PROPOSED TRANSFER PRICING REGS COVER USE OF PROFIT-SPLIT METHOD.

[Editor's Note: The following text incorporates corrections published by the IRS on June 9, 1993.

[Editor's Note: Treasury Decision 8552, July 8, 1994, 59 F.R. 34971-35030, finalized all temporary reg. sections except proposed reg. sections 1.482-1A and 1.482-2A; those proposed reg. sections were adopted by T.D. 8470, 58 FR 5263-5293, Jan. 21, 1993. Treasury Decision 8632, Dec. 20, 1995, 60 F.R. 65553-65566, finalized temporary reg. section 1.482-7T, with changes.]

CC:INTL-0401-88

ACTION: Notice of proposed rulemaking.

SUMMARY: In the Rules and Regulations section of this issue of the Federal Register, the Internal Revenue Service is issuing temporary regulations relating to intercompany transfer pricing under section 482 of the Internal Revenue Code. The Tax Reform Act of 1986 amended section 482. The text of those temporary regulations also serves as the comment document for this notice of proposed rulemaking and additional text is proposed in this document.

DATE: Written comments and request for a public hearing must be received by [INSERT DATE THAT IS 180 DAYS AFTER THE DATE THIS DOCUMENT IS PUBLISHED IN THE FEDERAL REGISTER] .

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

FOR FURTHER INFORMATION CONTACT: Sim Seo at (202) 622-3840 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

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

The collection of information in this notice of proposed rulemaking is in sections 1.482-1T, 1.482-3T, 1.482-4T, and 1.482-6T. This information is required by the Internal Revenue Service to implement section 482 of the Internal Revenue Code. This information will be used by the Service to ensure compliance with the relevant statutes and regulations. The likely respondents and/or recordkeepers are businesses. The following estimates are approximations. They are based on such information as is available to the Internal Revenue Service. Individual respondents/recordkeepers may require greater or less time, depending on their particular circumstances. Estimated total annual reporting and/or recordkeeping burden: 30,700 hours. The estimated annual burden per respondent is estimated to be 3.6 hours.

BACKGROUND

The temporary regulations published in the Rules and Regulations section of this issue of the Federal Register add new sections 1.482-OT, 1.482-1T, and 1.482-2T through 1.482-7T to the Income Tax Regulations. The final regulations that will result from the regulations proposed in this notice will be based on the text of the temporary regulations and will provide rules relating to intercompany transfer pricing under section 482 of the Internal Revenue Code. For the text of the temporary regulations, see T.D. 8470, published in the Rules and Regulations section of this issue of the Federal Register. The preamble to the temporary regulations contains a full explanation of the reasons underlying the issuance of the proposed regulations.

In addition to the text of the temporary regulations, the final regulations that will result from the regulations proposed in this notice will be based on the text of proposed sections 1.482-1T(f)(2) and 1.482-6T contained in this notice. These provisions are proposed to take the place of reserved sections of the temporary regulations.

Proposed regulations under section 482 were issued on January 30, 1992 (INTL-0372-88, INTL-0401-88, 57 FR 3571). With the exception of the cost sharing provisions of proposed section 1.482-2(g), the proposed regulations issued on January 30, 1992, are withdrawn.

COMMENTS AND PUBLIC HEARING

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

EXPLANATION OF PROPOSED REGULATIONS

SECTION 1.482-1T(f)(2)

Section 1.482-1T(f)(2) provides guidance on the extent to which foreign legal restrictions on payments between controlled taxpayers will be respected for purposes of section 482. In general, section 1.482-1T(f)(2)(i) provides that a foreign legal restriction will be recognized for this purpose if the taxpayer demonstrates that the receipt of an arm's length payment was prevented by a foreign legal restriction, and the taxpayer elects the deferred income method of accounting with respect to such payments.

Section 1.482-1T(f)(2)(ii) defines an applicable foreign legal restriction as a restriction that is publicly promulgated and generally applicable, with respect to which the controlled taxpayer has exhausted all practicable legal remedies afforded under foreign law for obtaining a waiver, expressly prevents the payment of an arm's length amount within the meaning of section 482, and was not circumvented through other transactions between the controlled taxpayers.

Section 1.482-1T(f)(2)(iii) provides that if the restriction meets the definition of an applicable foreign legal restriction and the taxpayer has elected the deferred income method of accounting, any section 482 allocation connected with the transaction will be deferrable until the restriction is removed. Deductions and credits chargeable against a deferred amount are subject to deferral under section 461.

Section 1.482-1T(f)(2)(iv) provides an exception from the election requirement in cases in which the taxpayer can demonstrate, based on a comparable uncontrolled transaction, that the transaction as structured was at arm's length.

SECTION 1.482-6T

In response to comments, the scope of application and flexibility of the profit split approach has been significantly expanded from that in the former proposed regulations. Section 1.482- 6T describes three profit split methods that may be employed. Like the comparable profits method (section 1.482-5T), this approach may be used in transactions involving either tangible or intangible property. The basic objective of this approach is to estimate an arm's length return by comparing the relative economic contributions that two parties make to the success of a venture, and dividing the returns from that venture between them on the basis of the value of such contributions.

Since the profit split method either wholly or in part relies on internal data rather than data derived from uncontrolled taxpayers, other methods often will provide the most reliable indicator of an arm's length result. Accordingly, several requirements have been imposed on taxpayers that wish to apply this method to ensure that it only is used in cases where it is the most appropriate method. A taxpayer may apply the profit split method only if both controlled taxpayers own valuable, non-routine self-developed intangible property (or an intangible acquired from an uncontrolled taxpayer, but only if the controlled taxpayer assumes significant risks and possesses the right to significant economic benefits attributable to the intangible) and the intangible contributes significantly to earning the combined income derived from the relevant business activity; there are significant transactions between the controlled taxpayers; and certain administrative requirements are followed. The most important administrative requirement is that the taxpayer must make a binding election to apply the profit split method that may be revoked only with the consent of the Commissioner.

Section 1.482-6T(c) provides that the three profit split methods are: the residual allocation rule; the capital employed allocation rule; and the comparable profit split rule.

Section 1.482-6T(c)(2) describes the residual allocation rule. This rule is similar to the Basic Arm's Length Return Method profit split that was described in the Section 482 White Paper ( Notice 88- 123, 1998-2 C.B. 458). It consists of two basic steps. First, applying an analysis similar to that described under other methods such as the comparable profits method, market returns to the parties' routine functions are estimated and allocated to the parties performing them. Such an allocation normally will not account for the income attributable to the exploitation of valuable intangible property, and a residual profit will remain in such cases. On the assumption that this residual amount is attributable to intangible property, the residual amount is divided between the controlled taxpayers based on a measure of their relative value of their contributions of intangible property. Of course, market values normally are unavailable and some other measure than a market price must be employed. Often a reliable measure will be the parties' relative expenditures related to the development of the intangible property exploited. Depending on the facts and circumstances, the expenditures that are compared may be limited to current expenditures, or may be capitalized expenditures over a period of years. Moreover, other measures may be more appropriate in particular cases.

