DELOITTE & TOUCHE ARGUES THAT AUDIT AND PLANNING ISSUES SHOULD BE ADDRESSED SEPARATELY UNDER TRANSFER-PRICING REGS.

Deloitte & Touche also writes that the current proposed regulations recast many transfers of tangibles into a transfers of intangibles. Further, the firm argues that the regs should encourage, if not require, agents to resolve audits using only data that would have been available to the taxpayer at the time of the transaction in question. Deloitte & Touche also states that the regulations would be enhanced if they emphasized broad policies, rather than details, because they give the misleading impression that auditing prices under section 482 is a mechanical issue, requiring little judgment.

This letter is in response to your request for comments on regulations published on January 30, 1992, concerning Section 482 of the Internal Revenue Code of 1986 (the Code). These comments also take into account the amendments to the proposed regulations published in the Federal Register on June 22, 1992.

INTRODUCTION

The proposed regulations address a difficult tax subject with important international trade implications. The proposed regulations in their current form have a number of provisions which raise taxpayer's transaction costs and increase their business uncertainty in ways that are unnecessary to achieving fair, equitable and enforceable provisions on the tax implications of transfer pricing. The effect of the regulations on international trade would be adverse. The suggestions below are intended to assist IRS in meeting the challenges of the subject in ways which facilitate, or at least do not interfere with, international commerce.

We share the concerns of many that the approach of the proposed regulations conflicts with the pricing rules of many of our treaty partners. There is a real likelihood of international double taxation of income unless the proposals take some different courses, such as those discussed below.

Our comments focus on the basic issues presented by the statute and proposed regulations. We believe that there should be some important changes in direction in the regulations.

The following paragraphs summarize, by way of an introduction, a number of our recommendations. These recommendations are explained in more detail below.

In our tax system voluntary compliance by taxpayers is vital. Thus, the Section 482 regulations should encourage taxpayers to plan their intercompany prices, consistent with the statute's goals.

The technical rules under Section 482 should apply, in theory, equally to taxpayers when they are planning their transfer prices and to IRS agents when, after the fact, they audit the taxpayer's results. However, the practical limitations on planning overwhelm the theoretical identity of rules for planning and audit situations. We suggest that new regulations carefully address planning and audit issues separately and, in many cases, differently. For example, to encourage compliance, the regulations might allow taxpayers to set their prices using certain transfer pricing methods if they are followed consistently and with contemporaneous marketplace documentation. On the other hand, an IRS agent could, in an audit where a taxpayer has not followed such a method, perform his analysis using different methods and data.

The regulations should emphasize the general principles that would guide taxpayers in their planning and IRS agents in their auditing. For example, there can be, and frequently are, many different arm's length prices and any one of them should be acceptable. The regulations should state this principle unambiguously.

Similarly, the basic issue should be whether a taxpayer's prices are at arm's length, not whether a taxpayer's profits or return on assets compares favorably with an industry average or group of companies. Thus, the regulations should be revised to maintain appropriate reliance on transactional pricing methods in audits.

For those audits where transaction methods fail, the regulations should be revised to better address the issues inherent in applying aggregate profitability-oriented measures such as return on assets or operating margin. Even when IRS appropriately evaluates a taxpayer's situation under Section 482 by using financial measures such as return on assets, any resulting proposed adjustment should be reanalysed by reference to transaction prices. For example, does a return on assets based adjustment that translates into a negative product price per unit appear reasonable? (IRS Field personnel have already proposed adjustments with similar effects.)

Another recommendation is to maintain more traditional standards for distinguishing between intangibles and tangibles. The current proposals go too far in recharacterizing transfers of what normally would be considered tangibles into transfers of intangibles.

In the case of audits of intangibles, we offer a number of suggestions, among them to limit the circumstances in which periodic adjustments will be necessary, to clarify buy-in requirements and to make some other needed changes to the cost-sharing provisions.

If the regulations are rewritten to distinguish between encouraging compliance and facilitating the resolution of disputes in audits, this will create a better balance between the burdens and goals of both taxpayers and IRS. However, the issue of burden of proof in an audit goes beyond offering taxpayers rules they can rely on for their planning. For example, the regulations should encourage, if not in some cases require, IRS to resolve audits using only data that would have been available to the taxpayer at the time of the transactions in question.

