Rev. Proc. 63-10

SECTION 1. SCOPE AND PURPOSE.

The purpose of this Revenue Procedure is to set forth guidelines to be followed for the proper application of section 482 of the Internal Revenue Code of 1954 (or section 45 of the Internal Revenue Code of 1939) in cases involving the allocation of income and expenses between United States companies and their manufacturing affiliates in Puerto Rico. These guidelines are directed specifically and solely to cases involving United States companies and their affiliates located in Puerto Rico. The guidelines are based on a recognition that Puerto Rican allocation problems arise in a unique factual context in that the economic relationship between Puerto Rico and the United States has special characteristics. Thus, the close ties between the economies of Puerto Rico and the United States mean that in many respects Puerto Rico is an integral part of the United States market. Accordingly, the determination of allocation questions involving pricing aspects in the case of products manufactured in Puerto Rico and sold to United States customers must take this relationship into account, in that these questions may be properly answered only with an approach which is appropriate to questions arising under the particular circumstances involved.

The guidelines concern what may be considered as the standard type of allocation problem that has arisen in these cases. They do not deal with other problems that may be involved particular cases, including those which may be present in cases involving the transfer of income-producing intangibles from the United States to an affiliate located in Puerto Rico. Nor do they purport to discuss all of the details that may be involved in various allocation problems, for example, problems of allocation of expenses.

The guidelines are provided for use in cases in which there may have been improper shifting of income between a mainland United States company and an affiliate company manufacturing in Puerto Rico. By focusing on issues likely to be involved, they are intended to narrow the points which may be in controversy and to provide a reasonable basis upon which to proceed in the case of any particular taxpayer. Consistency and uniformity of treatment, which are of great importance, will be promoted by application of these rules.

As used in these guidelines the terms `mainland affiliate' and `island affiliate' refer to related companies located on the United States mainland and in Puerto Rico, respectively. A company located in Puerto Rico may be either a United States corporation, frequently qualifying for exemption from United States tax on its Puerto Rican income under section 931 of the Code, or a Puerto Rican or other foreign corporation. The related companies involved may be affiliated in various ways, basically either as parent-subsidiary or as brother-sister corporations.

SEC. 2. BACKGROUND.

In 1948, the Puerto Rican Government instituted a development program, popularly known as `Operation Bootstrap,' to stimulate the industrial and economic growth of the island. As an attraction to industry the program provided that qualifying manufacturing companies would be exempted from Puerto Rican income tax, normally for a period of ten years although on occasion a longer period of exemption has been granted. Even in the absence of exemption from tax, Puerto Rican income tax rates are generally lower than those which would be applicable in the United States. There is, therefore, a tax advantage to be gained when income from operations having a connection with both Puerto Rico and the United States can be made subject to tax in Puerto Rico rather than the United States. This advantage has on occasion led to the avoidance of United States tax when income attributable to a mainland affiliate has been improperly shifted to an affiliate on the island. The problem is to determine in particular cases (a) whether an improper shifting has occurred, and ( b) the adjustment required in such situations.

Experience indicates that various practices may be employed to achieve an improper shifting of income. For example: (a) the island affiliate may sell its product to a mainland affiliate at a price which is higher than a fair market price for such a product; (b) the island affiliate may sell its product to a third party at a price which reflects the value of intangibles, such as patents, trade names, etc., which belong not to the island affiliate but to the mainland affiliate; (c) a mainland affiliate may sell materials or provide services to an island affiliate at a price less than the fair market price for such materials or services; or (d) the mainland affiliate may incur expenses for materials or services which are used by or rendered to the island affiliate.

Two aspects of these practices should be noted. First, they may be used in combination, so that merely focusing, for example, on the price at which a finished product is sold to a mainland affiliate does not permit an adequate appraisal of the ultimate problem of whether there has been an improper shifting of income to the island affiliate. Second, even if the island affiliate sells its finished product to independent third parties in the United States, as opposed to a mainland affiliate, improper shifting of income may still be achieved through techniques such as those described in examples (b), (c), and (d), above.

