Merck Favors Use Of Comparable Uncontrolled Prices.

Alan Dixler of Merck & Co., Inc., Whitehouse Station, N.J., has expressed disagreement with the approach taken in the proposed amendments to reg. section 1.936-6(b)(1). According to Dixler, "Merck favors the use of comparable uncontrolled prices to compute revenues coupled with the use of factual allocation of costs, rather than the use of an arbitrary formula, when figuring combined taxable income."

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March 10, 1994

Commissioner

Re: Comments on INTL-68-92, The Computation of Combined

Dear Madam:

Merck & Co., Inc. ("Merck") submits these comments with respect to the proposed regulations for computing combined taxable income under the profit split method for a taxpayer that has chosen a component product or an end-product form as its possession product. /1/ Merck disagrees with the approach of the amendment to section 1.936-6(b)(1), Q & A 12, which changes the method of computing combined taxable income from an arm's length, comparable uncontrolled price method to a formulary method in cases where the possession product is a component product or an end-product form.

The current Q & A 12 calls for the determination of combined taxable income by use of an independent sales price from comparable uncontrolled transactions if such price can be determined in accordance with 1.482-2A(e)(2). If no independent sales price /2/ exists, then combined taxable income is derived by use of a production cost ratio method. Under the production cost ratio method, the sales price used in lieu of the comparable uncontrolled sales price is a proportion of the third party sales price which the production costs attributable to either the Puerto Rican component product or the excluded component product bears to the total production costs for the integrated product. The proposed regulation would require the use of a production cost ratio in all cases.

It would appear that the Service wishes to avoid a situation where a taxpayer could use a comparable uncontrolled price to compute the revenues of combined taxable income, but then use the production cost ratio to apportion the costs of the combined taxable income to the domestic affiliates of the possession corporation. The crux of the matter is that the production cost ratio is a highly arbitrary method of apportionment. The most economically accurate method for figuring combined taxable income in cases where the possession product is a component or end product would be the use of a comparable uncontrolled price where it exists, and then using a direct allocation of costs, where possible, to domestic affiliates under regulation section 1.861-8(b), followed by an apportionment of costs only when direct allocation could not reasonably be made.

This is regulation section 1.861-8 methodology and it is called for in regulation section 1.936-6(b)(1) (Q&A 1). Abandoning the MARKET price, and then using an arbitrary cost apportionment system to compute combined taxable income serves no tax policy purpose. Indeed, Code section 936(h)(5)(c)(ii)(II) provides in relevant part:

"Combined taxable income shall be computed separately for each

Thus, Congress did not mandate arbitrary apportionments for partial

Comparable uncontrolled pricing is the preferred method of the new temporary regulations under section 482, as well as of the 1979 OECD report on Transfer Pricing. Therefore, the possession corporation will, as a matter of course, have to use the comparable uncontrolled price when selling to unrelated parties. However, for most section 936(h) purposes, "related parties" need only have more than a ten percent common ownership (see section 936(h)(3)(D) & (E)). Matters become even more complex when sales are made from the possession corporation to a foreign affiliate. This is because under international tax norms, in order to allocate income among affiliates, a comparable uncontrolled price must be used when it exists. However, formulary production cost ratio methodology could, under the right circumstances, be used to manipulate the final tax liability. Such would be the case where a relatively fungible product is made in Puerto Rico and it is a component of a trademarked integrated product.

Accordingly, Merck favors the use of comparable uncontrolled prices to compute revenues coupled with the use of factual allocation of costs, rather than the use of an arbitrary formula, when figuring combined taxable income.

Sincerely,

Alan Dixler

FOOTNOTES

/1/ INTL-68-92, 1/12/94, 59 Fed. Reg. 1690

/2/ Presumably, this is the "comparable uncontrolled price."

/3/ Emphasis supplied

END OF FOOTNOTES