Section 1.482-6T(c)(3) describes the capital employed allocation rule. This rule applies only if all the controlled taxpayers participating in the relevant business activity assume an approximately equal level of risk with respect to their capital employed. Risk is measured based on the probability of gain or loss rather than a measurement of total potential gain or loss from an activity. Comment is requested on the merits of a profit split based on this approach and the feasibility of measuring relative levels of risk.

Under the capital employed allocation rule, the parties' combined income is divided between the parties by allocating an equal return to each controlled taxpayer's capital employed. For this purpose, capital employed is equal to the book or fair market value of all operating assets employed in the relevant business activity plus the value of any intangible property employed. Intangible property value may be estimated by capitalizing past expenditures on intangible development. Tangible and intangible assets can be valued based on their fair market values only if reliable information regarding the fair market value of such assets is available.

Section 1.482-6T(c)(4) describes the comparable profit split rule. This rule is similar to the comparable profit split set forth in the former proposed regulations (proposed section 1.482- 2T(f)(6)(iii)(C)(3)). Finally, section 1.482-6T(c)(5) provides that other profit splits may be employed where capital is difficult to measure or is not a significant determinant of operating profit. The taxpayer must demonstrate to the district director that such a profit split provides an economically valid basis for the allocation of profit or loss arising from the relevant business activity.

Section 1.482-6T(d) describes the administrative requirements that a taxpayer must meet in order to apply the profit split method. In addition to the binding election requirement, the taxpayer also must document, to the satisfaction of the district director, the combined profit or loss attributable to the business activity and explain in such documentation why the profit split method provides the best method for determining an arm's length result under the facts and circumstances; prior to making the binding election the taxpayer must execute a pricing agreement setting forth the allocation method chosen; and the method must be applied consistently by all the parties to the agreement from year to year. Section 1.482- 6T(e) clarifies that the written pricing agreement has no effect other than satisfying these procedural requirements.

Section 1.482-6T(f) provides that, with the exception of the administrative requirements, the district director also must satisfy the requirements that the taxpayer must satisfy in order to apply the profit split method.

OTHER COMMENTS SOLICITED

In connection with the issuance of the proposed and temporary regulations under section 482, the Service considered a number of other provisions that have not been included in either the proposed regulations or the temporary regulations. Comment is solicited on these issues, which are described below.

(1) Exception from adjustment using current year data -- Comment is requested on the possibility of introducing an exception from the general, multiple year data rule under section 1.482-1T(d)(3), under which taxpayers would be permitted to determine an arm's length result for a particular year by reference to data derived from comparable uncontrolled transactions that occurred in previous years. Under this exception, the taxpayer would be required to update this data as new information became available. While the district director would be permitted to adjust the taxpayer's results obtained under this approach, such adjustments could be made only on the basis of data derived from transactions occurring in the same years as the transactions that the taxpayer employed to determine its prices.

(2) Definition of valuable, non-routine intangible -- A comprehensive definition of the term "valuable, non-routine intangible" is not included in the Temporary Regulations under section 482. Comment is requested on possible precise definitions for this term that could be provided by regulation.

(3) Other methods for determining arm's length consideration for transfers of intangible property -- Comment is requested as to whether, in addition to the methods enumerated in section 1.482-4T, a method could be provided that would measure an arm's length result for the transfer of an intangible by discounting the projected costs and benefits to the licensor or the licensee, employing valid measures of the cost of capital such as the capital asset pricing model. Alternatively, the projected costs and benefits of both the licensor and licensee could be determined and any residual amount apportioned between the parties based on a profit split.

(4) Definition of an intangible -- Comment is requested as to whether the definition of intangible property incorporated in section 1.482-4T(b) should be expanded to include items not normally considered to be items of intellectual property, such as work force in place, goodwill or going concern value.

DRAFTING INFORMATION

Personnel from the Internal Revenue Service and the Treasury Department participated in the development of these regulations.

LIST OF SUBJECTS

26 CFR 1.481-1 through 1.483-2T

Accounting, Income taxes, Reporting and recordkeeping requirements.

26 CFR part 602

Reporting and recordkeeping requirements.

PROPOSED AMENDMENTS TO THE REGULATIONS

Accordingly, the notice of proposed rulemaking published on January 30, 1992, (57 FR 3571) is withdrawn with the exception of proposed section 1.482-2(g), and 26 CFR parts 1 and 602 are proposed to be amended as follows:

Authority: 26 U.S.C. 7805.

Par. 5. Section 602.101(c) is amended by adding a new entry to the table to read as follows:

      "1.482-6T                     1545-1298"

CC:INTL-401-88 [4830-01]

ACTION: Temporary regulations.

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

EFFECTIVE DATE: [INSERT DATE THAT IS 90 DAYS AFTER DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER] [April 21, 1993].

FOR FURTHER INFORMATION CONTACT: Sim Seo of the Office of Associate Chief Counsel (International), Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, Attention: CC:CORP:T:R (INTL-0401-88) (202-622-3840, not a toll-free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

These regulations are being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collection of information contained in these regulations has been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget (OMB) under control number 1545-1369. The estimated annual burden per respondent/recordkeeper varies from .5 hours to 10 hours, depending on individual circumstances, with an estimated average 5.25 hours.

These estimates are approximations. They are based on such information as is available to the Internal Revenue Service. Individual respondents/recordkeepers may require greater or less time, depending on their particular circumstances.

For further information concerning this collection of information, and where to submit comments on this collection of information, the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble in the cross-reference notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register.

BACKGROUND

This document contains temporary regulations amending the Income Tax Regulations (26 CFR part 1) under section 482 of the Internal Revenue Code. Section 482 was amended by the Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 2085, 2561, et seq. Proposed regulations under section 482 were issued on January 30, 1992 (INTL-0372-88; INTL-0401-88, 57 FR 3571).

NEED FOR TEMPORARY REGULATIONS

The provisions contained in this Treasury decision are needed immediately to provide guidance to the public with respect to intercompany transfer pricing under section 482. Therefore, it is found impracticable and contrary to the public interest to issue this Treasury decision with prior notice under section 553(b) of title 5 of the United States Code.