The current proposed regulations have, without question, significantly advanced and elevated the discussion of how the tax administration and taxpayers should implement Section 482 in the future. Important steps remain, however, to achieve a workable set of regulations that will encourage compliance, provide even-handed results, and be workable in an audit context. To some extent, the current proposed regulations focus too much on details of one particular new pricing method called the comparable profit interval or CPI method. The regulations reflect IRS' concerns that, in reality, apply to only a narrow set of cases in the overall transfer pricing population. Stated differently, the regulations would be enhanced significantly if they emphasized the policies and principles that should guide taxpayers and IRS agents and moved away from some detailed explanations that give the misleading impression that auditing prices under Section 482 is a mechanical issue requiring little judgment.

In this connection, Treasury's and IRS 1992 Business Plan has relevant comments on how the regulations might be redrafted.

General principles are often better than detailed rules. All too often, detailed rules result in the worst of both worlds -- they suffocate the many taxpayers who try to do what's right, while providing a road map for the few with larceny in their hearts.

Thus, many of the suggestions below intentionally limit themselves to basic direction and issues.

PRINCIPLES, POLICIES, PURPOSES

The basic issue in Section 482 should be whether the price charged between related parties for a good, service, or intangible is at arm's length, not whether one or the other related party's profits, return on assets, or overall financial results are at "arm's length". Revised regulations should emphasize this guiding principle in two ways. In cases where IRS proposes an adjustment using non- transactional approaches, such as Berry ratio or return on assets, there should be a confirmation or reasonableness check based on unit or transaction prices. This is discussed in the immediately following paragraphs. Next, transaction-based analyses using the comparable uncontrolled price, resale price, or cost-plus method should take priority over non-transactional methods. This is discussed in a subsequent section under the heading Transaction Methods.

USING TRANSACTION PRICES AS A REASONABLENESS GUIDE. An example in the proposed regulations illustrates how important the issue of transaction prices can be when non-transactional pricing methods form the basis of an IRS proposed adjustment. In Example 4 of proposed regulations section 1.482-2(f)(11), a U.S. subsidiary (S) imports and distributes goods manufactured by its foreign parent (P). The U.S. subsidiary's expenses are:

          Purchases from Parent                   $350

Assume that only one fact changes in Example 4: S's purchases from P become $50 and S's purchases from others become $350. In other words, the amounts of related and unrelated purchases are reversed. How would Example 4 be analyzed under the current proposed regulations?

There is no provision in the current proposals that makes clear that this change in facts would cause Example 4 to be analyzed any differently. Presumably, an adjustment of $28 would be proposed by IRS based on the same comparables and methods. This would amount to a 56 percent reduction in the purchase price paid to P, whether or not such a reduction appears reasonable when viewed in terms of unit or transaction prices. (It is possible that proposed Regulations Section 1.482-2(f)(4)(i) was intended to address this issue in the context of the CPI method. The effect of this provision is, however, unclear and, in any case, discretionary and limited to the CPI method.)

Thus, we urge that any audit adjustment be tied to and reevaluated by its potential effect on the prices of intercompany transfers.

CONSISTENCY WITH ANY COMPARABLE'S ARM'S LENGTH PRICE. An important principle is that there can be, and frequently are, many different arm's length prices. Revised regulations should, as a statement of general policy, recognize this as well as a related point: for a taxpayer's price to be at arm's length, it need only be consistent with or supported by any one of the prices used in the comparable transactions, assuming that the volume of unrelated party transactions is significant enough for the comparison to be meaningful. Thus, we suggest that the regulations state that:

o there can be and usually are more than one arm's length price derived from comparable transactions or comparable companies whose financial results provide a basis to set arm's length prices;

o the taxpayer's prices meet the arm's length standard if they are consistent with any one of the prices of the arm's length transactions or results of any one of the comparables.

