TEI Sees Room For Improvement In Transfer Pricing Regs.

Robert H. Perlman writing on behalf of the Tax Executives Institute, Inc. (TEI), Washington, has commented that the temporary and proposed intercompany transfer regulations are a significant improvement over the 1992 regulations. However, despite the improvement, TEI remains concerned about the regulations' excessive documentation requirements, second-guessing of business decisions, limitations on the use of profit-split and other methods, and the interaction with the section 6662 penalty regulations.

Specifically, TEI asserts that the contemporaneous documentation requirement is "needlessly burdensome and costly," and it should be limited to information that is reasonably necessary to provide examiners with an audit trail of the transaction. TEI also contends that remnants of the virtually abandoned "sound business judgment" rule (from the 1992 regulations) still exist in certain provisions of the current regulations. Stating that the Service should not second- guess business decisions made by taxpayers, TEI suggests that the the Service focus instead on whether the result of a transaction is within the range of an arm's-length comparable result. In addition, TEI states that the regulations place undue limitations on the use of the profit-split method and questions whether the election requirement would withstand a court challenge.

Finally, TEI asserts that the possible imposition of a penalty is the most troublesome aspect of the regulations. Taxpayers, according to TEI, should not be penalized for inadvertent failures to satisfy a procedural requirement. It recommends that the penalty be imposed only when the taxpayer has engaged in "demonstrably culpable" conduct.

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August 6, 1993

Internal Revenue Service

Re: Temporary and Proposed Regulations Under Section 482 of the

Dear Commissioner:

On behalf of Tax Executives Institute, I am pleased to submit an original and eight copies of our written comments on the temporary and proposed regulations under section 482 of the Code relating to transfer pricing.

If you have any questions or need additional copies, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at (201) 573-3200 or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.

Respectfully submitted,

By: Robert H. Perlman

Enclosures

COMMENTS

On January 13, 1993, the Internal Revenue Service issued temporary and proposed regulations under section 482 of the Internal Revenue Code, relating to intercompany transfer pricing. The regulations were published in the Federal Register on January 21, 1993 (58 Fed. Reg. 5263, 5310), and in the Internal Revenue Bulletin on March 8, 1993 (1993-10 I.R.B. 5, 60). The regulations replace, in part, proposed regulations issued on January 24, 1992.

Concomitantly with the issuance of the temporary and proposed section 482 regulations, the IRS issued proposed regulations under sections 6662(e) and 6662(h) of the Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations. TEI filed comments on the proposed penalty regulations on April 21, 1993, and testified at an IRS hearing on May 14, 1993. /1/

BACKGROUND

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 4,800 members represent approximately 2,400 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed and temporary regulations under section 482 of the Code, relating to intercompany pricing.

OVERVIEW

TEI commends the Internal Revenue Service for its efforts to move the substantive section 482 regulations closer to international standards. The reaffirmation of the arm's-length standard, the expanded use of a range of arm's-length prices, and the emphasis on transaction-based comparables and results-oriented pricing all signal a greater appreciation for the realities of international competition and corporate America's global marketing organizations than did the 1992 regulations.

The temporary regulations represent a significant improvement over the 1992 regulations. For example, the temporary regulations eschew the rigid priority of methods set forth in the 1992 regulations. In addition, a controversial concept in the 1992 regulations -- the comparable profit interval (CPI) -- no longer serves as an automatic check on, or "backstop" for, the other pricing methods. These changes make the regulations more manageable and provide taxpayers with greater flexibility in choosing their pricing methodology. The Institute remains concerned, however, about several aspects of the substantive regulations, including their excessive documentation requirements, "second-guessing" of business decisions, limitations on the use of the profit-split and "other" methodologies, and their interaction with the proposed penalty regulations.

The best summary of the IRS's approach to section 482 is set forth in the proposed penalty regulations. The preamble to those regulations states that "[t]he experience of Internal Revenue Service examiners has been that the majority of taxpayers are unable to provide an explanation of how their intercompany pricing was established." 1993-7 I.R.B. at 79. The preamble avers that the lack of "contemporaneous documentation" of how a controlled transaction result was determined increases the time spent and the expense incurred by both the taxpayer and the IRS in determining whether that result is arm's length and also increases controversy between taxpayers and the IRS. According to the preamble, the proposed penalty regulations are designed to "encourage "taxpayers to document their transfer pricing transactions and to provide that documentation to the IRS upon request. 1993-7 I.R.B. at 79. The interaction of the proposed penalty regulations with the substantive section 482 regulations effectively impose a documentation requirement as a cornerstone of section 482.

The requirements of contemporaneous documentation imposed by the temporary regulations are needlessly burdensome and costly to taxpayers. TEI believes that the requirements should be limited to what is reasonably necessary to provide examiners with a "road map" or audit trail of a taxpayer's intercompany transactions, including information on the method used and any comparables relied upon. At a minimum, meaningful guidance must be provided on the scope of the contemporaneous documentation requirement.

The temporary regulations essentially require taxpayers to perform a functional analysis of every cross-border transaction. This requirement is particularly onerous for taxpayers having only routine intangibles. We submit that not every intercompany transaction deserves the scrutiny required by the substantive section 482 regulations. The depth of the required functional analysis and documentation should vary in accordance with the nature of the taxpayer's intercompany transactions. For example, taxpayers with an internal comparable uncontrolled price or transaction should not be required to perform in-depth functional analyses of the transaction -- the comparable should suffice.

Although the "sound business judgment" rule of the 1992 regulations /2/ has ostensibly been abandoned, echoes of the rule still remain in the temporary regulations. Provisions calling for the evaluation of the "alternatives [that are] realistically available" or "alternative commercial arrangements" resonate of the old concept with a new name. /3/ The temporary regulations are apparently intended to require taxpayers to perform a "make-or-buy" analysis to determine whether the taxpayer could have more profitably manufactured the product itself rather than purchase it from an affiliate. This approach, however, was soundly rejected by the courts in Bausch & Lomb v. Commissioner. /4/ Consistent with that result, TEI believes that hypothetical arrangements should not be a factor in determining comparability. The IRS's only concern should be whether the results of a taxpayer's pricing decisions are within the range of arm's-length, comparable results. In other words, the IRS should not second guess business decisions made by the taxpayer.

Although the regulations expand the use of the profit-split methodology, they place undue limitations on the use of that methodology. Under the proposed regulations, taxpayers must make a binding election to use the profit-split method and meet other procedural requirements. The requirement for a binding election creates a one-way street in section 482 enforcement: the IRS may use the methodology to challenge a taxpayer's transfer pricing structure, but the taxpayer (absent an election) may not use the profit-split method to defend its structure. Frankly, we question whether the election requirement is valid; certainly, it is unnecessarily restrictive. Courts have clearly accepted profit splits as a legitimate methodology under section 482, /5/ and the method is especially compatible with the statute's commensurate-with-income standard. Moreover, the use of the methodology should be expanded beyond situations where there are non-routine intangibles on both sides of the transaction. "Profit-split" is not a dirty word (or even two words); its use should not be unreasonably circumscribed.

