PROPOSED REGS COVER INTERCOMPANY TRANSFER PRICING AND COST-SHARING ARRANGEMENTS.

New proposed regulation section 1.482-1(b)(1) coordinates existing regulations that explain the scope and purpose of regulations under section 482 with new provisions interpreting the commensurate-with-income standard. Proposed section 1.482-1(b)(1) also clarifies the general meaning of the arm's-length standard and the relationship of section 1.482-1 to section 1.482-2. As revised, section 1.482-1(b)(1) provides that the test to be applied in all instances is whether uncontrolled taxpayers exercising sound business judgment would have agreed to the same terms given the actual circumstances under which controlled taxpayers dealt.

Proposed section 1.482-2(d) replaces the current rules applicable to intangible property. Section 1.482-2(d)(2) outlines how an arm's-length consideration for an intangible is determined; subsection (d)(2)(iii) prescribes the priority of the methods for determining an arm's-length consideration. Ordinarily, the method that relies on the most complete and accurate data and requires the fewest adjustments will most accurately reflect the amount of consideration that an unrelated taxpayer would have charged for the same intangible under the same circumstances. Highest priority, therefore, is assigned to the matching transaction method. Second priority is assigned to the comparable-adjustable-transaction method. If those methods cannot be applied, then an arm's-length consideration is determined under the comparable-profit method. Under proposed section 1.482-2(d)(2)(iv), all relevant facts and circumstances must be considered in applying these methods, including information from the tax year under review and from tax years before and after that tax year. The regs do not require the Service or the taxpayer to demonstrate the inapplicability of a higher priority method before applying a lower priority method. However, either party may establish the applicability of a higher priority method.

Proposed section 1.482-2(d)(3) describes the matching- transaction method. A matching transaction is an uncontrolled transfer of the same intangible under the same, or substantially similar, economic conditions and contractual terms. The comparable- adjustable-transaction method is described in section 1.482-2(d)(4). Under that method, an arm's-length consideration is determined with reference to the amount of consideration charged in an uncontrolled transfer of the same or a similar intangible under adjustable circumstances, subject to verification by the comparable-profit interval described in section 1.482-2(f).

Section 1.482-2(d)(5) describes the comparable-profit method. The method requires a comparison of the operating income that results from the consideration actually charged in a controlled transfer ("reported operating income") with the operating incomes of similar taxpayers that are uncontrolled. The consideration charged in the controlled transfer ordinarily will be considered an arm's-length amount when reported operating income falls within the comparable- profit interval, but will not be so considered when reporting operating income falls outside the comparable-profit interval.

Proposed section 1.482-2(e)(1) modifies the rules applicable to sales of tangible property. The regulations extend the use of the comparable-profit interval to the resale-price, cost-plus, and so- called "fourth" methods (sections 1.482-2(e)(1)(ii) through (iv)), which are used when the comparable-uncontrolled-price method is inapplicable. When one of those methods is used, the regulations provide that the comparable-profit interval is to serve as a check on the result indicated by the method. If the result produced by the method does not fall within the comparable-profit interval, then the result should be disregarded for purposes of determining an arm's- length price.

The comparable-profit interval is described in proposed section 1.482-2(f). According to the Service, the comparable-profit interval should provide taxpayers with greater certainty in establishing their intercompany transfer prices. Many taxpayers, the Service says, should be able to apply objective measures of profitability (referred to as profit level indicators) of similarly situated parties to their own financial data to develop their own estimates of the comparable- profit interval and confirm that their transfer prices produce results that fall within the comparable-profit interval.

Proposed section 1.482-2(g) provides rules for qualified cost- sharing arrangements. In general, the regs require that the structure of a cost-sharing arrangement reflect four general principles: each participant must have a reasonable expectation of using developed intangibles in the active conduct of its business; the costs of all related intangible development must be shared; each participant's share of the costs of developing intangibles must be proportionate to its share of the income attributable to developed intangibles; and participants must compensate the owners or developers of intangible property an arm's-length amount for the use of that property, unless the property is developed by the participants through the cost- sharing arrangement. The regulations are generally proposed to be effective for tax years beginning after December 31, 1992; however, some exceptions do apply. Comments on the proposed regs and requests for a public hearing must be received by the Service by May 29, 1992.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed Income Tax Regulations relating to intercompany transfer pricing and cost sharing under section 482 of the Internal Revenue Code. The Tax Reform Act of 1986 amended section 482. These regulations would provide guidance implementing the amendment.

DATE: Comments and requests for a public hearing must be received by June 1, 1992.

ADDRESSES: Send comments and requests for a public hearing to: Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Attention: CC:CORP:T:R (INTL-0372-88) [for comments on cost sharing provisions] or (INTL-0401-88) [for comments on other provisions], Room 5228, Washington, D.C. 20044.

FOR FURTHER INFORMATION CONTACT: Howard Berger, with respect to all provisions except cost sharing, and Lisa Sams, with respect to cost sharing provisions, both of the Office of Associate Chief Counsel (International) within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N. W., Washington, D.C. 20224, Attention: CC:CORP:T:R (INTL-0372-88 and INTL-0401-88) (202- 377-9059 (Berger) and 202-874-1490 (Sams), not toll-free calls).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. section 3504(h)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503, with copies to the Internal Revenue Service, Attention: IRS Reports Clearance Officer T:FP, Washington, D.C. 20224.

The collection of information in these regulations is in section 1.482-2(g)(2)(i) and (6). This information is required by the Internal Revenue Service to verify the existence of a qualified cost sharing arrangement and to determine the appropriateness of each participant's cost share. The likely respondents are businesses or other for-profit institutions.

These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents/recordkeepers may require more or less time, depending on their particular circumstances.

Estimated total annual reporting and/or recordkeeping burden: 4,250 hours.

The estimated annual burden per respondent/recordkeeper varies from 30 minutes to l0 hours, depending on individual circumstances, with an estimated average of 8.5 hours.

Estimated number of respondents and/or recordkeepers: 500.

EFFECTIVE DATE

These regulations are generally proposed to be effective for taxable years beginning after December 31, 1992. However, they will not apply with respect to transfers made or licenses granted to foreign persons before November 17, 1985, or before August 17, 1986 for transfers or licenses to others. Nevertheless, they will apply with respect to transfers or licenses before such dates if, with respect to property transferred pursuant to an earlier and continuing transfer agreement, such property was not in existence or owned by the taxpayer on such date. Although these proposed regulations are generally effective for taxable years after December 31, 1992, the final sentence of section 482 (requiring that the income with respect to transfers or licenses of intangible property be commensurate with the income attributable to the intangible) is generally effective for taxable years beginning after December 3l, 1986. For the period prior to the proposed effective date of these regulations, the final sentence of section 482 shall be applied using any reasonable method not inconsistent with the statute. The Internal Revenue Service considers a method that applies these proposed regulations or their general principles to be a reasonable method. A transitional rule is provided at section 1.482-2(g)(8) with respect to cost sharing arrangements entered into under current section 1.482-2(d)(4) in prior taxable years.

BACKGROUND

This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) under section 482 of the Internal Revenue Code. Section 482 was amended by the Tax Reform Act of 1986, P.L. 99- 514, 100 Stat. 2085, 2561, et seq.

EXPLANATION OF PROVISIONS

INTRODUCTION

The Tax Reform Act of 1986 ("the Act") amended section 482, to require that consideration for intangible property be commensurate with the income attributable to the intangible. The legislative history of the Act states that this change was intended to assure that the division of income between related parties reasonably reflects the economic activities each undertakes. See H.R. Rep. 99- 281, 99th Cong., 2d Sess. (1986) at II-637. The legislative history also expresses concern that insufficiently stringent standards previously had been used in determining whether an uncontrolled transfer is comparable to a controlled transfer. The legislative history specifically notes concern about the improper use of comparables with regard to "high profit-potential intangibles," noting that it is especially difficult to obtain realistic comparables with respect to such intangibles because they seldom if ever are transferred to unrelated parties. See H.R. Rep. 99-426, 99th Cong., 1st Sess. (1985) at 424.

The Conference Committee report on the Act recommended that the Internal Revenue Service (the "Service") conduct a comprehensive study of transfer pricing and consider whether regulations under section 482 should be modified. In response, the Treasury Department and the Service issued a study of intercompany transfer pricing (Notice 88-123, 1988-2 C.B. 458, the "White Paper") on October 18, 1988. Although the White Paper primarily considered transfers of intangibles, it also addressed the application of section 482 to other transactions. The White Paper specifically discussed the need to modify the regulations dealing with transfers of tangible property to take into account the common incorporation of the value of intangibles into tangible property. As described in greater detail below, such changes are found in amendments to section 1.482-2(e).

The White Paper proposed two approaches for determining the proper charge for an intangible under the commensurate with income standard. The first was a pricing approach. It included two methods: the exact comparable method and the inexact comparable method. The second was an income approach. It also included two methods: the basic arm's length return method ("BALRM") and BALRM with profit split. The BALRM generally allocated income to the parties to a transaction by assigning industry average rates of return to their assets.

Many comments on the White Paper criticized the prominent role given to BALRM, arguing that BALRM would be difficult to apply because the information BALRM required generally would not be available, would be unfair to corporations whose rates of return vary considerably from the average, and would allocate too much income to U.S. entities. The Service also was urged to assign a greater role to inexact comparable transactions and to reconsider the use of safe harbor rules. These comments were taken into account in the development of the three pricing methods described in section 1.482- 2(d) and (f) of these proposed regulations.

Both the exact comparable and inexact comparable methods, like the methods for determining an appropriate price described elsewhere in section 1.482-2, are intended to apply the general standard of section 1.482-1 (i.e., the price of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer) to specific situations. They should not be applied mechanically or without regard for this purpose. Thus, section 1.482-1(b)(1) has been modified to clarify that its principles are intended to guide application of the specific methods described in section 1.482-2.

The Conference Committee report also noted that Congress did not intend to preclude the use of a cost sharing arrangement to allocate income attributable to an intangible among related parties provided that such an arrangement is consistent with the requirement that the allocation of income among related parties reasonably reflect the actual economic activity undertaken by each. To satisfy this requirement, each participant should bear an appropriate portion of all research and development costs on unsuccessful as well as successful products within an applicable product area, each participant's cost share generally should be proportionate to profit determined before deduction for research and development, and an appropriate return should be provided to a participant that effectively put its funds at greater risk than other participants. See H.R. Rep. 99-281, 99th Cong., 2d Sess. (1986) at II-638.

The White Paper concluded that cost sharing arrangements should have standard terms. For instance, the White Paper stated that most shared research and development should be conducted with respect to products that were within the same three-digit Standard Industrial Classification code. This proposal was intended to prevent a U.S. participant from paying for unsuccessful research while receiving little or no benefit from successful research, and to prevent a foreign participant from failing to pay for unsuccessful research while receiving significant benefits from successful research. Other requirements proposed by the White Paper included the assignment to each participant of exclusive rights in developed intangible property, the restriction of membership in a cost sharing arrangement to those in a position to exploit developed intangibles by means of the manufacture of products, and the exclusion of marketing intangibles from the scope of an arrangement's research and development.

Comments on these proposals maintained that the White Paper's approach would unduly restrict the ability of taxpayers to enter into a cost sharing arrangement. Additional comments raised concerns with respect to the White Paper's proposed method for measuring anticipated benefits in computing cost shares (including assignment of exclusive geographic rights), the adjustments of cost shares in subsequent years to reflect changes in subsequent benefits, the exclusion of non-manufacturers as eligible participants, the identification of costs that must be shared pursuant to the arrangement, and buy-in or buy-out rules that govern cases where a portion of the intangible is considered to be transferred (including whether going concern value should be included and whether taxpayers should be permitted flexibility in selecting the form of payment for a buy-in or buy-out). Several comments suggested that the Service model new cost sharing regulations on rules proposed in 1966 and withdrawn in 1968. These suggestions were taken into account in developing section 1.482-2(g).

SUMMARY OF PROPOSED REGULATIONS

SECTION 1.482-1(b)(1)

Section 1.482-1(b)(1) coordinates existing regulations that explain the scope and purpose of regulations under section 482 with new provisions interpreting the commensurate with income standard. Section 1.482-1(b)(1) also clarifies the general meaning of the arm's length standard and the relationship of section 1.482-1 to section 1.482-2. As revised, section 1.482-1(b)(1) provides that the test to be applied in all instances is whether uncontrolled taxpayers exercising sound business judgment would have agreed to the same terms given the actual circumstances under which controlled taxpayers dealt.

For example, closely related transfers of tangible and intangible property, such as "round-trip" transactions, should be viewed together in determining whether the price of each transaction is arm's length. A round-trip transaction typically begins with a license of an intangible to a related party. The licensee uses the intangible to produce tangible property and sells the tangible property either to the licensor of the intangible or to the licensor's affiliates. Rather than analyzing each of these transactions independently, the proposed regulations allow the district director to consider the price charged for the tangible property as one of the circumstances that should be taken into account in determining whether an uncontrolled taxpayer would have agreed to the same consideration for the intangible property.

SECTION 1.482-2(d)

Section 1.482-2(d) replaces current rules applicable to intangible property. Section 1.482-2(d)(1)(i) provides that an arm's length consideration for an intangible must be commensurate with the income attributable to it. Section 1.482-2(d)(1)(ii) defines the terms intangible, transfer, controlled transfer, and uncontrolled transfer. Section 1.482-2(d)(1)(iii) provides that paragraph (d) applies to any transaction that in substance is a transfer of an intangible, regardless of the form of the transaction.

Section 1.482-2(d)(2) outlines how an arm's length consideration for an intangible is determined. Section 1.482-2(d)(2)(iii) prescribes the priority of the methods for determining an arm's length consideration. Ordinarily, the method that relies on the most complete and accurate data and requires the fewest adjustments will most accurately reflect the amount of consideration that an unrelated taxpayer would have charged for the same intangible under the same circumstances. Highest priority therefore is assigned to the matching transaction method. Second priority is assigned to the comparable adjustable transaction method. If those methods cannot be applied, then an arm's length consideration is determined under the comparable profit method. Under section 1.482-2(d)(2)(iv), all relevant facts and circumstances must be considered in applying these methods, including information from the taxable year under review, and from taxable years before and after that taxable year. The regulations do not require the Service or the taxpayer to demonstrate the inapplicability of a higher priority method before applying a lower priority method. However, either the Service or the taxpayer may establish the applicability of a higher priority method.

Section 1.482-2(d)(3) describes the matching transaction method. A matching transaction is an uncontrolled transfer of the same intangible under the same, or substantially similar, economic conditions and contractual terms.

The intangible involved in a controlled transfer will be considered the same as the intangible involved in an uncontrolled transfer only if the protected interest or body of knowledge that is subject to exploitation through the use of each intangible are identical. Geographic or use restrictions are considered differences in contractual terms, rather than differences in the interests transferred.

Section 1.482-2(d)(3)(iii) provides guidance for determining whether the economic circumstances in the controlled and uncontrolled transfers are substantially similar. Economic factors that could affect the amount of consideration charged in the two transactions will be considered. Section 1.482-2(d)(3)(iv) provides guidance for determining whether the contractual terms of the controlled and uncontrolled terms are substantially similar. Contractual terms that could affect the amount of consideration charged in the two transactions will be considered.

Under section 1.482-2(d)(3)(v), adjustments will be made when the economic conditions and contractual terms of controlled and uncontrolled transactions are substantially similar but are not identical. Adjustments may be made to compensate only for a limited number of differences that both alone and combined have only a minor effect on the consideration charged in the uncontrolled transfer. If other adjustments would be required to compensate for differences, the economic conditions and contractual terms are not substantially similar and the matching transaction method does not apply.

Section 1.482-2(d)(4) describes the comparable adjustable transaction method. Under this method an arm's length consideration is determined with reference to the amount of consideration charged in an uncontrolled transfer of the same or a similar intangible under adjustable circumstances, subject to verification by the comparable profit interval described in section 1.482-2(f). Verification of a comparable adjustable transaction by reference to the comparable profit interval is intended to ensure that adjustments under this method do not produce results that are inconsistent with the dealings of uncontrolled taxpayers. The same factors considered under the matching transaction method in determining whether economic conditions and contractual terms are substantially similar are considered in determining whether the economic conditions and contractual terms of controlled and uncontrolled transactions are adjustable. Contractual terms and economic conditions will be considered adjustable if they are sufficiently similar that the effect of any differences on the consideration charged in the uncontrolled transfer can be determined with reasonable accuracy.

The consideration charged in an uncontrolled transfer must be adjusted to compensate for material differences between the controlled and uncontrolled transfers. When more than one comparable adjustable transaction is available, an arm's length consideration should be determined with reference to the transaction for which the necessary adjustments can be most accurately determined.

Section 1.482-2(d)(5) describes the comparable profit method, which applies to determine an arm's length consideration when the matching and comparable adjustable transaction methods are inapplicable. This method requires a comparison of the operating income that results from the consideration actually charged in a controlled transfer ("reported operating income") with the operating incomes of similar taxpayers that are uncontrolled. See section 1.482-2(d)(5)(v) for the definition of "reported operating income." The consideration charged in the controlled transfer ordinarily will be considered an arm's length amount when reported operating income falls within the comparable profit interval but will not be considered arm's length, and may be adjusted, when reported operating income falls outside the comparable profit interval. In the latter case, the transfer price generally may be adjusted to produce operating income that is at the "most appropriate point" in the comparable profit interval. A special rule allows a smaller adjustment to be made when reported operating income is outside of, but corresponds closely to, the comparable profit interval. This special rule is intended to narrow the scope of controversies when reported operating income does not vary significantly from results that are within the comparable profit interval. Section 1.482- 2(d)(5)(iv) provides limited exceptions to this special rule.

Section 1.482-2(d)(6) provides guidance regarding transfers of intangibles for more than one taxable year. Section 1.482-2(d)(6)(i) provides that all relevant facts throughout the period the intangible is used may be considered. Ordinarily an adjustment may be made with respect to an intangible in the taxable year under examination even though the charge for the intangible was arm's length in an earlier year. Section 1.482-2(d)(6)(ii) provides three exceptions to this rule. The first exception applies only in the case of the matching or comparable adjustable transaction methods. Generally, an allocation may not be made under those methods if an arm's length consideration was charged for the intangible in the year it was transferred, operating income remained in the comparable profit interval for all subsequent years (including the year under examination), and there has been no more than a minor variation in the amount of operating income attributable to the transferred intangible.

The second exception requires that the transferee paid a royalty in exchange for the use of the intangible, the intangible has been used for at least 10 years since the date of its initial transfer, and the royalty was determined to be an arm's length royalty for each year of its use throughout the 10-year period under the matching or comparable adjustable transaction method.

The third exception requires that the relevant agreement contained no provision for adjustments to the royalty to reflect unanticipated changes in profitability, the use of the intangible was limited in a commercially reasonable way, and the transferee's operating income has moved outside the comparable profit interval due to changes in circumstances that were beyond the control of the taxpayers and neither anticipated nor reasonably foreseeable.

Section 1.482-2(d)(7), which will provide rules concerning the treatment of lump sum payments, is reserved. Chapter Six of the White Paper took the position that taxpayers may structure transactions with lump sum payments provided the economic consequences of a lump sum payment resemble those under a periodic payment approach. Chapter 8 of the White Paper suggested that a lump sum payment be treated as an open transaction, with the lump sum invested in a hypothetical certificate of deposit from which arm's length consideration would be subtracted year by year. Another approach would treat the lump sum as the present value of a stream of payments projected by the taxpayer. An adjustment could be made in the year of transfer to the extent the lump sum differed from the properly computed present value of the stream. Annual adjustments could be made to the extent the actual arm's length amount for a particular year differed from the projection for that year. The Service invites comments on these, or any other, approaches to lump sum payments.

Section 1.482-2(d)(8) clarifies the "developer-assister" rules now found in section 1.482-2(d)(1)(ii). New examples are provided illustrating the application of these rules to the development and enhancement of marketing intangibles.

SECTION 1.482-2(e)

Section 1.482-2(e)(1) modifies the rules applicable to sales of tangible property. Although the commensurate with income amendment to section 482 in the Act addressed the transfer of intangible property, the Conference Report also directed that "careful consideration be given to whether the existing regulations could be modified in any respect." H.R. Rep. 99-841, 99th Cong., 2d Sess. (1986) at II-637 - 638. The regulations extend the use of the comparable profit interval to the resale price, cost plus and so-called "fourth" methods (sections 1.482-2(e)(1)(ii)-(iv)), which are employed when the comparable uncontrolled price method is inapplicable. When one of these methods is employed, the regulations provide that the comparable profit interval is to serve as a check on the result indicated by such method; if the result produced by the method does not fall within the comparable profit interval, then the result should be disregarded for purposes of determining an arm's length price.