RESPECTING THE TAXPAYER'S BUSINESS AND CONTRACTUAL CHOICES. Under U.S. tax principles, taxpayers are allowed to organize their transactions and business in such a way as to minimize their income tax liability. Absent a sham transaction, U.S. judicial decisions have consistently validated the principle that a taxpayer "is not required to adopt or continue with that form or organization which results in the maximum tax upon business income." Polak's Frutal Works, Inc. v. Commissioner 21 T.C. 953 (1954) citing Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1942); Meldrum & Fenswith, Inc., 20 T.C. 790 (1953); Eli Lilly & Co. v Commissioner, 856 F.2d 855 (7th Cir. 1988); Bausch & Lomb v. Commissioner, 92 T.C. 525 (1989) aff'd 933 F.2d 1084 (2nd Cir. (1991); Sundstrand Corp. v. Commissioner, 96 T.C. 226 (1991); and Merck & Co. v. Commissioner, 91-2 USTC Par. 50,456 (1991). The regulations should recognize the application of these two principles to Section 482.

We respectfully suggest in this regard that the regulations acknowledge that contracts between related parties are a legitimate part of structuring for transfer pricing purposes. The courts have correctly respected contractual relations between related parties unless they are shams. Bausch & Lomb v. Commissioner, 92 T.C. 525 (1989) aff'd 933 F.2d 1084 (2nd Cir. (1991)) and Sundstrand Corp. v. Commissioner, 96 T.C. 226 (1991). This suggestion would involve a restatement of principles set forth in the last two sentences in proposed Regulations Section 1.482-1(b)(1). The restatement would clarify that related party contracts are entitled to respect unless they are shams and have no economic substance.

We also recommend that the regulations provide that in a Section 482 audit IRS and the courts must accept, as the starting point of analysis, the taxpayer's business facts as they were, not as they might have been if the taxpayer had behaved as a "normative" or "reasonable" person or as one having "sound business judgment". An exception to this recommendation would be for any circumstances in which the taxpayer engaged in transactions which had no business purpose or were a sham.

Thus, the proposed "sound business judgment" standard of proposed Regulations Section 1.482-1(b)(1) should be deleted. It adds an unfortunate and unnecessary element of subjectivity to Section 482 issues. Moreover, there is little, if any, support for such a standard either in the statute or in the court cases interpreting the statute.

SECTION 482 ADJUSTMENTS SHOULD NOT PENALIZE. In circumstances when IRS sustains an adjustment under Section 482, the amount of the adjustment should be based on the arm's length price, not by how near or far the taxpayer's prices, as reported on the taxpayer's tax return, are to the "true" arm's length price. The regulations should state that the goal of a transfer price adjustment under Section 482 should be to conform the related-party price to an arm's length price, not to penalize the taxpayer for having used incorrect prices. Thus, we suggest removing from the regulations concepts that vary the amount of the adjustment based on the closeness of the taxpayer's price to the "true" price or whether tangibles or intangibles are involved. (This proposal would change several rules in the proposed regulations such as those in the last two sentences of proposed Regulations Section 1.482-2(d)(5)(i) as well as those in proposed Regulations Section 1.482-2(d)(5)(iii)(B).)

Section 6662, with its 20 and 40 percent pricing-oriented penalties, is the appropriate mechanism for penalizing incorrect prices. We recommend that the Section 482 regulations so state.

PROVISIONS TO ENCOURAGE COMPLIANCE

We suggest that there be a separate portion in the Section 482 regulations focusing on methods taxpayers can use to comply with the statute. The overwhelming majority of multinationals want to comply with Section 482. They want to reduce controversy on audit. They desire regulations which, to the extent possible, offer clear, straightforward and practical methods with which to comply. Obtaining these objectives is, admittedly, difficult. We hope that the following suggestions assist.

PLANNING RULES FOR SMALL TRANSACTIONS. First, there are thousands of multinationals that have relatively small amounts of transactions that fall within the scope of Section 482. If these companies can voluntarily use relatively simple planning procedures to set their transfer prices, both they and IRS will have significantly narrowed the potential for controversy in audits. This would be good for both our tax system and our trade objectives.

