§ 1.482-7(g)(7)(v) Example 1.

Category: (g) Supplemental guidance on methods applicable to PCTs, Transfer Pricing Guidelines, US IRC Section 482 on Transfer Pricing, § 1.482-7 Methods to determine taxable income in connection with a cost sharing arrangement | Tag: , , , , , , , ,
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(i) For simplicity of calculation in this Example 1, all financial flows are assumed to occur at the beginning of each period. USP, a U.S. electronic data storage company, has partially developed technology for a type of extremely small compact storage devices (nanodisks) which are expected to provide a significant increase in data storage capacity in various types of portable devices such as cell phones, MP3 players, laptop computers and digital cameras. At the same time, USP’s wholly-owned subsidiary, FS, has developed significant marketing intangibles outside the United States in the form of customer lists, ongoing relations with various OEMs, and trademarks that are well recognized by consumers due to a long history of marketing successful data storage devices and other hardware used in various types of consumer electronics. At the beginning of Year 1, USP enters into a CSA with FS to develop nanodisk technologies for eventual commercial exploitation. Under the CSA, USP will have the right to exploit nanodisks in the United States, while FS will have the right to exploit nanodisks in the rest of the world. The partially developed nanodisk technologies owned by USP are reasonably anticipated to contribute to the development of commercially exploitable nanodisks and therefore the rights in the nanodisk technologies constitute platform contributions of USP for which compensation is due under PCTs. FS does not have any platform contributions for the CSA. Due to the fact that nanodisk technologies have yet to be incorporated into any commercially available product, neither USP nor FS transfers rights to make or sell current products in conjunction with the CSA.

(ii) Because only in FS’s territory do both controlled participants make significant nonroutine contributions, USP and FS determine that they need to determine the relative value of their respective contributions to residual divisional profit or loss attributable to the CSA Activity only in FS’s territory. FS anticipates making no nanodisk sales during the first year of the CSA in its territory with revenues in Year 2 reaching $200 million. Revenues through Year 5 are reasonably anticipated to increase by 50% per year. The annual growth rate for revenues is then expected to decline to 30% per annum in Years 6 and 7, 20% per annum in Years 8 and 9 and 10% per annum in Year 10. Revenues are then expected to decline 10% in Year 11 and 5% per annum, thereafter. The routine costs (defined here as costs other than cost contributions, routine platform and operating contributions, and nonroutine contributions) that are allocable to this revenue in calculating FS’s divisional profit or loss, are anticipated to equal $40 million for the first year of the CSA and $130 for the second year and $200 and $250 million in Years 3 and 4. Total operating expenses attributable to product exploitation (including operating cost contributions) equal 52% of sales per year. FS undertakes routine distribution activities in its markets that constitute routine contributions to the relevant business activity of exploiting nanodisk technologies. USP and FS estimate that the total market return on these routine contributions will amount to 6% of the routine costs. FS expects its cost contributions to be $60 million in Year 1, rise to $100 million in Years 2 and 3, and then decline again to $60 million in Year 4. Thereafter, FS’s cost contributions are expected to equal 10% of revenues.

(iii) USP and FS determine the present value of the stream of the reasonably anticipated residuals in FS’s territory over the duration of the CSA Activity of the divisional profit or loss (revenues minus routine costs), minus the market returns for routine contributions, the operating cost contributions, and the cost contributions. USP and FS determine, based on the considerations discussed in paragraph (g)(2)(v) of this section, that the appropriate discount rate is 17.5% per annum. Therefore, the present value of the nonroutine residual divisional profit is $1,395 million.

(iv) After analysis, USP and FS determine that the relative value of the nanodisk technologies contributed by USP to CSA (giving effect only to its value in FS’s territory) is roughly 150% of the value of FS’s marketing intangibles (which only have value in FS’s territory). Consequently, 60% of the nonroutine residual divisional profit is attributable to USP’s platform contribution. Therefore, FS’s PCT Payments should have an expected present value equal to $837 million (.6 × $1,395 million).

(v) The calculations for this Example 1 are displayed in the following table:

Time Period (Y = Year) (TV = Terminal Value) Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 Y11 TV
Discount Period 0 1 2 3 4 5 6 7 8 9 10 10
[1] Sales 0 200 300 450 675 878 1141 1369 1643 1807 1626
[2] Growth Rate 50% 50% 50% 30% 30% 20% 20% 10% −10%
[3] Exploitation Costs and Operating Cost Contributions (52% of Sales [1]) 40 130 200 250 351 456 593 712 854 940 846
[4] Return on [3] (6% of [3]) 2.4 8 12 15 21 27 36 43 51 56 51
[5] Cost Contributions (10% of Sales [1] after Year 5) 60 100 100 60 68 88 114 137 164 181 163
[6] Residual Profit = [1] minus {[3] + [4] + [5]} −102 −38 −12 125 235 306 398 477 573 630 567 2395
[7] Residual Profit [6] Discounted at 17.5% discount rate −102 −32 −9 77 124 137 151 154 158 148 113 477
[8] Sum of all amounts in [7] for all time periods = $1,395 million
[9] Relative value in FS’s division of USP’s nanotechnology to FS’s marketing intangibles = 150%
[10] Profit Split (USP) 60% = 1.5 × [11]
[11] Profit Split (FS) 40%
[12] FS’s PCT Payments [8] × [10] = $1,395 million × 60% = $837 million

 






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