Final Transfer Pricing Regs

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to intercompany transfer pricing under section 482 of the Internal Revenue Code. These regulations reflect the changes made to section 482 by the Tax Reform Act of 1986, and provide guidance implementing the amendment.

 EFFECTIVE DATES: Effective July 8, 1994, except sections 1.482-0T through 1.482-6T are removed effective October 6, 1994.

 FOR FURTHER INFORMATION CONTACT: Sim Seo of the Office of Associate Chief Counsel (International), IRS. (202) 622-3840 (not a toll-free number).

 SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1364. The estimated average annual burden per recordkeeper is .8 hour. The estimated average annual reporting burden per respondent is 1 hour.

 Comments concerning the accuracy of this burden estimate, and suggestions for reducing this burden, should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Office for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

BACKGROUND

 Section 482 was amended by the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, 2561, et. seq. On January 21, 1993, temporary regulations relating to the evaluation of intercompany transfer pricing under section 482 were published in the Federal Register (58 FR 5263). A notice of proposed rulemaking (INTL-401-88) cross- referencing the temporary regulations was published in the Federal Register for the same day (58 FR 5310).

 Written comments responding to the notice of proposed rulemaking were received, and a public hearing was held on August 16, 1993. After consideration of all the comments, the proposed regulations under section 482 are adopted as revised by this Treasury decision, and the corresponding temporary regulations are removed.

EXPLANATION OF REVISIONS AND SUMMARY OF COMMENTS

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 indicates 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 transaction is efficiently comparable to a controlled transaction. In particular, the legislative history observed that industry norms for transfers of less profitable intangibles frequently are not realistic comparables for transfers of so-called "high profit" intangibles. See H.R. Rep. 99-426, 99th Cong., 1st Sess. (1985) at 424. Finally, the Conference Committee report recommended that the IRS conduct a comprehensive study and consider whether the regulations under section 482, which had been issued in 1968 (the 1968 regulations) should be "modified in any respect."

THE WHITE PAPER

 In response to this directive, the IRS and the Treasury Department issued a study of intercompany pricing (Notice 88-123, 1988-2 C.B. 458) on October 18, 1988 (the White Paper). The White Paper proposed two approaches for implementing the "commensurate with income" standard with respect to transfers of intangible property. The first was based on either an "exact comparable" method or an "inexact comparable" method. The second was an income-based approach that also included two methods: the basic arm's length return method (the BALRM), and the BALRM with profit split. The BALRM generally assigned an average rate of return to the assets and functions devoted to the routine activities associated with the controlled transaction. When high profit intangibles were involved, any residual profit would be divided on the basis of the estimated relative values of the intangibles that each party contributed to the activity.

THE 1992 PROPOSED REGULATIONS

 The IRS issued proposed regulations under section 482 on January 30, 1992 (INTL-0372-88; INTL-0401-88, 57 FR 3571) (the 1992 regulations). The most significant change proposed was the introduction of three new pricing methods for transfers of intangible property: the matching transaction method (the MTM), the comparable adjustable transaction method (the CATM) and the comparable profit interval (the CPI). The CPI also could be used with respect to transfers of tangible property.

 The MTM and the CATM were based on exact and inexact comparable transactions, respectively. The CPI was an income-based method under which the operating income resulting from a controlled transaction was compared with the operating income of comparable uncontrolled taxpayers. The consideration charged in the controlled transaction would be considered arm's length if the taxpayer's operating income fell within a range of results derived from the uncontrolled taxpayers over a three-year period. Finally, the 1992 regulations required that the result derived from the CATM be verified by the CPI.

 In addition to providing new methods for transfers of intangibles, the 1992 regulations implemented the "commensurate with income" standard by providing that these methods could be applied to adjust the consideration charged in the year of examination (periodic adjustments) unless one of three narrow exceptions applied.

 Other changes made by the 1992 regulations included modification of the rules with respect to transfers of tangible property, principally by providing for the use of CPI with respect to tangible property, requiring that the results derived from the resale price or cost plus methods be verified by application of the CPI, introducing new cost sharing regulations, introducing a limited comparable profit split method, and relaxing the fixed priority of methods set forth in the 1968 regulations.