EXPLANATION OF PROVISIONS

INTRODUCTION

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

THE WHITE PAPER

The Conference Committee report on the Act recommended that the Internal Revenue Service (the Service) conduct a comprehensive study of transfer pricing and consider whether regulations under section 482 should be "modified in any respect." In response, the Treasury Department and the Service issued a study of intercompany pricing ( Notice 88-123, 1988-2 C.B. 458) on October 18, 1988 (the White Paper). Although the White Paper primarily addressed transfers of intangible property, it also addressed the application of section 482 to other types of transactions.

The White Paper proposed two approaches for determining an arm's length charge for intangible property in light of the commensurate with income standard. The first was a pricing approach that relied on two types of comparable transactions: the exact comparable method and the inexact comparable method. The second approach was an income- based approach that included two methods: the basic arm's length return method (the BALRM) and BALRM with profit split. The BALRM generally allocated income to the parties to a controlled transaction by assigning industry average returns to the assets and functions that the parties devoted to the business activity connected with the controlled transaction. In cases involving the exploitation of so- called "high-profit" intangibles, any residual profit would be divided among the parties on the basis of an estimate of the relative values of the intangibles that each contributed to the activity.

Many comments on the White Paper criticized the BALRM, arguing that the information needed to apply it generally would be unavailable, would be unfair to corporations whose returns vary considerably from the average, and would allocate too much income to U.S. entities. The Service also was urged to assign a greater role to inexact comparables and to reconsider the use of safe harbor rules.

THE PROPOSED REGULATIONS

In response to the comments received on the White Paper, the Internal Revenue Service issued proposed regulations under section 482 on January 30, 1992 (INTL-0372-88; INTL-0401-88, 57 FR 3571) (the proposed regulations). The proposed regulations proposed four major changes in the current regulations under section 482: that the scope and purpose of the regulations be modified to reflect the legislative changes to section 482; that new rules with respect to intangible property transfers be implemented; that the rules with respect to tangible property transfers be modified; and that detailed new cost- sharing regulations be introduced. The most significant change to the tangible and intangible property rules was the introduction of a new pricing method known as the comparable profit interval.

As part of the recommended changes to the scope and purpose of the regulations, the proposed regulations included a statement that a broad principle to be applied in all cases was whether uncontrolled taxpayers exercising sound business judgment would have agreed to the same terms in the same circumstances. In particular, the proposed regulations provided that so-called "round-trip" transactions (an integrated series of controlled transactions in which intangible property is licensed to an affiliate and the affiliate uses the intangible to produce tangible property for sale back to the licensor or another affiliate) be analyzed together.

The existing regulations (section 1.482-2(d)) contain two approaches for determining an arm's length consideration for intangible property. The preferred approach is based on the comparable uncontrolled price method set forth in the tangible property rules, and the second is based on an analysis of twelve factors. The proposed regulations recommended that these rules be replaced with three new methods: the matching transaction method (the MTM), the comparable adjustable transaction method (the CATM), and the comparable profits method (the CPM).

A controlled transaction would satisfy the MTM if there was an uncontrolled transfer of the same intangible under the same, or substantially similar, economic conditions and contractual terms. This standard represented a tightening of the standards of comparability under the analog to the comparable uncontrolled price method of the existing regulations.

A controlled transaction would satisfy the CATM if there was an uncontrolled transfer of the same or a similar intangible under "adjustable" circumstances. Adjustments to the contractual terms and economic circumstances would be allowed if the effect of any differences could be determined with reasonable accuracy. In addition, the result of the controlled transaction was subject to verification by application of the Comparable Profit Interval (the CPI).

Under the CPM, the operating income resulting from the consideration charged in a controlled transaction (reported operating income) was compared with the reported operating incomes of similar uncontrolled taxpayers. The consideration charged in the controlled transaction would be considered arm's length if the taxpayer's reported operating income fell within the "comparable profits interval" (CPI).

The CPI was constructed in steps. First, "profit level indicators" (e.g., rate of return on assets) for uncontrolled taxpayers in the applicable business classification of the controlled taxpayer were determined and applied to the controlled taxpayer's financial data for a period of three years to compute constructive operating incomes (COIs) for the controlled taxpayer. The COIs that tended to converge comprised the CPI. If a taxpayer's actual results fell outside the CPI, the taxpayer generally was subject to adjustment to a point within the CPI known as the "most appropriate point." Relatively little guidance was provided with respect to determining the constructive operating incomes that converged to form the CPI and to determining the most appropriate point.

Unless one of three narrow exceptions applied, the proposed regulations implemented the commensurate with income standard of the Act by providing that these three methods could be applied to adjust the consideration charged for an intangible in the year of examination despite the fact that the same consideration may have been determined to be arm's length for an earlier taxable year.

The proposed regulations also modified the rules with respect to transfers of tangible property (section 1.482-2(e)). The principal change was to require that results obtained from the application of the resale price method, the cost-plus method and so-called fourth methods fall within the CPI. This change was made in order to eliminate the need to allocate the value of an item of tangible property between its intangible and tangible components when such property contained elements of both types of property.

Finally, the proposed regulations altered the priority of methods under both the tangible and intangible property rules. While preserving a fixed priority of methods, the proposed regulations stated that it was not necessary to disprove the applicability of a method before applying a lower-priority method. Either the Service or the taxpayer could, however, subsequently establish that a higher- priority method applied and thereby override the results obtained under the lower-priority method.

The Service received numerous comments on the proposed regulations. In addition to receiving helpful comments from a large number of taxpayers and industry or professional groups, the Service received constructive comments from several tax treaty partners, both from individual countries and through such international fora as the Organization for Economic Cooperation and Development.

Commenters criticized several aspects of the proposed regulations. Many criticized the requirement that the results obtained under all methods except for exact comparables fall within the CPI, based on the view that such a requirement would elevate the CPM to equal or greater priority than the more traditional transaction-based methods such as the resale price method. Many commenters felt that elevating CPM to such a high level of priority was inconsistent with the arm's length standard. Other commenters criticized the very tight standards of comparability under the MTM, the narrow scope of the exceptions to the periodic adjustment rule, the degree of knowledge imputed to taxpayers under the sound business judgment rule, the relationship between the tangible and intangible property rules, the lack of guidance with respect to determining convergence and the most appropriate point under the CPM, and the failure to provide a safe harbor. Commenters generally praised the introduction of a range of acceptable results and the use of multi- year averages under the CPI, as well as the relaxation of the strict priority of methods under the existing regulations. Further description of the comments received is set forth in the discussion below.