The legal principle generally to be applied in correcting an improper shifting of income is contained in section 482 of the 1954 Code (section 45 of the 1939 Code) which provides:

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

When section 482 of the Code is properly applied to situations involving the practices described above, the result will include one or more of the following: (a) the price at which the island affiliate sells to the mainland affiliate is redetermined, i.e., decreased, with the consequence that the mainland affiliate has a smaller cost for goods purchased and, therefore, a greater gross income on resale of the goods and the island affiliate has smaller gross receipts from sales, thus allocating gross income from the island affiliate to the mainland affiliate; (b) a part of the gross income received by the island affiliate from third parties is reallocated to the mainland affiliate to which the income-producing intangibles belong, as a rental or royalty for the use of the intangibles by the island affiliate; (c) the price at which the mainland affiliate supplies materials or renders services is redetermined, i.e., increased, and gross income is allocated from the island affiliate to the mainland affiliate with the consequence that the mainland affiliate has increased gross income from such materials or services and the island affiliate has a larger cost for goods produced and thus decreased gross income; (d) the expenses incurred by the mainland affiliate for materials or services used by or rendered to the island affiliate may either be disallowed as not being ordinary and necessary business expenses of the mainland affiliate under section 162 of the Code, or, alternatively, may be allocated from the mainland affiliate to the island affiliate under section 482 of the Code.

SEC. 3 APPLICATION OF SECTION 482 OF THE CODE.

.01 General Standard .

In determining whether section 482 of the Code applies, and if it does, the manner of application, the standard is that transactions between related parties must take place according to terms which correspond to those which would have occurred in arm's-length dealings between unrelated companies. Thus, the price which an island affiliate charges a mainland affiliate for its product is required to be that price which the island company would receive from the mainland company if each were independent and unaffiliated, but otherwise unchanged. In this connection, wherever reference is made in the following paragraphs of this section to transactions between independent parties in order to establish usable independent prices, it is necessary to determine the material circumstances of the sales between the independent parties as well as the material circumstances of the sales between the mainland and island affiliates, including the nature and extent of the operations in each case, so that the comparison made is between sales which are comparable in all particulars.

.02 Methods of Determining Arm's Length Price .

1. Directly Applicable Independent Prices.-The best evidence of the applicable arm's-length price is the price paid in transactions between independent buyers and sellers for the same product under similar circumstances. Thus, if the island affiliate produces a standardized product which is sold independently in the United States by other firms, the applicable arm's-length price allowed the island affiliate will be the delivered cost to an independent buyer, at the same point where the Puerto Rican products are to be delivered, of products acquired from independent producers, less the costs incident to transporting the product from Puerto Rico to the United States. In this connection, the independent price is a generally prevailing price. In situations where there appears to be ambiguity as to the prevailing price, it is not appropriate simply to select a price at one extreme of a range of prices available. The independent price must accurately reflect the cost the mainland affiliate would have incurred had it obtained the identical product at prevailing prices on the open market.

In some instances, the mainland affiliate may concurrently obtain from independent firms a product which it also obtains from the island affiliate. Unless there is evidence that these independent purchases are entered into for the purpose of justifying artificial prices paid to the island affiliate or are otherwise unrealistic, for example, because of the small quantities involved, prices paid these independent sellers, with an appropriate adjustment for differential transportation costs should be allowed to the island affiliate.

Similarly, if the island affiliate sells to independent mainland buyers without the assistance of the mainland affiliate, prices received on such sales may be applied to transactions between the affiliates. Again, the quantities and surrounding circumstances of the sales must be such that the prices received are realistic.

Even if there are directly applicable independent prices, if the mainland affiliate measurably assists in third-party sales or permits the island affiliate to use property belonging to it, without being adequately compensated therefor, a part of the gross income received by the island affiliate from third parties may be allocated to the mainland affiliate as a fee for services or as a rental or royalty for the use by the island affiliate of tangible or intangible property belonging to the mainland affiliate. Similarly, where the island affiliate sells to the mainland affiliate and receives measurable assistance from the mainland affiliate or is permitted to use tangible or intangible property belonging to the mainland affiliate, it may be necessary to recognize such factor by allocating an amount to the mainland affiliate as a fee for services or as a rental or royalty for the use of property, or, in the alternative, as a reduction in determining the arm's length price which is to be received by the island affiliate.