 Commenters criticized several aspects of the 1992 regulations, including the inclusion of the CPI in the regulations, the requirement that the results of most methods be verified by the CPI, the tight standards of comparability for applying the MTM, the narrow scope of the exceptions from periodic adjustments, the narrow scope for the profit split method, and the lack of a safe harbor. Commenters generally approved of the introduction of a range of acceptable results and the use of a multi-year average under the CPI, and the relaxation of the strict priority of methods.

THE 1993 TEMPORARY AND PROPOSED REGULATIONS

 In response to comments, the IRS issued revised temporary and proposed regulations on January 21, 1993 (TD 8470; INTL 401-88, 58 FR 5263) (the 1993 regulations). With the exception of the provisions on cost sharing, the 1993 regulations replaced all the provisions contained in the 1992 regulations and added some new provisions. In addition, the 1993 regulations also modified other provisions under the 1968 regulations that had not been affected by the 1992 regulations. The 1993 regulations also adopted a structure different from that set forth under the 1968 regulations. Section 1.482-1T sets forth general rules applicable to all the subsequent provisions of the regulations under section 482. Most important of these rules is extensive guidance to be applied in determining whether an uncontrolled transaction is sufficiently comparable to serve as a basis for application of a pricing method. Determining comparability under these rules generally requires consideration of functions, risks, contractual terms, economic conditions and products. Detailed guidance is provided as to how these factors are to be assessed. Finally, the relative importance of any of these factors varies depending upon the method applied.

 Section 1.482-1T also provides a "best method rule" to be used in determining which method provides the most accurate measure of an arm's length result in a given case. The best method rule adopts a flexible approach under which the determination of which method is most accurate depends on the facts and circumstances of the case. Factors to take into account in this determination include the completeness and accuracy of available data, the degree of comparability between the controlled and uncontrolled transactions, and the extent of adjustments required to apply a method. The best method rule also provides that when two methods provide inconsistent results and the best method rule does not otherwise indicate which of the two analyses should be preferred, an additional factor to take into account is whether a third method provides a result that is consistent with the result of one of the first two methods.

 Section 1.482-1T also sets forth special rules to deal with issues presented by market penetration strategies, different geographic markets, "location savings," aggregation of transactions, analysis of contractual terms, multiple year analyses, collateral adjustments, coordination with section 936, and consideration of alternatives. Under the latter rule, the district director is instructed to determine an arm's length price based upon the structure actually adopted, and not to restructure the transaction as long as its form was consistent with its substance. The district director may, however, consider alternatives reasonably available to the taxpayer in determining whether a purported comparable transaction actually represents a reliable indicator of the terms to which the taxpayer would have agreed under arm's length conditions.

 In addition, section 1.482-1T provides that no allocation will be made if the taxpayer's result falls within a range of arm's length results. Under this rule, two or more valid applications of any single method create a range of acceptable results within which the taxpayer's result are considered to satisfy the arm's length standard. Results falling outside the range are subject to adjustment to any point within the range (generally the midpoint).

 Section 1.482-1T also provides a safe harbor for small taxpayers. That provision would permit a small taxpayer (generally defined as a group having less than $10 million in U.S. or foreign sales) to elect to determine its U.S. taxable income in accordance with annual published measures of profitability.

 Finally, the 1993 regulations include proposed regulations to be added to section 1.482-1 dealing with foreign legal restrictions. In general, this rule provides that a foreign legal restriction preventing or limiting payment of an arm's length amount will be respected for purposes of determining an arm's length consideration only if there is evidence of a comparable uncontrolled transaction in which unrelated parties agreed to enter a similar transaction subject to the restriction. In other cases, the foreign legal restriction will be disregarded in determining an arm's length amount, but the taxpayer is permitted to elect a deferred method of accounting to defer recognition of additional income until such time as the restriction is lifted, subject to the consistent deferral of related expenses.

 In addition to revising section 1.482-1, the 1993 regulations restructured the rules relating to transfers of tangible and intangible property. The 1993 regulations contain separate subsections for these rules, which were all contained in section 1.482-2 in the 1968 regulations. Specifically, section 1.482-3T governs transfers of tangible property, section 1.482-4T governs transfers of intangible property, and section 1.482-5T sets forth the comparable profit method (the CPM), which, as under the 1993 regulations, applies to transfers of tangibles or intangibles. In addition, the 1993 regulations contain a proposed set of profit split rules (to be added as section 1.482-6).