This change is necessary because applying the comparable profit interval solely to transfers of intangibles would create an artificial and unwarranted distinction between the treatment of tangible and intangible property, and would lead to disputes in cases involving tangible property incorporating an intangible. Adoption of similar transfer pricing rules for the tangible and intangible components of the transferred property will eliminate or reduce the need to allocate the property's value between its tangible and intangible components and then to determine the profits attributable to each such component.

A similar allocation and valuation problem may arise in cases in which the transfer of services is indistinguishable from the transfer of intangible property. See Hospital Corporation of America v. Commissioner, 81 T.C. 520 (1983). The Service solicits comments on how the services regulations (section 1.482-2(b)) should incorporate the commensurate with income standard.

These regulations modify the priority of methods under section 1.482-2(e). The comparable uncontrolled price method retains the highest priority. Second priority is given either to the resale price method or the cost plus method, depending on which of the two methods more accurately produces an arm's length price in a particular situation. A price determined under either the resale price method or the cost plus method will be considered arm's length only if it yields a level of operating income that is within the comparable profit interval. Other methods still may be applied, but such other methods also must yield a level of operating income that is within the comparable profit interval. The regulations do not require the Service or the taxpayer to demonstrate the inapplicability of a higher priority method before applying a lower priority method. However, either the Service or the taxpayer may establish the applicability of a higher priority method.

The legislative history expressed concern with judicial interpretations of the comparable uncontrolled price method. These regulations clarify that adjustments must be made to comparables when there are differences between them, in order to use them as comparables.

SECTION 1.482-2(f)

Section 1.482-2(f) describes the comparable profit interval. In general, the comparable profit interval should provide taxpayers with greater certainty in establishing their intercompany transfer prices. Many taxpayers should be able to apply objective measures of profitability (referred to as profit level indicators) of similarly situated parties to their own financial data to develop their own estimates of the comparable profit interval and confirm that their transfer prices produce results that fall within the comparable profit interval.

Section 1.482-2(f)(1) states that the comparable profit interval identifies levels of profits that the appropriate controlled taxpayer whose operating income is tested (the "tested party") would have earned if its profit level indicators had been equivalent to those of similarly situated uncontrolled taxpayers. Profit level indicators derived from uncontrolled taxpayers are applied to the financial data of the tested party to yield the "constructive operating income" that the tested party would have earned. The comparable profit interval then is derived from the constructive operating incomes that converge. If necessary, the most appropriate point within the comparable profit interval is selected.

Section 1.482-2(f)(2) provides that data used in constructing the comparable profit interval normally should be based on actual results before, during, and after the taxable year under examination.

Section 1.482-2(f)(3) identifies six steps that must be followed in developing a comparable profit interval. The steps are interdependent and, in some cases, certain steps may have to be repeated to match the availability of data used in later steps with the determination made in an earlier step.

Section 1.482-2(f)(4) provides rules for the first step: selecting the appropriate controlled taxpayer whose operating income should be tested. In the case of the transfer of an intangible, the tested party normally will be the transferee.

Section 1.482-2(f)(5) provides rules for the second step: determining the "applicable business classification" of the tested party. The applicable business classification normally includes the operations of the tested party that relate to transactions with controlled taxpayers, which are referred to as the "tested operations." The tested operations then are compared to the operations of uncontrolled taxpayers. If possible, operations of uncontrolled taxpayers are selected that closely correspond to the tested operations. If it is not possible to obtain reliable data regarding uncontrolled taxpayers with respect to products that closely correspond to the products related to the tested operations, then the scope of the applicable business classification is broadened.

Section 1.482-2(f)(6) provides rules for the third step: computing the constructive operating incomes that are used to determine the comparable profit interval. The constructive operating incomes are derived by applying profit level indicators obtained from a selection of uncontrolled taxpayers in the applicable business classification to financial data relating to the tested operations.

Profit level indicators should be selected that provide the most reliable basis for comparison under the particular facts and circumstances. Some profit level indicators will be more reliable in particular types of cases than others. Section 1.482-2(f)(6)(iii)(C) identifies a number of profit level indicators that may be used in appropriate cases. These include: rate of return on assets, ratio of operating income to sales, ratio of gross income to expenses, and profit splits. Before application of a profit level indicator to the data of the tested party, the data must be adjusted to reflect (1) any significant differences between the business practices of the tested party and the uncontrolled taxpayers, and (2) any other allocations under section 482. The Service invites comment on the specified profit level indicators and on other profit level indicators and the circumstances in which they might be used.

Section 1.482-2(f)(7) describes the fourth step: determining the comparable profit interval. The comparable profit interval normally is derived from a set of constructive operating incomes that are computed by applying various profit level indicators obtained from uncontrolled taxpayers to the financial data of the tested party. Data that tends to converge is used to form an interval that is reasonably restricted in size, and data that diverges significantly from other data is excluded from the interval.

Two tests are generally used to identify converging data. First, when constructive operating incomes computed with different profit level indicators from the same uncontrolled taxpayer converge, such data generally should be included within the comparable profit interval. Such convergence indicates that the uncontrolled taxpayer from which the data was drawn is comparable to the tested party. If the constructive operating incomes drawn from a single uncontrolled taxpayer diverge, such data generally should be excluded from the interval unless adjustments can be made that account for this lack of uniformity. The second type of convergence considered is convergence of constructive operating incomes obtained from one or more profit level indicators from different uncontrolled taxpayers. In determining both types of convergence, the reliability of all data must be considered, and greater weight accorded to data that is more reliable. If the number of uncontrolled taxpayers whose operations correspond to the applicable business classification is large enough to permit the use of valid statistical techniques, then convergence must be determined by using those techniques to identify a reasonably narrow area of concentration among all the constructive operating incomes computed. The Service solicits comments concerning which statistical techniques would be most appropriate for determining such an area of concentration.

Section 1.482-2(f)(8) describes the fifth step: selecting the most appropriate point within the comparable profit interval, when necessary. (It is not necessary to select the most appropriate point, for example, when the comparable profit method applies and the reported operating income was within the comparable profit interval.) If statistical techniques were used to construct the comparable profit interval, then the most appropriate point will be determined by using measures of central tendency. The Service solicits comments concerning which statistical methods would provide the most appropriate measures of central tendency. If statistical techniques were not used to construct the comparable profit interval, the most appropriate point will be determined by considering a number of factors relating to the comparability and reliability of the underlying data. These factors include similarity of functions performed by the tested party and the uncontrolled taxpayer, similarity of products or services, the extent to which different profit level indicators produce converging amounts of constructive operating income, the number and accuracy of the adjustments required to apply a profit level indicator to uncontrolled taxpayers, the extent to which the profit level indicator meets the reliability factors set forth in section 1.482-2(f)(7)(ii), and the extent to which the profit level indicator produces converging results when applied to the uncontrolled taxpayers.

Section 1.482-2(f)(9) describes the sixth step: determining the transfer price for the controlled transaction, when necessary. The transfer price is determined by adjusting the actual charge in the controlled transaction to produce an operating income for the tested party that equals the constructive operating income corresponding to the most appropriate point in the interval.

Section 1.482-2(g)

Section 1.482-2(g) provides rules for qualified cost sharing arrangements. In general, the regulations require that the structure of a cost sharing arrangement reflect the following general principles --

1. Each participant must have a reasonable expectation of using developed intangibles in the active conduct of its trade or business;

2. The costs of all related intangible development must be shared;

3. Each participant's share of the costs of developing intangibles must be proportionate to its share of the income attributable to developed intangibles; and

4. Participants must compensate the owners or developers of intangible property an arm's length amount for the use of that property, unless the property is developed by the participants through the cost sharing arrangement. Likewise, if a participant bears a portion of the costs incurred in developing an intangible, and subsequently transfers or abandons its rights in the intangible, the remaining participants must compensate the departing participant.

Section 1.482-2(g)(1) states that an intangible development cost sharing arrangement will not be considered a qualified arrangement unless it meets the requirements of section 1.482-2(g)(2), and a member of a controlled group will not be eligible to participate in a cost sharing arrangement unless the member meets the requirements of section 1.482-2(g)(3). If the requirements of section 1.482-2(g)(2) and (3) are met (that is, if a qualified cost sharing arrangement exists), the district director may nonetheless make allocations to cost shares, as provided in section 1.482-2(g)(4), to reflect each participant's arm's length share of the costs and risks of developing intangible property.

The requirements of a qualified cost sharing arrangement include the requirements contained in the current regulations (an agreement in writing between two or more eligible participants providing for the sharing of the costs and risks of developing intangible property in return for a specified interest in any intangible that may be produced), and two new conditions. The new conditions are that the arrangement comply with the administrative requirements of section 1.482-2(g)(6)(i), and that participants make a reasonable effort to measure the share of benefit that each expects to receive and divide costs accordingly. Costs shared must include the costs of unsuccessful or less successful intangible development. One of the objectives of this requirement is to prevent "cherry picking" (e.g., U.S. participants bearing disproportionate costs of unsuccessful research, or foreign participants deriving disproportionate benefits from successful research). The district director is also permitted under this paragraph to apply the cost sharing provisions to any arrangement that in substance constitutes a cost sharing arrangement, to the extent that application of the developer-assister rules under section 1.482-2(d)(8) would result in a failure to clearly reflect the income of a group of controlled taxpayers. The Service solicits comments on the appropriate scope of application of this rule. The Service also solicits comments on the appropriate application of the principles of section 1.482-2(g) in the context of partnerships that develop and exploit intangibles.

Section 1.482-2(g)(2)(ii) provides that a U.S. participant's cost share should be proportionate to the benefits that the participant reasonably anticipates it will derive from the research. Depending on the circumstances, anticipated benefits may be measured in several different ways, as long as the measure reasonably predicts the benefits to be shared. If the development activity relates to more than one cost sharing arrangement, the benefits derived by the participant must be compared to the benefits derived by all of the relevant participants, including those in the other arrangements, for purposes of determining an appropriate cost share. An effort to anticipate benefits generally should include annual review of the participants' cost shares, and permit any adjustments necessary to reflect changes in economic conditions and other factors.

To the extent that a cost sharing arrangement fails to divide cost shares in proportion to benefits, the regulations provide for three different types of adjustment. The type of adjustment to be applied is determined by a comparison of the U.S. participant's cost/income ratio and the cost/income ratio of the other participants.

The cost/income ratio used for purposes of the cost sharing provisions is generally the participant's three-year average cost share, divided by its three-year average operating income attributable to developed intangibles. Operating income attributable to developed intangibles is defined as income from the license or sale of developed intangibles plus income earned from the sale of products or services incorporating such intangibles.

First, if the cost/income ratio of a U.S. participant is "grossly disproportionate" to the cost/income ratio of the other participants, the method for dividing cost shares will be presumed not to reflect a reasonable effort to share costs in proportion to benefits, and the cost sharing arrangement will not be considered a qualified cost sharing arrangement. Second, if the cost/income ratio of a U.S. participant is "substantially disproportionate" to the cost/income ratio of the other participants, the cost sharing arrangement will be considered a qualified arrangement, but a partial transfer of intangible property may be deemed to have occurred outside of the scope of the arrangement. In such a "buy-in" or "buy- out" situation, consideration for the transfer of the intangible must be consistent with the provisions of section 1.482-2(d). Section 1.482-2(g)(4)(ii)(D) provides that a U.S. participant's cost/income ratio will not be considered substantially disproportionate if it is less than twice the cost/income ratio of the other eligible participants. Third, if the cost/income ratio of a U.S. participant is not substantially disproportionate to the cost/income ratio of the other participants, an adjustment will be limited to an adjustment of the participants' cost shares.

Section 1.482-2(g)(3) defines an eligible participant. As noted above, there must be at least two eligible participants in order for a cost sharing arrangement to be qualified. In order to be considered eligible, each participant must be able to use developed intangibles in the active conduct of its trade or business. The principles of section 1.367(a)-2T(b)(2) determine whether a participant's activities constitute a trade or business.

An active trade or business may exist even though activities are carried out by independent contractors on behalf of a participant. An intangible will not be considered used in the active conduct of a participant's trade or business if a principal purpose of the participant for entering into the arrangement was to obtain intangible property to transfer to an uncontrolled taxpayer.

One member of a group of controlled taxpayers may participate in a cost sharing arrangement on behalf of other members (the "cost sharing subgroup") for the purpose of meeting the "active trade or business" requirement. However, the intangible property must be transferred from the participating member to the other members of the subgroup on an arm's length basis, either under a separate cost sharing arrangement in effect within that subgroup or otherwise.

Section 1.482-2(g)(4) describes the allocations that may be made by the district director to reflect each participant's arm's length share of an arrangement's costs. First, if the intangible development encompassed by the arrangement is too broad or too narrow, then an adjustment in the participants' cost shares may be necessary to place the arrangement on an arm's length basis. An intangible development area is too broad if any participant will not be able to use developed intangibles in its active business, and it is too narrow if it does not encompass all related intangible development.

Second, if there is a variation between the share of the benefit that each participant expects to receive and the share that is actually received, then, as described above, cost share payments may be reallocated, a buy-in or buy-out may be required, or the cost sharing arrangement may be ignored. Unless another method is more reliable, allocations will be based on a comparison of the U.S. participant's cost/income ratio to the other participants' cost/income ratio, as described above.

Section 1.482-2(g)(5) provides that cost sharing payments will be characterized as costs of developing intangibles to the payor and reimbursements of such costs to the payee. That section also provides that if an arrangement is not considered a qualified arrangement, or if a "buy-in" or "buy-out" is deemed to have occurred, payments with respect to any transfer of intangible property must be treated in accordance with section 1.482-2(d).

Section 1.482-2(g)(6) provides the administrative requirements of a qualified cost sharing arrangement. It also lists the administrative requirements that an eligible participant must satisfy. The paragraph mandates substantial compliance with each requirement. Thus, a minor administrative error will not result in the disqualification of an arrangement or a participant.

Section 1.482-2(g)(7) defines three terms: "specified interest in any intangible," "U.S. participant," and "costs of developing intangibles." The regulations do not specify accounting principles that must be used in determining costs of developing intangibles. The Service invites comments with respect to whether U.S. generally accepted accounting principles, tax accounting principles, or other principles should be used. Section 1.482-2(g)(8) states that existing bona fide cost sharing arrangements, under current section 1.482- 2(d)(4), will be considered qualified cost sharing arrangements if modified, as necessary, to conform with section 1.482-2(g) within one year of the publication of the regulation.

SAFE HARBOR

In the absence of a matching transaction, an arm's length amount of consideration for an intangible may be determined by reference to a comparable adjustable transaction, defined in section 1.482-2(d)(4) as an uncontrolled transfer involving the same or similar intangible under adjustable economic conditions and contractual terms that results in a level of operating income for the tested party that is within the comparable profit interval. In this context the comparable profit interval is intended to verify the reasonableness of the amount of consideration derived by reference to the uncontrolled transfer.

Although the use of the comparable profit interval as a check on a comparable adjustable transaction should increase taxpayers' certainty regarding their transfer prices, a safe harbor for determining the comparable profit interval could provide even greater certainty. The Service solicits comments on whether such a safe harbor should be developed. Such a safe harbor, for example, could be created by multiplying the book value of the licensee's assets by published rates of return. These published rates of return could be based on an average country-wide ratio of operating income to book value of assets. For example, based on data from U.S. publicly-held companies, the average ratio of operating income to assets from 1980- 1989 was approximately eleven percent. A safe harbor might be created by reference to a narrow interval of profits surrounding eleven percent.

For licensees with a dollar functional currency, the dollar book value of their assets could be used. For licensees with a different functional currency, the dollar book value of their assets could be calculated using historical exchange rates for their balance sheet assets, and their current operating income could be translated into dollars at the current exchange rate in order to determine whether their operating income falls within the safe harbor interval.

Such a safe harbor raises significant issues that may outweigh the benefits of simplicity and certainty. Matching a narrowly defined rate of return to the wider variations of returns observed in the marketplace is one problem. Differences in assets held by different taxpayers or shifting of assets among related taxpayers might be more of a problem under a safe harbor that relies solely upon rate of return on assets than under the comparable profit method, which uses rate of return on assets together with other measures.

Due to the difficulty of constructing a workable safe harbor, the proposed regulations do not include a safe harbor and specific comments are requested concerning the feasibility of such an approach and its structure. The following questions are of particular interest. Will a safe harbor simplify the comparable adjustable transaction method? Should a safe harbor be based only on a rate of return on assets method, or are there alternatives? If a safe harbor is included in regulations, how should the problems identified above be addressed? Should a safe harbor be refined so that, for example, adjustments are made to account for differences in taxpayers' debt to equity ratios relative to the country-wide average embodied in the total assets number? Should industry-specific intervals be published? How would such intervals be established? Should there be a provision permitting adjustments to book values of assets by either the taxpayer or the Service to correct distortions in the value of the assets reported by the licensee?

OPERATION OF THE REGULATIONS

The regulations described above provide the basic framework for the operation of the transfer pricing rules under section 482 following the amendments made by the Act. The Service recognizes that the promulgation of regulations is only one step in the implementation of these rules, and that the practical effect of the rules proposed in this document will be affected by a variety of other factors. The Service continues to study the overall administration of section 482, and solicits comments on collateral administrative matters not directly relating to these regulations. Comments are particularly requested in the areas described below.

DOCUMENTATION AND PENALTIES

With respect to documentation, the White Paper noted that a "significant threshold problem in the examination of section 482 cases has been IRS access to relevant information to make pricing determinations." See 1988-2 C.B. at 461. In response to this problem, the White Paper suggested that the section 482 regulations be amended to require that the taxpayer document the methodology used to establish transfer prices prior to filing the tax return and to require that the taxpayer produce such documentation within a reasonable time during examination. The White Paper also suggested that the Government consider whether existing penalties are sufficient to compel production of such documentation. Commentators contended that such requirements would be overbroad and unduly burdensome. They proposed that if contemporaneous documentation is required at all, it be required only in cases of transfers of high profit or high volume intangibles to tax haven entities. Since the publication of the White Paper, Congress has enacted several amendments to the reporting and penalty provisions of the Code. Accordingly, questions regarding documentation and penalties will be addressed in regulations under sections 6001, 6038, 6038A, 6038C, and 6662(e) rather than under section 482. The Service requests comments on the implementation of these rules, and in particular on the appropriate scope of the "reasonable cause" and "good faith" exception to the new section 482-related penalty under sections 6662(e)(3)(B)(i) and 6664(c). For example, should a taxpayer's creation of contemporaneous documentation be a factor that is taken into account in determining whether the exception applies and, if so, what documentation should be required?

ADVANCE PRICING AGREEMENTS

The advance pricing agreement procedure permits taxpayers to reach an agreement with the Service concerning the appropriate transfer pricing methodology to be applied in a particular case. See Rev. Proc. 91-22, 1991-1 C.B. 526. Comments are requested concerning any aspect of this program, including the potential impact of these proposed regulations and suggestions for coordination of that program with these regulations.

IMPROVED RESOLUTION OF SECTION 482 CONTROVERSIES

It is well settled that, upon judicial review, the Commissioner's determination of a deficiency ordinarily is entitled to a presumption of correctness, and taxpayers thus bear the burden of proving that the Commissioner's determination is incorrect in judicial proceedings. Welch v. Helvering, 290 U.S. 111 (1933). A principal reason for this allocation of the burden of proof is that taxpayers possess the information necessary to establish the correct amount of their income and deductions. United States v. Rexach, 482 F.2d 10 (1st Cir. 1973). Further, when Congress specifically grants discretion to the Commissioner to make certain determinations, courts will review those determinations with a greater degree of deference. Dietz Corporation v. United States, 939 F.2d 1 (2d Cir. 1991); Asiatic Petroleum v. Commissioner, 31 B.T.A. 1152 (1935), aff'd, 79 F.2d 236 (2d Cir. 1935). Accordingly, in section 482 cases, courts generally have held that the Commissioner's determination will be revised only if it is arbitrary, capricious, or unreasonable. Sundstrand Corporation v. Commissioner, 96 T.C. 226 (1991); G.U.R. Company v. Commissioner, 41 B.T.A. 223 (1940), aff'd, 117 F.2d 187 (7th Cir. 1941).