To achieve this goal, both IRS and taxpayers would have to be willing to accept trade-offs and compromises. For their part, taxpayers may find that using a simple rule creates a transfer price that is imperfect or a tax liability different from what might otherwise apply. However, this may be preferable to incurring the costs associated with more complex and precise measures. In addition, reducing audit controversy and its associated costs are important. In deciding whether to adopt prices based on such an approach, a taxpayer could evaluate their likely acceptance in the other relevant tax jurisdiction. From IRS' perspective, assuring broader compliance and reducing the number of potentially controversial and time- consuming audits involving relatively small sums are worthy goals.

A small transaction rule would be based on readily available public information for industry groupings of companies. The Robert Morris Associates Annual Statement Studies is one data source which meets this goal. Allowing the use of such data would substantially reduce the time and cost of planning. This would, in turn, have a positive effect on compliance and international trade.

First, this rule would, by its terms, be limited to taxpayers with small Section 482 transactions. It might apply to a taxpayer if, for example, its total annual transfers subject to Section 482 were less than $25 million. It might not apply in specific circumstances thought by IRS to be unsuitable, high risk, or abusive. For example, the rule could exclude transactions involving highly profitable intangibles, complex transactions, or "round trip" transfers. The application of the rule could be limited in other ways. It could, for example, be limited to U.S. taxpayers (e.g., a U.S. distributor, whether U.S. or foreign owned) who could use U.S.-based data.

Second, it would be reasonable for IRS to require that the rule be applied consistently for a number of years (e.g., three) to be valid. Third, if IRS is concerned about giving taxpayers the benefit of "20/20" hindsight, it could consider allowing use of the rule only if it were chosen before or during the beginning part of a taxable year. Next, the regulations could also require that the method for setting prices chosen by the taxpayer must be disclosed on the taxpayer's return as filed. Of course, the company's prices must have actually been set in a manner consistent with reaching the industry results.

Fourth, if for some reason the taxpayer's results deviated significantly (e.g., plus or minus 20 percent) from that implied by the data and method chosen, the taxpayer could be required to have a correcting adjustment after the end of the year but before the filing of the tax return. (We would leave open for now the question whether such a correcting adjustment must involve the use of cash or whether it should be sufficient to make a change for tax return purposes, recognizing that this raises deemed dividend and deemed contribution to capital issues. There would also have to be steps taken to avoid creating problems for customs purposes and Code Section 1059A.)

IRS could go further in promoting the use of rules for small cases by publishing annually acceptable financial results for different industry groupings, at least for "simple" situations. Again, this is all in the context of voluntary or "electable" rules for small cases.

An example of how the small transaction rule might be structured and work is as follows.

EXAMPLE. Foreign corporation, F, manufactures an electronic consumer appliance and sells it to U, its U.S. affiliate. U resells the good to U.S. retailers. In June of 1992, U and F are planning their transfer prices for the consumer products sold by F to U during the last quarter of 1992 and the first quarter of 1993. The total intercompany transfers between S and P in 1992 are expected to be $11 million. They refer to SIC Code 5064 of RMA for 1991, the year for which RMA data is most recently available. Using data from RMA relevant to the Berry ratio and operating margin, as well as U's budgeted costs relevant to the six-month period, U and F construct a transfer price from F to U which would yield financial results for U consistent with the Berry ratio and operating margins of RMA for SIC Code 5064.

In February 1993, U and F review U's 1992 actual results and discover that they are 10 percent below what was anticipated. U makes a compensating adjustment to its results to increase them to where they would have been, consistent with the agreement between U and F to use the Berry ratio and operating margin results of 1991 from RMA.

In 1996, IRS audits U. IRS determines that U's choice of SIC Code 5064, while not necessarily the only relevant choice, is reasonable. IRS, through its normal audit process, verifies that the financial results of U are consistent with the agreement of U and F to use the Berry ratio.

PLANNING RULES FOR OTHER CASES. For larger or more complex transactions, a more demanding planning approach could be used. This approach could have certain elements in common with the small transaction rule just discussed. For example, it might require a contemporaneous agreement and then contemporaneous marketplace documentation. The particular pricing method and the reliance on particular data might have to be applied consistently for a period time (e.g., three years). Moreover, correcting adjustments might be mandatory.

