M8A: Transfer Pricing Part I
The problem of Practice 8125#1
Dr. David Bradford suggested the price to be $2.25 to $3.00, basing this price estimate upon the study of gross profit margins of several soft contact lens manufacturers and also determined that markup was more likely to have resulted from lens price, the tax court, however, argued that the prices of the other soft lens manufacturers were incomparable.
The Commissioner has adopted regulations implementing section 482 that are pivotal to the decision of this case. First, as to the transfer price for lenses, Treas. Reg. 1.482-2(e)(1) provides that in the event of a transfer of tangible property between commonly controlled entities.
Reg. § 1.482-2(d)(1) and (2), which deal with transfers of intangible property between commonly controlled entities, provide an essentially identical rule that applies to the royalty paid by B L Ireland for the use of B L’s intangibles.
Section 1.482-2(e) goes on to specify particular methods to deal with the transfers of tangible property, to wit:
1) The comparable uncontrolled price method relies upon the price prevailing in comparable sales between entities that are not members of the same control group. § 1.482-2(e)(2).
2) The resale price method starts with the price that the buyer in the controlled sale is anticipated to charge upon resale to an entity outside the control group; that resale price is then reduced by the profit markup of a comparable uncontrolled buyer/reseller. § 1.482-2(e)(3).
3) The cost plus method adds to the cost of producing the subject property a markup equal to the profit percentage of a comparable uncontrolled seller. § 1.482-2(e)(4).
the comparable uncontrolled price method must be utilized because it is the method likely to result in the most accurate estimate of an arm’s-length price. . . .” § 1.482-2(e)(1)(ii). “If there are no comparable uncontrolled sales, then the resale price method must be utilized if the standards for its application are met. . . .”. If not, either the resale price method or cost plus method may be used, “depending upon which method is more feasible and is likely to result in a more accurate estimate of an arm’s-length price”. If the standards for applying one of the three methods are met, that method must be utilized “unless the taxpayer can establish that, considering all the facts and circumstances, some [other] method of pricing . . . is more appropriate.” § 1.482-2(e)(1)(iii). If however, none of the three methods can reasonably be applied in a given case, “some appropriate method of pricing other than those described . . ., or variations on such methods, can be used.”
The general theory of the cited regulations, as well as the others promulgated by the Commissioner to implement section 482, is to treat each of the individual members of a commonly controlled group as a separate entity, transactions between which are taxable events to be conformed to the economic realities that would obtain between independent economic entities conducting the identical transactions at arm’s length.
Furthermore, the structure of the Commission’s regulations argues against the “contract manufacturer” thesis advanced by the Commissioner. The allowance of a markup of production costs, as the contract manufacturer theory postulates and as the Commissioner’s notice of deficiency in this case explicitly provided, is simply an application of the cost-plus method provided in the Commissioner’s regulations.Reg. § 1.482-2(e)(4). Those regulations explicitly provide, however, that the comparable uncontrolled price method is to be utilized, in preference to the cost-plus method, if the conditions for the application of the former method are satisfied. Reg. § 1.482-2(e)(1)(ii). Since, as will hereinafter appear, those conditions to be fulfilled in this case, accordingly constrained by section 1.482-2(e)(1)(ii) to reject the Commissioner’s contention that B L Ireland should be treated as a contract manufacturer.
The problem of Practice 8125#2
Uncontrolled sales are considered comparable to controlled sales if the physical property and circumstances involved in the uncontrolled sales are identical to the physical property and circumstances involved in the controlled sales, or if such properties and circumstances are so nearly identical that any differences either have no effect on the price, or such differences can be reflected by a reasonable number of adjustments to the price of uncontrolled sales. For this purpose, differences can be reflected by adjusting prices only where such differences have a definite and reasonably ascertainable effect on price. § 1.482-2(e)(2)(ii).
The Tax Court premised its ruling upon numerous sales by four different lens manufacturers to unrelated lens distributors. All comparable sales prices were reduced by $0.62, an adjustment that compensated for B L’s unique practice of paying the duty and freight charges on its lens purchases. After this adjustment, all these sales were at a price that exceeded the $7.50 transfer price paid by B L, with one exception. One manufacturer, the Amsco/Lombart division of the American Sterilization Company, transacted some sales (less than half) that, when adjusted, indicated a transfer price of less than $7.50, but the Tax Court gave these sales little weight because, unlike the uniform price charged by B L Ireland, they set different prices for standard and thin lenses. All other adjusted comparable sales, including Amsco/Lombart single price sales, indicated a transfer price above $7.50, with many exceeding $10.00.
The Tax Court’s conclusion that these sales were comparable was premised on findings of fact that B L functioned as a distributor for the lenses it purchased from B L Ireland, and that the soft contact lenses at issue were generally considered a fungible commodity. The Commissioner disputes the former finding. He contends that in addition to its distribution functions, B L “supplied the know-how necessary to manufacture the lenses, the Bausch Lomb and Soflens trademarks, the FDA approval required for sales on the United States market, the fruits of its ongoing research and development, and ready-made foreign and domestic markets.”
We find this argument unconvincing. As was implicit in our prior determination that the transfer price for lenses and royalty rate for intangibles should be accorded independent consideration, the provision of know-how, trademarks, FDA approval, and ongoing research and development is properly taken into account hereinafter concerning the royalty to be imputed to B L Ireland on an arms-length basis for the transfer of these intangibles. Further, the provision of ready-made markets is entirely consistent with the role of a distributor.
The position urged by the Commissioner would preclude comparability precisely because the relationship between B L and B L Ireland was different from that between independent buyers and sellers operating at arm’s length. This, however, will always be the case when transactions between commonly controlled entities are compared to transactions between independent entities.
the position urged by the Commissioner herein amounts to reading so broadly the requirement in Treas. Reg. § 1.482-2(e)(ii) that the “circumstances involved” incomparable uncontrolled sales and controlled sales under section 482 review be “identical,” or “nearly identical,” as to threaten effective nullification of the comparable uncontrolled price method. That method is postulated in the Commissioner’s regulations, however, as the method of choice for testing transfers of tangible property between commonly controlled entities. We, therefore, decline to adopt the suggested interpretation of section 1.482-2(e)(ii).
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