Some recent section 482 cases have found that the Commissioner's determination of a transfer price was arbitrary, capricious, or unreasonable, e.g., Merck & Company, Inc. v. United States, 24 Cl. Ct. 73, 68 AFTR2d 91-5524 (Cl. Ct. 1991). Courts generally have so held when a comparable price has not been available and the courts found that the Service could not demonstrate a suitable alternative method under the current regulations. In that regard, the current regulations dealing with intangibles provide little guidance on methods to be used where comparable transactions do not exist. These proposed regulations provide such methods and prescribe when they should be used.

The guidance provided by the proposed regulations should facilitate transfer pricing by taxpayers in ways that will lead to less controversy with the Service. Similarly, the regulations should facilitate determinations by the Service of appropriate arm's length pricing. The three pricing methods prescribed in the regulations are intended to reduce disputes between taxpayers and the Service and make it easier to resolve disputes that do arise. In particular, the proposed regulations should facilitate the use of comparable transactions by permitting adjustments under the comparable adjustable transaction method. Further, the comparable profit method addresses the situation in which a comparable adjustable transaction cannot be found.

The Service anticipates that taxpayers will use these regulations to establish transfer prices for controlled transactions using the best available data, and that they will provide the data as early as is practicable in the course of an examination by the Service.

SPECIAL ANALYSES

It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, an initial Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

COMMENTS AND REQUEST FOR A PUBLIC HEARING

Before adoption of these regulations, consideration will be given to any written comments that are submitted (preferably a signed original and eight copies) to the Internal Revenue Service. All comments will be available for public inspection and copying. A public hearing will be held upon written request by any person who submits timely written comments on the proposed rules. Notice of the time, place and date for the hearing will be published in the Federal Register.

DRAFTING INFORMATION

The principal authors of these regulations are Howard Berger (all provisions other than cost sharing) and Lisa Sams (cost sharing provisions). Mr. Berger and Ms. Sams are with the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal Revenue Service and Treasury Department participated in developing the regulations.

LIST OF SUBJECTS IN 26 CFR 1.481-1 THROUGH 1.483-2T

Accounting, Income taxes, Reporting and recordkeeping requirements.

PROPOSED AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 continues to read in part:

Authority: 26 U.S.C. 7805, 68A Stat. 917; 26 U.S.C. 7805. * * *

Par. 2. Section 1.482-1(a)(4) is amended as follows:

1. A second sentence is added at the end of paragraph (a)(4).

2. A new sentence is added at the end of paragraph (a)(5).

3. Seven new sentences are added at the end of paragraph (b)(1).

4. The additions read as follows:

SECTION 1.482-1 ALLOCATION OF INCOME AND DEDUCTIONS AMONG TAXPAYERS.

(a) * * * * *

(4) * * * The term "uncontrolled taxpayer" means any one of two or more organizations, trades, or businesses not owned or controlled directly or indirectly by the same interests.

(5) * * * The terms "uncontrolled group" and "group of uncontrolled taxpayers" mean the organizations, trades, or businesses not owned or controlled directly or indirectly by the same interests.

* * * * *

(b) * * *

(1) * * * In determining whether controlled taxpayers have dealt with each other at arm's length, the general principle to be followed is whether uncontrolled taxpayers, each exercising sound business judgment on the basis of reasonable levels of experience (or, if greater, the actual level of experience of the controlled taxpayer) within the relevant industry and with full knowledge of the relevant facts, would have agreed to the same contractual terms under the same economic conditions and other circumstances. In applying this principle, the district director may consider the combined effect of all transactions of a controlled taxpayer with other members of the group, as well as with uncontrolled taxpayers, before, during and after the taxable year under review, so that allocations described in section 482, taken as a whole, reflect the controlled taxpayer's true taxable income. For example, if a controlled taxpayer's business involves the use of intangibles licensed from another group member to produce finished products, the sale of those products to yet another member of the group, and financing arrangements with uncontrolled taxpayers, the combined effect of these transactions maybe considered to determine if they reflect the true taxable income of the controlled taxpayer. The district director also may disregard contractual arrangements, or the absence of contractual arrangements, between controlled taxpayers and instead give appropriate consideration to the taxpayers' actual conduct. For example, when a controlled taxpayer that produces tangible property regularly sells its entire output to another member of the controlled group, in determining the producer's true taxable income, the district director may determine from the course of conduct that the producer does not bear the risk that the buyer will fail to purchase its output even if there is no contract requiring the buyer to do so. In the case of any transfer of an intangible between or among controlled taxpayers, the true taxable income of the transferor with respect to such transfer must be commensurate with the income attributable to the intangible. See section 1.482-2(d).

* * * * *

Par. 3. Section 1.482-2 is amended as follows:

1. Paragraphs (d) and (e)(1) are revised.

2. The seventh sentence of paragraph (e)(2)(ii) is revised.

3. Example (4) and Example (5) are added to paragraph (e)(2)(ii).

4. Paragraphs (f) and (g) are added.

5. The additions and revisions read as follows:

SECTION 1.482-2 DETERMINATION OF TAXABLE INCOME IN SPECIFIC SITUATIONS.

* * * * *

(d) TRANSFER OR USE OF INTANGIBLE PROPERTY -- (1) IN GENERAL -- (i) ARM'S LENGTH STANDARD. If one member of a group of controlled taxpayers transfers an intangible to another member for other than an arm's length consideration, the district director may make appropriate allocations to reflect an arm's length consideration for that intangible or its use. An arm's length consideration for the intangible shall be commensurate with the income attributable to the intangible. See paragraph (g) of this section for special rules relating to qualified cost sharing arrangements.

(ii) DEFINITIONS -- (A) INTANGIBLE. For purposes of section 482, the term intangible means any of the following items that have substantial value independent of the services of any individual:

(1) Patents, inventions, formulas, processes, designs, patterns, or knowhow;

(2) Copyrights;

(3) Literary, musical, or artistic compositions;

(4) Trademarks, trade names, or brand names;

(5) Franchises, licenses, or contracts;

(6) Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data;

(7) Other similar items; and

(8) Any interests in any such items.

(B) TRANSFER. For purposes of this section, a transfer of an intangible occurs if it is licensed, sold, assigned, loaned, contributed, or otherwise made available in any manner.

(C) CONTROLLED TRANSFER. For purposes of this section, a controlled transfer includes any transfer between members of a group of controlled taxpayers.

(D) UNCONTROLLED TRANSFER. For purposes of this section, an uncontrolled transfer is one in which the transferor and the transferee are not members of the same group of controlled taxpayers. These include --

(1) Transfers between a member of one group and a party that is a member of a different group,

(2) Transfers between a member of one group and a party that is not a member of any group; and

(3) Transfers between parties each of which is not members of a group.

(E) OTHER DEFINITIONS. Definitions of other terms are set forth in connection with other provisions of these regulations. These include the following --

(1) Applicable business classifications, defined in paragraph (f)(5)(iii) of this section;

(2) Assets, defined in paragraph (f)(6)(iii)(B)(5) of this section;

(3) Assisters, defined in paragraph (d)(8)(i) of this section;

(4) Buy-in and buy-out payments, defined in paragraph (g)(4)(iv) of this section;

(5) Comparable adjustable transaction, defined in paragraph (d)(4)(i) of this section;

(6) Comparable profit interval, defined in paragraph (f)(1) of this section;

(7) Comparable profit method, defined in paragraph (d)(5)(i) of this section;

(8) Comparable profit split, defined in paragraph (f)(6)(iii)(C)(3) of this section;

(9) Constructive operating income, defined in paragraph (f)(1) of this section (see also Operating income, Reported operating income and Operating income attributable to intangibles);

(10) Controlled sale, defined in paragraph (e)(1)(i) of this section;

(11) Costs of developing intangibles, defined in paragraph (g)(7)(ii) of this section;

(12) Departing participant, defined in paragraph (g)(4)(iv)(C) of this section;

(13) Developer, defined in paragraph (d)(8)(i) of this section;

(14) Eligible participant, defined in paragraph (g)(3) of this section;

(15) Gross income, defined in paragraph (f)(6)(iii)(B)(2) of this section;

(16) Intangible development area, defined in paragraph (g)(4)(i) of this section;

(17) Margins, defined in paragraph (f)(6)(iii)(C)(2) of this section;

(18) Matching transaction, defined in paragraph (d)(3)(i) of this section;

(19) Most appropriate point, defined in paragraph (f)(8) of this section;

(20) Operating expenses, defined in paragraph (f)(6)(iii)(B)(3) of this section;

(21) Operating income, defined in paragraph (f)(6)(iii)(B)(4) of this section;

(22) Operating income attributable to intangibles, defined in paragraph (g)(2)(ii)(C)(3) of this section;

(23) Profit level indicators, defined in paragraphs (f)(1) and (6)(iii)(C) of this section;

(24) Proportionate profits rule, defined in paragraph (g)(4)(ii)(D) of this section;

(25) Qualified cost sharing arrangement, defined in paragraph (g)(2) of this section;

(26) Related group, defined in paragraph (g)(3)(v)(A) of this section;

(27) Related intangible development, defined in paragraph (g)(4)(i)(B) of this section;

(28) Reported operating income, defined in paragraph (d)(5)(v) of this section;

(29) Sales, defined in paragraph (f)(6)(iii)(B)(1) of this section;

(30) Same intangible, defined in paragraph (d)(3)(ii)(A) of this section;

(31) Similar intangible, defined in paragraph (d)(4)(ii) of this section;

(32) Specified interest in an intangible, defined in paragraph (g)(7)(i) of this section;

(33) Substantially similar contractual terms, defined in paragraph (d)(3)(iv) of this section;

(34) Substantially similar economic conditions, defined in paragraph (d)(3)(iii) of this section;

(35) Ten-year test, defined in paragraph (d)(6)(ii)(B) of this section;

(36) Tested operations, defined in paragraph (f)(5)(ii) of this section;

(37) Tested party, defined in paragraph (f)(4) of this section; and

(38) U.S. participant, defined in paragraph (g)(7)(ii) of this section.

(iii) COORDINATION WITH PARAGRAPH (e) OF THIS SECTION. This paragraph (d) applies to any transaction in which the transfer of an intangible occurs through transfers of tangible property or services, if the income attributable to the intangible is material in relation to the income attributable to the tangible property or services to which it relates. For an illustration of this rule, see Example 3 of paragraph (f)(11).

(iv) SCOPE OF REGULATIONS. Paragraph (d)(2) of this section provides general rules for determining the form and amount of an arm's length consideration. Paragraphs (d)(3), (4), and (5) of this section prescribe three methods for determining the amount of an arm's length consideration. They are, respectively, the matching transaction method, the comparable adjustable transaction method, and the comparable profit method. Paragraph (d)(6) of this section provides rules for multiple year transfers. Paragraph (d)(7) of this section is reserved for rules for regarding consideration that takes the form of a lump-sum payment. Paragraph (d)(8) of this section provides rules concerning assistance rendered in connection with the development of an intangible. Paragraph (f) of this section provides additional guidance regarding the comparable profit method of paragraph (d)(5) of this section. Paragraph (g) of this section addresses qualified cost sharing arrangements.

(2) ARM'S LENGTH CONSIDERATION -- (i) STANDARD TO BE APPLIED. An arm's length consideration for an intangible is the amount of consideration that an uncontrolled taxpayer would have paid for the same intangible under the same circumstances. The income of the transferor with respect to a controlled transfer of an intangible must be commensurate with the income of the transferee attributable to the intangible.

(ii) FORM. An arm's length consideration must be in a form that is consistent with a form that would be adopted in transactions between uncontrolled taxpayers under the same circumstances. If the transferee pays nominal or no consideration for an intangible and the transferor has retained a substantial interest in the property, the arm's length consideration shall be in the form of a royalty unless a different form is clearly more appropriate.

(iii) PRIORITY OF METHODS FOR DETERMINING AN ARM'S LENGTH CONSIDERATION. An arm's length consideration must be determined by applying the matching transaction method, the comparable adjustable transaction method, or the comparable profit method, described in paragraphs (d)(3), (4), and (5) of this section, respectively. Because the matching transaction method requires the fewest adjustments and relies on the most complete and accurate data, an arm's length consideration must be determined under that method if the standards for its application are met. If those standards are not met, an arm's length consideration must be determined under the comparable adjustable transaction method if the standards for its application are met. If the standards for applying neither of these methods are met, the amount of an arm's length consideration must be determined under the comparable profit method. The inapplicability of a higher priority method need not be specifically established before applying a lower priority method. However, an arm's length consideration must be determined under a higher priority method if it is established that the standards for its application are met.

(iv) APPLICATION OF METHODS. In applying the methods described in paragraphs (d)(3), (4), and (5) of this section, the district director may consider all relevant facts and circumstances throughout the period the intangible is used, including information from before, during and after the taxable year under review. The district director is not limited to considering projections or forecasts, and may consider the actual income derived from the use of an intangible. See paragraph (d)(6) of this section for additional guidance in this regard.

(3) MATCHING TRANSACTION METHOD -- (i) IN GENERAL. Under the matching transaction method, an arm's length consideration for a controlled transfer of an intangible is determined by reference to the consideration charged in an uncontrolled transfer of the same intangible under the same or substantially similar economic conditions and contractual terms (a "matching transaction"). If the uncontrolled transfer is under economic conditions and contractual terms that are not the same as, but are substantially similar to, those of the controlled transfer, the uncontrolled transfer must be adjusted as provided in paragraph (d)(3)(v) of this section. If the uncontrolled transfer is under economic conditions and contractual terms that are neither the same as, nor substantially similar to, those of the controlled transfer, the uncontrolled transfer is not a matching transaction but may be a comparable adjustable transaction under the method described in paragraph (d)(4) of this section.

(ii) SAME INTANGIBLE -- (A) IN GENERAL. A controlled transfer will be considered to involve the same intangible as an uncontrolled transfer if the property, protected interest or body of knowledge that is subject to exploitation through the use of each intangible and the relative stages of development of each intangible are identical. For example, a patented process used to manufacture a specific product is not the same intangible as a different patented process used to manufacture the same product merely because the products produced in each case are identical. Transfers must involve identical intangible property, interests or knowledge in order to be considered transfers of the same intangible.

(B) EFFECT OF DIFFERENT RIGHTS. Differences in the exploitation rights permitted under two transfers are considered differences in the contractual terms and economic conditions of the transfers rather than differences in the intangible itself. Thus, different geographic or use restrictions are not differences in the intangible itself. For example, the transfer of the right to use a patented process to manufacture, use, and sell a product within a specified market involves the same intangible as a separate transfer of the right to use the same patented process to manufacture, use and sell, the product in a different market. The right to sell a patented product with an attached trademark (or similar marketing intangible), however, is not the same intangible as the right to sell the same product without the trademark.

(iii) SUBSTANTIALLY SIMILAR ECONOMIC CONDITIONS. The determination of whether economic conditions in the controlled and uncontrolled transfers are substantially similar requires a comparison of all economic factors that could affect the amount of consideration in the two transfers. These factors include, but are not limited to --

(A) The similarity of geographic markets, including:

(1) The relative size of each market,

(2) The extent of overall economic development in each market, and

(3) The extent of competition in each market with regard to the uses to which the intangible is applied;

(B) The extent to which the products or services to which the intangible relates have been accepted within each market;

(C) The existence and extent of any collateral transactions or ongoing business relationship between the parties to each transfer; and

(D) The functions performed by the parties and the economic risks associated with those functions.

For example, the transfer of an intangible for use in a developing country would not constitute a transfer under substantially similar economic conditions as the transfer of the same intangible for use in an industrialized country if the overall level of economic development in the markets affects the consideration for the intangible.

(iv) SUBSTANTIALLY SIMILAR CONTRACTUAL TERMS. The determination of whether contractual terms in the agreements covering controlled and uncontrolled transfers are substantially similar requires a comparison of all contractual terms which could affect the amount of consideration under each agreement. These contractual terms include, but are not limited to --

(A) The amount and form of the consideration charged for the transferred intangible;

(B) The duration of the contracts, and any termination or renegotiation rights;

(C) The portion of the total interests in the intangible to which the contracts apply, including any limitations on the ways the transferee may use the intangible;

(D) Provisions for accelerating or delaying payment; and

(E) Provisions describing the functions to be performed by each party, including any ancillary services (such as technical assistance, marketing, and product development).

For example, if the uncontrolled transfer provides for the transferee to receive a specified level of technical assistance and training, the controlled transfer must contain corresponding rights in order for the contractual terms to be considered substantially similar. If one agreement calls for the transferee to perform significant marketing functions, while in the other the transferor agrees to perform such marketing functions, the contractual terms of the two transfers are not substantially similar.

(v) ADJUSTMENTS TO ECONOMIC CONDITIONS AND CONTRACTUAL TERMS -- (A) IN GENERAL. If the same intangible is transferred in a matching transaction under economic conditions and contractual terms that are not the same as, but are substantially similar to, those of the controlled transfer, the consideration charged in the uncontrolled transfer must be adjusted to compensate for those differences. Proper adjustments to the matching transaction will thus reflect the consideration that would have been charged had its economic conditions and contractual terms been the same as those of the controlled transfer.

(B) LIMITATION. Adjustments to an uncontrolled transaction under this paragraph (d)(3)(v) are permitted to compensate only for a limited number of minor differences in economic conditions and contractual terms that have a definite and precisely determinable effect on the consideration for the intangible. The differences for which adjustments will be permitted under this method must be sufficiently limited so that each adjustment alone and all the adjustments combined have only a minor effect on the consideration charged in the uncontrolled transfer. If these standards are not met, then the economic conditions and contractual terms will not be considered substantially similar and the matching transaction method will not apply.

(vi) EXAMPLES. The following examples illustrate matching transactions:

EXAMPLE 1. (i) USCo is a U.S. corporation that develops and distributes business software for personal computers. USCo has developed a new line of specialized accounting software that it sells mainly in foreign markets. USCo serves the market in country F for this software by licensing it to an uncontrolled country F corporation, UF. USCo serves the market in country B through its wholly-owned foreign subsidiary, RB. UF and RB have identical license agreements with USCo which entitle them to be exclusive distributors of the product in their respective countries in exchange for a royalty of 20 percent of the net selling price.

(ii) In 1996, the IRS audits USCo's 1994 taxable year, the second year in which the agreement was in place. Since the accounting software sold by RB is identical to the software sold by UF, the two transfers involve the same intangible. In addition, the UF license satisfies the requirement of substantially similar contractual terms because the terms of the license that USCo has with UF are identical to the terms of the license it has with RB. Furthermore, RB and UF perform the same functions relating to marketing and distribution of the software. Reliable sales information relevant to these transactions for the years 1993 through 1995 shows that both RB and UF are relatively significant distributors in their respective markets; however, neither holds a monopoly position or a dominant market share. Based on the review of these and other relevant factors, it is determined that the economic conditions with respect to the two transfers are substantially similar and that no adjustments under paragraph (d)(3)(v) of this section need be made. Accordingly, the matching transaction method is applicable, and the royalty rate of 20 percent in the controlled transfer to RB is determined to be an arm's length amount of consideration for 1994.

EXAMPLE 2. The facts are the same as in Example 1, except that the controlled transfer to RB covers all future revisions and updates to the accounting software while the uncontrolled transfer to UF covers only the current version of the software. Since the intangibles transferred in the two transactions are different, the transfers do not involve the same intangible. Therefore, the UF transfer is not a matching transaction.

EXAMPLE 3. The facts are the same as in Example 1, except that the uncontrolled transfer to UF includes contractual terms that require USCo to furnish technical assistance to UF (including information concerning marketing and packaging of the accounting software). The UF agreement provides that USCo will be reimbursed for its costs attributable to any technical assistance it provides. The RB agreement does not contain a similar provision and it provides that the level of technical assistance that can be demanded by UF is relatively modest and will have little effect on the value of the accounting software. Minimal levels of technical assistance are actually provided to UF and RB by USCo. Definite and precisely determinable adjustments to the consideration charged for the accounting software can be made with respect to this difference in contract terms on the basis of the costs to USCo of the technical assistance actually provided. Accordingly, the contractual terms are substantially similar and the UF license is a matching transaction. However, the district director may make an allocation to reflect any differences in technical assistance actually provided.