PROVISIONS OF THE TEMPORARY REGULATIONS

SECTION 1.482-1T

The scope and purpose provisions have been reorganized to make clear that the arm's length standard is the guiding principle for all allocations under section 482, and to provide additional guidance for determining comparability under the arm's length standard. Section 1.482-1T(a)(1) reaffirms that the purpose of section 482 is to ensure that taxpayers clearly reflect their income by placing a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the controlled taxpayer's true taxable income. Section 1.482-1T(a)(2) authorizes the district director to allocate income, deductions, credits, allowances, basis, or any other item or element affecting taxable income among a group of controlled taxpayers when they have not reflected their true taxable income. Section 482-1T(a)(3) provides, as do the current regulations, that only the district director may apply the provisions of section 482, but clarifies that this restriction does not limit the taxpayer's ability to report its true taxable income. It has been asserted in the past that taxpayers were not permitted to report results that differed from transactional results in order to reflect an arm's length result on the tax return. A taxpayer's ability to report results that differ from its transactional results may be limited, however, by section 1059A.

Section 1.482-1T(b) summarizes several key principles that guide the application of section 482. These principles are summarized in this portion of the regulation because they are relevant under subsequent provisions. More specific guidance is provided under such subsequent provisions.

Section 1.482-1T(b)(1) reaffirms that in determining a taxpayer's true taxable income, the standard to be applied is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer (the arm's length standard). In this respect the regulations are consistent with the current regulations and reflect many comments on the proposed regulations, which stressed the importance of adhering to the arm's length standard. The arm's length standard is satisfied if the results of controlled transactions are consistent with the results that would have been realized had uncontrolled taxpayers engaged in a comparable transaction under comparable circumstances. Guidance for determining comparability of an uncontrolled transaction is provided in section 1.482-1T(c), discussed below.

Section 1.482-1T(b)(2) provides rules for determining the method or methods that will be applied in a particular case to test whether transactions between controlled taxpayers are at arm's length. First, section 1.482-1T(b)(2)(ii) provides that for some transactions it may be necessary to apply different methods to related transactions where such transactions are most reasonably tested on a separate basis (such as services and property).

Second, section 1.482-1T(b)(2)(iii)(A) provides a "best method rule" for selecting the method to be applied to test the arm's length character of a controlled transaction. In response to comments, the strict priority of methods in the proposed and current regulations has been abandoned. Rather, a much more flexible approach has been adopted. While the problems with a strict priority of methods are acknowledged, the drawbacks of such rigidity must be balanced against the need to provide some guidance as to which methods are most appropriate for particular cases. The best method rule attempts to achieve this balance by recognizing that the method that provides the most accurate determination of an arm's length result will vary depending upon the facts and circumstances of the transaction under review. In considering which method provides the best measure of an arm's length result, factors to be considered include the completeness and accuracy of the available data, the degree of comparability between controlled and uncontrolled transactions, and the extent of adjustments necessary to apply the method. While the best method rule provides that any available method may be employed to determine an arm's length result without first disproving the applicability of other methods, if it subsequently is demonstrated that under the facts and circumstances another method provides a more accurate determination, the district director must apply such method. Further guidance concerning the circumstances under which particular methods may apply is provided under the provisions describing each method.

In addition, section 1.482-1T(b)(2)(iii)(B) provides for the application of the best method rule when two or more methods produce inconsistent results. If the best method rule does not clearly indicate the preferred method, this paragraph provides that an additional factor to be considered in selecting a method is whether any of the competing methods produce results that are consistent with results obtained under another appropriate method. A similar analysis applies when two or more applications of the same method produce different results.

Section 1.482-1T(c) provides general guidance for determining comparability. General guidance on comparability is provided in this portion of the regulation because the factors set forth in this section are applicable under all the methods. Section 1.482- 1T(c)(1)(i) provides that under all methods an arm's length result generally is estimated based on data derived from comparable uncontrolled taxpayers. In determining whether controlled and uncontrolled taxpayers are comparable, functions, risks, contractual terms, economic conditions, and property or services normally must be compared.

Section 1.482-1T(c)(1)(ii) provides that the relative importance of these factors depends on the method applied, because some methods emphasize product comparability, others emphasize functional comparability, and others emphasize broad similarity in terms of products and functions while comparing financial returns.

Section 1.482-1T(c)(2)(i) provides that for two transactions to be comparable, they do not need to be identical, but only must be sufficiently similar that the uncontrolled transaction provides a reasonable and reliable benchmark for estimating an arm's length result. When there are differences between uncontrolled and controlled transactions, section 1.482-1T(c)(2)(ii) permits a reasonable number of adjustments to account for differences between the transactions if they have a definite and reasonably ascertainable effect on the result. If such adjustments cannot be made (either because of a lack of data or the extent of the adjustments renders them unduly speculative), the uncontrolled transaction normally cannot serve as a comparable transaction. Finally, section 1.482- 1T(c)(2)(iii) emphasizes that these general standards of comparability are subject to modification under each method.

Section 1.482-1T(c)(3) describes the factors for determining comparability in more detail. The first factor discussed is functions. A functional analysis compares the activities performed by the parties to two transactions. For two transactions to be comparable, the parties normally should perform the same functions with respect to the transactions. A list of functions that normally must be considered is provided.

The second factor that must be considered is risk. For two transactions to be comparable, the risks borne by the parties to each transaction should be similar. Allocation of risk is potentially subject to manipulation by controlled taxpayers, who may purport to allocate risk inconsistently with the substance of their transactions. Accordingly, section 1.482-1T(c)(3)(ii)(B) provides that with respect to adequately documented risk (as described in section 1.482-1T(c)(3)(ii)(C)), the allocation will be subject to review under the following factors: whether the risks assumed are commensurate with the potential economic benefit from the controlled transaction; whether the controlled taxpayer's capacity to absorb losses attributable to the risk is proportionate to the risk; and whether the controlled taxpayer is engaged in the active conduct of a trade or business to which the risk relates and exercises control over the activities that influence the amount of income or loss to be realized from the controlled transaction. These factors are intended to ensure that a controlled taxpayer only will be considered to have assumed a risk in cases where the economic substance of the transactions consistent with the assumption of such risk. Section 1.482-1T(c)(3)(ii)(C) provides that, with the exception of routine risks (such as those assigned by operation of the Uniform Commercial code), the district director may disregard a purported allocation of risk unless the taxpayer executed documentation substantiating the asserted allocation of risk, before the result of the risk was known or reasonably knowable, and the actual conduct of the taxpayers was consistent with such allocation. Finally, section 1.482- 1T(c)(3)(ii)(D) provides that risks must be allocated consistently from year to year, so that, for example, a risk that causes a taxpayer to earn a below average return in the early years of an activity will tend to cause above average returns in subsequent years for the same taxpayer. It would not be consistent with the arm's length standard for a party to bear a risk when that risk is most likely to cause losses, and then not to derive the subsequent returns attributable to the assumption of the risk in the preceding years.

