Rev. Rul. 62-68

Advice has been requested concerning the method of computing the manufacturers excise tax under section 4216(b)(1)(C) of the Internal Revenue Code of 1954, where an article is sold otherwise than through an arm's length transaction at less than the fair market price.

Under an arrangement between X (hereinafter sometimes referred to as the `manufacturer'), a parent company, and Y (hereinafter sometimes referred to as the `selling company'), a wholly-owned subsidiary, X performs the engineering, product development, and manufacturing functions. Y is organized to perform the selling and distribution function. X sells its products to Y and Y resells to one or more independent wholesale distributors. In conducting its selling and distributing function, Y has its own employees, place of business, adequate working capital, and property. Under these circumstances, it is generally considered that Y has such substance and reality as to evidence that it operates separate and apart from X , and that the transactions between X and Y are actual sales. However, Y is wholly owned by X , and the sales between the related entities are not at arm's length. Further, it has been determined the intercompany price between X and Y is less than the fair market price. Therefore, the provisions of section 4216(b)(1)(C) of the Code are applicable.

Section 4216(b)(1)(C) relates to determination of a constructive sale price and provides, in general, that where an article is sold otherwise than through an arm's length transaction at less than the fair market price, the tax under Chapter 32 (if based on the price for which the article is sold) shall be computed on the price for which such articles are sold, in the ordinary course of trade, by manufacturers or producers thereof, as determined by the Secretary of the Treasury or his delegate.

G.C.M. 21114, C.B. 1939-1 (Part 1), 351, outlines the position of the Service, relating to the authority of the Commissioner to determine constructive sale price. It states, in part, that there is a close relation between the terms of section 619(a) and (b) of the Revenue Act of 1932, comparable to section 4216(a) and (b)(1) of the 1954 Code. Thus, in determining constructive sale price under section 4216(b)(1), the Commissioner must necessarily take into consideration all elements, including those items which would be included or excluded under authority of the Code, but once the constructive sale price is determined, the tax must be based on that price and the statute does not contemplate any further adjustments.

It is the position of the Service that on intercompany sales at less than arm's length and less than the fair market price, a manufacturer of an article taxable under Chapter 32 of the Code (where tax is based on sale price) may elect to use as a basis for tax, pursuant to section 4216(b)(1)(C), a constructive sale price equal to 95 percent of its selling company's lowest established resale price for the article to unrelated wholesale distributors in the ordinary course of trade. This 5 percent margin is an allowance for those exclusions from, and readjustments of, the selling company's resale price which, under sections 4216 and 6416, the law would allow a manufacturer selling in the ordinary course of trade to unrelated distributors. Where the selling company's resale price includes the tax and the rate of tax applicable is 10 percent, for example, the tax may be computed at 1/11 ( 10/110 ) of the constructive sale price in order to exclude the amount of tax from the tax base as provided by law. No further exclusions from or readjustments to, this constructed tax base are to be made for any items under Code sections 4216(a), 4216(f), or 6416(b)(1), except as provided in the following sentence. Where a sale is rescinded and the manufacturer makes a readjustment in respect of the full selling price of the article, including tax, an overpayment of tax will be recognized under section 6146(b)(1).

In cases in which a manufacturer does not exercise the election provided in the preceding paragraph, his liability for tax shall be a constructive sale price based upon the actual selling price at which the taxable article leaves the corporate family in the ordinary course of trade. In other words, the basis for tax is the actual wholesale price at which the selling company sells to unrelated customers. If, however, the sale by the selling company is at retail, the basis for tax shall be the lower of (1) the actual price for which the article is sold, or (2) the highest price for which such articles are sold by the selling company to wholesale distributors. In the latter event, it must be shown that the selling company has an established bona fide practice of selling such articles in substantial quantities to wholesale distributors. If the selling company has no such sales to wholesale distributors, the fair market price for the retail sales shall be determined by the Commissioner.

The constructive sale price determined under the methods set forth in the preceding paragraph will be subject to the exclusions from and readjustments to, such price as provided in section 4216(a), section 4216(f) effective January 1, 1961, and section 6416(b)(1). These exclusions and readjustments may be taken into consideration only when made in connection with the sale of the article by the selling company and when they constitute items of expense or allowance actually incurred or made by the manufacturer in respect of the sale price of the article as herein determined.

In any case where the constructive sale price, determined either under the election method or by using the adjusted selling price at which the article leaves the corporate family, results in a basis for tax which is lower than the actual price between the related companies, the liability for tax shall be based on the intercompany price.

In selecting the method by which a manufacturer computes and pays tax due under Chpater 32 of the Code, pursuant to this ruling, he must follow the procedure outlined below:

(1) Where a manufacturer desires to exercise an election to compute and pay tax based on 95 percent of the selling company's lowest established wholesale price, the manufacturer shall notify the District Director of such election by attaching a statement to the return, Form 720, filed for the quarter in which the election is made. If the election is not made, no notice need be served upon the District Director.

(2) Where a manufacturer using the election method no longer wishes to use this optional basis for tax, he must notify the District Director of his intent to use the alternative tax base prescribed in this ruling by attaching a statement to this effect to the return filed for the quarter preceding the quarter in which the change is to be made.

Under the authority contained in section 7805(b) of the Code, this Revenue Ruling shall apply with respect to sales by the manufacturer made on and after July 1, 1962.

¹ Also released as Technical Information Release 380, dated May 7, 1962.