EXAMPLE 4. The facts are the same as in Example 3, except that USCo is required to provide the same forms of technical assistance at cost to both UF and RB under the contractual terms of the two transfers. In practice, however, the assistance actually provided by USCo to RB involves extensive transfers of knowhow with respect to developing effective distribution networks within the country B market. The marketing function in the uncontrolled transfer, however, is carried on primarily by UF with little actual assistance provided by USCo. The uncontrolled transfer in this case fails to meet the standards for a matching transaction for two reasons. First, because the transfer to RB involves different and more extensive areas of knowhow developed by USCo than the transfer to UF, the two transactions do not involve the same intangible. Second, because the economic conditions of the two transfers involve significantly different functions actually performed by USCo, and any adjustments to compensate for these differences could be relatively large, these conditions are not substantially similar. Accordingly, the uncontrolled transfer is not a matching transaction.

EXAMPLE 5. The facts are the same as in Example 1 and no adjustment is made in 1994. Due to RB's capacity for expansion of its distribution network, however, USCo anticipates that future growth in worldwide markets will be met by RB. Beginning in 1995, RB expands its marketing network beyond the country B market. By 1998, RB has significantly expanded its worldwide sales and has developed a dominant market share in several substantial new markets where it is able to charge premium prices for its product. The same factors are not present in country F, and UF continues to hold a relatively stable market share. These changes in economic conditions have a major effect on RB's operations. The adjustment to the consideration charged by UF to account for these differences in economic conditions would be material in comparison to the overall consideration paid to USCo. Accordingly, the economic conditions in the uncontrolled transfer are no longer substantially similar to those of the controlled transfer, and the standards for the matching transaction method are not met with respect to the 1998 taxable year. Nevertheless, the uncontrolled transfer may continue to be a comparable adjustable transaction described in paragraph (d)(4) of this section.

(4) COMPARABLE ADJUSTABLE TRANSACTION METHOD -- (i) IN GENERAL. Under the comparable adjustable transaction method, an arm's length consideration for an intangible is determined by reference to the consideration charged in an uncontrolled transfer involving the same or similar intangible under adjustable economic conditions and contractual terms, adjusted as provided in paragraph (d)(4)(iv) of this section. An uncontrolled transfer will not meet the standards of this paragraph (d)(4) if the consideration determined by reference to that transfer results in a level of operating income for the tested party, as defined in paragraph (f)(4) of this section, that is outside of the comparable profit interval, as provided under the rules of paragraph (f) of this section. An uncontrolled transfer that meets the standards of this paragraph (d)(4) is a "comparable adjustable transaction."

(ii) SAME OR SIMILAR INTANGIBLE. A controlled transfer will be considered to involve the same or similar intangible as an uncontrolled transfer if the property, protected interest or body of knowledge that is subject to exploitation through the use of each intangible and the relative stages of development of each intangible are sufficiently similar that the effect of any material differences can be determined with reasonable accuracy.

(iii) ADJUSTABLE ECONOMIC CONDITIONS AND CONTRACTUAL TERMS. Whether economic conditions and contractual terms are adjustable must be determined using the same factors that apply in determining whether such conditions and terms are substantially similar for purposes of the matching transaction method (as described in paragraphs (d)(3)(iii) and (iv) of this section). The comparable adjustable transaction method does not require that all such terms and conditions be substantially similar, or that adjustments compensate for only a limited number of minor differences. To be considered adjustable, however, the contractual terms and economic conditions must be sufficiently similar that the effect of any material differences can be determined with reasonable accuracy.

(iv) ADJUSTMENTS FOR DIFFERENCES IN INTANGIBLES, ECONOMIC CONDITIONS, AND CONTRACTUAL TERMS. If the same or similar intangible is transferred under adjustable economic conditions and contractual terms, the consideration called for in the uncontrolled transfer must be adjusted to compensate for material differences between the intangibles, economic conditions, and contractual terms of the transfers. Adjustments to the uncontrolled transfer will reflect the consideration that would have been charged had its terms and conditions been the same as those of the controlled transfer.

(v) SELECTION OF MOST SIMILAR COMPARABLE ADJUSTABLE TRANSACTION. If more than one comparable adjustable transaction is available, the arm's length consideration is determined under this method by using the uncontrolled transfer most similar to the controlled transfer, determined by reference to the factors described in paragraphs (d)(4)(ii), (iii) and (iv) of this section. The most similar comparable adjustable transaction will generally be the uncontrolled transfer for which the necessary adjustments can most accurately be determined.

(vi) EXAMPLES. The following examples illustrate comparable adjustable transactions. See also paragraph (f)(11) of this section, which provides examples of the application of the comparable profit interval to test a potential comparable adjustable transaction.

EXAMPLE 1. X is a domestic corporation engaged in the manufacture and distribution of small plastic products. X has developed and patented certain processes used in the injection molding of its plastic products. In 1994, X expands its operations through a wholly-owned subsidiary, Y, incorporated in country F. Y uses the same manufacturing processes as X and sells its products in country F and other nearby markets. Y agrees to pay X a royalty of 6.5% of gross sales for its use of the injection molding process and related knowhow. In 1996, the district director examines the royalty agreement to determine if the consideration agreed to in 1994 was an arm's length amount. Intangibles related to various types of injection molding processes have been licensed between uncontrolled taxpayers, but none of the processes involve a property, protected interest or body of knowledge which is identical to the process developed by X. Accordingly, these uncontrolled taxpayer licenses do not involve the same intangible and cannot serve as matching transactions. The most similar transaction to the transfer between X and Y involves a process used for injection molding of soap products that was developed by corporation A and licensed to uncontrolled corporation B, a country F corporation. The royalty rate in the agreement between A and B is 5% of gross sales. B uses the licensed technology to manufacture soap products that it distributes in country F. Reasonably determinable adjustments can be made to reflect the following differences between the two transactions:

(i) The injection molding process developed by X is more sophisticated than the process developed by A and it affects more aspects of the manufacturing process;

(ii) The improved manufacturing technology in Y's plastic business in country F has a significant effect on Y's market share and overall profitability, while improvements to B's manufacturing process in country F have a less beneficial economic effect;

(iii) The contract between X and Y provides for continued technical assistance to be provided at no additional cost by X while the agreement between A and B does not mention technical assistance; and

(iv) Technical assistance has in fact been provided by both A and X to their respective licensees, but the costs of providing the technical assistance has been slightly more in the case of X.

Considering each of the above factors, it is determined that a 1.5% increase over the royalty rate charged in the transaction between A and B is an appropriate adjustment to reflect the differences between the two transactions. In addition, the operating income earned by Y after payment of the 6.5% royalty is within the comparable profit interval described in paragraph (f) of this section. Accordingly, the royalty rate set between X and Y will be an arm's length amount of consideration under the comparable adjustable transaction method.

EXAMPLE 2. The facts are the same as in EXAMPLE 1, except that the license agreement between X and Y contains a royalty rate of 3% of gross sales and there is no comparable adjustable transaction between A and B. X defends the 3% royalty as an arm's length amount by reference to a license agreement between uncontrolled taxpayers C and D. C is a developer of an intangible that involves improvements to the computer controls in the production of advance machine tools. D licenses this intangible for use in its country F machine tool manufacturing business and pays C a royalty of 3% of gross sales. The differences between the functions performed with the two intangibles are substantial. For instance, C's process is used for only one step of many stages of the manufacturing of the machine tools and has little effect on the size of D's labor force. By contrast, the injection molding process developed by X replaces or significantly affects each stage of the manufacture of Y's plastic products and results in a major labor force reduction. Due to these differences between the intangibles involved in the two transfers, and the differences in the overall economic benefit to be derived from the cost reductions achieved, compensating adjustments to the royalty charged in the uncontrolled transfer cannot be reasonably ascertained. Accordingly, the transfer of the intangible from C to D is not a comparable adjustable transaction.

EXAMPLE 3. The facts are the same as in EXAMPLE 1, except that the assistance actually provided by X to Y in the controlled transfer is substantially greater than the assistance provided by A to B in the uncontrolled transfer. The assistance provided in the controlled transfer extends to all aspects of Y's manufacturing and marketing efforts, and constitutes a wide body of knowledge accumulated by X in its manufacturing and marketing of plastic products in the U.S. market. This assistance is a substantial factor in the success of Y's manufacturing and marketing operations. In contrast, B's assistance from A is limited solely to the operational aspects of A's injection molding process. B's other manufacturing expertise, and all of its marketing knowhow, were developed through B's long term experience in country F. Accordingly, there are substantial differences between the intangibles transferred by A and X; the transfer to Y involves knowhow relating to all of Y's manufacturing and marketing operations, whereas the transfer to B is limited to one aspect of the manufacturing process. Due to the lack of reliable data concerning the value to B of its self-developed intangibles as well as the comparative economic effects between the plastic and soap markets resulting from these broader types of intangibles, the adjustments to account for these differences are not reasonably determinable. Accordingly, the transfer from A to B is not a comparable adjustable transaction.

EXAMPLE 4. The facts are the same as in EXAMPLE 1, except that Y's use of the injection molding processes in 1994 is only in an early stage of implementation within country F. As expected by X and Y, the process becomes fully operational in 1995 allowing Y to significantly reduce manufacturing costs, lower the prices of its products, and expand its market share within country F. By 1998, Y is the largest manufacturer of these products in the market and has significantly increased both its volume of sales and its profitability. As a result, the operating income earned by Y in 1998 (after payment of the 6.5% royalty to X) substantially exceeds the comparable profit interval described in paragraph (f) of this section. Moreover, the economic conditions involved in Y's operations have grown sufficiently different from the economic conditions involved in B's soap production that adjustments to the royalty rate paid by B to account for those differences are no longer reasonably determinable. Accordingly, the transfer between A and B is not a comparable adjustable transaction for the 1998 taxable year.

(5) COMPARABLE PROFIT METHOD -- (i) IN GENERAL. If there are no uncontrolled transfers that meet the standards for either matching transactions or comparable adjustable transactions, then an arm's length consideration for the controlled transfer of an intangible must be determined by reference to the comparable profit interval of the tested party under the rules of paragraph (f) of this section. Paragraphs (d)(5)(ii), (iii), and (iv) of this section provide rules concerning application of the comparable profit method based on whether the reported operating income (as defined in paragraph (d)(5)(v) of this section) of the tested party is within or outside of the comparable profit interval. These rules do not apply for purposes of using the comparable profit interval to test a potential comparable adjustable transaction, as required in paragraph (d)(4)(i) of this section, or for purposes of testing a result under any method described in paragraph (e)(1)(iii) or (iv) of this section.

(ii) EFFECT IF REPORTED OPERATING INCOME OF THE TESTED PARTY IS WITHIN THE COMPARABLE PROFIT INTERVAL. If the comparable profit method applies (i.e., the standards for the matching or comparable adjustable transaction methods have not been met) and the consideration charged in the controlled transfer results in reported operating income of the tested party that is within the comparable profit interval, that amount of consideration will generally be treated for purposes of this paragraph (d) as an arm's length consideration. Accordingly, allocations with respect to those transfers ordinarily will not be made under this paragraph (d). See paragraph (d)(5)(iv) of this section for exceptions to this rule.

(iii) EFFECT IF REPORTED OPERATING INCOME OF THE TESTED PARTY IS OUTSIDE OF THE COMPARABLE PROFIT INTERVAL -- (A) GENERAL RULE. If the comparable profit method applies (i.e., the standards for the matching or comparable adjustable transaction methods have not been met) and the consideration due in the controlled transfer results in reported operating income of the tested party outside of the comparable profit interval, an adjustment under this method may be made to the amount of consideration for such transfer. Except as provided in paragraph (d)(5)(iii)(B) of this section, the adjustment must result in a level of operating income of the tested party at the most appropriate point within the comparable profit interval, as described in paragraph (f)(8) of this section.

(B) DISCRETION TO LIMIT ADJUSTMENTS. In determining the amount of any adjustment to be made under this method, the district director will consider how closely the reported operating income corresponds to the comparable profit interval. If reported operating income of the tested party is not significantly outside the comparable profit interval, any adjustments made by the district director will take into account the amount of deviation between the comparable profit interval and the reported operating income. The closer the reported operating income is to the comparable profit interval, the smaller an appropriate adjustment may be. The adjustment must bring the operating income within the comparable profit interval but may be smaller than necessary to reach the most appropriate point in the interval. See paragraph (d)(5)(iv) of this section for exceptions to this rule.

(C) EXAMPLES. The following examples illustrate an adjustment of the tested party's operating income:

EXAMPLE 1. The transferee of an intangible is the tested party and the comparable profit interval for the transferee, as determined under paragraph (f) of this section, consists of operating income falling between $1.5 and $2 million. The transferee's reported operating income is $2.1 million. Under all the facts and circumstances of this case, the most appropriate point within the comparable profit interval is $1.7 million. However, the district director determines that the transferee's reported operating income is not significantly outside the comparable profit interval. Consequently, rather than adjusting the transferee's reported operating income to $1.7 million (the most appropriate point within the interval), the district director adjusts the transferee's reported operating income to $1.9 million.

EXAMPLE 2. Assume the facts are the same as in EXAMPLE 1, except that the transferee's reported operating income is $5.0 million. The transferee's reported operating income lies significantly outside the appropriate profit interval. Consequently, the district director adjusts the transferee's reported income to the most appropriate point, $1.7 million.

(iv) EXCEPTIONS. If the comparable profit method applies, the district director may make an adjustment that results in a level of operating income for the transferee at the most appropriate point within the comparable profit interval, as described in paragraph (f)(8) of this section, if --

(A) The transferee paid no consideration in connection with the controlled transfer; or

(B) The consideration paid by the transferee in connection with the controlled transfer was substantially disproportionate to the value of the intangible.

In such cases the rules of paragraphs (d)(5)(ii) and (iii)(B) of this section that would permit no adjustment or a more limited adjustment shall not apply.

(v) REPORTED OPERATING INCOME. The term "reported operating income of the tested party" means the operating income of the tested party reflected on a timely U.S. income tax return (or an amended return) filed before the Internal Revenue Service first contacts the tested party or any other member of the same group of controlled taxpayers concerning an examination of the return for the taxable year. If the tested party files a U.S. income tax return, its operating income is considered reflected on a U.S. income tax return if the calculation of taxable income on its return for the taxable year takes into account income attributable to the transferee's use of the intangible or consideration charged for the intangible by the transferor. A written statement furnished by a taxpayer subject to the Coordinated Examination Program will be considered an amended return for purposes of this paragraph (d)(5)(v) if it satisfies the requirements of a qualified amended return for purposes of section 1.6661-6(c) as set forth in those regulations or as the Commissioner may prescribe by Revenue Procedure. If the tested party does not file a U.S. income tax return, its operating income is considered reflected on a U.S. income tax return in any taxable year for which income attributable to the transferee's use of the intangible or consideration charged for the intangible by the transferor affects the calculation of taxable income on the U.S. income tax return of any other member of the same group of controlled taxpayers.

(vi) EXAMPLE. The following example illustrates reported operating income:

EXAMPLE: USCo, a domestic corporation, wholly owns two foreign subsidiaries F1 and F2. F1 is the developer of an intangible, which it licenses to F2 for a royalty of 5% of gross sales. The royalty received by F1 constitutes foreign personal holding company income under section 954(c). USCo timely files a return for 1994 that includes the amount of the royalty payment as gross income under section 951. The royalty amount has no other effect on the taxable income reportable for 1994 on a U.S. tax return by any person. F2 is the tested party with respect to the controlled transfer of the intangible. In determining whether the royalty paid by F2 was an arm's length consideration, the operating income of F2 will be considered its reported operating income for purposes of applying the comparable profit method.

(6) TRANSFERS FOR MORE THAN ONE TAXABLE YEAR -- (i) TIMING OF REVIEW. If an intangible is transferred under an agreement with a term covering more than one taxable year, the consideration charged in each taxable year may be adjusted to assure that it is commensurate with the income attributable to the intangible. The district director may consider all relevant facts and circumstances throughout the period the intangible is used in determining whether to make allocations in the taxable year under examination. Except as provided in paragraph (d)(6)(ii) of this section, the determination in an earlier year that the amount charged for an intangible was arm's length will not preclude the district director in a subsequent taxable year from making an adjustment to the amount charged for the intangible.

(ii) EXCEPTIONS -- (A) OPERATING INCOME OF THE TESTED PARTY REMAINS WITHIN THE COMPARABLE PROFIT INTERVAL. No allocation will be made under paragraphs (d)(3) (matching transaction method) and (d)(4) (comparable adjustable transaction method) of this section for the use of an intangible if:

(1) An arm's length consideration (within the meaning of this paragraph (d)) was charged for the intangible in the year it was transferred;

(2) The reported operating income of the tested party was within the comparable profit interval (as described in paragraph (f) of this section) in all years subsequent to the year of the transfer, including the taxable year under examination; and

(3) There has not been a major variation in the annual amounts of revenue attributable to the transferred intangible.

(B) TEN-YEAR TEST. No allocation shall be made under this paragraph (d) to increase the consideration for the use of an intangible if:

(1) The intangible was transferred pursuant to a written agreement that meets the following conditions:

(i) At the time the agreement was entered into, the intangible was in existence and was reasonably susceptible of valuation;

(ii) The agreement was in effect throughout a 10 year period ending at any time prior to the taxable year under examination; and

(iii) The agreement remained in effect in the taxable year under examination;

(2) Significant commercial production involving the intangible occurred throughout the 10 year period;

(3) The consideration charged under the agreement is set by reference to a royalty rate that was applied throughout the 10 year period and continued to apply with respect to the taxable year under examination; and

(4) Either of the following conditions is satisfied:

(i) The consideration charged with respect to each of the 10 years previously was determined, or is determined subsequently, to be an arm's length amount under either paragraph (d)(3) (matching transaction method) or (d)(4) (comparable adjustable transaction method) of this section; or

(ii) The transferee's reported operating income was within the comparable profit interval throughout the 10 year period and the taxable year under examination.

(C) LIMITATION ON ALLOCATIONS IN SUBSEQUENT TAXABLE YEARS DUE TO UNANTICIPATED EVENTS. No allocation will be made under this paragraph (d) to increase the consideration for the intangible for any taxable year if each of the following facts is established:

(1) The controlled taxpayers entered into a written agreement that provided for an amount of consideration with respect to any prior taxable year that is determined to be an arm's length amount under either the matching transaction method or the comparable adjustable transaction method.

(2) The written agreement between the uncontrolled taxpayers that entered into the matching or comparable adjustable transaction contained no provision that would have permitted adjustment or termination due to unanticipated changes of profitability, and no adjustment or termination was in fact made by the uncontrolled taxpayers in any taxable year through the taxable year under review.

(3) The written agreement between the controlled taxpayers limited the use of the intangible to a specified field or purpose in a manner that was consistent with industry practices and any limitation in the agreement between the uncontrolled taxpayers.

(4) The tested party's operating income moved outside of the comparable profit interval solely because of changes in economic conditions that were --

(i) Beyond the control of any member of the group of controlled taxpayers, and

(ii) Neither anticipated nor reasonably foreseeable.

(5) The written agreement between the controlled taxpayers contained no provision that would have permitted an adjustment of the amount of consideration charged for the intangible, and that agreement remained in effect in the taxable year under review.

(D) EXAMPLES. The unanticipated events test as set forth in paragraph (d)(6)(ii)(C) of this section is illustrated by the following examples:

EXAMPLE 1. X is a U.S. corporation with a wholly-owned foreign subsidiary Y. X and Y perform pharmaceutical research, and manufacture and market pharmaceutical products worldwide. X has discovered, patented and obtained FDA approval for Lolip, a cholesterol-lowering drug the active ingredient of which is different from the other competitive drugs which perform similar therapeutic functions. Several of these competitive drugs are licensed to uncontrolled taxpayers in Europe and Asia under long term arrangements which do not provide a mechanism for adjusting the royalty payments in the event of unanticipated changes in economic circumstances. After trial marketing in Europe and Asia to determine expected levels of acceptance, X computes a royalty on the transfer from X to Y of the right to manufacture and market Lolip in Europe and Asia on the basis of the expectation that the competitive drugs will remain in those markets. Two years after X licenses Lolip to Y, a study is published linking the competing drugs to high rates of liver cancer. As a result, in a short time Lolip captures a substantially higher percentage of the European and Asian markets than originally anticipated. Based on reliable documentation, X establishes the five facts listed in paragraph (d)(6)(ii)(C) of this section. Accordingly, no adjustment will be made based solely on the increase in the profitability experienced by Y that was attributable to loss of market share by its competitors due to the liver cancer connection.