2. Independent Prices for Similar Products.-The problem of applying section 482 of the Code is more difficult as a practical matter when directly applicable independent prices are not available. However, when a product manufactured in Puerto Rico and sold only to a mainland affiliate differs only slightly from other products bought and sold by independent firms, an arm's-length price for the island affiliate may be determined by adjusting these independent prices to take account of such minor differences as are present.

3. No Independent Prices.-In some cases, similar products may not be sold independently so that information regarding independent prices for even similar products is not available. In this event, so long as the product in question represents a type which is manufactured in the United States or for which it is reasonable to assume that the mainland affiliate could, without incurring a loss, have contracted for United States manufacture, the price which would have been necessary to induce an independent United States firm to produce in the United States the product in question for the mainland affiliate in the quantities involved constitutes the best approximation of the applicable arm's length price, subject to appropriate adjustment for differences, if any, in costs incident to transportation. That price normally would be those costs which would be incurred in the United States if the activities performed by the island affiliate were performed in the United States rather than in Puerto Rico plus a rate of profit which is representative for that type of United States manufacturing activities. The procedure here will involve determining what activities are carried on in Puerto Rico and what an independent United States firm would charge to perform the same activities in the United States. This procedure properly allocates to the island affiliate all income or loss resulting from the choice of Puerto Rico rather than the United States as a location for manufacturing activity. A factor which must be considered in applying this procedure is whether the mainland affiliate, without being adequately compensated therefor, renders measurable assistance to the island affiliate or permits the island affiliate to use tangible or intangible property belonging to it. If such factor is present in the case, it may be recognized by allocating an amount to the mainland affiliate as a fee for services or as a rental or royalty for the use of property, or, in the alternative, as a reduction in determining the arm's length price which is to be received by the island affiliate. The arm's length price which is determined under this procedure includes no return to the island affiliate for intangibles since it assumes that any significant intangibles, if present, do not belong to the island affiliate. If, in fact, significant intangibles are present in the case and belong in whole or in part to the island affiliate, the applicable price which may properly be received by the island affiliate will be higher, and the rules in section 4, below, are applicable to allocate as between the island and mainland affiliates the income attributable to the intangibles.

It may be, in some instances, that the island affiliate manufactures a product for sale in the United States which product is not manufactured in the United States and for which type of product it is not reasonable to assume that the mainland affiliate could have contracted for United States manufacture. For example, there may be situations in which competition among foreign manufacturers holds the United States price of the product in question at a level insufficient to permit profitable United States production. In this regard, Puerto Rico may be the foreign country whose production holds the United States price of the product in question at a level insufficient to permit United States production. Generally, in these cases, directly applicable or related independent prices in the United States will be available, in which case a determination of the arm's length price will be made under subparagraphs 1 and 2, above. However, in some cases such independent prices may not be available and it may not be reasonable to assume that the mainland affiliate could have contracted for United States manufacture of the product. In this case, the arm's length price should be based on the costs, including United States import duties, and profit which is representative for the type of manufacturing activities involved in the country which dominates the United States market for the product. Except for basing the costs and profit on an assumed foreign producer rather than, as in the preceding paragraph, on an assumed United States producer, the procedure here is the same as in the preceding paragraph. The procedure here is based on foreign costs and profit because competition among foreign producers has held the price for the product at a level that makes United States manufacture of the product unprofitable. As in the preceding paragraph, the arm's length price which is so determined includes no return to the island affiliate for intangibles since it assumes that any significant intangibles, if present, do not belong to the island affiliate. If, in fact, significant intangibles are present in the case and belong in whole or in part to the island affiliate, the applicable price which may properly be received by the island affiliate will be higher, and the rules in section 4, below, are applicable to allocate as between the island and mainland affiliates in the income attributable to the intangibles.

SEC. 4. APPLICATION OF SECTION 482 IN CASES INVOLVING INTANGIBLES.

.01 Meaning and Significance of Intangibles .