Finally, TEI remains troubled by the interaction of the substantive section 482 rules with the transfer pricing penalty imposed under section 6662(e). The most disquieting aspect of the temporary regulations is the specter of a penalty imposition for what could not possibly be viewed as noncompliant behavior. We are particularly concerned that a taxpayer could fail the reasonable cause and good faith test simply because it inadvertently failed to satisfy certain procedural rules (for example, a failure to disclose that precludes a taxpayer from using an "other" method). We continue to believe that section 482 adjustments should give rise to a penalty only where the taxpayer engages in demonstrably culpable behavior.

In sum, the temporary regulations represent a vast improvement over the 1992 regulations, but they should be clarified and revised to take into account the ways in which multinational corporations do business and to avoid imposing undue administrative burdens with little or no revenue effect.

SPECIFIC COMMENTS

TEMP. REG. SECTION 1.482-1T(b)(2)(iii): THE BEST METHOD RULE

The temporary regulations affirm that the standard to be applied in transfer pricing cases is that of a taxpayer dealing at arm's length with an uncontrolled party. Temp. Reg. section 1.482-1T(d)(1) provides that a section 482 allocation may be made in any case in which either by inadvertence or design the taxable income of a controlled taxpayer is other than it would have been had the taxpayer been dealing at arm's length. Temp. Reg. section 1.482-1T(b)(2)(iii) provides that the arm's-length result must be determined under the method that provides the most accurate measure under the facts and circumstances of the transaction under review (the "best method rule"). The temporary regulations therefore abandon the rigid priority of methods provided for in the 1992 regulations.

Although we applaud the increased flexibility under the temporary regulations, TEI suspects that the best method rule will spawn audit controversies with the IRS over which method is the "best." The temporary regulations aver that an arm's-length result may be determined under any of the available methods without first establishing the inapplicability of any other method. In operation, however, the best method rule will likely require taxpayers to prove the inapplicability of other pricing methodologies. Such an approach effectively requires the taxpayer to prove a negative -- that the other pricing methodologies do not produce an arm's-length price. This is a difficult, if not impossible, burden to meet. Taxpayers should only be required to show that the pricing method they used is reasonable. /6/

TEMP. REG. SECTIONS 1.482-3T(e) and 1.482-4T(d): CONTEMPORANEOUS

Temp. Reg. sections 1.482-3T(e)(2)(ii) and 1.482-4T(d)(2)(ii) require "contemporaneous documentation" of a taxpayer's transfer pricing methodology as a prerequisite for using an "other" method. In addition, the proposed penalty regulations effectively require that taxpayers contemporaneously document their use of any prescribed method under the temporary regulations. /7/ The regulations, however, provide no guidance on how a taxpayer can satisfy the requirements of "contemporaneousness" or on what constitutes sufficient documentation within the meaning of the regulations.

The absence of meaningful guidance on these questions leaves TEI unable to assertion whether the regulations are workable or reasonable -- and threatens to leave taxpayers in the lurch. In particular, the contemporaneous documentation requirement may prompt taxpayers to devote inordinate resources to the preparation of such documentation. If left amorphous, the requirement will represent an unnecessarily heavy and potentially uneven burden on taxpayers. To avoid overburdening taxpayers while protecting the government's interest in auditing the taxpayer's transfer pricing methodology, we recommend that the IRS publish guidance on what constitutes adequate documentation as expeditiously as possible. /8/

TEMP. REG. SECTION 1.482-1T(c): COMPARABILITY

a. BASIC TYPES OF COMPARABLES. Temp. Reg. section 1.482-1T(c)(1) provides that the arm's-length character of a controlled transaction is tested by comparing the results of that transaction with the results of uncontrolled taxpayers engaged in comparable transactions under comparable conditions. The standards provided under this regulation are intended to apply to all the transfer pricing methodologies under section 482. Comparability is evaluated by using the following five factors: (i) functions; (ii) risks; (iii) contractual terms; (iv) economic conditions; and (v) property or service. Under Temp. Reg. section 1.482-1T(c)(1)(ii), the relative importance of the factors may depend upon the pricing method used. The regulation states, however, that "[i]n particular, the analysis of functions and risks will be essential to the application of any method." Because the regulations view an analysis of functions and risks as "essential," two transactions involving identical products may not be sufficiently comparable for purposes of the CUP method, if the relevant functions, risks, or other factors are different.

An analysis of functions and risks should not be viewed as ESSENTIAL to the application of any method. Functional analysis is an economic -- not a tax, legal, or accounting -- exercise that many corporate tax departments can only perform with substantial and costly assistance. Rather than impose a blanket mandate to employ an economist, the regulations should take a flexible approach that aims at reducing a taxpayer's burden in analyzing transactions where comparable data are likely to bear a high degree of accuracy. For example, the regulations could provide that a taxpayer relying on an internal CUP or CUT, or on internal comparables under the resale- price or cost-plus method, will be permitted to make a representation concerning the comparability of the transactions, rather than performing a full-blown functional analysis. In addition, the IRS should consider publishing a list of products that are exempt from the functional analysis requirement because the probability is high that accurate comparables exist (e.g. commodities or generic products).

Moreover, although we applaud the listing of the factors and issues to be considered in assessing comparability, we believe that the temporary regulations unnecessarily restrict the ability of taxpayers to rely on comparables in determining an arm's-length price. Temp. Reg. section 1.482-1T(c)(2)(i) provides that under all methods an arm's-length result generally is estimated based on data derived from comparable uncontrolled taxpayers. The regulation states that an uncontrolled transaction does not have to be identical, but it must be "sufficiently similar that it provides a reasonable and reliable benchmark for determining whether the controlled transaction led to an arm's-length result, though adjustments are permitted for "minor" differences. The temporary regulations are, therefore, more restrictive in permitting what qualifies as a comparable than the 1968 regulations, which provide that differences in price merely have to be "readily ascertainable."