 The section on transfers of tangible property provides five principal methods: the comparable uncontrolled price (CUP) method, the resale price method, the cost plus method, the CPM, and (when authorized by the regulations) profit split. The CUP method was modified to provide that this method may be applied only if there are at most minor differences between the controlled and uncontrolled transactions. The 1968 regulations provided that CUP could be used only if the transactions were "so nearly identical" that any differences could be reflected by a reasonable number of adjustments. Since the CUP method is likely to achieve the highest degree of comparability of any method potentially applicable to a transfer of tangible property, the 1993 regulations state that the CUP method generally provides the most reliable measure of an arm's length result when it can be applied. The rules under the resale price and cost plus methods were not substantially changed from their predecessors in the 1968 regulations. Section 1.482-3T also provides that when none of the enumerated methods can be applied, other (unspecified) methods may be used. In order to employ an unspecified method, taxpayers are required to disclose the use of such method on the tax return and to prepare contemporaneous documentation explaining why the method provides the most accurate measure of an arm's length result. Finally, section 1.482-3T provides rules coordinating the application of the tangible and intangible rules in cases involving transfers of so-called imbedded intangibles.

 Section 1.482-4T combine the MTM and CATM from the 1992 regulations into a single method known as the comparable uncontrolled transaction (CUT) method. Unlike the CATM, the results of the CUT method are not subject to mandatory check by the CPI. As with the CUP method under section 1.482-3T, the regulations provide that this method ordinarily provides the most reliable measure of an arm's length result. The mandatory CPI check in the 1992 regulations is replaced in the 1993 regulations by requiring that the intangibles transferred in the controlled and uncontrolled transactions have substantially the same profit potential. In addition, to apply this method, the property transferred must be from the same class of intangible property and relate to the same class of products or services. Further, the underlying circumstances of tile two transactions must be sufficiently similar that reliable adjustments may be made to account for the effect of any differences.

 Section 1.482-4T also permits the application of unspecified methods, subject to the same constraints on taxpayer use that are imposed under section 1.482-3T. The preamble of the proposed regulation also requested comment on the merits of including a method 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 licensee, employing valid measures of the cost of capital such as those derived from the capital asset pricing model.

 The 1993 regulations broaden the exceptions from periodic adjustments that were contained in the 1992 regulations by providing two exceptions. The first applies if the consideration for the intangible was determined to be arm's length under the CUT Method in the first year when substantial periodic consideration was paid, the taxpayer's actual profits from the intangible remained within a band between 80 and 120 percent of the profits projected at the time of the controlled transactions, and certain other conditions are met. The second exception is similar but applies to methods other than the CUT Method.

 The 1993 regulations also provide rules for identifying the owner of an intangible for purposes of section 482 (the developer- assister rule). These rules generally track rules provided in prior regulations, under which the owner normally is considered to be the controlled taxpayer that bears the greatest share of the risk of developing the intangible. The party that bears the greatest risk of development generally is determined by identifying costs of development. Under this rule the owner for purposes of income allocation under section 482 would not necessarily be the legal owner.

 Section 1.482-5T describes the CPM. The CPM may be applied to transfers of tangible and intangible property. In broad terms the CPM is similar to the CPI set out in the 1992 regulations. However, it no longer serves as a mandatory check on the results provided by certain other methods. In addition to the general comparability factors and other considerations that must be applied before a method can be considered to provide a reasonable and reliable benchmark, section 1.482-5T provides that CPM ordinarily is inappropriate if the tested party owns 'valuable non-routine intangible" property. This limitation was added to the other limitations generally applicable to all methods because CPM could be expected to understate the income attributable to such property due to the difficulty in locating uncontrolled taxpayers that possess comparable intangible property.

 The 1993 regulations do not define the term "valuable non- routine intangible." The preamble to the regulations, however, states that in general the term would encompass intangible property "that is central to the conduct of a business activity and without which the business activity could not be conducted." The preamble to the proposed regulations requested comment on possible more precise definitions.

 The CPM generally is applied to the taxpayer with the simplest and most easily compared operations (the tested party). In identifying potential comparables, the regulations provide that the standard of comparability is not as strict as other methods. Some diversity in terms of the functions and products is permitted, although the degree of comparability affects the reliability of the results in relation to the results of other methods under the best method rule. It also affects the derivation of the arm's length range under this method. In addition, the regulations describe a number of adjustments, including adjustments to achieve accounting consistency, that should be made when possible to the results of the uncontrolled comparables to enhance comparability.

