cost sharing agreement is what law will apply to it. Some states have only general, weak versions of the common law as well as weak statutes that govern cost sharing agreements. These solutions, such as the ABA Cost Sharing Model Provisions, should be further supplemented and are not a substitute for a well-drafted cost sharing agreement. Some states depart from the federal model by requiring a 10-year term or five-year tax period, and having a decoupling provision. In addition, states vary widely in their treatment of computer software, intangible assets, the capitalization of R&D costs and the ability to transfer or sell a cost shared asset.
For example, in California, COSTS (California’s intercompany transfer pricing guidelines) require a study and annual reporting on all product R&D agreements. California also requires that the R&D not be funded out of current earnings. California has transfer pricing control and examination rules which require cost sharing R&D agreements to be submitted.
The IRS looks at transfer pricing agreements as an area of high risk and presently has international attention towards cost sharing agreements. The IRS has always looked carefully at cost sharing agreements and is constantly expanding its guidance. They constantly consider cost sharing agreements as being at risk for transfer pricing manipulation. The IRS had a proposal in 2006 for consistent treatment of cost sharing agreements and a safe harbor.
The cost sharing regulations require transferors to receive a substantial interest in future income before entering into a cost sharing agreement. The transferor should be entitled to a residual allocation of income over a threshold rate of return. In addition, the transferor has to be entitled to a return on investment that is within a range that would be negotiated at arm’s length.
The regulations impose a penalty on participants for failure to meet the periodic evaluation requirement. If the projected revenues show significant deviation from the projected revenues contained in the agreement, the participants set a starting point at the end of the original agreement and enter into a second cost sharing agreement. The second cost sharing agreement will likely trigger the redetermination rules.
How to prepare a cost sharing agreement
A Cost Sharing Agreement is a contract entered into by members of a consolidated group or affiliated group of corporations or partnerships (as applicable) engaged in group financing involving the sharing of costs. The steps involved in drafting and finalising a cost sharing agreement (or CSA) are as follows:
- Costs and Allocations Involved. The first step is to identify the costs to be shared, to discuss and agree the method proposed for allocating the costs involved.
- Related Intangible Assets. The next step is to identify any related intangible assets that may be involved as well as the contribution each party is to make to the pool of assets and costs.
- Term. The duration of the Agreement should also be discussed at this stage and a term agreed (if possible). In the absence of an agreed term it the CSA can be entered into indefinitely on an open-ended basis.
- Drafting of the Agreement (or CSA). Following the discussions referred to above, the draft agreement is prepared.
- Detailed Provision. Provisions are then inserted regarding the jurisdiction of the parties, the manner in which the CSA will be governed and issues such as: or information regarding the review of methodologies, setting up of accounts and procedures for compliance.
- Cost Statements. Procedures for the preparation of annual Cost Statements is established. Cost Statements are to be attached as schedules to the agreement. The text of the agreement should refer the reader to the applicable schedule.
- Qualification. The agreement will also usually be qualified by certain required statements such as those set out below:
- Compliance with APA. The following is one important statement that may be required: It is recommended that where there is an Advance Pricing Agreement issued by the IRS, that the obligations and responsibilities imposed by such agreement should be expressly stated.
- Application for APAs. Where it is necessary to secure an Advance Pricing Agreement, a request can then be made to the IRS for an APA under the regime for "Cost Sharing Arrangements or Joint Development Agreements" as outlined in Revenue Procedure 2006-9.
- Dispute Resolution. Provisions for Deliberate Dispute Resolution (DRP) will be contained in the agreement. This is a step all parties must exhaust prior to litigation and can include both mediation and arbitration.
- Execution. Following execution the agreement is administered by the parties under the supervision of the accountants of the group and reviewed and amended on a regular basis (usually annually). The agreement will then be monitored and where necessary revised.
Conclusion – Cost sharing agreements shape business strategies
In recent years we have seen an increase in the number of cost sharing agreements in multinational groups. However, these carefully drafted and sophisticated documents come with more than tax planning benefits. These agreements will often require a group to identify business synergies and implement strategies for commercialization of a broad range of products and services. At a minimum, cost sharing agreements mandate that groups create a business strategy on a global scale. In addition to the initial investment in R&D , business strategy and commercial plan, a cost sharing agreement can impose significant compliance and administrative burdens. Careful structuring of these agreements to ensure that the terms are clear, compliant and reflect the facts will facilitate administration and drive best outcomes from the cost sharing arrangement. Multinational groups need to understand the long term implications and potential disruptions of a poorly structured cost sharing agreement and how to mitigate these issues.