The use of comparable transactions should be the predominant means of determining an arm's-length consideration. Thus, the results of the controlled transaction need only be consistent with -- not identical to -- the result of the uncontrolled transaction. For example, the requirement that the comparable be the same TYPE of product is unnecessarily narrow; the better rule would require that the nature of the activity be similar. Products in different industries that use the same kind of process development should be considered comparable under the regulations. In addition, the regulations should acknowledge that isolated transactions may be the best available indicator of an arm's-length price. /9/ More important, the "make-or-buy" analysis -- which could eliminate the use of potential comparables by hypothesizing what a taxpayer COULD have done -- is contrary to the principle that a taxpayer may structure its tax affairs in any reasonable manner. /10/ The analysis should be abandoned. Finally, with respect to intangibles, we recommend that the regulations retain (as a non-exclusive list) the factors set forth in Treas. Reg. section 1.482-2(d)(2)(iii) of the 1968 regulations, which provides useful guidance to taxpayers.

b. MARKET SHARE STRATEGY. The temporary regulations expand upon the 1968 regulations by recognizing that prices for goods and services may be reduced to permit the company to enter a new market or to expand an existing one. Subparagraph (i) describes the "special circumstances" that may affect comparability. Temp. Reg. section 1.482-1T(c)(4)(i) provides that the price for a controlled transfer may be other than the amount charged in a comparable uncontrolled transaction "because the controlled transfer is subject to a pricing strategy that is undertaken to enter new markets, to increase a product's share in an existing market, or to meet competition in an existing market." The controlled transaction must bear a price that would have been charged in an uncontrolled transaction under comparable conditions. This "market share strategy" must meet certain conditions, including a requirement that the strategy, related costs and returns, and any agreement between the parties to share the related costs be documented BEFORE the strategy is implemented.

TEI submits that it is unreasonable to require taxpayers to document market share strategies before they are implemented. In today's commercial world, tax departments may not regularly be involved in marketing decisions. Such decisions are often highly de- centralized and require quick implementation. It should be sufficient that the taxpayer can, upon audit, document its pricing strategies.

c. LOCATION SAVINGS. Temp. Reg. section 1.482-1T(c)(4)(ii)(C) provides that lower production costs in a taxpayer's geographic market may justify higher profits "only where the location savings would increase the profits of uncontrolled taxpayers operating at arm's-length, given the competitive positions of buyers and sellers in that market." The accompanying example indicates that the significantly lower manufacturing costs for designer clothes incurred in the subsidiary's country do not, by themselves, justify an additional attribution of profits to that subsidiary. The example provides that, although the designer clothes affixed with the U.S. parent corporation's label sell for a premium price, their production requires no specialized knowledge and could have been produced by comparable firms in similar geographic markets. Under the arm's- length standard, the allocation of the location savings between the subsidiary and the parent in the example must be based on an analysis of these comparable, unrelated firms. The result of this analysis will be to allocate the location savings to the parent to the extent this analysis proves that the uncontrolled parties could achieve this same savings.

Location savings generally result from a decision to place a manufacturing facility in a foreign location after comparing costs at the foreign and domestic locations. Factors giving rise to location savings include labor costs, transportation costs, raw material costs, duties, income and franchise taxes, property taxes, personnel training costs, cost of capital, technical assistance, and overhead costs.

Although TEI commends the IRS for addressing location savings in the regulations, we are disappointed that the temporary regulations give no guidance concerning when location savings may be allocated to the manufacturing subsidiary. In Ross Glove Co. v. Commissioner, 60 T.C. 569 (1973), the Tax Court noted that the entity that assumes manufacturing risk should enjoy the manufacturing rewards, including location savings. Similarly, in Sundstrand Corp. v. Commissioner, 96 T.C. 226 (1991), the court compared the taxpayer's costs in Singapore with hypothetical U.S. manufacturing costs. See also Rev. Proc. 63- 10, 1963-1 C.B. 490 (recognizing that location savings inure to the Puerto Rico manufacturing affiliate). More guidance on this issue can only prevent disputes. We suggest adding an example to demonstrate when location savings are properly allocated to the manufacturing subsidiary.

DEFINITION OF VALUABLE, NON-ROUTINE INTANGIBLES

The term "valuable, non-routine intangible" appears in several places throughout the regulations. Its meaning is significant in determining when certain methods (such as the profit-split or comparable profits method) may be used, as well as in determining whether the separate rules governing intangible property transfers are applicable to a transaction involving tangible and intangible components. /11/ The term "valuable, non-routine intangible" is expressly not defined in the regulations, but the preamble to the temporary regulations states:

In general, this term means intangible property that is central

The IRS requests comments on this definition. 1993-10 I.R.B. at 62.

Defining a valuable, non-routine intangible is akin to defining pornography: it is difficult to articulate a precise, all-inclusive definition, but people know it when they see it. Thus, TEI cannot improve upon the general definition set forth in the preamble and recommends that it be incorporated into the final regulations. Any attempt to expand on the statement would undoubtedly introduce undue rigidity into the regulations. More important, we believe that the significance of the concept should be de-emphasized in the regulations.

The use of any particular method, including the profit-split method, should be based on the availability and accuracy of data to establish the taxpayer's transfer prices. The regulations should not prejudge whether any methodology is the best method, based on whether both parties to a transaction own a "valuable, non-routine intangible." Rather, the term should be significant only in identifying intangible components of a transaction that warrant separate valuation. A taxpayer should not be precluded from using the profit-split method in the absence of a valuable, non-routine intangible on both sides of the transaction. Nor should a taxpayer be precluded from using the comparable profits method where both parties possess such an intangible.

PROP. REG. SECTION 1.482-1(f)(2): FOREIGN LEGAL RESTRICTIONS

Prop. Reg. section 1.482-1(f)(2) provides that, with certain exceptions, the district director may make a section 482 allocation without regard to the effect of any foreign legal restriction. The section 482 adjustment will be "deferrable" if the taxpayer establishes that the payment or receipt of the arm's-length amount otherwise required was prevented because of a foreign legal restriction. Under the regulations, however, the taxpayer must elect the deferred income method of accounting with respect to such payments on a return filed before the IRS first contacts the taxpayer concerning the examination of the year in issue. /12/ A foreign legal restriction will be taken into account under this regulation if (i) the restriction is publicly promulgated and generally applicable to all similarly situated persons; (ii) the taxpayer exhausts all effective and practical remedies prescribed by foreign law; (iii) the restriction expressly prevents the payment or receipt of the arm's- length amount; and (iv) the related parties do not engage in any transaction that has the effect of circumventing the restriction.

The proposed regulation constitutes a not-too-subtle attempt to overrule Procter & Gamble Co. v. Commissioner. /13/ In that case, the Sixth Circuit upheld the Tax Court's finding that Spanish law prevented the payment of royalties to related parties. Since foreign law prevented the transfer, the court held that section 482 was inapplicable. The Spanish law at issue, however, apparently applied only to controlled parties and, consequently, the regulations would subject a taxpayer in similar circumstances to a section 482 adjustment.

TEI rejects the government's effort to overrule the Procter & Gamble case by administrative fiat. The Sixth Circuit in that case relied upon the Supreme Court's decision in Commissioner v. First Security Bank of Utah. /14/ We submit that the IRS cannot conjure up the authority to make an adjustment by promulgating a regulation when the country's highest court has held that no authority for such an action exists under section 482.

