§ 1.482-7(g)(4)(viii) Example 7.

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Application of income method with a terminal value calculation.

(i) For simplicity of calculation in this Example 7, all financial flows are assumed to occur at the beginning of each period. USP’s research and development team, Q, has developed a technology, Z, for which it has several applications on the market now and several planned for release at future dates. In Year 1, USP, enters into a CSA with its wholly-owned subsidiary, FS, to develop future applications of Z. Under the CSA, USP will have the rights to further develop and exploit the future applications of Z in the United States, and FS will have the rights to further develop and exploit the future applications of Z in the rest of the world. Both Q and the rights to further develop and exploit future applications of Z are reasonably anticipated to contribute to the development of future applications of Z. Therefore, both Q and the rights to further develop and exploit the future applications of Z are platform contributions for which compensation is due from FS to USP as part of a PCT. USP does not transfer the current exploitation rights for current applications of Z to FS. FS will not perform any research or development activities on Z and does not furnish any platform contributions to the CSA, nor does it control any operating intangibles at the inception of the CSA that would be relevant to the exploitation of either current or future applications of Z.

(ii) At the outset of the CSA, FS undertakes an analysis of the PCTs involving Q and the rights with respect to Z in order to determine the arm’s length PCT Payments owing from FS to USP under the CSA. In that evaluation, FS concludes that the cost sharing alternative represents a riskier alternative for FS than the licensing alternative. FS further concludes that the appropriate discount rate to apply in assessing the licensing alternative, based on discount rates of comparable uncontrolled companies undertaking comparable licensing transactions, would be 13% per annum, whereas the appropriate discount rate to apply in assessing the cost sharing alternative would be 14% per annum. FS undertakes financial projections and anticipates making $100 million in sales during the first two years of the CSA in its territory with sales in Years 3 through 8 increasing to $200 million, $400 million, $600 million, $650 million, $700 million, and $750 million, respectively. After Year 8, FS expects its sales of all products based upon exploitation of Z in the rest of the world to grow at 3% per annum for the future. FS and USP do not anticipate cessation of the CSA Activity with respect to Z at any determinable date. FS anticipates that its manufacturing and distribution costs for exploiting Z (including its operating cost contributions), will equal 60% of gross sales of Z from Year 1 onwards, and anticipates its cost contributions will equal $25 million per annum for Years 1 and 2, $50 million per annum for Years 3 and 4, and 10% of gross sales per annum thereafter.

(iii) Based on this analysis, FS determines that the arm’s length royalty rate that USP would have charged an uncontrolled licensee for a license of future applications of Z if USP had further developed future applications of Z on its own is 30% of the sales price of the Z-based product, as determined under the comparable uncontrolled transaction method in § 1.482-4(c). In light of the expected sales growth and anticipation that the CSA Activity will not cease as of any determinable date, FS’s determination includes a terminal value calculation. FS further determines that under the cost sharing alternative, the present value of FS’s divisional profits, reduced by the present values of the anticipated operating cost contributions and cost contributions, would be $1,361 million. Under the licensing alternative, the present value of the operating divisional profits and losses, reduced by the operating cost contributions, would be $2,113 million, and the present value of the licensing payments would be $1,585 million. Therefore, the total value of the licensing alternative would be $528 million. In order for the present value of the cost sharing alternative to equal the present value of the licensing alternative, the present value of the PCT Payments must equal $833 million. Accordingly, FS pays USP a lump sum PCT Payment of $833 million in Year 1 for USP’s platform contributions of Z and Q.

(iv) The Commissioner undertakes an audit of the PCTs and concludes, based on his own analysis, that this lump sum PCT Payment is within the interquartile range of arm’s length results for these platform contributions. The calculations made by FS in determining the PCT Payment in this Example 7 are set forth in the following tables:

Cost Sharing Alternative

Time Period (Y = Year, TV = Terminal Value) Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 TV
Discount Period 0 1 2 3 4 5 6 7 7
Items of Income/Expense at Beginning of Year:
1 Sales 100 100 200 400 600 650 700 750 (3% annual growth in each year from previous year).
2 Routine Cost and Operating Cost Contributions (60% of sales amount in row 1 of relevant year) 60 60 120 240 360 390 420 450 (60% of annual sales in row 1 for each year).
3 Cost Contributions (10% of sales amount in row 1 for relevant year after Year 5) 25 25 50 50 60 65 70 75 (10% of annual sales in row 1 for each year).
4 Profit = amount in row 1 reduced by amounts in rows 2 and 3 15 15 30 110 180 195 210 225 (row 1 minus rows 2 and 3 for each year).
5 PV (using 14% discount rate) 15 13.2 23.1 74.2 107 101 95.7 89.9 842.
6 TOTAL PV of Cost Sharing Alternative = Sum of all PV amounts in Row 5 for all Time Periods = $1,361 million.

Licensing Alternative

Time Period (Y = Year, TV = Terminal Value) Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 TV
Discount Period 0 1 2 3 4 5 6 7 7
Items of Income/Expense at Beginning of Year:
7 Sales 100 100 200 400 600 650 700 750 (3% annual growth in each year from previous year).
8 Routine Cost and Operating Cost Contributions (60% of sales amount in row 7 of relevant year). 60 60 120 240 360 390 420 450 (60% of annual sales in row 7 for each year).
9 Operating Profit = amount in Row 7 reduced by amount in Row 8 40 40 80 160 240 260 280 300 (Row 7 minus row 8 for each year).
10 PV of row 9 (using 13% discount rate) 40 35.4 62.7 111 147 141 135 128 1313.
11 TOTAL PV FOR ALL AMOUNTS IN ROW 10 = $2,112.7 million
12 Licensing Payments (30% of sales amount in row 7) 30 30 60 120 180 195 210 225 (30% of amount in row 7 for each year).
13 PV of amount in row 12 (using 13% discount rate) 30 26.5 47 83.2 110 106 101 95.6 985.
14 TOTAL PV FOR ALL AMOUNTS IN ROW 13 = $1,584.5 million.
15 TOTAL PV of Licensing Alternative = Row 11 minus Row 14 = $528 million.

Calculation of PCT Payment

16 TOTAL PV OF COST SHARING ALTERNATIVE (FROM ROW 6 ABOVE) = $1,361 million.
17 TOTAL PV OF LICENSING ALTERNATIVE (FROM ROW 15 ABOVE) = $528 million.
18 LUMP SUM PCT PAYMENT = ROW 16 − ROW 17 = $833 million.

 

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