The third factor is contractual terms. For two transactions to be comparable, the contractual terms that would affect the prices charged should be comparable.

Fourth, section 1.482-1T(c)(3)(iv) provides that the economic conditions surrounding the two transactions also should be similar. Among the economic conditions that must be considered are the realistic alternatives to the actual transactions that were available to the parties. The treatment of alternatives is addressed in more detail in section 1.482-1T(d)(2)(ii), which is discussed below.

Fifth, section 1.482-1T(c)(3)(v) provides that various degrees of similarity between the products or services that are the subject of the controlled and uncontrolled transactions are required under the various methods, and more specific guidance is provided under those methods.

Section 1.482-1T(c)(4) describes special circumstances that require analysis in addition to that described in section 1.482- 1T(c)(3) to determine comparability. First, section 1.482-1T(c)(4)(i) provides that in certain cases the arm's length charge may, for a limited time, differ from that charged in an otherwise comparable uncontrolled transaction because the parties in the controlled transaction have agreed to a market penetration strategy. Next, section 1.482-1T(c)(4)(ii)(A) provides rules for making allocations when the controlled taxpayers operate in different geographic markets than the uncontrolled taxpayers. Adjustments reflecting the effect of such differences may be made to the extent information permitting such adjustments is available, and if not, then information from uncontrolled taxpayers operating in the most similar market for which information is available must be used. Finally, in cases where the controlled taxpayer realizes "location savings" from operating in a low-cost jurisdiction and the uncontrolled taxpayers do not realize such savings, section 1.482-1T(c)(4)(ii)(B) provides that the adjustments to make the two transactions comparable must reflect the allocation of location savings that would occur between unrelated parties, taking into account competitive conditions in the low-cost market; the effect of such competition may be that all or a portion of the location savings might inure to the benefit of the other party to the controlled transaction.

Sections 1.482-1T(c)(4)(iii) and (iv) relates to isolated transactions and mineral transactions, respectively, and are consistent with guidance provided in the current regulations.

Section 1.482-1T(d) describes the scope of review under section 482. Consistent with the current regulations, this section provides that a section 482 allocation may be made whenever the taxable income of a controlled taxpayer differs from what it would have been had the controlled taxpayer been dealing at arm's length with an uncontrolled party. More specifically, section 1.482-1T(d)(1)(i) provides that the district director is not limited to cases in which the taxpayer intentionally distorted its taxable income, and section 1.482- 1T(d)(1)(ii) provides that the district director may make an allocation even if the ultimate income anticipated (by any party to the controlled transaction) from a series of transactions is not realized. Sections 1.482-1T(d)(1)(iii) and (iv) relate to the interaction between section 482 and the nonrecognition and consolidated returns provisions, respectively, and are consistent with guidance set forth in the current regulations.

Section 1.482-1T(d)(2) provides several limitations on adjustments. Section 1.482-1T(d)(2)(i)(A) provides that no allocation will be made when the controlled taxpayer's results fall within a range of arm's length results (the "arm's length range") derived from two or more applications of the same pricing method to different uncontrolled comparables. This rule responds to comments that were received with respect to the CPM under the proposed regulations, in which many commenters approved of the recognition of a range of arm's length results rather than a single arm's length price. It was felt that requiring a single precise result was inconsistent with the fact that the various methods were not always precise measures of an arm's length result, and ignored the economic fact that there often will be more than one arm's length price. The temporary regulations therefore extend the use of a range to all methods. To form a part of the range, however, each application of the applicable pricing method must independently satisfy the criteria for the application of that method and the general comparability standards under section 1.482- 1T(c)(2). With the exception of the comparable profit method, there is no limitation on the extent of the range, although a wide range may suggest that insufficient adjustments have been made for differences between the controlled and uncontrolled transactions.

Section 1.482-1T(d)(2)(i)(C) provides that results falling outside the arm's length range may be adjusted to any point in the range, and ordinarily will be adjusted to the midpoint of the range. Section 1.482-1T(d)(2)(i)(D) states that the district director may properly Propose an allocation based on a single comparable uncontrolled price. However, if the taxpayer subsequently demonstrates that its results are within a range established by additional comparable transactions, then no allocation will be made.

Section 1.482-1T(d)(2)(ii) provides that it is not necessary for the district director to determine whether the method that a taxpayer employs to determine the amounts charged in its controlled transactions correspond to the method that the taxpayer might have used in uncontrolled transactions. The only relevant consideration is whether the result of those transactions is arm's length, as determined under one of the prescribed methods.

Section 1.482-1T(d)(3) provides guidelines for allocations under section 482. Section 1.482-1T(d)(3)(i) provides that multiple transactions (generally within the same product grouping) may be aggregated for purposes of determining an arm's length result when they are so interrelated that it is necessary to view them as a whole. Section 1.482-1T(d)(3)(ii) provides that the terms of contractual arrangements will be respected as long as the parties' conduct is consistent with such terms. In addition, when no written agreement exists, but the conduct of taxpayers is consistent with an agreement in substance, the district conclude that if such parties were unrelated they would have executed an agreement, and therefore may give effect to such an agreement in determining an arm's length result. This section responds to comments indicating that the proposed regulations gave the district director too much latitude to disregard the existence of contracts between controlled taxpayers, by clarifying that such contracts will only be disregarded when the parties themselves do not in economic substance adhere to their terms.

Section 1.482-1T(d)(3)(iii) provides that the district director ordinarily will evaluate controlled transactions based on the structure of the actual transaction, and will not treat the transaction as if it were structured differently. The district director, may, however, consider the alternatives that were available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with alternatives similar to those that the controlled taxpayer faced.

This analysis is central to the arm's length standard and the traditional notion of comparability. For example, under the comparable uncontrolled price method, the objective is to identify an alternative price at which the taxpayer could have conducted the controlled transaction. This section merely broadens this traditional analysis by permitting examination of other alternatives when the controlled taxpayer has the option of internally obtaining the goods or services that it obtained in the controlled transaction. In such a case, an otherwise acceptable comparable transaction may not provide a reliable measure of an arm's length result if the controlled taxpayer could have obtained the object of the controlled transaction more cheaply by obtaining it from internal sources. This approach duplicates the analysis that an uncontrolled taxpayer would employ in considering whether to obtain a product from an unrelated party or to produce the product itself, and the amount that it would be willing to pay an unrelated supplier of that product. This section responds to comments on the provisions of the proposed regulations indicating that the district director was authorized to impose his own judgment on taxpayers after the fact and to restructure transactions based on perfect ex knowledge of the results of a series of transactions. This provision significantly limits the ability of the district director to examine alternatives, generally limiting such authority to permit examination of alternatives only for the purpose of determining an arm's length price.