Moreover, even if the IRS has authority to prescribe when section 482 overrides foreign law, the temporary regulations overreach. A legal restriction should not have to apply to all businesses in the foreign jurisdiction in order to trigger First Security Bank's limitation on section 482. Some countries in Latin America, for example, apply such restrictions only to payments between related parties. The requirement for general applicability should be eliminated. The regulations should also clarify (perhaps in an example) when taxpayers will be considered to have exhausted their remedies under foreign law. The requirement should not compel taxpayers to pursue futile, costly actions.

Finally, the proposed regulations require taxpayers to elect to use the deferred income method on a return filed BEFORE the issue arises on audit. The regulations thus create a trap for the unwary: A taxpayer who believes its pricing satisfies the arm's-length standard will not make the deferred income method election -- it will have no reason to do so (except on a speculative, protective basis). TEI believes that the current regulations -- which provide that the taxpayer may elect the deferred income method after the adjustment has been made and before the occurrence of certain events (such as the execution of a Form 870) /15/ -- embody the better approach.

PROP. REG. SECTION 1.482-6: PROFIT-SPLIT METHOD

Prop. Reg. section 1.482-6 sets forth the rules for applying the profit-split method. Under Prop. Reg. section. 1.482-6(b), four conditions are imposed for use of the method: (i) each party must contribute an acquired or self-developed valuable, non-routine intangible; (ii) the intangibles must contribute significantly to generating the combined profit from the business activity; (iii) there must be significant transactions between the controlled taxpayers and the activities of each taxpayer must contribute significantly to the combined profit or loss; and (iv) the controlled taxpayer must elect to apply the profit-split method.

a. ELECTION TO APPLY PROFIT-SPLIT METHOD. TEI questions whether the government has the statutory authority to require taxpayers to make a binding election to use the profit-split method. Section 482 is a results-oriented statute: as long as the end result is reasonable, it is irrelevant what method the taxpayer used to obtain them. We seriously doubt that a court would refuse to allow a taxpayer to defend its prices under the profit-split method merely because it had failed to make an election.

At the May 14 hearing on the proposed penalty regulations, IRS representatives stated that when the proposed regulations become final, the profit-split method will be considered a prescribed method for purposes of the substantive section 482 regulations and the penalty regulations. If so, we believe that no policy reason exists to impose stricter conditions on its availability than the other prescribed methods. (Even with respect to the use of an "other" method, the regulations do not require a binding election.) At a minimum, the regulations should clarify that a taxpayer may use the profit-split method to rebut a section 482 allocation on audit, without requiring a prior election.

b. AVAILABILITY OF PROFIT-SPLIT METHOD. In addition, TEI can discern no policy justification for limiting the use of the profit- split method to transactions involving valuable, non-routine intangibles on both sides. The courts have repeatedly looked to profit splits as the best solution where comparable products or transactions are lacking. The limitation on the use of the profit- split method under the regulations will effectively force taxpayers to use the comparable profits or an "other" method when comparables are unavailable. In many cases, however, a CPM analysis will be based on less accurate data than a profit-split analysis. The profit-split method should be available whenever a taxpayer determines that it is the best method, based on the accuracy of the obtainable data.

c. ACQUIRED OR SELF-DEVELOPED INTANGIBLES. Prop. Reg. section 1.482-6(b) provides that in order to apply the profit-split method, a taxpayer must own an intangible that it either acquired from an uncontrolled party or developed itself. Temp. Reg. section 1.482- 5T(a) provides a similar rule with respect to the application of the comparable profits method.

TEI believes that this "acquired or developed" rule is too restrictive, particularly with respect to transfers between related foreign enmities that are not engaged in a U.S. trade or business. As a practical matter, the requirement will often make the use of the profit-split (or comparable profits) method unavailable. The restriction is an improper limitation on the use of the two methods and should be eliminated. /16/

d. APPROPRIATE SHARE OF PROFITS AND LOSSES. Prop. Reg. section 1.482-6(a)(2) provides that profit allocated to any particular member of a controlled group under the profit-split method is not limited to the total net profit of the group from the relevant activity. This provision essentially permits the IRS to hypothecate and then allocate income to a taxpayer when none exists. Such an approach ignores economic reality and, effectively, grants the IRS a taxing power that has not been authorized by legislation. TEI recommends that the regulations be revised to eliminate any suggestion that the IRS may allocate income to a taxpayer when the combined activity has sustained an overall loss.

e. MOST ACCURATE MEASURE. Prop. Reg. section 1.482-6(d)(2) provides that, in addition to making an election, a taxpayer must meet certain procedural requirements in order to apply the profit- split method, including satisfactorily documenting that the profit- split method "provides the most accurate measure of an arm's-length result." TEI believes that it is improper to require taxpayers to make such a showing. How do taxpayers determine what result is the "most accurate" when a range of prices exists? Taxpayers should only be required to show that the result fits within the range of arm's- length results. Moreover the best method rule effectively renders this "most accurate measure" requirement redundant. It should be eliminated.

COORDINATION WITH THE PROPOSED REGULATIONS UNDER SECTION 6662

a. IN GENERAL. TEI remains concerned that the rigid procedural and documentation requirements in the temporary regulations create a multitude of traps that may subject diligent taxpayers to the section 6662(e) penalty. Moreover, the in terrorem effect of the regulations may cause taxpayers to devote inordinate resources to analyzing transfer prices under multiple methods in order to protect themselves from such penalties. Thus, even taxpayers that perform such comprehensive analyses cannot be confident that no penalty will be imposed.

TEI believes that a penalty should, above all, be applicable only under well-defined circumstances. As the substantive section 482 regulations acknowledge, the determination of the "correct" transfer methodology is an inherently factual, complex undertaking and there is rarely any single, unassailable "right" answer. The possible imposition of the penalty is a potent threat to taxpayers. TEI is concerned that the section 482 penalty may become a "bargaining chip" in disputes over substantive section 482 adjustments. We submit that such an approach undermines the integrity and fairness of the tax system and is scarcely consistent with the IRS's Compliance 2000 initiatives.

The Institute is particularly concerned about the assertion of the penalty in situations where the taxpayer fails to meet certain procedural requirements (such as disclosing the use of an "other" method on its return or filing the required election for use of the profit-split method). Consider, for example, a taxpayer relying upon a CUP that is later determined to be inapplicable. The taxpayer determines that the use of an "other" method is proper, but is precluded from defending its transfer pricing under that method because it did not disclose the use of that "other" method on its tax return. /17/ Or consider the case of a taxpayer concluding that one party to a transaction does not possess a valuable, non-routine intangible and applying the comparable profits method. If it is subsequently determined that valuable, non-routine intangibles are present on both sides of the transaction, the regulations declare the use of CPM improper. The taxpayer might be barred, however, from contesting a proposed adjustment on the basis of, say, the profit- split method if there were no written pricing agreement. We believe that, even if the IRS's proposed adjustment is sustained, the assertion of a penalty in these circumstances is improper.

