ATTORNEY SAYS TRANSFER-PRICING REGS SHOULD NOT ADOPT SPECIAL RULES FOR MARKETING ROYALTIES.

Enclosed herewith are an original and nine copies of a letter containing our comments on the cost sharing of the proposed regulations under Section 482 which were published in the Federal Register on January 30, 1992. Please date stamp as received one of the copies and return it in the enclosed self addressed envelope.

Sincerely,

By letter dated July 24, 1992, our firm furnished you with comments on several aspects of the cost sharing provisions of the proposed regulations under I.R.C. Section 482 which were issued on January 24, 1992 (the "proposed regulations"). The purpose of this letter is to furnish you with certain additional comments on the proper treatment of royalty under these provisions.

The proposed regulations provide that, in order for an entity to be an "eligible participant" in a cost sharing arrangement, the entity must utilize the intangibles developed under the cost sharing arrangement in the active conduct of its trade or business. With respect to the "active conduct of a trade or business" requirement, Prop. Reg. 1.482-2(g)(3)(iv)(A) provides as follows:

"An intangible is not used in the active conduct of a participant's trade or business if a substantial purpose for participating in the arrangement is to obtain an intangible to transfer to an uncontrolled taxpayer. It will be presumed that a substantial purpose for participating in a cost sharing arrangement is to obtain an intangible to transfer to an uncontrolled taxpayer if there are any significant direct or indirect transfers of developed intangibles to an uncontrolled taxpayer during the course of the arrangement or within four years of the termination of the arrangement."

In the July 24th letter, we suggested that this rule is too harsh. We indicated that entities deriving third party royalties from intangibles should be treated as eligible participants under a cost sharing arrangement, whether or not the royalties are derived in the active conduct of the business of marketing intangible property. We further suggested that the treatment of royalties received in the active conduct of the business of marketing intangibles ("Marketing Royalties") should be different from royalties which are not so received. We maintained that there should be no prohibition against receipt of royalties of either kind but that royalties other than Marketing Royalties should be allocated on an appropriate basis among the participants to the agreement, including the participant which received the royalties.

This letter will expand on our earlier comments as to Marketing Royalties. The final regulations should indicate that no special rules or requirements apply to the receipt of Marketing Royalties. Instead, such royalties should be treated the same as any other business income, and expenses should be allocated accordingly.

Several provisions of the Code recognize that an entity that actively sells or licenses technology to third parties is engaged in the active conduct of a trade or business. See I.R.C. section 954(c)(2)(A) and Treas. Reg 1.954-2T(d)(1)(ii) (exempting royalties derived in the active business of marketing intangibles from foreign personal holding company income). Treas. Reg. 1.864-4(c)(3)(i) ("The business-activities test is of primary significance, for example, where . . . royalties are derived in the active conduct of a business consisting of the licensing of patents or similar intangible property . . ."); Prop. Reg 1.1362-3(d)(5)(ii)(A)(2) ("'Royalties' does not include royalties derived in the ordinary course of a trade or business of licensing property"); See also Treas. Reg. 1.864- 4(c)(3)(ii), Example (2); Treas. Reg. 1.864-6(b)(2)(i), Example (1).

An example of the type of entity to which we refer would be an entity that engages in research and development in order to create improved computer software technology and then reproduces and licenses the computer software resulting from such research and development. This should be compared to the situation in Prop. Reg. 1.482-2(g)(3)(iv)(B), which permits cost sharing where an entity engages in research and development to create improved Product X and then reproduces and sells the improved Product X resulting from its research and development efforts. In both cases, the entities involved are not only engaged in the research and development function, but are also actively engaged in one or more of the reproduction, packaging, marketing and selling functions. The fact that the end product is intangible property should be irrelevant.

Sincerely