EXAMPLE 2. Assume the same facts as in Example 1 except that there is no linkage of the competing drugs to liver cancer and the competitors do not lose their anticipated market share. Furthermore, it is determined that the process for manufacturing Lolip generates and releases into the atmosphere high concentrations of a certain pollutant in violation of the U.S. Clean Air Act. Rather than modify the process used in X's U.S. plant, X closes its manufacturing operation and purchases from Y 100 percent of the Lolip needed to supply the U.S. market. The plant closing is not a change that is beyond the control of the parties. Accordingly, the exception described in paragraph (d)(6)(ii)(C) of this section will not apply. Any allocation made by the district director for subsequent taxable years will take into account the fact that Y has acquired the right, in effect, to manufacture Lolip for the U.S. market.

(7) LUMP-SUM PAYMENTS. [Reserved]

(8) DEVELOPMENT OF AN INTANGIBLE -- (i) IDENTIFICATION OF THE DEVELOPER. Except as provided in paragraph (g) of this section, when two or more members of a controlled group undertake the development of an intangible, one member will be regarded as the developer of the intangible, and, therefore, as its owner for purposes of section 482. The other participating members will be regarded as assisters. Which controlled taxpayer is the developer and which controlled taxpayers are assisters will be determined under all the facts and circumstances. In making this determination, greatest weight must be given to the extent to which each member --

(A) Bears the direct and indirect costs and corresponding risk of developing the intangible; and

(B) Makes available without adequate compensation property or services likely to contribute substantially to developing the intangible.

A controlled taxpayer will be treated as bearing the costs and corresponding risk of development only if it is legally bound before the costs are incurred to bear the costs without regard to the success of the project. For this purpose, the risk to be borne with respect to development activity is the possibility that such activity will not result in the production of intangible property or that the intangible property produced will not be of sufficient value to allow for the costs of developing it. Other factors that may be relevant in determining which controlled taxpayer is the developer include the location of the development activities, the capability of each controlled taxpayer to carry on the project independently, the extent to which each controlled taxpayer controls the project, and the actual conduct of the controlled taxpayers.

(ii) ALLOCATIONS WITH RESPECT TO TRANSFERS BY THE DEVELOPER. If the developer of an intangible makes the intangible available to another controlled taxpayer (including any assister), the district director may make an allocation with respect to that transfer to reflect an arm's length consideration for the intangible. See paragraph (d)(1) of this section.

(iii) ALLOCATIONS WITH RESPECT TO ASSISTANCE PROVIDED TO THE DEVELOPER. The district director may make allocations to reflect arm's length consideration for assistance provided to the developer by another controlled taxpayer in connection with the development of an intangible. Such assistance may include loans, services, or the use of tangible or intangible property. The amount of any allocation required with respect to that assistance must be determined in accordance with the applicable rules of this section. For example, if one member of a controlled group allows another member of the group to use tangible property, such as laboratory equipment, in connection with the latter's development of an intangible, any allocations with respect to the developer's use of the tangible property will be determined under paragraph (c) of this section. If consideration for assistance provided to the developer is not arm's length, instead of making an allocation with respect to the assistance, the district director may treat the difference between the amount of an arm's length consideration for the assistance and the consideration charged by the assister as a loan, either from the assister to the developer (if consideration charged is less than an arm's length amount) or as a loan from the developer to the assister (if consideration charged exceeds an arm's length amount), that is subject to paragraph (a) of this section.

(iv) EXAMPLES. The following examples illustrate the principles of this paragraph (d)(8). In all these examples, it is assumed X and Y are members of the same group of controlled taxpayers.

EXAMPLE 1. X, at the request of Y, undertakes to develop a new machine that will function effectively in the climate in which Y's factory is located. Y agrees in writing before X incurs any costs to bear all the direct and indirect costs of the project whether or not X successfully develops the machine. X does not make any of its own property available for use in connection with the project without adequate compensation. The machine is successfully developed and X provides to Y the process necessary to produce it. Y is considered the developer of the process and, therefore, shall not be treated as having obtained it in a transfer subject to the rules of this paragraph (d). The district director may make appropriate allocations with respect to assistance rendered by X. The district director also may treat any use of the process by X as a transfer by Y that is subject to the rules of this paragraph (d) and make allocations with respect to that transfer.

EXAMPLE 2. Assume the same facts as in Example 1 except that Y agrees to bear the costs only if the machine is successfully developed. X is considered the developer and Y is regarded as having obtained the process in a transfer subject to the rules of this paragraph (d). Therefore, the district director may make allocations to reflect an arm's length consideration for the transfer of the process.

EXAMPLE 3. X undertakes to develop a new chemical product M in its research and development department and incurs direct and indirect costs of $1,000,000 per year in 1994, 1995, and 1996. X employs the formula for compound N which it developed and owns. The value of the use of the formula for compound N in connection with the project is $750,000. In 1995, four chemists employed by Y spend six months working on the project in X's laboratory. The salary and other expenses connected with the chemists' activities during that period total $200,000 and are paid by Y without charge to X. In 1996, product M is perfected and Y obtains patents on its formula. X is considered the developer of product M because, among other things, it bore the greatest share of the costs and risks incurred in connection with the project and made available valuable property (the formula for compound N). The formula for product M is deemed to have been transferred to Y in 1996 by virtue of Y's obtaining patent rights to product M. The district director may make allocations in that year to reflect arm's length consideration for the transfer. The district director also may make allocations in 1995 with respect to the assistance rendered by Y. If the district director does not make an allocation for 1995 with respect to the services of the chemists in accordance with the principles of paragraph (b) of this section, the district director may treat the amount of an arm's length consideration as a loan to X from Y.

EXAMPLE 4. X, a foreign producer of cheese, markets its cheese in countries other than the United States under the trade name DR. X owns all worldwide rights to this name. The name is widely known and is valuable outside the United States but is not known within the United States. In 1995, X decides to enter the U.S. market and organizes U.S. subsidiary Y to be its U.S. distributor and to supervise the advertising and other marketing efforts that will be required to develop the name DR in the United States. Y incurs $5,000,000 of expenses promoting the name DR in that year for which it is not reimbursed by X. Y is considered the developer of the enhanced U.S. rights to the trade name.

(e) SALES OF TANGIBLE PROPERTY -- (1) IN GENERAL -- (i) ARM'S LENGTH STANDARD. Where one member of a group of controlled taxpayers sells or otherwise disposes of tangible property to another member of the group ("controlled sale") at other than an arm's length price, the district director may make appropriate allocations between the seller and the buyer to reflect an arm's length price for that sale or disposition. An arm's length price is the price that an uncontrolled taxpayer would have paid under the same circumstances for the property involved in the controlled sale.

(ii) PRIORITY OF METHODS. Paragraphs (e)(2), (3), and (4) of this section prescribe three methods for determining an arm's length consideration. They are, respectively, the comparable uncontrolled price method, the resale price method, and the cost plus method. In addition, a special rule is provided in paragraph (e)(1)(vi) of this section for the sale of an ore or mineral. Because the comparable uncontrolled price method generally will involve the most complete and accurate data and require the fewest and most readily quantifiable adjustments, the amount of an arm's length consideration must be determined under this method if the standards for its application are met. If those standards are not met, the amount of an arm's length consideration must be determined under either the resale price method or the cost plus method, depending upon which method relies on the most complete and accurate data, and requires the fewest and most readily quantifiable adjustments. Use of the resale price method ordinarily is more appropriate when a manufacturer sells products to a controlled distributor which, without further processing or the use of significant intangibles, resells the products in uncontrolled transactions. Use of the cost plus method ordinarily is more appropriate when a manufacturer sells products to a controlled taxpayer that after further processing, or the use of significant intangibles, resells the products in uncontrolled transactions. The inapplicability of a higher priority method need not be specifically established before applying a lower priority method. However, an arm's length consideration must be determined under a higher priority method if it is established that the standards for its application are met.

(iii) CONFIRMATION OF RESALE PRICE AND COST PLUS METHODS BY THE COMPARABLE PROFIT INTERVAL. A transfer price determined under either the resale price method or the cost plus method reflects arm's length consideration only if that price results in a level of operating income for the tested party that is within the comparable profit interval described in paragraph (f) of this section.

(iv) OTHER METHODS. Where none of the three methods of pricing described in paragraph (e)(1)(ii) of this section can reasonably be applied under the facts and circumstances of a particular case, a method of pricing other than those described in that paragraph, or a variation on those methods, may be used, but only if that method yields a level of operating income for the tested party that is within the comparable profit interval described in paragraph (f) of this section. Such methods may include an analysis based on profit level indicators, described in paragraph (f)(6)(iii) of this section. Generally, the best such method will result in operating income for the tested party that is at the most appropriate point within the comparable profit interval as described in paragraph (f)(8) of this section. The inapplicability of a higher priority method need not be specifically established before applying an "other method" under this paragraph (e)(1)(iv). However, an arm's length consideration must be determined under a higher priority method if it is established that the standards for its application are met.

(v) PRODUCT LINE AND STATISTICAL ANALYSIS. The methods of determining arm's length prices described in this paragraph (e) are stated in terms of their application to individual sales of property. However, because a taxpayer may make controlled sales of many different products, or many separate sales of the same product, it may be impractical to analyze every sale for the purpose of determining the arm's length price. Therefore an arm's length price may be determined or verified by applying the pricing methods to product lines or other groupings where it is impractical to ascertain an arm's length price for each product or sale. In addition, the district director may determine or verify the arm's length price of all sales to a controlled taxpayer by employing reasonable statistical sampling techniques.

(vi) MINERAL PRODUCTS. The price for a mineral product which is sold at the stage at which mining or extraction ends shall be determined under the provisions of sections 1.613-3 and 1.613-4.

(2) * * * * *

(ii) * * * * * Some of the differences that may affect the price of property are differences in the quality of the product, terms of sale, intangible property associated with the sale, time of sale, sales volume, inventory turnover rate, advertising and warranty practices and the level of the market and the geographic market in which the sale takes place. * * *

EXAMPLE (4). Assume that the circumstances surrounding the controlled and uncontrolled sales are identical, except that, in the controlled sales, the transferee bears the warranty obligations that arise in the resale of the product. If the effect of this difference on the price is not reasonably ascertainable, then the uncontrolled sales will not be comparable to the controlled sales.

EXAMPLE (5). Assume that the circumstances surrounding the controlled and uncontrolled sales are identical, except for the fact that the volume of controlled sales is different from the volume of uncontrolled sales and such volume of controlled sales would produce a reasonably ascertainable volume discount. The adjusted uncontrolled sales will be comparable to the controlled sales. * * * * *

(f) COMPARABLE PROFIT INTERVAL -- (1) IN GENERAL. The comparable profit interval is composed of various amounts of profit that a tested party would have earned if objective measures of its profitability ("profit level indicators") had been equivalent to those of various uncontrolled taxpayers that performed similar functions. Specifically, profit level indicators derived from the financial data of uncontrolled taxpayers are applied to the tested party to recalculate its operating income. Each recalculated amount is referred to in this section as "constructive operating income." The comparable profit interval is then derived from those constructive operating incomes that converge. This comparable profit interval is used to confirm the validity of a transfer price calculated through the use of other methodologies, under the rules of paragraphs (d)(4), and (e)(1)(iii) and (iv) of this section. In addition, under the rules of paragraphs (d)(5) and (e)(1)(iv) of this section, the comparable profit interval may be used in determining the transfer price for the controlled transfer of intangible property. Paragraph (f)(3) of this section describes the six steps of the analysis that is applied in this paragraph (f) to derive the comparable profit interval. While in many cases this analysis will consist of a sequential application of the six steps, the steps are interdependent and certain steps may have to be reapplied to take into account results derived in succeeding steps.

(2) DATA FROM MULTIPLE YEARS. Unless the circumstances indicate that a different period is more appropriate, the interval will be based on actual results (rather than projections) from the three-year period that includes the taxable year under review, the preceding year and the following year. Circumstances that may warrant the use of a different period include the unavailability of reliable data from the relevant time periods, the normal business cycles of the industry under review, and the life cycle of the products or intangibles being examined. To the extent that reliable data is available, data pertaining to uncontrolled taxpayers and data pertaining to the tested party should relate to comparable time periods.

(3) DEVELOPMENT OF A COMPARABLE PROFIT INTERVAL. The development of a comparable profit interval consists of the following steps:

(i) STEP 1. Select the party to a controlled transaction to be tested. This determination is made under paragraph (f)(4) of this section.

(ii) STEP 2. Determine the applicable business classification of the tested party. This determination is made under paragraph (f)(5) of this section.

(iii) STEP 3. Compute constructive operating incomes, as described in paragraph (f)(6) of this section.

(iv) STEP 4. Determine the comparable profit interval, as described in paragraph (f)(7) of this section.

(v) STEP 5. When necessary, determine the most appropriate point in the comparable profit interval, as described in paragraph (f)(8) of this section.

(vi) STEP 6. Determine the transfer price for the controlled transaction, as described in paragraph (f)(9) of this section.

(4) STEP 1: SELECT THE PARTY TO A CONTROLLED TRANSACTION TO BE TESTED -- (i) IN GENERAL. The first step in constructing a comparable profit interval is to determine which of the parties to the controlled transaction will be the tested party. The party selected need not be the person that is under examination. For example, if an examination concerns the income of a U.S. parent corporation attributable to the transfer of an intangible to a foreign subsidiary, the comparable profit interval may be calculated with respect to the subsidiary.

(ii) BASIS FOR SELECTION OF THE TESTED PARTY. The tested party is the party to the controlled transaction whose operating income can be verified using the most reliable data and with the fewest and most accurately quantifiable adjustments. In the case of a transfer of an intangible, the tested party ordinarily will be the transferee. In cases involving the controlled sale of tangible property in which the resale price method applies, the tested party ordinarily will be the buyer. In cases involving the controlled sale of tangible property in which the cost plus method applies, the tested party ordinarily will be the seller. However, the comparable profit interval may be applied to check the operating income of any party to a controlled transaction if the operating income of such party can be more reliably and accurately tested than the operating income of other parties.

(5) STEP 2: DETERMINE THE APPLICABLE BUSINESS CLASSIFICATION OF THE TESTED PARTY -- (i) IN GENERAL. The constructive operating incomes that are used to establish the comparable profit interval are derived from the operations of uncontrolled parties that are similar to the tested operations of the tested party. This paragraph (f)(5) provides rules for identifying these operations, which are referred to as the applicable business classification. As described in paragraphs (f)(5)(ii) and (iii) of this section, determining the applicable business classification is a two-stage process. First, the operations of the tested party that are related to the transactions between the tested party and the other members of the group of controlled taxpayers are identified (the "tested operations"). Second, the tested operations are matched as closely as possible to similar operations of uncontrolled taxpayers based on the data available to determine the applicable business classification. In some cases, the analyses of the constructive operating incomes discussed below may indicate that there is insufficient reliable data related to the applicable business classification to construct a comparable profit interval. In such a case it will be necessary under this paragraph (f)(5) to identify a different applicable business classification (or classifications) that may be more specific or more general than the original applicable business classification in order to obtain sufficient reliable data to construct the comparable profit interval.

(ii) TESTED OPERATIONS. Tested operations include that portion of the tested party's operations that are related to or integrated with the transactions with controlled parties that are under review. These operations may include manufacture and sale of products, product lines, or other product groupings, as well as types of services or other functions that the tested party performs. The identification of tested operations must consider both the types of products and the functions that are related to the transactions between the tested party and controlled taxpayers. For example, if the tested party's only transactions with other members of the group of controlled taxpayers consist of purchases of a single product for resale, and such purchases represent a small portion of the tested party's overall inventory purchases, then the tested operations should be those that relate to purchases and sales of that product. If, however, the tested party engages in multiple transfers of tangible and intangible property with other members of the group of controlled taxpayers, the tested operations should be those that relate to all such transfers. In appropriate cases, the tested operations will include all of the operations of the tested party.

(iii) APPLICABLE BUSINESS CLASSIFICATION. The applicable business classification is the broadest category of tested operations that most corresponds to the products and functions of uncontrolled taxpayers for which sufficient reliable data is available. If, however, there is insufficient reliable data from uncontrolled taxpayers that corresponds to the tested operations, then the tested operations are divided into more than one applicable business classification, each of which corresponds to products and functions of uncontrolled parties for which reliable data is available. If the tested operations must be divided, each applicable business classification selected must be as broad as possible, while still ensuring that reliable data regarding uncontrolled parties is available. A broad classification that corresponds to the tested operations may not be divided into more specific classifications if there is sufficient reliable data relating to the broad classification. If, however, it is not possible to obtain reliable data regarding uncontrolled taxpayers that perform functions with respect to products that closely correspond to the products related to the tested operations, then the scope of the applicable business classification is broadened to include the functions performed by the tested party and as broad a category of products as is necessary to obtain reliable data. For example, if the tested operations are distribution of compact disc players, in the absence of sufficient reliable data a broader applicable business classification, such as distribution of consumer electronic products, may be appropriate. Although it is not necessary to demonstrate that there is inadequate data relating to a narrow category of products before applying a broad category of products, if it subsequently is established that there is adequate reliable data relating to a narrow category of products, then the applicable business classification will be based on that narrow category.

(6) STEP 3: COMPUTE CONSTRUCTIVE OPERATING INCOMES -- (i) IN GENERAL. Constructive operating income is computed by applying profit level indicators derived from uncontrolled taxpayers to financial data of the tested party. The selection of profit level indicators under this step depends upon two interdependent factors: first, the extent to which reliable data is available concerning similar uncontrolled taxpayers; and second, the extent to which particular profit level indicators provide a reliable basis for comparing profits of controlled and uncontrolled taxpayers under the facts and circumstances of the case.

(ii) SELECTION OF DATA RELATING TO UNCONTROLLED TAXPAYERS. Data relating to uncontrolled taxpayers must be selected from the data used for purposes of selecting the applicable business classification under paragraph (f)(5)(iii) of this section. In determining which data to select, further consideration must be given to the similarity between the uncontrolled taxpayers and the tested party. Similarity with respect to the size of the operations composing the applicable business classification and the relevant markets, as well as other factors indicating similarity, must be considered. When an uncontrolled transfer used in a method described in paragraph (d)(4)(i) of this section, or an uncontrolled transaction used in a method described in paragraphs (e)(1)(iii) and (iv) of this section is tested to determine whether it results in a level of operating income that is within the comparable profit interval, the selected group generally should include the relevant party to such uncontrolled transfer or transaction.

(iii) SELECTION OF PROFIT LEVEL INDICATORS THAT PROVIDE A RELIABLE BASIS FOR COMPARING PROFITS -- (A) IN GENERAL. Profit level indicators measure the relationship between various factors and income. A variety of different profit level indicators can be calculated in any given case. Thus, this step requires the selection of the profit level indicator (or indicators) that will produce an accurate comparison under the facts and circumstances of the particular case, depending on the nature of the activities being examined and the reliability of the available data from uncontrolled taxpayers. A profit level indicator may provide a reliable basis for comparing profits even if it can be appropriately applied only to some, but not all, of the uncontrolled taxpayers.

(B) DEFINITIONS. The following definitions apply for purposes of determining profit level indicators and computing constructive operating income:

(1) SALES. The term "sales" means the amount of total revenue from sales, less discounts and returns.

(2) GROSS INCOME. The term "gross income" means sales less cost of goods sold.

(3) OPERATING EXPENSES. The term "operating expenses" includes expenses associated with advertising, sales, marketing, administration, research and development, and a reasonable allowance for depreciation and amortization. It does not include interest expense, foreign income taxes (as described in section 1.901-2(a)), and domestic income taxes.

(4) OPERATING INCOME. The term "operating income" means gross income less operating expenses.

(5) ASSETS. The term "assets" generally means the book value of total assets (measured by the average of the book values for the beginning of the year and the end of the year). Where recent acquisitions, leased assets, purchased intangibles or currency fluctuations, or other factors create a significant difference between the book value of the assets of the controlled taxpayer and the book value of the assets of the uncontrolled taxpayers that would distort the comparison, appropriate adjustments must be made so that the asset values in each case are measured on a comparable basis.

(C) PROFIT LEVEL INDICATORS. Profit level indicators that provide a reliable basis for comparing profits may include the following:

(1) RATE OF RETURN ON ASSETS. The rate of return on assets is the ratio computed by dividing the operating income of the uncontrolled taxpayer by the assets of that taxpayer. It may be necessary to make certain adjustments to the assets of the uncontrolled taxpayers as described under the definition of assets in paragraph (f)(6)(iii)(B)(5) of this section. This profit level indicator is more reliable when the values of self-developed intangibles held by the tested party and the uncontrolled taxpayers are similar.