The effect of the substantive regulations and the procedural requirements is to require the taxpayer to document not only the method actually used, but all other methods that might be used to defend its transfer pricing. Even where the taxpayer goes to such extraordinary lengths, the failure to "check the box" could subject it to a penalty. TEI believes that the inadvertent failure to satisfy a procedural requirement for use of a particular method should not automatically result in the assertion of a penalty, even if such a failure precludes the availability of another method to defeat the substantive adjustment. We recommend that the final regulations expressly recognize that --

o A taxpayer who has substantially complied with the

o A taxpayer who relies upon a prescribed method will not be

b. THE TEMPORARY REGULATIONS. Temp. Reg. section 1.482-3T(d)(3) states that the use of an "other" method will not "in itself be sufficient to establish reasonable cause and good faith," thereby implying that the use of an "other" method should at least be considered a factor in determining reasonable cause for purposes of the section 482 penalty. Temp. Reg. section 1.482-4T(d) contains a similar rule relating to intangible property. The proposed penalty regulations provide, however, that the "other" methods described in Temp. Reg. sections 1.482-3T(e) and 1.482-4T(d) are not considered to be methods prescribed in the substantive section 482 regulations, and thereby signal that the use of such other method is NOT a factor to be considered. TEI recommends that the proposed penalty regulations be revised to conform with the rule in the substantive section 482 regulations.

TEMP. REG. SECTION 1.482-1T(d): SCOPE OF REVIEW

a. LIMITATIONS ON ALLOCATION. Temp. Reg. section 1.482- 1T(d)(2)(i)(A) recognizes that transactions by uncontrolled parties may produce a range of results, and that a controlled transaction will not be subject to a section 482 allocation if it falls within the range established by two or more comparables. A result falling outside the range will generally be adjusted to the mid-point of the range. Under Temp. Reg. section 1.482-1T(d)(2)(i)(D), however, the district director is not required to establish a arm's-length range in order to make an adjustment; a single comparable can be used.

TEI believes that adjusting results that fall outside the range to its mid-point is contrary to the range concept. Adjusting to any point within the range is in accordance with the arm's-length standard. /19/ We recommend that the "mid-point" concept be abandoned.

Moreover, TEI submits that permitting an adjustment based on a single comparable is inconsistent with Temp. Reg. section 1.482- 1T(c)(4)(iii), which states that isolated transactions are "ordinarily" insufficient to establish an arm's-length result. The interaction of these two provisions also creates a whipsaw for taxpayers who may have a single comparable they are proscribed from relying upon, only to have the IRS adjust their transfer pricing based on that same comparable. The better approach is not to apply a hard-and-fast rule with respect to single comparable transactions for either party.

b. ALLOCATIONS TO RESULTS, NOT METHOD. Temp. Reg. section 1.482- 1T(d)(2)(ii) provides that in determining whether a result is arm's length, it is not necessary for the district director to determine whether the method that the controlled taxpayer employs corresponds to the method that might have been used by a taxpayer dealing with an uncontrolled taxpayer. The example used to illustrate this paragraph is confusing. /20/ In the example, a foreign distributor of household appliances earns an aggregate gross margin of 18 percent on sales from its U.S. parent. The example finds this result consistent with an uncontrolled party's aggregate gross margin, "[a]fter adjusting for minor differences in the level of inventory, volume of sales, and warranty programs." It concludes that the district director does not need to consider whether the U.S. parent and foreign subsidiary have treated inventory and warranty in the same manner as these factors have been treated by the uncontrolled party since the results of the controlled transaction are the same as the results of the uncontrolled comparable transaction.

How does this example relate to the example in Temp. Reg. section 1.482-1T(e)(2)(iv) (dealing with collateral adjustments), which considers an adjustment to items such as advertising, as well as the gross margin? The two examples seemingly permit the IRS to compare only the gross margin when it benefits the government, but to look behind that margin when it does not. Such a one-way street is improper.

c. AGGREGATION OF TRANSACTIONS. Temp. Reg. section 1.482- 1T(d)(3)(i) permits the district director to aggregate two or more separate transactions that are so interrelated that consideration of multiple transactions is necessary to determine the arm's-length consideration for the controlled transactions. Generally transactions will be aggregated only when they involve related products or services, as defined in Treas. Reg. section 1.6038A-3(c)(7(vii).

The examples illustrating this rule are apparently aimed at overruling the Bausch & Lomb case. The first example involves a parent that enters into a licensing agreement with a subsidiary (S1) to use a proprietary manufacturing process and to sell the output throughout the area. S1 manufactures the product and sells the output to a second subsidiary (S2) that, in turn, resells to third parties. The example concludes that, in testing the arm's-length character of the royalty paid by S1 to the parent, the district director may consider the arm's-length character of the transfer prices charged by S1 to S2 and the aggregate profits earned by S1 and S2 from the use of the manufacturing process and the sales to uncontrolled parties. The regulations are flawed because they permit the IRS to aggregate transactions but forbid taxpayers from doing so.

d. MULTIPLE-YEAR DATA. Temp. Reg. section 1.482-1T(d)(3)(v)(A) grants discretionary authority to the district director to consider information about uncontrolled comparables or the controlled taxpayer for one or more years before or after the year under review. Circumstances warranting consideration of multiple-year data are specified in Temp. Reg. section 1.482-1T(d)(3)(v)(B).

The preamble to the proposed regulations requests comments on whether taxpayers should be permitted to determine an arm's-length result for a particular year by reference to data derived from comparable transactions in previous years. 1993-10 I.R.B. at 62. Although the use of multiple-year data may increase the taxpayer's burden of substantiation, TEI favors such an approach. In many cases, reliance on multiple-year data will provide a more accurate result than a single year "snapshot" approach. We therefore endorse the concept that a taxpayer may also employ multiple-year data.

TEMP. REG. SECTION 1.482-1T(e)(2): COMPENSATING ADJUSTMENTS

Temp. Reg. section 1.482-1T(e) sets forth the rules for making collateral adjustments arising as a result of a section 482 allocation. Temp. Reg. section 1.482-1T(e)(2) defines a compensating adjustment as an adjustment made to reflect an arrangement between controlled taxpayers for reimbursement or other payments. In essence, the regulations permit taxpayers to make adjustments after the transaction is completed to reach an arm's-length price. /21/

TEI applauds the IRS and Treasury for recognizing that taxpayers may not always be in a position to ensure that an arm's-length price is charged for intercompany transactions at the time the transactions are completed. The compensating adjustment procedure provides a reasonable mechanism for taxpayers to comply with the commensurate- with-income standard. We are concerned, however, that taxpayers availing themselves of this mechanism may have to choose between the Scylla of double taxation (if treaty partners do not recognize post- year-end adjustments for tax purposes) or the Charybdis of incurring a penalty. In fact, in some countries (such as Italy) it is illegal to report taxable income that deviates from the company's financial books. Moreover, a taxpayer that is precluded by law from making an adjustment for foreign tax purposes may be denied access to competent authority in that country because the adjustment is taxpayer -- rather than government -- initiated.