Section 1.482-1T(d)(3)(iv) provides that the district director will ordinarily evaluate the results of controlled transactions based on data from uncontrolled taxpayers attributable to the same period as the controlled transactions. The district director may, however, use data from different years under certain specified conditions. Data from multiple years also may be relevant for purposes of certain enumerated provisions. If data from other years is employed, such data should be compared to the controlled taxpayer's results from the same years. Section 1.482-1T(d)(3)(iv)(C) provides that the district director may examine results from other years to determine whether the same economic conditions that caused the uncontrolled taxpayer's result also caused the controlled taxpayer's result. For example, in cases where a controlled taxpayer realizes a loss from a controlled transaction, the taxpayer may seek to demonstrate that the loss is within the arm's length range, based upon losses realized by comparable uncontrolled taxpayers. The district director may consider data from other taxable years to determine whether the same conditions that caused the controlled taxpayer's loss also had a similar effect on the uncontrolled taxpayers. If the controlled taxpayer consistently realizes losses from year to year, and the uncontrolled taxpayers with losses on average are profitable over a period of years, then the transactions may not be considered to be sufficiently comparable.

Section 1.482-1T(d)(3)(v) permits evaluation of product lines and statistical groupings in a manner analogous to that permitted under the current regulations.

Section 1.482-1T(e) provides procedural rules with respect to collateral adjustments arising as a result of a section 482 allocation. Such adjustments include compensating, correlative and conforming adjustments.

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. The arrangement will be given effect if it is written, it provides for adjustments as necessary to ensure that the controlled transactions produce arm's length results, and the adjustments are made before the filing of the controlled taxpayer's timely U.S. income tax return. The adjustment accrues to the recipient as of the earlier of the date of payment or the last day of the taxable year to which it relates. Finally, section 1.482-1T(e)(2)(iii) provides an anti-abuse rule.

Section 1.482-1T(e)(3) provides guidance on correlative adjustments that is generally consistent with the guidance set forth in the current regulations.

Section 1.482-1T(e)(4), relating to conforming adjustments, provides that the Commissioner may provide revenue procedures under which the district director may permit adjustments to conform a taxpayer's accounts to an adjustment under section 482.

Section 1.482-1T(e)(5) provides rules relating to setoffs that are similar to those provided in the current regulations.

In response to many comments requesting that a safe harbor be included in the regulations, section 1.482-1T(f)(1) provides a safe harbor under section 482. A safe harbor has been provided for taxpayers that have relatively small levels of controlled transactions. While taxpayers electing this safe harbor would face a much reduced compliance burden, some taxpayers may find that the results they achieve under the safe harbor are somewhat less favorable than they could have achieved if they did not elect the safe harbor, and others might achieve a more favorable result, reflecting the consequences of a less flexible but more certain rule.

This provision provides that an electing controlled taxpayer will not be subject to an adjustment under section 482 if its taxable income is determined in accordance with published measures of profitability, and the taxpayer complies with various procedural rules. To be eligible for the safe harbor, either the U.S. party or the foreign counterpart to a cross border controlled transaction must have less than $10 million in gross receipts for the year at issue. For this purpose, all U.S. affiliates must be aggregated with the U.S. controlled taxpayer, and all foreign affiliates that also engage in cross border transactions with the U.S. controlled taxpayer must be aggregated. The definition of an eligible taxpayer does not include the U.S. branch of a foreign corporation. It was felt that relatively few taxpayers would benefit from the inclusion of a branch rule, and that the additional complexity entailed in including branches in the definition was not justified. The election to apply the safe harbor may only be revoked with the consent of the Commissioner, and section 1.482-1T(f)(1)(iv)(C) provides that the election will not apply for any year in which the eligible taxpayer test is not met, but that the election will be effective if the taxpayer meets the test in a succeeding year, subject to an anti- abuse rule.

Section 1.482-1T(f)(2), relating to foreign legal restrictions, is reserved.

Section 1.482-1T(f)(3) provides a coordination rule between sections 936 and 482. It provides that in the case of a controlled taxpayer that has made a cost sharing election under section 936(h), the amount of the cost sharing payment required under section 936 will not be less than that required under the section 482 regulations, and further that such payment may not be computed under the provisions of section 1.482-2T(d)(4).

Section 1.482-1T(g) defines ten terms that are employed in the regulations.

An important term used under several methods is "non-routine intangible." This term has not been defined because it has not been possible to formulate an acceptably precise definition. In general, this term means intangible property that is central to the conduct of a business activity and without which the business activity could not be conducted. It normally would be expected that such property is unique or nearly unique, that its use or application is very valuable, and that there consequently would not be examples of substantially similar transactions between unrelated parties. Examples of such an intangible would be a composition of matter patent for a pharmaceutical, or a manufacturing intangible without which a particular product could not be produced. The term would not include intangible property that is a normal result of conducting a business, such as manufacturing economies resulting from protracted manufacturing operations, or intangible property for which there may be acceptable substitutes available in the marketplace at a comparable price.

SECTION 1.482-2T(d)

Section 1.482-2T(d) provides that guidance with respect to transfers of property is set forth in sections 1.482-3T through 1.482-5T.

SECTION 1.482-3T

Section 1.482-3T provides rules with respect to the transfer of tangible property. Five methods are provided: the comparable uncontrolled price method; the resale price method; the cost plus method; the comparable profits method; and other methods. In addition, a sixth method based on profit splits is proposed in the accompanying notice Of proposed rulemaking.

Section 1.482-3T(b) describes the comparable uncontrolled price (CUP) method. It is generally similar to the CUP method under the current regulations. For purposes of the best method rule, a result obtained under the CUP method generally will provide the most accurate measure of an arm's length result. Section 1.482-3T(b)(2) sets forth specific guidance with respect to the standard of comparability that must be satisfied for an uncontrolled transaction to be sufficiently comparable to a controlled transaction under this method. The property transferred and the underlying circumstances of the two transactions must be substantially the same. This requirement is met if any minor differences can be reflected by a reasonable number of adjustments that have a definite and reasonably ascertainable effect on the amount charged. If there are material differences between the transactions, thin method cannot be applied based on the uncontrolled transaction. Although the text of this rule differs somewhat from its counterpart under the final regulations, the changes were intended to be clarifications of the current standard rather than substantive changes.