The primary distinction between this planning rule and the one mentioned above is the level of detail and analysis that would be required. Unlike the small transaction planning rule, it would not be sufficient to rely on industry-level data, such as that published by RMA. Instead, the taxpayer would be required to select those specific companies which are most comparable and then rely on their most recently available financial results as reflected in measures such as operating margin, Berry ratio, or return on assets. This selection process might require taking into account the information on file with the SEC. In this context, the regulations should mention which items should be adjusted in making the comparisons with specific companies. Adjustments might be required for differences between the taxpayer and the unrelated comparables for items such as:

o inventory

One way to think of this proposal is that for those taxpayers that choose to use it, it would entail the level of contemporaneous analysis and documentation that the advance pricing agreement process now involves, except that a reasonableness review by IRS would occur in an audit.

At least two factors should help keep the choice of companies and adjustments as objective as possible. First, the choice of companies is to be made for a multi-year period, absent some fundamental change in facts. The first year's results of the comparables will be known, but the results of subsequent years will not. Secondly, IRS could challenge the appropriateness of the comparables as well as the adjustments. If, in the audit process, IRS establishes the unreasonableness of the taxpayer's choice of comparables, and the appropriateness of another group of comparables, this planning rule would be retroactively inapplicable.

In evaluating the reasonableness of the comparables and the adjustment, it could be relevant whether the taxpayer gathered the information and performed the analysis itself or, instead, turned to an external tax advisor. If a taxpayer reasonably relied on the opinion of an external tax advisor, and such opinion was appropriately supported by marketplace data and analysis, IRS should have a higher burden before making a transfer pricing adjustment. For example, the IRS might have to show that the method or data relied upon by the taxpayer was substantially erroneous before making an adjustment.

By way of simplified or more detailed but defined planning rules such as those mentioned here, IRS can significantly improve transfer pricing situations both for taxpayers and itself.

Neither the simplified nor more detailed voluntary sharing rules constitute an endorsement of the mandatory CPI approach, at least as currently presented. As is explained below, there are important aspects of the CPI approach which should be changed for it to be a reasonable and effective pricing method in an audit context.

TRANSACTION METHODS

In a number of ways, the proposed regulations would substantially diminish the traditional reliance in audits on prices for unrelated party transactions or groups of transactions. The comparable uncontrolled price method for tangible property would, under the terms of the proposed regulations, almost never apply. The CPI method will be the prime rule for most cases. Similarly, the proposed method of comparing transactions involving intangibles is so tightly drawn that it almost will never apply.

We suggest first that the rules for planning and audit situations allow the use of prices in uncontrolled transactions even when differences exist for which there is no reasonably ascertainable adjustment, provided that the value of the difference, if it were quantifiable, would only serve to reduce taxable income in the United States. For example, in an audit context a taxpayer should be permitted to compare OEM and brand name transactions, even though the adjustment for this difference is not quantified, or is not readily ascertainable, if the value of the brand name would only serve to increase the transfer price and, therefore, reduce U.S. taxable income. (The taxpayer should also be allowed to estimate broadly the value of this difference for purposes of a set-off, where relevant.)

In addition, the regulations should permit the use of comparable uncontrolled prices when imprecisely quantifiable differences exist, provided that it can be demonstrated that the differences can be reasonably quantified within a range.

Similarly, the regulations should not use the CPI or" other" methods to override the resale price method in circumstances where that method relies on actual transaction data, as opposed to a resale price method using financial statements data of comparable companies or of industry aggregates.

Along the same lines, the regulations should retain priority for a cost-plus method that relies on actual transaction data, as opposed to financial statement data of comparable companies or of industry aggregates.

Again, both transaction-based resale price and transaction-based cost-plus methods should allow for imprecisely quantifiable differences to be taken into account. These differences should be taken into account provided that it can be demonstrated that they can be reasonably quantified within a range.

We make these suggestions for several reasons. First, transaction-based analyses avoid many of the data and conceptual problems inherent in analyses that focus on a company's overall results. Second, transaction-based methods are given priority in the pricing rules of our trading parties, as has been true in the United States. Thus, retaining a priority for transaction-based methods is likely to help avoid conflicts with the rules of other countries and, therefore, help avoid international double taxation of income.