We urge the IRS, through the U.S. Competent Authority, to pursue discussions with the major treaty partners to develop mutual understandings on whether, and under what conditions, compensating adjustments will be recognized by both countries.

TEMP. REG. SECTION 1.482-1T(f)(1): SAFE HARBORS

Temp. Reg. section 1.482-1T(f)(1) provides a small taxpayer safe harbor for U.S. persons with less than $10 million in sales revenue or engaged in cross-border transactions with a controlled taxpayer that has less than $10 million in sales revenues for the taxable year in issue. For purposes of applying the safe harbor, the sales revenues of members of the U.S. controlled group or the foreign controlled taxpayer must be aggregated. The preamble to the regulations states:

While taxpayers electing this safe harbor would face a reduced

TEI endorses the regulations' recognition of the efficacy of safe harbors in the intercompany pricing area. We are disappointed, however, that additional safe harbors were not provided. The small taxpayer safe harbor represents an attempt to get "small issues" off the tax controversy table. We suggest that other taxpayers may also be willing to exchange a reduction in uncertainty for a less favorable result. Many more situations are equally meritorious for safe harbor consideration, including (i) joint ventures where an unrelated party owns a significant interest, and (ii) long-standing pricing methodologies that have been examined and accepted by examiners. In addition, a valid cost-sharing agreement should be given effect as a safe harbor.

TEMP. REG. SECTION 1.482-3T: TRANSFERS OF TANGIBLE PROPERTY

a. USE OF AN "OTHER" METHOD. Temp. Reg. section 1.482-3T outlines the permissible methods that may be used to determine taxable income in connection with the transfer of tangible property. The methods are (i) the comparable uncontrolled price method; (ii) the resale-price method; (iii) the cost-plus method; (iv) the comparable profits method; and (v) other methods. Selection of a method is subject to the best method rule. In a welcome departure from the 1992 regulations, the temporary regulations do not require taxpayers using the resale-price and cost-plus methods to test their results under the comparable profits method. In addition, unlike the 1992 regulations, the temporary regulations do not prescribe a hierarchy of methods.

TEI commends the IRS for recognizing that the CPI concept set forth in the 1992 regulations was not compatible with the arm's- length standard. We are also pleased with the increased flexibility for choosing an appropriate pricing methodology. The Institute is concerned, however, about the undue burdens the temporary regulations impose on the use of an "other" method.

Temp. Reg. section 1.482-3T(e) provides the circumstances under which a taxpayer may use an other" method to determine the arm's- length consideration for a controlled transaction. Paragraph (2) requires the taxpayer to (i) disclose the use of the method on its return; (ii) prepare contemporaneous documentation setting forth the specific analysis adopted and an analysis of why the method used provides the "most accurate" measure of an arm's-length price; and (iii) produce the documentation within 30 days of a written request. /22/ The regulations specifically provide that, for purposes of the proposed penalty regulations, the documentation required in connection with the use of an "other" method will not, in and of itself, satisfy the reasonable cause and good faith test of section 6662(e).

The regulations contain no rationale for why the taxpayer must show the use of an "other" method is the "most accurate" method. Taxpayers should not be required to show the inapplicability of the prescribed methods in order to use an "other" method. Such a requirement creates a presumption that the use of an "other" method is inherently suspect -- despite the frequent acceptance of the "other" methodology by the courts. See, e.g., Bausch & Lomb v. Commissioner; Eli Lilly v. Commissioner. We submit that the requirement for use of an "other" method should be only that its use achieves an arm's-length result within the appropriate range.

Furthermore the rigid 30-day requirement for producing documentation ignores the problems a multinational corporation may have in operating overseas. Although we question the need for requiring a specific time frame for production of documents, we suggest that any general time frame give consideration to the myriad facts and circumstances that may reasonably necessitate a longer response time. If a specific time is denied necessary, we suggest that -- consistent with Treas. Reg. section 1.6038A-3(f) -- the time period be lengthened to 90 days. At a minimum, the district director should be given the discretion to extend the time for production.

b. COORDINATION WITH INTANGIBLE PROPERTY RULES. Temp. Reg. section 1.482-3T(f) states that the methods described in Temp. Reg. section 1.482-3T will ordinarily not take adequate account of "significant, non-routine intangibles that may be transferred or used with the sale of tangible property." In such cases, it may be necessary to adjust the results obtained under the methods described in Temp. Reg. section 11.482-3T by applying the principles of Temp. Reg. section 1.482-4T (relating to transfers of intangible property). Similarly, the tangible rules may be applied in connection with the determination of the arm's-length consideration for transfers of intangible property where, for example, the value of the property reflects a combination of tangible and intangible elements.

We agree with Temp. Reg. section 1.482-3T to the extent it permits taxpayers to sever intangible from tangible components of a transaction, thereby increasing the likelihood that a comparable will be available to value the tangible component. We recommend that the regulation is accord taxpayers flexibility to rely on the most accurate data available by expressly stating that tangible and intangible components of a transaction may be valued either separately or together. Moreover, the regulations should confirm that, whatever approach a taxpayer takes, the use of a combination of prescribed methods will not result in the use of an "other" method.

In addition, in the event that an adjustment for the presence of an intangible is appropriate, the regulations should clarify that, where functional or product comparables exist for either the resale- price or cost-plus method, the requirement to adjust for the presence of intangibles under Temp. Reg. section 1.482-4T does not result in the use of a "other" method under Temp. Reg. section 1.482-3T(e).

TEMP. REG. SECTION 1.482-4T: TRANSFERS OF INTANGIBLE PROPERTY

a. DEFINITION OF INTANGIBLE PROPERTY. Temp. Reg. section 1.482- 4T(a) describes the methods to be used to determine taxable income in connection with the transfer of intangible property. These methods are (i) the comparable uncontrolled transaction method; (ii) the comparable profits method; and (iii) "other" methods. In addition, the profit-split method (now set forth in Prop. Reg. section 1.482-6) will apply when those regulations become final. Temp. Reg. section 1.482-4T(b) defines "intangible" as any commercially transferable interest in any item in six classes of intangibles that has substantial value independent of the services of any individual. /23/ In the preamble, the IRS requests comments on whether the definition should be expanded. 1993-10 I.R.B. at 62.