Section 1.482-3T(c) describes the resale price method. It is generally similar to the resale price method under the current regulations. In response to comments, the results achieved under the resale price method are not subject to a mandatory check under the CPI. For purposes of the best method rule, the resale price method ordinarily will provide an accurate measure of an arm's length result if the controlled taxpayer performs a distribution function and does not add substantial value to the goods that are distributed. Section 1.482-3T(c)(3) sets forth specific guidance with respect to the standard of comparability that must be satisfied for an uncontrolled transaction to be sufficiently comparable to a controlled transaction under this method. The controlled and uncontrolled transactions should involve distribution of products within the same broad product categories. Adjustments may be made to account for the differences enumerated in section 1.482-1T(c)(3) between the transactions, but only if such differences have a definite and reasonably ascertainable effect on gross profit.

Section 1.482-3T(d) describes the cost plus method. It is generally similar to the cost plus method under the current regulations. As with the resale price method, the results obtained under the cost plus method are not subject to a mandatory check under the CPI. For purposes of the best method rule, the cost plus ordinarily will provide an accurate measure of an arm's length result if the controlled taxpayer manufactures or assembles goods that are sold to related parties. Section 1.482-3T(d)(3) sets forth specific guidance with respect to the standard of comparability that must be satisfied for an uncontrolled transaction to be sufficiently comparable to a controlled transaction under this method. The controlled and uncontrolled transactions should involve production of products within the same broad product categories or within the same industry. Adjustments may be made to account for the differences enumerated in section 1.482-1T(c)(2) between the transactions, but only if such differences have a definite and reasonably ascertainable effect on gross profit. Section 1.482-3T(d)(3)(iv) provides that in determining an appropriate markup percentage, accounting reclassifications may be required to ensure consistent treatment of the elements that enter into the computation of the production price.

Section 1.482-3T(e) provides that when none of the other enumerated methods can reasonably be applied, any other reasonable method may be used. A taxpayer may employ an other method only if such method is disclosed on the taxpayer's U.S. income tax return and the taxpayer prepared contemporaneous documentation supporting the method adopted. Such documentation must explain why the method selected provides the most accurate measure of an arm's length price. The taxpayer must furnish such documentation to the district director within 30 days of a written request for such documentation. Section 1.482-3T(e)(3) provides that application of a method under section 1.482-3T(e) does not in itself satisfy the reasonable cause and good faith exception from the application of penalties under section 6662(e) or 6664(c).

Section 1.482-3T(f) provides rules coordinating the application of the tangible property rules with the rules governing transfers of intangible property.

SECTION 1.482-4T

Section 1.482-4T provides rules with respect to the transfer of intangible property. Three methods are provided: the comparable uncontrolled transactions method; the comparable profits method; and other methods. In addition, the proposed profit split method would apply with respect to transfers of intangibles.

Section 1.482-4T(b) provides a definition of intangible property that is similar to that provided in the proposed regulations.

Section 1.482-4T(c) describes the comparable uncontrolled transactions (CUT) method. Unlike the proposed regulations, which included two comparable transaction methods, only one such method is provided. Comments on the proposed regulations asserted that the scope of the first such method (the MTM) was too narrow, and further that the CPI should not be a mandatory check on the results obtained under the second method (the CATM). In response to these comments, the MTM and the CATM have been combined into a single method, and the results obtained under this method are not subject to mandatory check under the CPI. The removal of this check is offset by incorporating a reference to profit potential in the definition of comparability, reflecting Congressional concern that royalty rates for "high-profit" intangibles could "be set on the basis of industry norms for transfers of much less profitable items." General Explanation of the Tax Reform Act of 1986, H.R. 3838, P.L. 99-514 (May 4, 1987) at 1014. For purposes of the best method rule, a result obtained under the CUT method generally will provide the most accurate measure of an arm's length result. Section 1.482-4T(c)(2) sets forth specific guidance with respect to the standard of comparability that must be satisfied for an uncontrolled transaction to be sufficiently comparable to a controlled transaction under this method. In addition to the factors enumerated in section 1.482-1T(c)(3), the property transferred in the two transactions must be from the same class of intangible property, relate to the same class of products or services, and have substantially the same profit potential. In addition, section 1.482- 4T(c)(2)(B) requires that the underlying circumstances of the two transactions must be sufficiently similar that any differences can be reflected by a reasonable number of adjustments that have a definite and reasonably ascertainable effect on the amount charged. These circumstances are similar to the factors listed in the final regulations. Section 1.482-2(d)(2)(iii).

Section 1.482-4T(d) provides that when none of the other enumerated methods can reasonably be applied, any other reasonable method may be used. A taxpayer may employ an other method only if such method is disclosed on the taxpayer's U.S. income tax return, the taxpayer prepared contemporaneous documentation supporting the method adopted, explaining why the other enumerated methods cannot be applied, and explaining why the method selected provides the most accurate measure of an arm's length price, and the taxpayer furnishes such documentation to the district director within 30 days of a written request for such documentation. Section 1.482-4T(d)(3) provides that application of a method under section 1.482-4T(d) does not in itself satisfy the reasonable cause and good faith exception from the application of penalties under section 6662(e) or 6664(c).

Section 1.482-4T(e) provides special rules for the transfer of intangible property. Section 1.482-4T(e)(1) provides that the form of the consideration for a transfer of intangible property must be consistent with that which would be adopted by unrelated parties under comparable circumstances, and that consideration normally should be in the form of a royalty.

Section 1.482-4T(e)(2)(i) provides that if an intangible is transferred for a period in excess of one year, the consideration charged is generally subject to annual adjustment to ensure that it is commensurate with the income attributable to the intangible. This provision is required by the 1986 amendment to section 482.

Section 1.4824T(e)(2)(ii) sets forth two exceptions from this rule. In response to comments on the proposed regulations that indicated that the scope of the exceptions in the proposed regulations was too narrow, the scope of the exceptions from periodic adjustments has been broadened. The first exception provides that no periodic adjustment will be made if certain specified conditions are met, including that the controlled taxpayers entered into a written license agreement with a comparable term to an actual license agreement between uncontrolled taxpayers, the consideration charged was an arm's length amount under the CUT method for the first year in which substantial royalties were required to be paid under the agreement, the comparable license agreement generally did not permit changes to the royalty, and the aggregate profits earned by the controlled transferee from the exploitation of the intangible fall within a range of the profits that were anticipated when the license agreement was executed. The second exception is generally similar, except that it applies if the consideration was determined to be arm's length under any method other than the CUT method.

Section 1.482-4T(e)(3) provides rules for identifying the controlled party that is considered the developer of an item of intangible property that are similar to the rules set forth in the proposed regulations.