(2) MARGINS. Margins are ratios that are determined by relationships between income and costs. Different margins divide income and costs in different ways. Accordingly, a number of different margins may be examined, when appropriate, depending on the type of data available from the uncontrolled taxpayers. Reliable margins may include:

(i) RATIO OF OPERATING INCOME TO SALES. The ratio of operating income to sales is frequently more reliable than other margins. Because it is based on broad measures, it accommodates some variation between the functions performed by uncontrolled taxpayers and the functions performed by controlled taxpayers. Nevertheless, similarity of the economic level of production for the functions performed (e.g., manufacturer or distributor) and the type of business generally is necessary to ensure reliability.

(ii) GROSS INCOME TO OPERATING EXPENSES. The ratio of gross income to operating expenses is most reliable when the uncontrolled taxpayers perform functions that are similar to the functions performed by the controlled taxpayer. If the functions performed are different, this ratio may not be used because the composition of operating expenses will be different and may lead to inappropriate results. Review of the classification of expenses for consistency is necessary even if the functions performed by the taxpayers being compared are virtually identical. This profit level indicator may be used only when the uncontrolled taxpayers being compared have characterized material items consistently or when adjustments can be made to the accounting entries so that such items are classified consistently.

(iii) OTHER MARGINS. Other margins include, but are not limited to, the ratio of operating income to labor costs and the ratio of operating income to all expenses other than those included in cost of goods sold. Other margins should be used only when they provide reasonable indications of the income that the tested party would have earned had it dealt with controlled taxpayers at arm's length.

(3) COMPARABLE PROFIT SPLIT -- (1) IN GENERAL. A comparable profit split is derived from the combined operating income of uncontrolled taxpayers that entered transactions and performed functions similar to those of the members of the group of controlled taxpayers. Each such uncontrolled taxpayer's percentage of the combined operating income is determined and used to divide the combined operating income of the group of controlled taxpayers.

(ii) METHODS FOR DETERMINING COMPARABLE PROFIT SPLIT. Depending on the reliability of the data, a residual profit split or an overall profit split may be used.

(A) RESIDUAL PROFIT SPLIT. Under the residual profit split, income attributable to assets is determined by applying a rate of return to the value of assets held by the uncontrolled taxpayers. This amount then is subtracted from the operating income of each such uncontrolled taxpayer to yield the residual income. The sum of the uncontrolled taxpayers' residual incomes is the residual combined income. The profit split is the percentage of the residual combined income earned by each uncontrolled taxpayer. This profit split then is applied to the tested party to calculate its constructive operating income. The same rates of return that were applied to the uncontrolled taxpayers are applied to the assets of the group of controlled taxpayers, and the resulting amount then is subtracted from the combined operating income of the group of controlled taxpayers. The residual combined income then is apportioned among the group of controlled taxpayers in the same percentages that were determined for the uncontrolled taxpayers. For purposes of this paragraph (f)(6)(iii)(C)(3) of this section, assets are defined by reference to paragraph (f)(6)(iii)(B)(5) of this section, except that assets do not include intangible property. The rate of return applied to the assets should be an average rate of return earned by uncontrolled taxpayers that perform functions similar to those performed by the controlled taxpayers but that do not have significant intangibles.

(B) OVERALL PROFIT SPLIT. Under the overall profit split, the group of controlled taxpayers' profit split is determined in the same manner as under the residual profit split, but without first providing a return to assets.

(iii) RULES FOR APPLICATION OF COMPARABLE PROFIT SPLIT -- (A) LIMITATIONS ON USE OF PROFIT SPLIT. A comparable profit split may be used only if reliable financial data is available regarding the members of the group of controlled taxpayers and the uncontrolled taxpayers. In addition, a comparable profit split may be used only if the functions performed by each of the uncontrolled taxpayers are the same as the functions performed by each member of the group of controlled taxpayers. A profit split may not be used if the combined rate of return on assets earned by the uncontrolled taxpayers varies significantly from the combined rate of return on assets earned by the members of the group of controlled taxpayers. Furthermore, a profit split may not be used if an uncontrolled transferee possesses self-developed intangibles that are relevant to the applicable business classification and that contribute significantly more (or less) to the profits derived from the applicable business classification than self-developed intangibles that the related transferee owns. See EXAMPLE 8 of paragraph (f)(11) of this section for a case in which a comparable profit split cannot be used as a profit level indicator.

(B) APPROPRIATE USES OF PROFIT SPLITS. A comparable profit split is most appropriately used where the tested party and the other members of the group of controlled taxpayers employ significant self- developed intangibles that are not reflected on their financial statements, and the combined rate of return of the uncontrolled taxpayers is similar to the combined rate of return earned by the members of the group of controlled taxpayers. See Example 1 of paragraph (f)(11) of this section for a case in which a comparable profit split is applicable as a profit level indicator. Use of the residual profit split generally is most appropriate when the proportion of the combined value of assets held by each of the uncontrolled taxpayers significantly differs from the proportion of the combined value of assets held by each member of the group of controlled taxpayers. The overall profit split generally is more appropriate when the relative book value of assets is approximately equal.

(4) OTHER INDICATORS. [Reserved]

(iv) APPLYING PROFIT LEVEL INDICATOR TO CONTROLLED TAXPAYER TO COMPUTE CONSTRUCTIVE OPERATING INCOME -- (A) IN GENERAL. The profit level indicators selected in paragraph (f)(6)(iii) of this section and calculated for the uncontrolled taxpayers selected in paragraph (f)(6)(ii) of this section are applied to the relevant financial data of the tested party, adjusted as provided in paragraph (f)(6)(iv)(B) of this section, in order to compute constructive operating income.

(B) ADJUSTMENTS TO FINANCIAL DATA OF THE TESTED PARTY. For purposes of this paragraph (f), financial data of the tested party must be adjusted in two ways. First, adjustments must be made to reflect any allocations under section 482, other than adjustments made under this paragraph (or made under paragraph (d) or (e) of this section and verified under this paragraph) that affect the tested party's financial data. Second, adjustments must be made to account for material differences between the assets of the tested party and the assets of uncontrolled taxpayers, such as differences in the relative amounts of financial assets or inventory held. If the tested party's assets are adjusted, the tested party's operating income ordinarily must be adjusted to reflect income and expenses attributable to the adjusted assets. For example, an adjustment to impute carrying charges attributable to adjusted inventory may affect operating income. See Examples 5 and 9 of paragraph (f)(11) of this section, illustrating adjustments that may be made to the tested party's assets and operating income.

(C) EXAMPLES. The following examples illustrate the principles described in paragraphs (f)(6)(iv)(A) and (B) of this section.

EXAMPLE 1. Assume a selected profit level indicator is the rate of return on assets, the rate of return on assets for selected uncontrolled taxpayer A is 10.4 percent, and the assets of the tested party are $1,000. When using the rate of return on assets the relevant financial data of the tested party is the book value of the assets of the tested party. Therefore, the constructive operating income computed using the rate of return on assets derived from A is $104 (.104 x $1,000).

EXAMPLE 2. Assume the ratio of gross income to operating expenses is selected as a profit level indicator, the ratio of gross income to operating expenses for selected uncontrolled taxpayer B is 1/3, and the operating expenses of the tested party are $150. In addition, assume that a $10 rental adjustment has been made under paragraph (c) of this section. This adjustment increases the tested party's operating expenses to $160. When using the ratio of gross income to operating expenses, the relevant financial data of the tested party is its operating expenses. Therefore, constructive operating income computed for the ratio of gross income to operating expenses derived from B is $53 (1/3 x $160).

(7) STEP 4: DETERMINE THE COMPARABLE PROFIT INTERVAL. The comparable profit interval is constructed by selecting amounts of constructive operating income that converge to form an interval that is reasonably restricted in size. If there is a small number of uncontrolled taxpayers whose operations correspond closely to the applicable business classification, two types of convergence should be considered in constructing the comparable profit interval. The first type of convergence is convergence of constructive operating incomes of the tested party derived from several profit level indicators of a single uncontrolled taxpayer. Convergence of multiple constructive operating incomes derived from a single uncontrolled taxpayer indicates that the uncontrolled taxpayer and the tested party are comparable and suggests that constructive operating incomes derived from that taxpayer should be included within the comparable profit interval. When multiple profit level indicators derived from a single uncontrolled taxpayer produce amounts of constructive operating income that diverge, those amounts will be excluded from the comparable profit interval unless the uncontrolled taxpayer's financial data can be adjusted appropriately to account for the factors contributing to this lack of conformity. See paragraph (f)(6)(iii)(C) of this section for a description of potential adjustments. The second type of convergence that must be considered is convergence of constructive operating incomes derived from one or more profit level indicators obtained from multiple uncontrolled taxpayers. Constructive operating incomes that diverge from other points in the interval will be excluded from the comparable profit interval. Factors that must be considered in determining whether the constructive operating income diverges include the relative distance between the constructive operating income and the closest points in the interval compared to the distance between other points within the interval. In determining convergence, greater weight will be given to the more reliable constructive operating incomes. Reliability will be assessed by considering the quality of the underlying data with regard to its relative specificity, the similarity of the products and functions of the uncontrolled taxpayer from which the data is drawn and the tested operations, the similarity of the markets from which data is drawn, and the degree to which it fits the profit level indicator. If the number of uncontrolled taxpayers whose operations correspond to the applicable business classification is large enough to permit the use of valid statistical techniques, then convergence must be determined by using those techniques to identify a reasonably narrow area of concentration among all of the constructive operating incomes computed.

(8) STEP 5: DETERMINE THE MOST APPROPRIATE POINT IN THE COMPARABLE PROFIT INTERVAL. It may be necessary to identify the most appropriate point within the comparable profit interval under this paragraph (f)(8) for purposes of the comparable profit method described in paragraph (d)(5) of this section and other methods described in paragraph (e)(1)(iv) of this section. The most appropriate point must be determined considering all the facts and circumstances. If statistical techniques were used to construct the comparable profit interval, the most appropriate point is determined using statistical measures of central tendency. Otherwise, in selecting the constructive operating income that represents the most appropriate point, the following factors should be considered:

(i) The comparability of each uncontrolled taxpayer from which the constructive operating income was derived. Comparability for this purpose is based on --

(A) The similarity of the functions performed by the tested party to those performed by the uncontrolled taxpayer, and the similarity of the economic risks associated with those functions;

(B) The similarity of the products or services provided by the tested party to those provided by the uncontrolled taxpayer; and

(C) The extent to which different profit level indicators of the uncontrolled taxpayer produce converging results when applied to the tested party;

(ii) The extent to which adjustments are necessary to apply the profit level indicator that generated the constructive operating income. Constructive operating incomes derived from a profit level indicator requiring the fewest and most accurately quantified adjustments is accorded the greatest weight;

(iii) The extent to which the profit level indicator that generated the constructive operating income meets the reliability factors described in paragraph (f)(7)(ii) of this section; and

(iv) The extent to which the profit level indicator that generated the constructive operating income produces converging results when applied to each of the uncontrolled taxpayers used in determining the comparable profit interval.

(9) STEP 6: DETERMINE THE TRANSFER PRICE FOR THE CONTROLLED TRANSACTION. When the most appropriate point within the comparable profit interval has been determined as described in paragraph (f)(8) of this section (or, where appropriate, only the comparable profit interval has been determined under paragraph (f)(7) of this section), a transfer price for the controlled transaction is determined under the principles of paragraphs (d) and (e) of this section. The transfer price is determined by adjusting the actual charge for the controlled transaction to produce an operating income for the tested party that is equal to the constructive operating income corresponding to the most appropriate point.

(10) COORDINATION OF THE USE OF THE COMPARABLE PROFIT INTERVAL WITH OTHER ALLOCATIONS UNDER SECTION 482 -- (i) ALLOCATIONS THAT AFFECT OPERATING INCOME. For purposes of paragraph (d) of this section, the tested party's reported operating income must be adjusted to reflect all other allocations under this section that affect operating income. Similarly, for purposes of paragraph (e)(1) of this section, adjustments must be made to account for allocations that affect operating income before determining whether operating income falls within the comparable profit interval. For example, if the resale price method under paragraph (e)(3) of this section is applied, and a rental allocation is made under paragraph (c) of this section, this adjustment should be taken into account in computing operating income before determining whether operating income falls within the comparable profit interval. As described in paragraph (f)(6)(iv) of this section, such adjustments also may affect the construction of the comparable profit interval.

(ii) ALLOCATIONS THAT DO NOT AFFECT OPERATING INCOME. Income or expense adjustments under section 482 that do not affect the amount of operating income have no bearing on the application of this paragraph (f). For example, interest expense is an item of expense that is not deducted from gross income in order to calculate operating income. Therefore, any adjustments to interest expense have no effect on the determination of the comparable profit interval.

(11) EXAMPLES. The application of this paragraph (f) is illustrated by the following examples.

EXAMPLE 1 -- COMPARABLE PROFIT INTERVAL APPLIED TO CONFIRM A COMPARABLE ADJUSTABLE TRANSACTION -- (i) BACKGROUND. Controlled taxpayer CE is a foreign corporation that is wholly-owned by a domestic corporation, USCorp. In 1994, CE and USCorp conclude a 10-year license agreement pursuant to which USCorp licensed the right to use a patented manufacturing process related to the production of product P in exchange for royalty payments of 5 percent of CE's net sales of P. During the audit of USCorp's 1999 taxable year, the district director reviews whether the consideration charged for the patent is arm's length. Uncontrolled taxpayer UE operates in the same market and performs functions similar to those of CE. UE licenses rights to manufacture and sell its product Q solely from an uncontrolled taxpayer, X, and pays a royalty to X at the rate of 25 percent of its sales. Since the two transfers do not involve the same intangibles (and no other potentially matching transactions are located), the matching transaction method is not applicable. The district director determines, however, that the intangibles involved in the two transactions are similar and that the economic conditions and contractual terms involved in the two transfers meet the standards described in paragraph (d)(4)(iii) of this section. Moreover, the district director determines that differences in the intangibles, contract terms and economic conditions offset one another in such a way that the royalty rate derived from the uncontrolled transaction for purposes of determining an arm's length royalty rate for the controlled transaction should remain 25 percent. Accordingly, the transaction will serve as a comparable adjustable transaction if the royalty rate from the uncontrolled transfer results in a level of operating income for CE that is within the comparable profit interval. To make this determination, the district director develops profit level indicators from UE and other companies that perform functions similar to those that CE performs.

(ii) FINANCIAL DATA FOR CE AND UE. In order to develop profit level indicators from UE, financial data is reviewed for both CE and UE. For this purpose, data from years 1998 through 2000 is compiled and averaged. In addition, the profit earned by USCorp and X attributable to products P and Q, respectively, is calculated in order to determine the combined operating income with respect to these products. This review of financial data provides the following results (in $ thousands):

                              Data from CE            Data from UE

(iv) PROFIT LEVEL INDICATORS. The profit level indicators described in paragraph (f)(5) of this section are first analyzed with respect to the above financial data of UE to yield a percentage for each separate indicator. Those percentages can then be applied to the financial data for CE in order to derive an amount of constructive operating income for CE that conforms to each profit level indicator. The director determines that in the present case, the four following profit level indicators are appropriate, and CE's financial data does not need to be further adjusted in order to make them applicable:

(A) RETURN ON ASSETS. The UE data indicates that UE has earned a rate of return on its assets of 28.4 percent ($125 of operating income divided by $570 of assets). If CE had earned 28.4 percent on its assets, its constructive operating income would have been $162 ($570 of assets multiplied by 28.4 percent).

(B) RATIO OF GROSS INCOME TO OPERATING EXPENSES. The district director determines that given the type of intangible transferred in the controlled transaction and given the fact that royalty payments are included in operating expenses by UE, royalty payments should be included in operating expenses for purposes of applying this ratio. The UE data provides a ratio of gross income to operating expenses in the amount of 138.5 percent ($450 divided by $325). Since the controlled transaction being reviewed for CE (i.e., the royalty expense) is part of the operating expenses in this case, this ratio is applied to CE by determining the level of operating expenses yielding this ratio in relation to gross income of $550. The operating expenses required in this case would be $397 (550 divided by 138.5 percent). If CE had made royalty payments of $307 ($397 of total operating expenses minus $90 of other operating expenses), its gross income would have been $240, and its constructive operating income would have been $153 ($550 gross income minus $397 operating expenses).

(C) RATIO OF OPERATING INCOME TO SALES. The ratio of operating income to sales for UE is 12.5 percent ($125 divided by $1,000). If CE's ratio were the same, its constructive operating income would have been $150 ($1,200 of sales multiplied by 12.5 percent).

(D) PROFIT SPLIT. An analysis of the functions performed and income earned by CE and UE suggests that each has valuable self-developed intangibles. In addition, the combined rate of return on assets earned by CE and US Corp of 36.3% ([400 + 150]/[570 + 1000]) does not differ significantly from the combined rate or return on assets earned by UE and X of 34.1% ([125 + 400]/[440 + 1100]). Based on the foregoing, the district director determines that a profit split is an appropriate profit level indicator in this case. The district director determines that an appropriate return for UE's measurable assets is 15.0% and that an appropriate return for X's measurable assets is 10.0%. Subtracting these amounts from the operating income of each leaves a residual combined operating income of $349 (125 - [.15 x 440] + 400 - [.10 x 1100]). UE's residual operating income of 59 (125 - .15 x 440) represents 16.9% of the residual combined operating income. If CE had earned 15.0% on its measurable assets of 570 and X had earned 10% on its measurable assets of 1000 their residual combined operating income would be $384 (570 - [.15 x 570] - [.10 x 1000]). If CE had earned 16.9% of this residual combined operating income, then CE's constructive operating income would have been $151 ([.15 x 570] + [.169 x 384]).

(v) SUMMARY OF PROFIT LEVEL INDICATORS FROM UE. The following chart summarizes each of the profit level indicators derived from UE and the profit results when those indicators are applied to CE's financial data:

                                              Constructive

(vii) FURTHER ANALYSIS. The district director reviews other companies that are less comparable to CE than UE, but that perform functions similar to those performed by CE and operate in similar markets. Data from these other companies is not given as much weight as the data from UE. Nevertheless, the data confirms that any reasonable construction of an comparable profit interval would include $160 as an appropriate amount of constructive operating income for CE. Since the results from other similar companies confirm the above findings, it can be concluded that the royalty rate of 25 percent used by UE would have resulted in CE being within the comparable profit interval and that the transaction between UE and X meets the requirements for the comparable adjustable transaction method under paragraph (d)(4) of this section.

(viii) ADJUSTMENT. Based on the above review of UE and other similar companies, the district director determines that the royalty rate of 25 percent derived from the license between UE and X, resulting in $160 of operating income for CE, should serve as a comparable adjustable transaction as defined in paragraph (d)(4) of this section. Accordingly, for 1999 the district director adjusts the royalty to be received by USCorp to 25 percent of CE's sales.

EXAMPLE 2 -- COMPARABLE PROFIT INTERVAL APPLIED TO DISQUALIFY POTENTIAL COMPARABLE ADJUSTABLE TRANSACTION. (i) The facts are the same as in Example 1 except that a different uncontrolled taxpayer, DE, also is found. DE licenses rights to manufacture and sell its product B solely from an uncontrolled taxpayer, G, and pays a royalty to G at a rate of 5 percent of its sales. CE paid an amount of consideration consistent with the DE license agreement. If DE's license from G were a comparable adjustable transaction, the district director would need to determine whether CE's operating income result of $400 were within the comparable profit interval. The results from other uncontrolled taxpayers derived in Example 1 suggest that CE's operating income of $400 would have been outside of this interval. Nevertheless, the district director examines DE's financial data to determine if this information suggests that inappropriate weight was given to the results in Example 1.

(ii) FINANCIAL DATA FOR DE. Averaged data for DE from years 1998 through 2000 is as follows (in $ thousands):

                                 Data from DE

                                PLI              Operating

EXAMPLE 3 -- TRANSFER OF TANGIBLE PROPERTY RESULTING IN NO ADJUSTMENT. (i) Foreign Parent (FP) is a publicly-traded foreign corporation with a U.S. subsidiary (USS) that is under audit for its 1994 taxable year. FP manufactures a consumer product for worldwide distribution and has developed a trademark that has significant U.S. marketing value. USS imports the finished product and distributes it within the United States under that trademark. USS's income attributable to the trademark is material in relation to the income attributable to the sale of the product alone.