The definition of intangible property in the temporary regulations is consistent with the definition of the statutory definition of the term under section 936(h)(3)(B) of the Code. TEI does not believe that the definition can be efficaciously expanded. /24/

b. COMPARABLE UNCONTROLLED TRANSACTION METHOD. Temp. Reg. section 1.482-4T(c) provides that under the CUT method, the arm's- length consideration for a controlled transfer of intangible property is equal to the consideration charged or incurred in a comparable uncontrolled transaction. For purposes of the best method rule, the regulations state that the CUT method, when it can be reasonably applied on the basis of available information, ordinarily will provide the most accurate measure of an arm's-length charge for the transfer of intangible property.

To use the CUT method, the controlled transaction must meet certain standards of comparability. The intangibles in the controlled and uncontrolled transactions must (i) be in the same class of intangibles; (ii) relate to the same type of products, processes, or know-how within the same general industry or market; and (iii) have substantially the same "profit potential." /25/ Eight factors are deemed relevant in determining whether the two transactions are comparable. /26/ These factors are similar to the factors set forth in the current regulations, but exclude items such as prevailing rates in the same industry or for similar products, competing bids or offers, and prospective profits. /27/ We believe that the omitted factors should be retained.

The regulations provide an example in Temp. Reg. section 1.482- 4T(c)(2)(iv) in which the parent licenses to its subsidiary a proprietary process permitting the manufacture of product X at a substantially lower cost than otherwise would be possible. The example provides that -- in spite of the presence of an uncontrolled transaction -- the district director may consider the parent's alternative of producing and selling the product as a factor potentially affecting the amount the parent would demand as a royalty for the proprietary process if it were dealing with an uncontrolled taxpayer at arm's length. The example thus focuses on the fact pattern presented in the Bausch & Lomb case.

The example effectively allows the IRS to trump the CUT method with the comparable profits method. This is wrong, however, because it fails the statute's commensurate-with-income standard and because it conflicts with other provisions of the temporary regulations. Under Temp. Reg. section 1.482-1T(b), the "best" method is the one that entails the fewest adjustments; there is no priority of methods. In the example, however, the district director may use a "make-or- buy" analysis to set the royalty. That approach was rejected in Bausch & Lomb and it should be rejected here.

c. DEVELOPMENT OF AN INTANGIBLE. Temp. Reg. section 1.482- 4T(e)(3)(iv), Example 4 describes a foreign corporation X, that produces and distributes cheese throughout the world under a trade name owned by X. X distributes the cheese in the United States through its subsidiary. The subsidiary enhances the value of the trade name in this country by spending $5 million in advertising and other marketing efforts that is not reimbursed by X. The example concludes that the subsidiary is considered the "developer" of the enhanced U.S. rights to the trade name.

The conclusion in Example 4 seems to conflict with Temp. Reg. section 1.482-4T(e)(3)(i), which provides that a controlled taxpayer will be treated as bearing the costs of developing an intangible "only if it is legally bound before the costs are incurred to bear the costs without regard to the success of the project." Moreover, Temp. Reg. section 1.482-4T(e)(3)(iii) suggests that the proper response to non-arm's-length assistance rendered to a developer by a affiliate is an allocation under section 482 with respect to the assistance. /28/ In essence, the subsidiary in the example has created its own intangible. TEI recommends that the example be clarified to reflect this result.

Example 4 also seems to conflict with Example 10 in Temp. Reg. section 1.482-3T(c)(4). Example 4 equates the development of brand recognition with the development of an intangible. Presumably, this means that the taxpayer must use an "other" method to test the U.S. distributor. Example 10 also provides that brand recognition is an intangible. In that example, however, the transfer price is set under the resale-price method; the existence of the intangible does not force the taxpayer to use an "other" method. TEI believes that, if the concept of a valuable, non-routine intangible is retained in the regulations, further guidance should be issued on whether a marketing intangible is a valuable, non-routine intangible. In this regard, Example 10 should be the rule for both tangible transfers and intangible transfers. Taxpayers should be permitted to use the resale-price or comparable profit method for these transfers, even when both parties possess valuable intangibles.

d. USE OF AN "OTHER" METHOD. The regulations show a strong bias toward use of an "other" method in circumstances where both parties have valuable, non-routine intangibles, thereby bypassing the use of the comparable profits method. We suggest a taxpayer should be permitted to use the comparable profits method even when both sides have valuable intangibles. Alternatively, the regulations could permit the use of the comparable profits method when the intangible owned by one party is a marketing intangible rather than a technology intangible. /29/

TEMP. REG. SECTION 1.482-5T: COMPARABLE PROFITS METHOD

a. INTERACTION WITH THE BEST METHOD RULE. Temp. Reg. section 1.482-5T(a) states that "the comparable profits method (CPM) ordinarily will provide an accurate measure of an arm's-length result unless the tested party . . . uses valuable, non-routine intangibles. . . . " This language suggests that CPM is preferable to the resale-price or cost-plus method and will likely yield correct results if certain requirements are met.

Temp. Reg. section 1.482-5T(a) seemingly conflicts with the best method rule which specifically declines to provide a priority among the potentially applicable methods. Temp. Reg. sections 1.482- 3T(b)(1) and 1.482-4T(c)(1) recognize that CUPs and CUTs are generally the best evidence of an arm's-length price. In contrast, CPM creates a great deal of uncertainty and controversy. There is a serious lack of reliable data on the profitability of transactions between unrelated parties. Such information is almost never available from public sources. Consequently, CPM should not be given priority -- either explicitly or implicitly -- over the resale-price and cost-plus methods. Temp. Reg. section 1.482-5T(a) should be revised to remove any inference to the contrary.

b. RELATED-PARTY COMPARABLES. Example 3 of Temp. Reg. section 1.482-1T(d)(3)(i)(B) provides that sales between two related parties may serve as a comparable for sales between two other related parties, even though comparables from unrelated party transactions exist. It is unclear, however, how this example meshes with other examples in the regulations. Does comparability exist in these circumstances only for purposes of establishing a CUP or CUT, or does it extend to the use of the resale-price or comparable profits method? In Temp. Reg. section 1.482-5T(g), Example 1, similar products are produced by other companies, but none is sold to uncontrolled entities. In applying CPM, the district director ignores the transactions between the other related parties and, instead, seeks data from independent operators of wholesale distribution businesses. The example thus implies that related-party transactions may not be used for purposes of applying CPM.

There are many vertically integrated industries in which no company sells products to non-related distributors. The question whether one related group is comparable to another group is key. We believe that in such circumstances one vertically integrated group should be considered comparable to another group. The example in Temp. Reg. section 1.482-5T(g) should be clarified to permit consideration of the related-party data.

TEMP. REG. SECTION 1.482-1T(g)(3): DEFINITIONS

Temp. Reg. section 1.482-1T(g)(3) defines the term " taxpayer" as any person, organization, trade or business, whether or not subject to any internal revenue tax. The definition conflicts with the definition set forth in section 7701(a)(14) of the Code, which requires that a person be subject to any internal revenue tax. The definition in the regulations should be amended to conform to the statutory definition.