 Like the CPI under the 1992 regulations, a result will satisfy the arm's length standard under the CPM if it falls within a range of results, based on a single profit level indicator derived from uncontrolled comparables. Profit level indicators include the rate of return on capital employed (i.e., rate of return on assets) and financial ratios such as operating profit to gross sales and gross profit to operating expenses (Berry ratio).

 Unlike the other methods in the 1993 regulations, the arm's length range may be constructed under the CPM in one of two ways. First, if reliable adjustments for all material differences that would affect profitability are made, the arm's length range includes all the results obtained, as under the other methods. In other cases, however, the range is limited by statistical methods. The range so determined consists either of the interquartile range or the range constructed under some other statistically valid method. No additional guidance was provided as to how the range would be established if the interquartile range were not used.

 The 1993 regulations also contain a set of proposed regulations (section 1.482-6) providing profit split methodologies. Three methods are described: the residual allocation rule, the capital employed allocation rule and the comparable profit split. In addition, other profit splits may be used if they provide an economically valid basis for the allocation of the combined profit or loss of the relevant business activity. The basic objective of the profit split methods is to estimate an arm's length return by comparing the relative economic contributions that two parties make to the success of an activity (the relevant business activity), and dividing the returns from the relevant business activity between them on the basis of the value of such contributions.

 The residual allocation rule is similar to the BALRM with profit split described in the White Paper. It consists of two basic steps. First, using other methods such as the CPM, market returns for routine functions are estimated and allocated to the parties that performed them. The remaining, residual amount then is allocated between the parties on the assumption that this residual is attributable to intangible property contributed to the activity by the controlled taxpayers. Based on this assumption, the residual is divided based on the estimate of the relative value of the parties' contributions of such property. Since fair market value of the intangible property usually would not be readily ascertainable, the regulations permit use of other measures of the relative values of intangible property including capitalized research and development expenses.

 The capital employed allocation rule may be applied only if all the controlled taxpayers participating in the relevant business activity assumed an approximately equal level of risk with respect to their capital employed. Comment was requested on the feasibility of measuring relative levels of risk. This method divides the combined operating profit from the relevant business activity by allocating an equal return to each controlled taxpayer's capital employed. Capital employed may be measured by either book or fair market value, as long as all assets are valued on the same basis. Further, if book value is used and there are intangible assets that have no book value, some other measure (such as capitalized research and development expense) must be used.

 The comparable profit split rule is similar to the profit split rule set forth in the 1992 regulations. It essentially may be applied only if it is possible to locate two unrelated parties that are each comparable to one of the controlled taxpayers and that deal with one another in a comparable manner. In such a case the combined operating profit from the relevant business activity is divided among the controlled taxpayers in the same percentage as it was divided among the unrelated parties.

 There are a number of substantive and procedural restrictions on the use of the profit split method. These restrictions were imposed because the profit split method relies either wholly or in part on internal data rather than data derived from uncontrolled taxpayers, and it is therefore likely that other methods will provide a more reliable measure of an arm's length result under the best method rule.

 There are three substantive limitations on the use of the profit split method. The profit split method may be applied only if both controlled taxpayers own valuable non-routine intangible property, the intangibles contribute significantly to the combined operating profit derived from the relevant business activity, and there were significant transactions between the controlled taxpayers.

 The most important administrative requirement is that the taxpayer must make a binding election to apply the profit split method, which can be revoked only with the consent of the Commissioner. In addition, the taxpayer also is required to document the combined profit or loss attributable to the relevant business activity to the satisfaction of the district director and explain in such documentation why the profit split method provides the best method for determining an arm's length result. Further, prior to electing the profit split method the taxpayer must execute a pricing agreement setting forth the method chosen, and the method must be applied consistently from year to year. The district director also is required to meet all of the substantive, but not the procedural requirements, to apply the profit split method.

COMMENTS ON THE 1993 REGULATIONS

 The IRS received comments on the 1993 regulations from many taxpayers and industry and professional groups. In addition, comments were received from several tax treaty partners, both individually and through the international forum of the organization for Economic cooperation and Development (OECD).

 The commenters generally approved of the introduction of the best method rule and the flexibility implied by reliance on comparability, rather than a hierarchy of methods, to identify the method that would provide the most accurate measure of an arm's length result. Commenters also generally approved of the extension of the concept of an arm's length range to all the methods, the proposal of a set of profit split methods, the inclusion of exceptions from periodic adjustments that were broader than the exceptions provided under the 1992 regulations, and the elimination of the requirement that the CPM be a mandatory check on the results of most other methods.