The foregoing section 3 of this Revenue Procedure assumes that either no income-producing intangibles are present in the case, or, if any intangibles are present, that they belong to the mainland affiliate, not the island affiliate. Accordingly, the arm's length price determined under the provisions of paragraph .02 of section 3 allows the island affiliate none of the income produced by intangibles, if any such income is in fact present in a particular case, and results in allocating any such income to the mainland affiliate. It follows, therefore, that if intangibles are present in a particular case and belong in whole or in part to the island affiliate, income properly allocable to the island affiliate will be increased, and the price properly allowable to the island affiliate will be higher than the arm's length price determined under the provisions of paragraph .02 of section 3. In no case will the price allowed to the island affiliate be less than the arm's length price determined in accordance with section 3, above.

Intangibles for this purpose include property or rights, such as patents, trademarks, trade names, etc., as well as items such as market position and consumer acceptance, flowing from guaranty and warranty practices, distribution and servicing organizations, advertising, etc., and similar factors in the nature of good will.

The significance of `intangibles' is that when they are present they constitute an advantage possessed by the related firms which enable them collectively to obtain a higher rate of profit from their joint operations than could be achieved by existing or potential competitors producing an equivalent product and paying the same prices for labor and other factors of production. For example, an established corporation might be able to obtain a premium for its trademarked product over and above the price which could be obtained for a lesser known, though equivalent product. Thus, corporation A might be able to buy a product from an independent manufacturer B for a price of $2.00, affix its trademark, and sell the branded product to an independent distributor for $3.00, while the independent manufacturer B could not obtain more than $2.00 for the unbranded product were it to sell directly to that distributor. In such cases, the $1.00 differential less the cost of labels and handling would approximate the per unit value of A's intangibles. Alternatively, perhaps because of a patent, a particular firm might for a period of time be able to produce a product at lower cost than its competitors even while paying identical prices for the same factors of production. Again, the differential, in this case in terms of cost, would represent a return on intangibles.

Not infrequently, the return attributable to intangibles is substantial. Therefore, in cases where significant income-producing intangibles are present the determination whether they belong to the island affiliate or to the mainland affiliate is important in the proper application of section 482 of the Code.

Where the product involved is widely produced and sold by a number of independent and actively competing firms, income attributable to intangibles is not likely to be present. In this situation, useable independent prices will, in general, be available and the principles in subparagraphs 1 and 2 of paragraph .02 of section 3, above, will be applicable. It is in the absence of direct competition that intangibles are likely to be important, and also in such cases independent prices will not in general, be available so that the principles of subparagraph 3 of paragraph .02 of section 3, above, will be applicable.

It is a question to be decided under the facts and circumstances of a particular case (a) whether significant intangibles are present, and (b) if significant intangibles are present, whether they belong to the mainland or to the island affiliate.

It may be expected that as to certain intangibles no supportable contention could be made that they belong to the island affiliate. For example, if the mainland affiliate acts as the marketing and servicing organization for products produced by the island affiliate, any market position, consumer acceptance, or similar factors of good will attributable to the distribution and product servicing activities in the United States do not, as a matter of substance, belong to the island affiliate.

.02 All Income-Producing Intangibles Belong to the Mainland Affiliate .

If all applicable intangibles are treated as belonging to the mainland affiliate, none of the income produced by the intangibles is allowed to the island affiliate, and the price allowed to the island affiliate is limited to the arm's length price determined in accordance with section 3, above.

.03 All Income-Producing Intangibles Belong to the Island Affiliate .

If all applicable intangibles are treated as belonging to the island affiliate, all of the income produced by the intangibles is allowed to the island affiliate. In this case, gross income of the island affiliate would be determined on the basis of a selling price equal to the highest price which a representative independent United States company comparable to the mainland affiliate would pay for the product involved. In principle, this price would approximate the final United States market price for the product less (a) the mainland affiliate's costs of distribution, (b) a reasonable margin of profit for distribution, and (c) all costs incident to transportation from the point of sale in Puerto Rico.

.04 Some Income-Producing Intangibles Belong to the Island Affiliate .

If some, but not all intangibles which are significant in a joint operation are treated as belonging to the island affiliate, it would be allowed a price, which assumed the ownership of no intangibles plus an amount representing an estimated payment by the mainland affiliate for those intangibles owned by the island affiliate. This amount would be based on evidence available regarding what an independent company would receive as royalties or fees or as an increased price in such circumstances.

¹ Based on Technical Information Release 441, dated Jan. 11, 1963.