CONCLUSION

Tax Executives Institute appreciates this opportunity to present our views on the proposed and temporary regulations under section 482 of the Code, relating to intercompany pricing. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at (201) 573-3200 or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.

Respectfully submitted,

TAX EXECUTIVES INSTITUTE, INC.

Robert H. Perlman

FOOTNOTES

/1/ For simplicity's sake, the temporary and proposed section 482 regulations are referred to as the "substantive section 482 regulations" or the "temporary regulations"; the proposed section 6662 regulations are referred to as the "proposed penalty regulations"; the proposed section 482 regulations issued last year are referred to as the "1992 regulations"; and the current section 482 regulations are referred to as the "1968 regulations." Specific provisions are cited as "Treas. Reg. section.," Temp. Reg. section," or "Prop. Reg. section."

/2/ The 1992 regulations purported to give the IRS the authority to disregard contractual terms if uncontrolled taxpayers "exercising sound business judgment" would not have agreed to them. See Prop. Reg. section 1.482-1(b)(1) (1992). See also Prop. Reg. section 1.482- 1(b)(1) (1992) (if the developer of an intangible had exercised "sound business judgment," the transferee-manufacturer never would have been permitted to share in the profits attributable to the intangible).

/3/ See Temp. Reg. sections 1.482-1T(c)(3)(iii)(A) (factors to be taken into account in comparing significant economic conditions include alternatives realistically available to a buyer and seller); 1.482-1T(d)(3)(iii) (district director may consider alternatives available to taxpayer in determining extent to which an allocation should be made under section 482); 1.482-3T(6)(2)(ii)(F) (in comparable uncontrolled price method, factors to be considered in determining comparability and required adjustments include the alternative commercial arrangements realistically available to the buyer and seller); and 1.482-4T(c)(2)(iv) (example involving available alternatives in determining an arm's-length range).

/4/ 92 T.C. 525 (1989), aff'd, 933 F.2d 1084 (2d Cir. 1991). The Tax Court stated:

Finally, the respondent argues that B&L COULD HAVE produced the

/5/ See, e.g., Baush & Lomb v. Commissioner, supra; Eli Lilly v. Commissioner, 84 T.C. 996 (1985), aff'd in part, rev'd in part, and rev'd in part, 856 F.2d 855 (7th Cir. 1988).

/6/ Rather than sending taxpayers on a quest for the "best" method, perhaps the language of the regulations could be modified to require a "reasonably reliable" method. See Temp. Reg. section 1.482- 1T(c)(2)(i) (referring to the standard of comparability as providing a comparable that is "sufficiently similar" and provides a "reasonable and reliable benchmark" for determining an arm's-length result).

/7/ Prop. Reg. section 1.6662-5(j)(5)(ii). The prescribed methods are the comparable uncontrolled price (CUP) or transaction (CUT) method, the resale-price method, the cost-plus method, and the comparable-profits method.

/8/ At a minimum, the IRS Audit Manual should contain guidelines to ensure the consistency of approach on audit. While we recognize that the determination of what constitutes "adequate" documentation will vary according to a taxpayer's particularized circumstances, we believe taxpayers will be able to comply more efficiently if the IRS provides general guidance, perhaps by means of examples, on the scope of the requirement.

/9/ Accord U.S. Steel Corp. v. Commissioner. 617 F.2d 942 (2d Cir. 1980).

/10/ Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd sub nom., Gregory v. Helvering, 293 U.S. 465 (1935). See also, Bausch & Lomb v. Commissioner, supra.

/11/ For example as a prerequisite to using the profit-split methodology, Prop. Reg. section 1.482-6(b) requires that both parties to the controlled transaction possess a valuable, non-routine intangible that contributes significantly to the business activity.

/12/ An exception to making the deferred income method election is provided where the taxpayer can demonstrate that the controlled transaction was at arm's length under CUT or CUP. Temp. Reg. section 1.482-1T(f)(2)(iv).

/13/ 961 F.2d 1255 (6th Cir. 1992).

/14/ 405 U.S. 394 (1972). The Supreme Court in First Security, Bank held that the Commissioner could not allocate income under section 482 if federal law prevented the taxpayer from reporting the income in the manner suggested by the Commissioner. The Sixth Circuit in Procter & Gamble said the same reasoning applied in respect of foreign law.

/15/ Treas. Reg. section. 1.482-1(d)(6) (1968).

/16/ In many circumstances (e.g., a transfer of an intangible developed by a U.S. person to a foreign affiliate), section 367 requires an arm's-length return to the transferor. This requirement is sufficient to prevent abuse.

/17/ This possibility has led some tax advisors to recommend that taxpayers make an affirmative election to use an "other" method, even if they are relying upon a prescribed method. We suggest that this reduces the requirement to make a election to a nullity or a trap for the unwary.

/18/ The distinction between the use of a prescribed method and a "other" method will become even more important should the pending legislation be enacted.

/19/ Westreco, Inc. v. Commissioner, 64 T.C.M. (CCH) 849 (1992).

/20/ Temp. Reg. section 1.482-17(d)(2)(iii).

/21/ The temporary regulations also provide for correlative adjustments and setoffs, which are essentially the same rules provided under the 1968 regulations. Temp. Reg. section 1.482- 1T(e)(3)(i) contemplates that a compensating adjustment made by one party to the transaction will be accompanied by a correlative adjustment to the transaction by the other party.

/22/ The same requirements are imposed under Temp. Reg. section 1.482-4T(d) with respect to the use of an "other" method to determine the arm's-length consideration for the transfer of intangible property.

/23/ The six classes of intangibles include (i) patents, inventions, formulae, processes, designs, patterns, or know-how; (ii) copyrights or literary, musical, or artistic compositions; (iii) trademarks, trade names, or brand names; (iv) franchises, licenses, or contracts; (v) methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and (vi) other similar items.

/24/ A different definition of the term would create significant tension between sections 482 and 936.

/25/ Profit potential is measured by the net present value of the benefits to be realized (based on prospective profits to be realized or costs to be saved) through the use or subsequent transfer of the intangible, taking into consideration the capital investment and start-up expenses required, the risks to be assumed, and other relevant consideration. Temp. Reg. section 1.482-4T(c)(2)(ii)(A)(3).

/26/ Temp. Reg. section 1.482-4T(c)(2)(ii)(B).

/27/ See Treas. Reg. section 1.482-2(d)(2) (1968).

/28/ The provision states: "The district director may make a allocation to reflect arm's length consideration for assistance provided to the developer by another controlled taxpayer in connection with the development of an intangible."

/29/ Under the regulations, a taxpayer may be able to use the tangible property rules if the intangible is sufficiently integrated with tangible property, but this possibility is too amorphous to rely upon.

END OF FOOTNOTES