Cost-Sharing Agreements (CSAs) allow two or more related entities to share contributions and risks associated with the joint development, production, or acquisition of assets, services, or intangibles, with the expectation of deriving benefits from those results.
In cases involving intangible assets, these types of agreements can be used, for example, to jointly finance the development of technology or intellectual property.
However, from a Transfer Pricing perspective, it is not sufficient to simply distribute costs among the participating entities. It must also be analyzed whether each party effectively assumes and controls the risks that correspond to it, whether it has the financial capacity to assume them, and whether there is a reasonable expectation of deriving benefits from the outcome of the agreement.
Therefore, sharing costs or making financial contributions does not automatically mean sharing the risks associated with the project.
Proportionality as a Central Principle
The OECD Guidelines state that the value of the contributions made by each party must be consistent with its proportional share of the expected benefits from the agreement.
This implies that, from the outset, there must be a reasonable basis for estimating what benefits each party expects to obtain. In development agreements, this determination may involve a significant degree of uncertainty, especially when the results will depend on future factors (market acceptance, technological development, or market trends).
For this reason, participations in expected benefits and contributions made should be reviewed periodically when there are significant changes in economic circumstances or in the expectations originally considered.
These changes may give rise to prospective adjustments to the contributions or to the formulas used to distribute them.
Cost-sharing does not automatically mean risk-sharing
One of the most important aspects is that the contractual allocation of a risk is not sufficient on its own.
For an entity to be considered a party in a CSAs, it must have the ability to control the risks it assumes and the financial capacity to bear them. Furthermore, it must effectively carry out the decision-making functions related to those risks.
It is not enough for an entity to contribute financially to the arrangement if, practically speaking, it does not participate in the relevant decisions related to the risks of the project.
Thus, two entities may contribute to the same project but are not necessarily in an equivalent financial position if one merely finances costs while the other controls the decision-making and assumes the economically significant risks.
Likewise, to be considered a member of a CSAs, the entity must have a reasonable expectation of benefiting from the agreement’s results. The entity that merely performs activities for the CSAs, without obtaining rights or a share in its results, may be considered a service provider rather than a party to the agreement.
Pre-existing Contributions and Compensatory Payments
When an entity contributes a pre existing intangible, asset, or right to the arrangement, such contribution must be valued in accordance with the arm’s-length principle.
In such cases, it may be necessary for the parties to make a compensatory payment to one another, to ensure that the value of each party’s contributions is consistent with its participation in the expected profits.
Therefore, not every entry into an agreement should automatically be interpreted as a simple buy-in payment. The analysis should focus on the economic value of the existing contributions, as well as determining whether adjustments are necessary to maintain the balance of the agreement.
What evidence supports the arrangement during an audit?
A defensible CSAs must demonstrates: who the parties are, the purpose and scope of the agreement, the contributions made by each entity, the risks assumed and controlled by each party, how the expected benefits were estimated, the criteria used to allocate contributions, how pre-existing contributions were valued, and what adjustments were made when relevant circumstances changed.
The document must be consistent with the actual conduct of the parties. If the agreement allocates certain risks or functions to one entity, but, in practice, the relevant decisions are controlled by another entity within the group, the contractual characterization may be challenged.
Furthermore, the OECD states that parties must have sufficient information regarding the CSA’s activities, the forecasts used to determine expected benefits and estimated and actual expenses. Such information must be provided sufficiently detailed in accordance with the complexity and significance of the agreement.
At TPC Group, we evaluate existing or pending cost sharing agreements, analyzing whether the contributions, expected profits, and risks assumed by each party are aligned with the arm’s-length principle.
Source: OECD - Chapter VIII