(ii) In accordance with paragraph (d)(1)(iii) of this section, the district director applies an analysis based on paragraph (d)(5) of this section to determine an arm's length price for sales of the product from FP to USS.

(iii) Based on all the facts and circumstances, the district director determines that USS should be the tested party. Accordingly, the district director reviews the financial data of USS for the taxable years preceding and following the taxable year under review. The district director determines that no adjustments to the financial data of USS are necessary under paragraph (f)(6)(iv)(B) of this section. For the taxable years 1993 through 1995, USS shows the following results (in $ thousands):

                       1993     1994       1995       Average

 Unrelated           USS              USS               USS

EXAMPLE 4 -- TRANSFER OF TANGIBLE PROPERTY RESULTING IN ADJUSTMENT. (i) The facts are the same as in Example 3 except that USS reported the following income and expenses (in $ thousands):

                           1993      1994       1995     Average

     Operating Income/Sales (OI/S)                  0%

      Unrelated           USS              USS                USS

EXAMPLE 5 -- TRANSFER OF TANGIBLE PROPERTY WITH ADJUSTMENT FOR INVENTORY. (i) The facts are the same as Example 4 except that USS has assets of $450 million in 1993, 1994 and 1995. Applying the same profit level indicators derived from the same uncontrolled distributors to USS now produces the following constructive operating incomes for USS (in $ thousands):

      Unrelated            USS              USS               USS

     USS          1993        1994      1995       Average

(v) Based on the foregoing, the district director reduces USS's reported operating income for 1993 and 1994 by $5,800,000, and the reported operating income for 1995 by $6,496,000. Thus, USS's reported operating income for 1993 is $14,200,000, for 1994 it is ($15,800,000) and for 1995 it is ($16,496,000). The average reported operating income for the three years is adjusted under paragraph (f)(6)(iv)(B) of this section to ($6,032,000).

(vi) The comparable profit method under paragraph (d)(5) of this section is then applied, based on the assets as adjusted above, to determine whether the adjusted operating income of ($6,032,000) is within the comparable profit interval.

EXAMPLE 6 -- TRANSFER OF INTANGIBLE TO OFFSHORE MANUFACTURER. (i) DevCo is a U.S. developer, producer and marketer of widgets. DevCo develops and patents new production techniques for the widgets. The widgets are manufactured by Devco's foreign subsidiary, ManuCo, located in Country H. ManuCo and Devco enter a license agreement pursuant to which Devco transfers the right to use the patent to ManuCo in return for a royalty equal to 5 percent of ManuCo's widget sales. ManuCo sells the widgets to MarkCo, a U.S. subsidiary of DevCo, for distribution and marketing in the United States. The price that DevCo charges to MarkCo for the widgets is determined to be a comparable uncontrolled price within the meaning of paragraph (e)(2) of this section. The district director examines whether the royalty rate of 5 percent paid by ManuCo to DevCo for taxable year 1994 is an arm's length consideration for the patent. No matching transactions or comparable adjustable transactions are available. Accordingly, the district director examines whether the operating income of ManuCo is within the comparable profit interval. To begin this analysis, the district director examines ManuCo's financial data from 1993-1995, which is as follows (in $ thousands):

                                1993    1994      1995     Average

(ii) In order to compare ManuCo's profits with those of other companies, the district director analyzes companies performing similar functions. No information on uncontrolled taxpayers in country H that perform similar functions is available. Other uncontrolled manufacturers exist in country H. However, the functions they perform are significantly different from those performed by ManuCo. The country H uncontrolled manufacturers produce products at the direction of their purchasers, who maintain supervision over all aspects of the production, including the amount produced. In addition, raw materials are either purchased from the buyer or made at the direction of the buyer and all processes employed in the manufacturing operation are owned by the buyers.

(iii) Since reliable data from comparable country H companies is unavailable, companies performing the most similar functions in the most similar markets are considered. The district director determines that data available in country M provides the best match of companies in a similar market performing similar functions.

(iv) Applying the principles of paragraph (f)(6) of this section to financial information from the uncontrolled country M companies, the district director computes the following constructive operating incomes from the uncontrolled country M companies (in $ thousands):

      Unrelated                ManuCo                        ManuCo

EXAMPLE 7 -- TRANSFER OF INTANGIBLE TO MANUFACTURER/ DISTRIBUTOR. The facts are the same as Example 6 except that ManuCo no longer sells to its controlled affiliate, MarkCo. ManuCo manufactures the widgets for sale in a region outside the United States and is responsible for distribution and marketing in that region. No information on uncontrolled taxpayers performing this set of functions in country H is available. In addition, no companies performing similar functions can be found in country M (since these functions are significantly different from the functions reviewed under the facts of Example 6). Companies performing the most similar functions in the most similar market are found in the United States. Therefore, the type of analysis undertaken in EXAMPLE 6 is repeated using a selection of U.S. companies to generate profit level indicators which are then applied to ManuCo.

EXAMPLE 8 -- TRANSFER OF INTANGIBLE WITH PROFIT SPLIT.

(i) The facts are the same as Example 7 except that more information is available with respect to RW, an uncontrolled U.S. taxpayer. Specifically, enough information is available to calculate the way that the profits are split between company RW and the uncontrolled taxpayer from which company RW licenses its intangible. The district director examines the following information to determine whether the analysis in EXAMPLE 7, above, should be reconsidered:

                                                       Percent of

EXAMPLE 9 -- TRANSFER OF INTANGIBLE WITH ADJUSTMENT FOR FINANCIAL ASSETS. The facts are the same as Example 6, above, except that ManuCo has assets of $45 million. Examination of ManuCo's balance sheet suggests that ManuCo has an unusually high ratio of financial assets to total assets. Based on a comparison of the financial assets held by ManuCo and those held by the comparable companies, the district director determines that $20 million of ManuCo's assets should be segregated as excess financial assets. These financial assets are invested with uncontrolled taxpayers and earn a market rate of return. Segregation of the excess financial assets is necessary in order to enhance the reliability of the ratio of operating income to assets. Therefore, these financial assets are not included in the total assets when calculating constructive operating income and the income earned from these financial assets is not included in ManuCo's reported operating income within this applicable business classification. ManuCo's assets used in the calculation of operating income/assets are adjusted to $25 million and the analysis proceeds as in Example 6.

(g) SHARING OF COSTS AND RISKS -- (1) IN GENERAL -- (i) LIMITATION ON ALLOCATIONS. If a member of a group of controlled taxpayers acquires an intangible as an eligible participant in a qualified cost sharing arrangement, the district director may make allocations with respect to that acquisition to reflect each participant's arm's length share of the costs and risks of developing the intangible, under the rules of this paragraph (g). If a member of a group of controlled taxpayers acquires an intangible from another member of the group through any means other than as an eligible participant in a qualified cost sharing arrangement, then the district director may make appropriate allocations to reflect an arm's length consideration for the intangible under the rules of paragraph (d) of this section.

(ii) SCOPE OF REGULATIONS. An arrangement for the development of intangibles will be considered a qualified cost sharing arrangement only if it meets the requirements of paragraph (g)(2) of this section. A member of a group of controlled taxpayers will be considered an eligible participant only if it meets the requirements of paragraph (g)(3) of this section. Paragraph (g)(4) of this section describes the allocations that may be made by the district director to reflect an eligible participant's arm's length share of the costs and risks of developing intangible property in a qualified cost sharing arrangement. The character of payments made pursuant to a qualified cost sharing arrangement is described in paragraph (g)(5) of this section. Paragraph (g)(6) of this section sets forth administrative requirements, and additional definitions are provided in paragraph (g)(7) of this section. Paragraph (g)(8) of this section sets forth a transitional rule.

(2) QUALIFIED COST SHARING ARRANGEMENT -- (i) IN GENERAL. A qualified cost sharing arrangement must --

(A) Include two or more eligible participants;

(B) Be recorded in writing contemporaneously with the formation of the cost sharing arrangement;

(C) Provide for the sharing among eligible participants of the costs and risks borne by any participant of developing one or more intangibles in return for a specified interest in any intangible that may be produced;

(D) Reflect a reasonable effort by each eligible participant to share all of the costs and risks of intangible development, including the costs and risks of unsuccessful or less successful related development, such that each eligible participant's share of the costs and risks is proportionate to the benefits that each eligible participant reasonably anticipates it will receive from the exploitation of intangibles developed under the arrangement; and

(E) Meet the administrative requirements described in paragraph (g)(6)(i) of this section.

A cost sharing arrangement that includes ineligible participants may still be a qualified cost sharing arrangement but only with respect to its eligible participants. See paragraph (g)(3)(vi) of this section for rules applicable to ineligible participants.

(ii) COSTS PROPORTIONATE TO BENEFITS -- (A) IN GENERAL. A cost sharing arrangement must establish a method that, under all the facts and circumstances (including information about the markets in which the intangible is likely to be exploited), reflects a reasonable effort to share the costs of developing intangibles in proportion to the benefits that each eligible participant anticipates it will receive from the exploitation of intangibles developed under the arrangement. Under appropriate circumstances, anticipated benefits may be measured by reference to anticipated units of production (where there is a uniform unit of production for all participants), anticipated sales (measured at the same level of the production or distribution process for all participants), anticipated gross or net profit, or any other measure that reasonably predicts the benefits to be shared. If the intangible development benefits more than one qualified cost sharing arrangement, the anticipated benefits of a participant of any of those arrangements must be measured by reference to all such arrangements.

(B) ADJUSTMENTS TO THE METHOD USED. A method reflects a reasonable effort to share costs in proportion to benefits only if it provides that the costs shared by each eligible participant must be adjusted to account for changes in economic conditions, the business operations and practices of the participants, and the ongoing development of intangibles under the arrangement. Such adjustments must ensure that the method continues to reflect a reasonable effort to share costs in proportion to benefits over time, and they should generally be made on an annual basis.

(C) PRESUMPTION BASED ON OPERATING INCOME -- (1) IN GENERAL. A method will be presumed not to reflect a reasonable effort to share costs in proportion to benefits if a U.S. participant's cost/income ratio is grossly disproportionate to the cost/income ratio of all other eligible participants. The U.S. participant may rebut this presumption by establishing that the method used in the arrangement provides a reasonably accurate measure of benefits.

(2) COST/INCOME RATIO. The cost/income ratio of a U.S. participant is the average of the cost of developing intangibles borne by the participant divided by the participant's average operating income attributable to intangibles developed under the arrangement. The cost/income ratio of other eligible participants is the sum of the other participants' average costs divided by the sum of their average operating incomes attributable to intangibles developed under the arrangement. For this purpose, the average cost of developing intangibles and average operating income is calculated by using the average of such amounts from the current taxable year and the two preceding taxable years. However, different periods for costs, income, or both may be used if amounts from such periods more clearly reflect the relationship between the cost of developing intangibles and operating income attributable to intangibles developed under the arrangement. For example, different periods may be used to reflect the effect of the time between the year in which the development costs were incurred and the year in which the benefits from developed intangibles were realized.

(3) OPERATING INCOME ATTRIBUTABLE TO INTANGIBLES. Operating income attributable to intangibles developed under the arrangement is all operating income that is directly or indirectly attributable to the intangible development area, without reduction for the cost of developing intangibles and without regard to cost sharing payments. Such income includes income from the license or sale of intangibles developed under the cost sharing arrangement, and income earned with respect to the sale of products or services incorporating developed intangibles.

(4) CROSS REFERENCES. U.S. participant is defined in paragraph (g)(7)(iii) of this section. Operating income is defined in paragraph (f)(6)(iii)(B)(4) of this section. Cost of developing intangibles is defined in paragraph (g)(7)(ii) of this section.

(iii) DISCRETION TO APPLY COST SHARING. In unusual circumstances in which application of the developer-assister rules under paragraph (d)(8) of this section would not clearly reflect the income of a member of a group of controlled taxpayers, the district director may apply the rules of this paragraph (g) to any arrangement that in substance constitutes a cost sharing arrangement (notwithstanding a failure to comply with any requirement of this section).

(3) ELIGIBLE PARTICIPANT -- (i) IN GENERAL. For purposes of this paragraph (g), an eligible participant is a member of a group of controlled taxpayers that agrees to participate in a qualified cost sharing arrangement, if the participant meets the administrative requirements described in paragraph (g)(6)(ii) of this section, and if intangibles developed under the arrangement are, or will be, used in the active conduct of the participant's trade or business. Rules describing whether an intangible is used in the active conduct of a participant's trade or business are provided in paragraphs (g)(3)(ii), (iii), and (iv) of this section. A special rule for the treatment of a group of controlled taxpayers as a single eligible participant is provided in paragraph (g)(3)(v) of this section.

(ii) TRADE OR BUSINESS. The rules of section 1.367(a)-2T(b)(2) apply in determining whether the activities of a participant in a cost sharing arrangement constitute a trade or business. For this purpose, the term "participant in a cost sharing arrangement" must be substituted for the term "foreign corporation".

(iii) ACTIVE CONDUCT. In general, a participant actively conducts a trade or business only if it carries out substantial managerial and operational activities. For this purpose, managerial and operational activities carried out on behalf of the participant by independent contractors may be attributed to the participant, but only to the extent that the participant bears the economic risks, and receives the benefits, of those activities.

(iv)(A) USE OF INTANGIBLES IN THE ACTIVE CONDUCT OF A TRADE OR BUSINESS. In general, an intangible is used in the active conduct of a trade or business of a participant if it is held for the purpose of promoting the participant's conduct of that trade or business, or is otherwise held in a direct relationship to that trade or business. 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.

(B) EXAMPLE. The following example illustrates a substantial purpose:

EXAMPLE. Controlled corporations A, B and C enter into a qualified cost sharing arrangement for the purpose of developing an improved Product X. Costs are shared equally among the three taxpayers. A, B, and C have exclusive rights to sell Product X in North America, South America and Europe, respectively. When an improved Product X is developed, C manufacturers and sells the new product in most of Europe. However, for sound business reasons, C licenses the right to use the new product technology to manufacture and sell products, within a small European country, to an unrelated manufacturer. Exploitation of the new Product X technology in that country is not a substantial transfer of the technology. The district director will not presume that C entered into the cost sharing arrangement with a substantial purpose of obtaining intangible property to license or sell to an uncontrolled taxpayer.

(v) TREATMENT OF CONTROLLED TAXPAYERS AS A SINGLE PARTICIPANT -- (A) IN GENERAL. One member of a group of controlled taxpayers may participate in a cost sharing arrangement on behalf of one or more other members of the group (the "cost sharing subgroup"). For purposes of applying the rules of this paragraph (g) to such a cost sharing arrangement, the cost sharing subgroup will be treated as a single participant in the arrangement. Whether the coat sharing subgroup is treated as an eligible participant under the arrangement will be determined on the basis of all of the activities performed by members of the cost sharing subgroup. Whether the arrangement establishes a method that reflects a reasonable effort to share the costs of developing intangibles in proportion to the anticipated benefits must be determined on the basis of the benefits that the cost sharing subgroup reasonably anticipates receiving from the exploitation of intangibles developed under the arrangement.

(B) TRANSFERS WITHIN COST SHARING SUBGROUP -- (1) IN GENERAL. Any intangible acquired pursuant to a qualified cost sharing arrangement in which a cost sharing subgroup is treated as a single eligible participant will be considered acquired solely by the member participating in the arrangement on behalf of the cost sharing subgroup. Accordingly, any transfer of that intangible by the participating member to any other member of the cost sharing subgroup is a transfer of an intangible subject to the rules of paragraph (d) of this section.

(2) ARRANGEMENT WITHIN COST SHARING SUBGROUP. The rule of the preceding paragraph (g)(3)(v)(B)(1) of this section will not apply if all the members of the cost sharing subgroup have themselves entered into a separate qualified cost sharing arrangement, pursuant to which they have reimbursed the participating member for an appropriate share of the arrangement's costs. In that case, any intangible acquired pursuant to the first cost sharing arrangement will be considered acquired by each member of the cost sharing subgroup that is an eligible participant in the separate cost sharing arrangement. The treatment of the separate cost sharing arrangement within the cost sharing subgroup must be determined under the rules of this paragraph (g).

(vi) TREATMENT OF INELIGIBLE PARTICIPANT. If a qualified cost sharing arrangement has one or more ineligible participants in a taxable year, the costs of developing intangibles incurred by those participants in that taxable year must be taken into account by the eligible participants in determining their cost shares. An ineligible participant that is a member of the controlled group of taxpayers must be treated as an assister under the rules of paragraph (d)(8) of this section. Consideration for the transfer of an intangible that is due from an ineligible participant must be allocated among eligible participants in proportion to the share of costs of each eligible participant. See paragraph (g)(4)(iv) of this section for rules applicable to eligible participants that become ineligible participants in a qualified cost sharing arrangement.

(4) ALLOCATIONS WITH RESPECT TO QUALIFIED COST SHARING ARRANGEMENTS -- (i) APPROPRIATE SCOPE OF INTANGIBLE DEVELOPMENT AREA -- (A) IN GENERAL. The district director may make allocations with respect to a qualified cost sharing arrangement to ensure that the intangible development area covered by the agreement is broad enough to encompass related intangible development (as described in paragraph (g)(4)(i)(B) of this section), and narrow enough so that the costs shared are for the development of products or services that are of potential use (as described in paragraph (g)(4)(i)(C) of this section) to each eligible participant. An intangible development area is a classification of products or services with respect to which intangible development is conducted under a qualified cost sharing arrangement.

(B) RELATED INTANGIBLE DEVELOPMENT. Related intangible development consists of all intangible development, including basic research, that may reasonably be regarded as leading to the development of any product or service in the stated intangible development area, without regard to whether such products or services are ever successfully developed or sold. Related intangible development also includes any activity, conducted or funded by any participant, relating to similar products or services. Whether products or services are similar for this purpose will be determined by examining all facts and circumstances that demonstrate the practical or scientific relationship between the intangible development activities engaged in with respect to the products or services. For this purpose, consideration will be given to the participants' prior business practices, the business practices of uncontrolled taxpayers in the same or related businesses, and the three-digit Standard Industrial Classification code which includes such products or services. If an intangible development area used in a qualified cost sharing arrangement is determined to be too narrow, the district director may make appropriate allocations to cost shares under this paragraph (g) so that all costs attributable to related intangible development are shared by the eligible participants. See paragraph (g)(4)(iii) of this section for rules pertaining to the taxable years with respect to which allocations will be made and the computation of interest charges with respect to such allocations.

(C) POTENTIAL USE OF PRODUCTS OR SERVICES. An intangible development area covers costs for the development of products or services that are of potential use to an eligible participant if it is reasonable to expect that new products or services within the area will be used in the active conduct of a trade or business of that participant in a commercially significant manner. An intangible development area must exclude any significant area of intangible development if it is reasonable to expect that the intangible development will lead to products or services that are not of potential use to an eligible participant. If an intangible development area used in a qualified cost sharing arrangement is determined to be too broad, the district director may make appropriate allocations under this paragraph (g) so that only those costs attributable to the development of products or services that are of potential use to eligible participants are shared under the arrangement. See paragraph (g)(4)(iii) of this section for rules pertaining to the taxable years with respect to which allocations will be made and the computation of interest charges with respect to such allocations.

(D) EXAMPLES. The following examples illustrate the appropriate scope of an intangible development area:

EXAMPLE 1. A group of controlled taxpayers in the automotive industry enters a cost sharing arrangement under which they develop new engine technologies. The group has members in Country A and the United States. Part of the intangible development conducted by the members relates exclusively to electric motors and has no potential application to internal combustion engines. The Country A members of the group do not presently and do not anticipate in the future producing or selling automobiles with electric motors. An appropriate intangible development area for the group' s cost sharing arrangement will not include the electric motor development since it is reasonable to expect that such intangible development will lead to products that are not of potential use to the Country A members.

EXAMPLE 2. The facts are the same as in Example 1, above. In addition, one member of the group conducts intangible development related to developing high performance engines that are used in race cars. This intangible development is not directly related to any products that the group markets commercially. However, in the past certain advances made in race car development have been applied commercially, and it is reasonable to expect that the intangible development will continue to yield technologies that will be exploited commercially. An appropriate intangible development area for the group's cost sharing arrangement will include this high performance intangible development, since it is reasonable to expect that new products within the area could be used by each member of the arrangement.