Section 1.482-4T(e)(4) clarifies that the arm's length consideration for an intangible is not limited to the prevailing rates in an industry or the rates paid in any uncontrolled transactions that do not meet the requirements of the CUT method. This provision was included to clarify that arm's length consideration in a controlled transaction, particularly for non- routine intangibles that are not ordinarily transferred between uncontrolled taxpayers, may not be limited by the amount of consideration identified in uncontrolled transactions.

Section 1.482-4T(e)(5), relating to lump sum payments, is reserved.

SECTION 1.482-5T

Section 1.482-5T describes the comparable profits method. The comparable profits method relies on the general principle that similarly situated taxpayers will tend to earn similar returns over a reasonable period of time. In broad outline this method is similar to the comparable profits method set forth under the proposed regulations. Although this method is included in the methods available under both sections 1.482-3T (tangible property) and 1.482- 4T (intangible property), in response to comments it no longer provides a mandatory check on the results obtained under other methods. This method generally will provide an accurate measure of an arm's length result unless the tested party uses a valuable, non- routine intangible that is either (1) acquired from uncontrolled taxpayers, and the tested party assumes significant risks and possesses the right to significant economic benefits from the use of the intangible, or (2) is self-developed. The comparable profits method generally will not provide an accurate measure of an arm's length result in cases involving non-routine self-developed intangibles or many intangibles that were acquired from third parties because it will be difficult, if not impossible, to locate uncontrolled taxpayers that also possess comparable intangible property, and the comparable profits method could understate the income properly attributable to such assets.

Section 1.482-5T(b) provides that the tested party generally will be the controlled taxpayer that performs the simplest and therefore most easily compared operations. In the case of the license of intangible property, this party normally will be the licensee. Generally the comparable profits method will be applied separately to each industry segment (as defined under the section 6038A regulations). In addition, the comparable profits method only is applied after taking into account all other adjustments under section 482.

Section 1.482-5T(c) provides that the standard of comparability required to apply this method is not as strict as under other methods. Some diversity between the transactions, products and functions of the controlled and uncontrolled taxpayers is acceptable. The degree of comparability achieved will, however, affect the reliability of the results, and the size of the arm's length range, as discussed below.

Section 1.402-5T(c)(2) describes a number of adjustments that should be (but are not required to be) made with respect to the comparable parties. Such adjustments are made only to the extent that they have a definite and reasonably ascertainable effect on operating profits. Accounting reclassifications also may be made to ensure that various items are measured consistently.

Section 1.482-5T(d)(i) provides that a result will be an arm's length result if it falls within the range of constructive operating profits, based on a single profit level indicator, derived from comparable parties. As under the comparable profits method of the proposed regulations, constructive operating profit is calculated by measuring profit level indicators of uncontrolled taxpayers, and applying those indicators to the financial data of the tested party to measure an arm's length result for the tested party.

Unlike the other methods, section 1.482-5T(d)(ii) provides that the arm's length range can be determined in two ways, depending on the degree of comparability between the tested party and the uncontrolled taxpayers and the adjustments that were made to account for any differences. If the adjustments described in section 1.482- 5T(c)(2) have been made, the arm's length range will include all the results obtained, as with the other methods. If, however, the specified adjustments are not made, the range will be limited to either the interquartile range, or the range determined by some other statistically valid method. In the latter case the comparable profits method cannot be used if there are less than four comparable parties.

Section 1.482-5T(e) describes the profit level indicators that may be used under the comparable profits method. They include two types of measures: the rate of return on capital employed and financial ratios. Financial ratios include the ratio of operating profit to sales and the ratio of gross profit to operating expenses. Finally, section 1.482-5T(e)(3) provides that other reliable measures may be employed.

Section 1.482-5T(f) sets forth a number of definitions that are relevant for purposes of the comparable profits method.

SECTION 1.482-6T

Section 1.482-6T, which deals with the profit split method, is reserved under these temporary regulations. However, the provisions of the profit split method are proposed in the accompanying notice of proposed rulemaking.

ADVANCE PRICING AGREEMENTS

Based on the Service's experience to date with the advance pricing agreement program, as well as favorable comments received in response to the proposed regulations, the principle of advance pricing agreements continues to be an integral component of the Service's overall section 482 compliance effort. The Service may execute an advance pricing agreement addressing the prospective application of section 482 to any transaction between or among members of a controlled group. Such agreements may also address any collateral income tax consequences related to such transactions. Where an advance pricing agreement is in effect, an allocation under section 482 is permitted only to the extent provided in the agreement. The procedures for obtaining an advance pricing agreement are contained in Revenue procedure 91-22, 1991-1 C.B. 526.

SPECIAL ANALYSES

It has been determined that these regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative

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

DRAFTING INFORMATION

Personnel from the Internal Revenue Service and Treasury Department participated in developing these regulations

LIST OF SUBJECTS

26 CFR 1.481-1 through 1.483-2T

Accounting, Income taxes, Reporting and recordkeeping requirements.

26 CFR part 602

Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

Authority: 26 U.S.C. 7805. * * * section 1.482-1T also issued under 26 U.S.C. 482 and 936. Section 1.482-2T also issued under 26 U.S.C. 482. Section 1.482-3T also issued under 26 U.S.C. 482. Section 1.482-4T also issued under 26 U.S.C. 482. Section 1.482-5T also issued under 26 U.S.C. 482. Section 1.482-2A also issued under 26 U.S.C. 482.

[Editor's Note: Treasury Decision 8552 finalized all temporary regulations sections except sections 1.482-1A, 1.482-2A. Those proposed reg. sections were adopted by T.D. 8470, 58 FR 5263-5293, Jan. 21, 1993.]

[Editor's Note: Temporary reg. section 1.482-7T was removed by T.D. 8632 on December 20, 1995 and a new regulations section 1.482-7 was added.]

Par. 1a. Sections 1.482-1 is redesignated as section 1.482-1A and an undesignated centerheading preceding section 1.482-1A is added to read as follows:

"REGULATIONS APPLICABLE FOR TAXABLE YEARS BEGINNING ON OR BEFORE [INSERT DATE THAT IS 90 DAYS AFTER DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER]."

Par. 1b. Section 1.482-2A is added and section 1.482-2(d) and (e) are redesignated as section 1.482-2A(d) and (e) to read as follows:

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

(a)-(c) For applicable rules, see section 1.482-2T (a) through (c).

Par. 2. Sections 1.482-0T, 1.482-1T and 1.482-3T through 1.482-7T are added. Section 1.482-2 is redesignated as section 1.482-2T, and section 1.482-2(d) is added to read as follows:

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par 4. Section 602.101(c) is amended by adding the following citations to the table to read as follows:

SECTION 602.101 OMB CONTROL NUMBERS.

* * * * *

(c) * * *

 CFR part or section where                         Current OMB