ONLY SALES IN PARENT'S GEOGRAPHIC MARKET MAY BE USED IN DETERMINING ARM'S LENGTH SALES PRICE IN TRANSACTIONS BETWEEN U.S. PARENT AND FOREIGN SUBSIDIARY.

Rev. Rul. 87-71

ISSUE

How is the arm's length price of iron ore determined under section 482 of the Internal Revenue Code under the circumstances described below?

FACTS

S, a wholly owned foreign mining subsidiary of domestic corporation P, operates an iron ore mine in a foreign country. The ore is extracted from the ground and loaded at the mine for shipment by rail to a seaport. The ore is a direct shipping grade ore suitable for blast furnace feed and needs no concentration. After nonmining transportation, the ore is unloaded from rail cars at the seaport and loaded on seagoing vessels for shipment to purchasers.

All of the ore is sold at the port to various purchasers, including P and unrelated purchasers in geographic market A and unrelated persons in geographic market B. The ore is processed in the geographic market of each purchaser. All sales prices include the cost of transportation to the purchasers in both geographic markets. The cost of transportation to the purchasers in both geographic markets is the same. Due to economic conditions existing in each marketplace, S is able to sell its ore to unrelated purchasers in geographic market B at a price which is substantially higher than the price at which the ore is sold to unrelated purchasers located in market A. The economic conditions have a definite but not reasonably ascertainable effect on the price of ore in each market.

The price charged by S for the sale of ore to P is substantially higher than the price charged for the sale of ore to unrelated purchasers located in geographic market A.

LAW AND ANALYSIS

Section 1.482-2(e)(1) of the Income Tax Regulations provides that, where one member of a group of controlled entities sells or otherwise disposes of tangible property to another member of such group at other than an arm's length price, the district director may make appropriate allocations to reflect an arm's length price for such sale or disposition. An arm's length price is the price that an unrelated party would have paid for the property under the same circumstances. Section 1.482-2(e)(1)(v) of the regulations provides that the selling price, for purposes of section 482 of the Code, of mineral products (other than oil and gas) sold to related parties at the stage at which mining ends will be determined under the provisions of section 1.613-4. Section 1.613-4 provides rules for the determination of gross income from minerals (other than oil and gas at the stage at which mining ends.

Under the facts of this case, the direct shipping grade ore was extracted and shipped by rail to the seaport. The only processes applied at the mine were extraction and loading for shipment to the port. Therefore, mining ended when the ore was loaded for shipment to the port. This was followed by nonmining transportation to the port prior to sale. Since a nonmining process involving transportation occurred before the sale in the case of both related and unrelated party sales, the special rule in section 1.482-2(e)(1)(v) of the regulations does not apply.

The determination of an arm's length selling price under section 1.482-2(e)(2) of the regulations is primarily factual. Section 1.482- 2(e)(2)(ii) provides that uncontrolled sales are considered comparable to controlled sales if the circumstances involved in the uncontrolled sales are so nearly identical to the controlled sales that any differences can be reflected by a reasonable number of adjustments to the price of the uncontrolled sales. Differences can be reflected by adjusting prices only where such differences have a definite and reasonably ascertainable effect on price. One difference which may affect the price of property is a difference in the geographic market in which the sale takes place.

In this case, the economic conditions present in geographic market B have a definite effect on the price of ore sold in that marketplace. However, the amount of the adjustment in price to reflect the difference in economic conditions cannot be reasonably ascertained. Thus, the price of ore sold to unrelated purchasers in geographic market B cannot be adjusted to account for differences in economic conditions in the two geographic markets and, therefore, cannot be considered to be comparable to the arm's length price charged for ore in geographic market A.

In Paccar, Inc. and Subsidiaries v. Commissioner, 85 T.C. 754 (1985), Tax Court held that the comparable uncontrolled price method was not applicable due, in part, to the fact that the controlled sales and uncontrolled sales were made into different geographic markets and the adjustments needed to account for the differences in the geographic markets had not been established.

The uncontrolled sales by S to purchasers in geographic market A, in which P is located, are comparable to the sales S made to P. The price S charged P for ore is substantially higher than the price charged to unrelated purchasers located in the same market. Accordingly, the price S charged P for ore is not an arm's length price.

HOLDING

The provisions of section 1.482-2(e)(2) of the regulations are applicable under the circumstances described, and only the uncontrolled sales made to the purchasers located in geographic market A are considered in establishing an arm's length selling price for purposes of section 482 of the Code.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 79-216, 1979-2 C.B. 224, is revoked.

PROSPECTIVE APPLICATION

Pursuant to the authority contained in section 7805(b) of the Code, the holding herein will not be applied to intercompany transactions occuring before August 3, 1987, if the taxpayer demonstrates that the price for such transaction was determined in reliance on Rev. Rul. 79-216.