(ii) APPROPRIATE METHOD FOR SHARING COSTS -- (A) IN GENERAL. The district director may make allocations with respect to a qualified cost sharing arrangement to ensure that the method used for sharing costs is an appropriate measure of the benefits reasonably anticipated by each eligible participant. Such allocations may be required when the method chosen fails to accurately reflect the reasonably anticipated benefits over time. Unless another method of sharing costs provides a more reliable measure of the participant's reasonably anticipated benefits over time, an allocation may be made by reference to a comparison of the participant's cost/income ratio and the cost/income ratio of the other eligible participants. Paragraphs (g)(4)(ii)(B) through (E) of this section describe the allocations that may be made to reflect an appropriate method of sharing costs. See paragraph (g)(4)(iii) of this section for rules pertaining to the taxable years with respect to which allocations will be made and the computation of interest charges with respect to such allocations.

(B) ADJUSTMENTS TO COSTS SHARED. If a U.S. participant's cost/income ratio is not substantially disproportionate to the cost/income ratio of the other eligible participants, allocations that may be made under this paragraph (g)(4)(ii) will be limited to appropriate adjustments with respect to the costs of developing intangibles shared by that participant. Paragraph (g)(4)(ii)(D) of this section describes when a participant's cost/income ratio will not be considered substantially disproportionate. The cost/income ratio is defined in paragraph (g)(2)(ii)(C)(2) of this section.

(C) ADJUSTMENTS BASED ON A SUBSTANTIALLY DISPROPORTIONATE COST/INCOME RATIO. If a U.S. participant's cost/income ratio is substantially disproportionate to the cost/income ratio of the other eligible participants, a transfer of an intangible may be deemed to have occurred outside of the scope of the arrangement; in that case, allocations may be made under the rules of paragraph (g)(4)(iv)(A) of this section (buy-in and buy-out) to reflect an arm's length consideration for that portion of the intangible deemed to have been transferred. The portion of the intangible deemed to have been transferred will be measured by the difference between the U.S. participant's cost/income ratio and the cost/income ratio of the other eligible participants. Alternatively, appropriate adjustments with respect to the costs of developing intangibles shared by that participant may be made under paragraph (g)(4)(ii)(B) of this section.

(D) PROPORTIONATE PROFITS RULE. A U.S. participant's cost/income ratio will not be considered substantially disproportionate if it is less than twice the cost/income ratio of the other eligible participants. That is, this rule will apply if:

                                         Sum of Other

EXAMPLE 1. (i) A U.S. participant in a long-standing cost sharing arrangement for the development of manufacturing technology is audited for its 1993 taxable year. In order to determine the type of adjustment that potentially could be made, the district director applies the formula described in paragraph (g)(4)(ii)(D) of this section. Paragraph (g)(2)(ii)(C)(2) of this section requires that this formula generally be applied to the current year and the two preceding years. The following information is known about the participants in the cost sharing arrangement:

                                          ($ Thousands)

(iii) Since the U.S. participant's cost/income ratio in paragraph (ii) of this Example 1 is less than twice the other participant's cost/income ratio, the U.S. participant's cost/income ratio will not be considered substantially disproportionate to the other participant's cost/income ratio. Accordingly, the district director will limit any allocation to an adjustment to the costs borne by the U.S. participant.

(iv) The district director determines, based on all the facts and circumstances, that the intangible development expenses generate only current benefits and that the participants' current operating incomes attributable to the product area encompassed by the cost sharing arrangement accurately reflect the relative benefits that each participant derives from current intangible development expenses. Accordingly, the participants' cost/income ratios for 1993 should be approximately equal. The U.S. participant's cost/income ratio of .56 is not approximately equal to the other participant's cost/income ratio of .4. Therefore, the district director decreases the U.S. participant's 1993 cost share payment in the amount of $3. The district director also increases the 1993 cost share payment of the other participant in the amount of $3, which is treated as a reimbursement of intangible development expenses to the U.S. participant in accordance with paragraph (g)(5) of this section. After these allocations, the U.S. participant's 1993 cost/income ratio is .49 ($17/$35), and the other participant's 1993 cost/income ratio is .47 ($28/$60).

EXAMPLE 2. (i) The facts are the same as in Example 1, above, except that the U.S. participant manufactures the product, markets it and distributes it under its trade name, and the other participant manufactures the product and immediately sells it to an unrelated entity. Because the U.S. participant performs significant non-manufacturing functions not performed by the other participant, the district director determines that the participants' operating incomes are not an accurate measure of the relative benefits that the participants derive from intangible development conducted pursuant to the cost sharing arrangement. Rather, the district director determines that the relative benefits that the participants derive are most accurately measured by a comparison of their respective unit sales volumes. The participants' unit sales volumes for 1993 are as follows:

     U.S. Participant

(iii) To reflect accurately the benefits that each participant derived from the research and development conducted pursuant to the cost sharing arrangement, the district director compares the number of unit sales per dollar of cost share payment generated by the U.S. participant and the other participant in 1993. The U.S. participant's ratio of cost share payments to unit sales for 1993 is .2 ($20/$100), and the ratio of the other participant's cost share payments to unit sales for 1993 is .12 ($25/$215). To approximately equalize these ratios, the district director decreases the U.S. participant's 1993 cost share payment by $6, and increases the other participant's payment by $6. After adjustment, the U.S. participant's ratio of cost share payments to unit sales is .14 ($14/$100), and the other participant's ratio of cost share payments to unit sales is .14 ($31/$215).

EXAMPLE 3. (i) Assume that the facts are the same as in Example 1, above, except that the cost share payments of the participants are as follows:

                                        ($ Thousands)

(iii) The U.S. participant presents data relating to later years that demonstrates that its cost/income ratio would not be considered substantially disproportionate if data from such years were used. The U.S. participant explains that in its business there normally is a two year lapse between the time that development of a new product is completed and the time that the product is introduced commercially. In order to match its costs and benefits more precisely, the cost sharing arrangement apportions the cost sharing payments among the participants based on anticipated sales two years in the future. Therefore, 1993 costs were apportioned based on anticipated sales in 1995. The relatively high payment by the U.S. participant in 1993 was in anticipation that the U.S. market for the product line was expanding.

(iv) The following data from the years 1990 through 1995 confirms that the U.S. market was expanding relative to the other markets:

                                     ($ Thousands)

                            ($ Thousands)

EXAMPLE 4. (i) The facts are the same as in Example 3, above, except that after modifying the analysis, as described in paragraph (iv) of Example 3, the U.S. participant's cost/income ratio is still more than twice the cost/income ratio of the other participant. The district director determines that the portion of costs borne by the U.S. participant from 1990-1995 was substantially disproportionate to the portion of costs borne by the other participant. Therefore, the district director may deem a transfer of an intangible to have occurred outside of the scope of the arrangement.

(ii) The district director determines that the portion of the intangible deemed to have been transferred (measured by the difference between the U.S. participant's cost/income ratio and the cost/income ratio of the other eligible participant) is 50%. Pursuant to paragraph (d) of this section, the district director determines that at arm's length the U.S. participant would have charged a royalty equal to 6 percent of sales to an uncontrolled taxpayer using the intangible in the same markets as the other participant. Therefore, the district director determines that the other participant should pay the U.S. participant a royalty for the use of the patent equal to 3 percent of sales (i.e., half of an arm's length royalty).

EXAMPLE 5. (i) In 1993, a U.S. corporation enters a cost sharing arrangement with a foreign affiliate. Neither party contributes any intangibles to the arrangement. The parties anticipate that the intangible development performed in connection with the cost sharing arrangement will result in commercial sales in 1995, and that the relative benefits that the parties will derive from the intangible development will be most accurately measured by the dollar sales volumes of products incorporating developed intangibles. The written agreement representing the terms of the arrangement provides that the U.S. participant will bear 70 percent and the foreign participant 30 percent of the costs of developing intangibles, respectively. The actual cost share payments by the two participants and their incomes attributable to sales of products incorporating developed intangibles are as follows:

                            ($ Thousands)

                            ($ Thousands)

(iii) TIMING OF ALLOCATIONS AND THE COMPUTATION OF INTEREST CHARGES. If the district director makes an allocation under the provisions of paragraph (g)(4)(ii)(B) of this section, the allocation must be included in income in the taxable year under review, even if the costs to be allocated were incurred in a prior taxable year. If such an allocation is made, appropriate interest adjustments must be made in accordance with paragraph (a)(2) of this section. Thus, for example, if the district director allocates additional cost sharing payments from a foreign subsidiary to its U.S. parent corporation, the allocation must include the computation of interest with respect to the subsidiary's underpayment of costs in prior taxable years.

(iv) BUY-IN AND BUY-OUT PAYMENTS -- (A) IN GENERAL. If an eligible participant in a qualified cost sharing arrangement transfers an intangible that it owns to another member of the group of controlled taxpayers, an arm's length consideration for the transfer must be determined under the provisions of paragraph (d) of this section. Such a transfer may occur, for example, if the intangible is developed outside of the arrangement, if the intangible is developed inside the arrangement but transferred to a new participant in the arrangement, or if the intangible is developed inside the arrangement but additional rights in it are transferred to existing participants upon the departure of a participant. Paragraph (g)(4)(iv)(B) of this section addresses the form of consideration in such cases. Paragraph (g)(4)(iv)(C) of this section addresses transfers accomplished by the relinquishment of rights. In addition, the provisions of paragraph (d)(8) of this section apply to determine whether any member of the controlled group must receive compensation for assistance rendered in the development of the intangible. For the purposes of paragraph (d)(8) of this section, the eligible participants of a cost sharing arrangement may be treated as a single person.

(B) FORM OF CONSIDERATION. The consideration for a transfer described in this paragraph (g)(4)(iv) may take any of the following forms:

(1) LUMP SUM PAYMENTS. [RESERVED]

(2) INSTALLMENT PAYMENTS. Installment payments spread over the period of use of the intangible by the transferee, with interest calculated in accordance with paragraph (a)(2) of this section; and

(3) ROYALTIES. Royalties or other payments contingent on the use of the intangible by the transferee. The consideration is owed to the person that transfers the intangible to the eligible participant. For example, if a new participant receives rights to an intangible being developed under a qualified cost sharing arrangement, and those rights are limited to the use of that intangible in a portion of the geographic area in which exclusive rights were previously held by a single participant, the consideration is owed solely to the participant who owned the exclusive geographic rights.

(C) RELINQUISHMENT OF RIGHTS. An eligible participant in a qualified cost sharing arrangement may be deemed to have acquired rights in an intangible if another participant (a "departing participant") transfers, abandons, or otherwise relinquishes some or all of its rights under the arrangement, to the benefit of one or more of the remaining participants. Once a relinquishment of rights occurs, a departing participant may not subsequently exploit the rights to any intangible deemed relinquished unless it pays the remaining participants an arm's length consideration determined in accordance with the rules of paragraph (d) of this section.

(D) EXAMPLES. The following examples illustrate payments described in this paragraph (g)(4)(iv):

EXAMPLE 1. Three members of a controlled group decide to form a cost sharing arrangement for the development of a car that can run at normal speeds without the use of fossil fuels. Based on a reasonable projection of their future benefits, each company agrees to bear an equal share of the costs incurred during the term of the agreement. Each member contributes $1 million. The third member also contributes plans for a motor. The two members contributing only money must pay the member contributing intangible property their share of the fair market value of the motor plans, in accordance with paragraph (d) of this section.

EXAMPLE 2. In year one, four foreign controlled taxpayers enter into a cost sharing arrangement to develop a commercially feasible process for capturing energy from nuclear fusion. The cost of developing intangibles for each participant with respect to the project is approximately $1 million per year. Based on a reasonable projection of their future benefits, each company bears an equal share of the costs. In year ten, a fifth controlled taxpayer joins the cost sharing group and agrees to bear one-fifth of the future costs in exchange for rights which are anticipated to represent one-fifth of the total benefit. The fair market value of intangible property within the arrangement at the time the fifth company joins the arrangement is $45 million. The new member pays one-fifth of that amount to the prior participants (that is, $9 million dollars total, or $2.25 million to each existing member). The principles of paragraph (d) of this section may be used to determine whether the new member's payment was commensurate with the income attributable to any intangible that is eventually developed.

EXAMPLE 3. Domestic corporation M enters into a qualified cost sharing arrangement with its foreign parent, N, for the purpose of developing new products within the Group X product line. M and N share costs on the basis of the dollar value of sales in Group X products. Under an informal arrangement, M sells products in North America and N sells products in the rest of the world. N sells $10 million of Group X products every year. M sells $1 million of Group X products in the first year of the arrangement. However, each year M's Group X product line sales increase by $1 million resulting in $10 million in annual sales in the tenth year of the arrangement. Accordingly, M increases the share of costs it bears. In the arrangement's tenth year, the Group X product developers make a major breakthrough. N decides to open a manufacturing plant in Mexico, and to sell its Group X product line in North America. M subsequently closes most of its factories, decreasing its total Group X product line sales to $1 million per year, and reducing its share of the costs of developing intangibles accordingly. M may be deemed a departing member of the cost sharing arrangement in the arrangement's tenth year.

EXAMPLE 4. In year one, domestic pharmaceutical corporation M enters into a qualified cost sharing arrangement with its foreign parent, N, and a sister company, O, to develop a cure for the common cold. For ten years, each company contributes $1 million annually to the cost sharing arrangement. In the tenth year, M withdraws from the arrangement and is paid a buy-out amount of $10 million, plus interest. This amount is based on the supposition that the value of intangible property within the arrangement is equal to its development cost. Within a short period of M's withdrawal, however, N and O file a new drug application for a cure for the common cold. N and O will be required to pay M an additional amount, consistent with the provisions of paragraph (d) of this section, in consideration for M's ownership of one-third of the property. The amount may be reduced by development costs incurred by N and O after M's departure.

EXAMPLE 5. In year one, domestic pharmaceutical corporation M enters into a qualified cost sharing arrangement with its foreign parent, N, and a sister company, O, to develop a cure for the common cold. For ten years, each company contributes $1 million annually to the cost sharing arrangement. In the tenth year, N withdraws from the arrangement, and is paid a buy-out payment of $10 million, plus interest. Within a short period of N's withdrawal, however, M and O decide that the intangible development is a complete failure, and they end the cost sharing arrangement. The buy-out payment will be deemed inappropriate on the basis that the group's intangibles were worth less than their cost at the time of N's departure.

(5) CHARACTER OF PAYMENTS MADE PURSUANT TO A QUALIFIED COST SHARING ARRANGEMENT. Payments made pursuant to a qualified cost sharing arrangement (other than payments described in paragraph (g)(4)(iv) of this section) will be considered costs of developing intangibles of the payor and reimbursements of the same kind of costs of developing intangibles of the payee. Any payment made or received by a taxpayer pursuant to an arrangement that the district director determines not to be a qualified cost sharing arrangement, or a payment made or received pursuant to paragraph (g)(4)(iv) of this section, will be considered a payment in consideration for the transfer of an interest in intangible property, and will be subject to the provisions of paragraph (d) of this section.

(6) ADMINISTRATIVE REQUIREMENTS -- (i) COST SHARING ARRANGEMENT. A cost sharing arrangement meets the administrative requirements of this paragraph (g)(6)(i) if it substantially complies with each of the following rules --

(A) The material provisions of the arrangement are recorded in writing contemporaneously with the formation of the cost sharing arrangement; and

(B) Any change to a material provision of the arrangement is recorded in writing and is reported on the attachment described in paragraph (g)(6)(ii)(A) of this section.

(ii) PARTICIPANTS. A participant meets the administrative requirements of this paragraph (g)(6)(ii) if the participant substantially complies with each of the following rules --

(A) The material provisions of the arrangement are summarized in (or a copy of the agreement is attached to) the income tax return filed by the participant, if any, or they are summarized in any attachment to Schedule M of Form 5471 or Schedule N of Form 5472 filed with respect to that participant in each year that the arrangement is in effect;

(B) The participant maintains records that are sufficient to verify the material provisions of the arrangement, the amount of the costs borne under the arrangement by each participant during the taxable year, and the computation of each participant's operating income resulting from the arrangement; and

(C) The records described in paragraph (g)(6)(ii)(B) of this section are produced within 60 days of a request by the district director for such records (and translations of those records into English are provided within 30 days of a request for translations of specific records), or those records are produced (and translations are provided) within a period agreed upon by the district director.

(iii) MATERIAL PROVISIONS OF A COST SHARING ARRANGEMENT. The material provisions of a cost sharing arrangement are --

(A) Identification of the arrangement's participants;

(B) The duration of the arrangement;

(C) The intangible development area(s) covered by the arrangement;

(D) The arrangement's method for dividing costs of developing intangibles;

(E) The extent to which any tangible or intangible property not developed under the arrangement is made available to the participants for use in the arrangement;

(F) The extent to which any entity other than an eligible participant is permitted to use intangibles developed under the arrangement (including any entity on whose behalf an eligible participant is sharing costs of developing intangibles under paragraph (g)(3)(v) of this section);

(G) Whether any participant has received an exclusive right to use developed intangibles (such as an exclusive right to manufacture particular products or an exclusive right to sell products in a particular geographic area), and, if so, the nature of that right. If a participant receives an exclusive right to use an intangible, permitting another entity to exploit the intangible in exchange for an arm's length consideration does not make the right non-exclusive;

(H) The conditions under which the arrangement may be modified or terminated; and

(I) The general administrative provisions of the arrangement.

(iv) EXAMPLE. The following example illustrates recording and reporting changes in the material provisions of an arrangement:

EXAMPLE. Corporations A, B and C are members of a group of controlled taxpayers. A, B and C enter into a qualified cost sharing arrangement for the development of an improved Product X. They divide costs on the basis of units of Product X currently produced by each: 60%-30%-10% respectively. A year later, C decides to switch to the production of Product Y, and C leaves the arrangement. A and B compensate C in an amount equal to C's share of the fair market value of the intangible property developed to date, and they change their cost shares to 66%-34%. They also license some of the intangible property already developed to D, an uncontrolled party. All of these changes (participants, users of intangible property and division of cost shares) must be recorded in writing and reported on the appropriate return.

(7) DEFINITIONS. The following definitions apply for purposes of this paragraph (g).

(i) SPECIFIED INTEREST IN AN INTANGIBLE. A specified interest in any intangible that may be produced pursuant to a qualified cost sharing arrangement is any legally enforceable interest, the benefits of which are susceptible of valuation, and which would ordinarily be transferred between uncontrolled taxpayers acting at arm's length under an arrangement to share costs of developing intangibles.

(ii) COSTS OF DEVELOPING INTANGIBLES. The costs of developing intangibles to be shared under a qualified cost sharing arrangement include all of the direct and indirect costs of the intangible development area. When a cost sharing payment is owed by one member of a qualified cost sharing arrangement to another member, the district director may make appropriate allocations to reflect an arm's length rate of interest for the use of the amount owed, if the provisions of paragraph (a) of this section so require.

(iii) U.S. PARTICIPANT. The term "U.S. participant" means any eligible participant of a cost sharing arrangement whose income or earnings may be relevant for U.S. federal income tax purposes. Thus, for example, a "U.S. participant" includes a controlled foreign corporation as defined in section 957.

(8) TRANSITIONAL RULE. A cost sharing arrangement will be considered a qualified cost sharing arrangement, within the meaning of this paragraph (g), if the arrangement was considered a bona fide cost sharing arrangement under the provisions of section 1.482- 2(d)(4), but only if the arrangement is amended, if necessary, to conform with the provisions of this paragraph (g) by the date that is one year after publication of section 1.482-2(g) in the Federal Register.

Par. 4. These amendments are effective for taxable years beginning after December 31, 1992. However, these amendments will not apply with respect to transfers made or licenses granted to foreign persons before November 17, 1985, or before August 17, 1986 for transfers or licenses to others. Nevertheless, these amendments will apply with respect to transfers or licenses before such dates if, with respect to property transferred pursuant to an earlier and continuing transfer agreement, such property was not in existence or owned by the taxpayer on such date. Although these amendments are generally effective for taxable years beginning after December 3l, 1992, the final sentence of section 482 (requiring that the income with respect to transfers or licenses of intangible property be commensurate with the income attributable to the intangible) is generally effective for taxable years beginning after December 3l, 1986. For the period prior to the effective date of these regulations, the final sentence of section 482 shall be applied using any reasonable method not inconsistent with the statute.

David G. Blattner