 Commenters also expressed concerns with various aspects of the 1993 regulations. In particular, the most critical comments focused on the CPM and profit split portions of the regulation. With respect to the CPM, some commenters expressed a belief that the method was inconsistent with the arm's length standard and should be eliminated. Others felt that it could provide useful evidence in certain cases and therefore should be retained, but the scope for its application should be circumscribed further than it was in the 1993 regulations. In addition, some commenters were concerned that examiners might apply the CPM without regard to the evidence provided by other methods. Contributing to this concern was the fact that the comparability standards under other methods were generally tighter than under the CPM, potentially making the CPM more readily available. Finally, commenters evidenced some confusion over certain language in section 1.482-5T; some interpreted the scope language under that section as indicating that the CPM was preferred to other methods, in contradiction to the best method rule.

 With respect to the profit split method, many commenters urged that the elective and other procedural requirements for its use by taxpayers be eliminated. Commenters expressed some ambivalence with respect to the requirement that both parties to the transaction own valuable non-routine intangibles in order to employ the profit split method. Some were concerned that this requirement would make profit split unavailable in some cases in which it might otherwise provide the most reliable measure of an arm's length result. Others were uncertain of its effect given the absence of an explicit definition of the term in the regulations. Many suggestions were received as to possible definitions of this term, which was relevant not only under profit split but also under the CPM.

 In addition to the comments received on the CPM and profit split methods, numerous concerns were expressed with regard to other aspects of the regulations. The most significant of these included the following. In connection with the provisions relating to tangible property, a large number of commenters expressed concerns about the limited role accorded to evidence provided by "inexact comparables," particularly under the CUP method, arguing that in some instances the evidence provided by an "inexact comparable" would be more reliable than other available information. Some also perceived the modified comparability standard under the CUP method as being more restrictive than the standard under the 1968 regulations, and several comments objected to the restrictions placed on the use of unspecified methods.

 In connection with the provisions relating to intangibles, several commenters objected to the high comparability standard under the CUT method, particularly the requirement that profit potential of the controlled transaction and the uncontrolled transaction be substantially the same. Further, the continued availability of periodic adjustments was viewed by some as potentially conflicting with the arm's length standard. Others criticized the failure of the developer-assister rule to give sufficient weight to legal ownership in identifying the owner of an intangible, and objected to an example illustrating the potential use of alternatives in applying the arm's length standard.

 Commenters also requested further guidance as to the interaction of the tangible and intangible property rules. Finally, some commenters requested that the thresholds for application of the safe harbor be liberalized to make it more widely available, and others requested that the published measures of profitability allow electing taxpayers to report less income than they would be expected to report under the otherwise applicable methods.

 Further discussion of the comments received is included in the following description of the changes reflected in the final regulations.

THE FINAL REGULATIONS

 While the final regulations reflect numerous modifications in response to the comments received on the 1993 regulations, both the format and the substance of the final regulations are generally consistent with the 1993 regulations. The changes adopted are intended to clarify and refine those provisions of the 1993 regulations that required improvement, without fundamentally altering the basic policies reflected in the 1993 regulations.

 The most noteworthy feature of the 1993 regulations in comparison to earlier versions of the regulations under section 482 was the emphasis on comparability, and the resulting flexibility. This feature of the 1993 regulations was generally well received by taxpayers and foreign governments. The final regulations adhere to this emphasis, and in some cases increase it. For instance, so-called "inexact" comparables potentially may be used under all the methods in the final regulations, while they were generally not taken into account under the 1993 regulations. Further, the elective and other procedural barriers to the use of profit split and "other" (i.e., unspecified) methods have been removed, and the limitations regarding the presence of valuable non-routine intangibles under CPM and profit split have been eliminated. These restrictive rules were contained in the 1993 regulations primarily out of a concern that in their absence taxpayers or the IRS might employ methods that did not provide the best measure of an arm's length result.

 By removing these restrictions, the final regulations are intended to maximize the extent to which relevant information may be taken into account in evaluating taxpayers' results under the arm's length standard. As a consequence, however, the emphasis on comparability and the importance of the best method rule are increased; because ex ante restrictions will no longer prohibit the use of potentially less reliable information or methodologies, it is critically important that the best method rule be properly applied to select the most reliable measure of an arm's length result from the available evidence. Thus, taxpayers and the IRS will be required to exercise considerable judgment in applying the arm's length standard. To assist taxpayers and the IRS in exercising this judgment, the discussion of the factors to consider in applying the best method rule has been substantially expanded. Set forth below is a more detailed explanation of the provisions in the final regulations.