OTHER METHODS

GENERAL COMMENTS. We recommend that the regulations be revised to better apply financial measures of transfer pricing when transaction methods fail. To explain this, consider a case when transfer pricing is, in fact, done properly; by hypothesis, the transfer prices are at arm's length. This hypothetical taxpayer is in an unusual situation in that there is a very large number (e.g., hundreds) of available and directly comparable companies. In an audit, IRS chooses one or more particular financial measures for the comparable companies, such as operating margin and Berry ratio. Once these financial measures are in a graph, their frequency looks like that of the familiar bell curve. What would such a curve or distribution of outcomes say about the taxpayer?

The proposed regulations would have us believe that the taxpayer, who hypothetically used arm's length prices, should be in the middle at some measure of central tendency. In fact, the taxpayer can and will be at any point on the bell-shaped curve. Thus, the proposal to "force" the taxpayer to the middle will create more or less profit than a company that should, and in fact did, use arm's length prices.

This example has been constructed to illustrate, in the best possible case, that it is inappropriate to impose in an audit measures using a central tendency to determine whether transfer pricing was or was not appropriate.

There are number of factors that can affect the financial measures or profitability of one company as compared to others that are otherwise similar. These factors have absolutely nothing to do with transfer pricing issues:

o the efficiency with which the technology is implemented;

Thus, in an audit context, measures of central tendency should not be imposed on the taxpayer. Instead, if the taxpayer's financial results or measures of profitability are consistent with those of one or more of comparable companies, the taxpayer should have met his burden of proof in establishing that his prices were at arm's length.

COMMENTS ON CPI. As mentioned above, the proposed regulations offer a new "other" method called the comparable profit interval or CPI method. Our suggestions for basic principles and direction that the regulations might take have the following implications for the proposed CPI method:

o Any such method should apply in an audit context only if transaction-based CUP, RPM or cost-plus approaches are inapplicable;

o If transaction-based methods fail and CPI or some other method is used in an audit, the results of such other method should be verified by and constrained by a reality check which is, again, transaction-based;

o Either the CPI or any "other" method that relies on financial results of segments or overall operations of publicly-traded companies should not require that the taxpayer's financial results be at a mean, median, "most appropriate point," "other interval," or range. Instead, the guiding principle should be that taxpayer's results are verified if they are consistent with those of any one of the comparables. (If there is a question about comparability, perhaps the results of outliers should be discarded.)

o In using segments or entire operations of publicly-traded companies in an audit context, adjustments must be made to improve comparability.

DISTINGUISHING SERVICES AND TANGIBLES FROM INTANGIBLES

In the proposed regulations, a test is used to distinguish transactions that will be analyzed under transfer pricing rules for tangible personal property or intangibles, such as patents, trademarks, etc. If the rules for intangibles apply, then the new "commensurate with income" standard of the 1986 amendment comes into play. The same concepts would apply to services.

The proposed regulations would resolve the distinction between transfers of services or tangibles and intangibles by determining whether in a specific transaction there is income attributable to an intangible which is material in relation to the income attributable to a tangible or service.

In the paragraphs that follow, we discuss problems raised by the approach of the proposed regulations, an alternative marketplace approach, and examples illustrating our suggested alternative.

MATERIALITY APPROACH. The materiality approach of the proposed regulations has four problems:

o It focuses on relative value of tangibles and intangibles rather than on how arm's length parties would price a transaction to determine the appropriate method.

o The regulations contain no definition of material; this will lead to substantial controversy.

o The regulations would apply the commensurate with income standard to transactions in which it is very unlikely that the related parties would negotiate agreements which are "commensurate with income."

o The proposed approach is not in conformity with international norms and is, therefore, likely to increase the risk of double taxation.

ALTERNATIVE APPROACH. We recommend an alternative to the current "materiality" standard. In determining whether the intangible or tangible rules should be applied, the IRS and taxpayer should first look at the structure of comparable transactions in the marketplace and the functions and risks of the comparable transactions or companies. If the tested transaction and company can best be compared to unrelated parties using tangible property rules (i.e., rules with a fixed amount of compensation), those rules should apply. Alternatively, if the tested transaction and company can best be compared to unrelated parties using rules relevant to intangibles (i.e., rules where compensation varies over time), then the latter should apply.

This recommendation can be illustrated by using four cases:

1. U.S. Co. manufactures a machine tool which has a material software element. Controlled F Co. purchases the machine from U.S. Co. and sells it to unrelated parties outside the United States.

2. F Co. manufactures a machine which has a material software element. Controlled U.S. Co. purchases the machine for use in its U.S. manufacturing business.

3. F. Co. manufactures a consumer product and attaches F Co.'s name. F Co.'s name is widely known in the United States and has significant U.S. value. Controlled U.S. Co. purchases the consumer product for resale to unrelated U.S. retailers.

4. U.S. Co. develops "off-the-shelf" computer software. Controlled F Co. purchases the software and sells it to unrelated retailers outside the United States.

Our suggested approach in deciding whether the rules for tangibles or intangibles would apply would mean the following for these four examples:

o In Examples 1 and 3, if in the marketplace the machine or trademark product is sold for a fixed price which includes the software or tradename and an unrelated distributor pays a fixed price and receives a mark-up on the cost of the product, the appropriate way to determine the arm's length price is transaction-based CUP, resale price, or cost-plus, or other methods relevant to tangibles.

o In Example 2, machines of this type are generally sold for a fixed price. Again, it seems appropriate to determine the transfer price between the controlled companies under tangible property rules. It may be possible if several machines are being sold that a "process" is also being transferred. If the process is valuable and goes beyond normal application engineering, one may expect that an additional payment, probably varying based on factors such as usage, for this process would be made between arm's length parties. In such a case, the additional payment may be more properly tested under intangible property rules.

o In Example 4, even though an "intangible" is being licensed, the marketplace treats the intangible as a "product for which there is a fixed price." It is likely that the comparable companies will be resellers of computer products that would expect to pay a fixed price and earn a mark-up on the cost of the "product." Thus, the appropriate way to determine the arm's length price is transaction-based CUP, resale price, or cost-plus, or other methods relevant to tangibles.

We would distinguish the above situations from those that Congress was most concerned about when amending Section 482 in 1986. In enacting the commensurate-with-income rules, Congress was concerned that taxpayers were licensing high value intangibles that were unlikely to be transferred between unrelated parties. The focus was not on transfers of tangibles which might involve an intangible or a transfer of an intangible that is traded in the marketplace as a product.

In Examples 1, 2, and 3, it is probable that taxpayers and IRS will, in an audit, be able to find comparable, in the general sense used here, transactions or companies engaged in transactions that perform similar functions and incur similar business risks. It is possible that, in Example 2, a generally comparable transaction could not be found because of the unique nature of the machine. However, in most cases, a generally comparable transaction should be available.

If the marketplace approach to distinguishing transfers of tangibles from transfers of intangibles is used, the problem of defining "materiality" is avoided.

We recommend a similar marketplace standard test for distinguishing services from intangibles.

BALANCING BURDENS AND RESPONSIBILITIES

By providing voluntary or elective simplified or more detailed planning rules, as suggested above, IRS would encourage compliance, easing the burden for both itself and taxpayers. There will remain, nonetheless, cases to be audited. In audits, there is an important question whether IRS or the taxpayer must go forward in confirming the viability of transfer prices or establishing their incorrectness. Today a taxpayer may have to establish that an IRS proposed adjustment is "arbitrary and capricious" and that the taxpayer's prices were "correct" within the meaning of Section 482.

It is our recommendation that this double burden on taxpayers be changed by regulation for those circumstances in which IRS proposes using information about comparable companies or comparable transactions that is not publicly available and that, therefore, could not have been used by the taxpayer at the time that it prepared its prices. In such circumstances, we recommend that the taxpayer need only demonstrate that its transfer prices were consistent with information that was publicly available at the time the prices were set. If IRS wants to use the data that was not publicly available, it should have to show first that the taxpayer's prices were not consistent with data that was publicly available.

Our second suggestion in this connection is intended to reinforce the view that transaction-based analyses are more likely to reach superior results than analyses that are based on industry-wide results or overall results of selected companies. If, in an audit, a taxpayer is defending its prices by using transaction-based analyses, it should be the burden of the government to demonstrate that these analyses are flawed before resorting to industry-wide or company-wide approaches. In this connection, the taxpayer should be allowed to reasonably estimate adjustments for differences between the comparable and uncontrolled transactions even if that estimate is imprecise, as is explained above.

Of course, if either the simplified small case or more detailed planning rule had been used and its standards were met, a taxpayer's transfer pricing should be sustained even if, in an audit context, there appear to be other approaches or other sources of information that IRS might otherwise have used to achieve a different transfer pricing result.

That is, revised regulations should encourage and reward taxpayer planning by reducing the taxpayer's burden of proof in an audit if the taxpayer reasonably set its prices using planning guidelines set by IRS, such as those suggested above. In these circumstances, the burden should be on IRS and the courts to demonstrate that the taxpayer's prices were not at arm's length. Moreover, in these circumstances, the government should make that demonstration based only on information that was publicly available at the time when the taxpayer established its prices. If implemented, this suggestion should encourage voluntary compliance. To assure compliance, tax laws should have a reasonably predictable outcome. Fairness dictates that the tax laws be predictable.

PRICING FOR INTANGIBLES

Intangibles will be tested under Section 482 by taking into account the "commensurate-with-income" standard. In applying this standard, one must address the question of "periodic adjustments."

We believe that the proposed regulations have too narrowly constrained the circumstances in which periodic adjustments will not be made. Making periodic adjustments will create double taxation problems and deviate from what normally occurs in the marketplace. It is our recommendation that periodic adjustments only be made in circumstances in which there are problems of the magnitude that prompted Congress to enact the "commensurate with income" in the first place. We believe there are probably only two categories of such transactions: round trip transaction involving significant intangibles; extremely high profit or "crown jewel" intangibles.

Profit splits are, under the proposed regulations rarely, if ever, applicable. We believe that, particularly for intangibles, a judgmental profit split approach should be available, at least as a double check or confirmation of results arrived through other methods.

In the case of cost-sharing, we offer two suggestions concerning buy-ins and the use of gross receipts rather than operating income in the fraction used to test the reasonableness of the cost-sharing arrangement.

As to buy-ins, the regulations could clarify the circumstances in which basic research and development (R&D) requires a buy-in. If basic R&D has not resulted in an identifiable intangible, no buy-in should be necessary for that R&D.

Our next comment concerns the use of operating income in the fraction used to test the reasonableness of the cost-sharing arrangement. By using operating income, the regulations use financial results affected by items or costs such as plant efficiency, labor cost and marketing costs that may have little to do with the intangible being transferred under the cost-sharing arrangement. Thus, the operating income comparison can be unfair. To cope with this difficulty, consideration should be given to using gross receipts in the denominator of the fraction.

CONCLUSION

In a meaningful way, the 1992 proposed regulations open the door to a more workable transfer pricing system. At the same time, as written, the proposed regulations would create many difficulties.

Our comments are intended to take the best ideas of the proposed regulations and complement them with other suggestions to move forward. We hope that we have achieved our objective and are willing to work with you to iron out the details necessary to implement our suggestions.

These comments were prepared on behalf of Deloitte & Touche by the Deloitte & Touche National Transfer Pricing Team. The Team is led by Steven Hannes of our Washington National office. The members of the Team contributing to these comments were Ken Brewer (Stamford office), John Brown (Washington National office), Richard Clark (Washington National office), Mike Knee (San Francisco office), Mark Nehoray (Los Angeles office), Alan Shapiro (Washington National office), Peter Simpson (Chicago office), Todd Wolosoff (New York office) and Steven Hannes.

Please call Mr. Hannes if you have any questions or would like to discuss our suggestions (202/879-4988). Also, Mr. Hannes would like an opportunity to present our views at the public hearing that will be scheduled on these regulations. An outline of the oral presentation will be submitted separately.

Sincerely,