SECTION 1.482-1

 With one exception, the scope and purpose provision of the regulations (section 1.482-1(a)(1)) is substantially similar to its counterpart in the 1993 regulations. The final regulations delete the statement that section 482 places uncontrolled and controlled taxpayers on a parity by determining the controlled taxpayer's true taxable income "in a manner that reasonably reflects the relative economic activity undertaken by each taxpayer." The definition of true taxable income in section 1.482-1(i)(9) already incorporates the notion that, under section 482, the controlled taxpayer should earn the amount of income that would have resulted had it dealt with other controlled taxpayers at arm's length. Because a transaction at arm's length naturally would reflect the "relative economic activity undertaken," this definition incorporates that concept, and it is unnecessary to include the additional language in this provision.

 The provision authorizing the IRS to make allocations (section 1.482-1(a)(2)) is unchanged from the 1993 regulations.

 The provision regarding the taxpayer's use of section 482 (section 1.482-1(a)(3)) has been revised to clarify that, although the taxpayer is generally barred from invoking the provisions of section 482, the taxpayer may report an arm's length result on its original tax return, even if such result reflects prices that are different from the prices originally set forth in the taxpayer's books and records. In response to comments, the requirement in the 1993 regulations that such differences be eliminated through the use of "compensating adjustments" has been deleted. Section 482 is concerned only with whether the taxpayer reports its true taxable income, and whether or not this result is consistent with the taxpayer's books, or is corrected in the books, is generally irrelevant to this inquiry. However, the absence of a requirement to eliminate book and tax differences for section 482 purposes has no effect on the mechanisms otherwise provided for reporting and reconciling such differences (e.g., Schedule M-1 of Form 1120). Further, the limited exception provided by this rule does not permit taxpayers to apply section 482 at will; thus, for example, a taxpayer may not rely on section 482 to reduce its taxable income on an amended return.

 Section 1.482-1(b) summarizes some key principles that guide application of section 482. Section 1.482-1(b)(1) states that the governing principle under section 482 is the arm's length standard. Under this standard controlled taxpayers are expected to realize from their controlled transactions the results that would have been realized if uncontrolled taxpayers had engaged in the same transactions under the same circumstances. This expression of the arm's length standard differs from that set forth in the 1993 regulations, which stated that the arm's length standard was satisfied if the results of a controlled transaction were consistent with the results of "comparable transactions between uncontrolled taxpayers." The latter definition has been replaced because it is inconsistent with the notion underlying the arm's length standard that controlled and uncontrolled taxpayers should be placed on the same (rather than a merely similar) footing. However, this provision recognizes that in most cases identical transactions between unrelated parties will not be located, and it therefore will be appropriate to consider uncontrolled transactions that are comparable rather than identical.

 Section 1.482-1(b)(2) provides rules for determining the type of method that will be applied to evaluate whether controlled transactions are at arm's length, given that different methods apply to different types of transactions (e.g., transfers of property or services). In some cases it may be necessary to apply more than one method to a single transaction when the transaction is most reliably evaluated under more than one method. This provision is identical to its counterpart in the 1993 regulations, except that it, along with a number of other provisions, has been revised in response to comments to make clear that it applies to taxpayers as well as the district director. Thus, such provisions apply with equal force to the district director and to a taxpayer that seeks to apply the final regulations for purposes of determining and reporting its true taxable income on its original return, consistent with section 1.482-1(a)(3).

 Section 1.482-1(c) contains the best method rule. Although similar in purpose and substance to its counterpart in the 1993 regulations, this provision contains considerably more detail and guidance for application than its predecessor, and has been given more prominence in the structure of the regulation. The best method rule guides the application of all the methods in the final regulations. Whenever the available data creates the possibility that more than one method could be applied to a controlled transaction (or that one method could be applied in more than one way), the best method rule must be applied to determine which of those methods (or applications) will be selected.

 The best method rule provides that an arm's length result must be determined under the method that, given the facts and circumstances, provides the "most reliable measure" of an arm's length result. This formulation modifies the 1993 regulation's reference to the "most ACCURATE measure," to conform to the factors that are taken into account in applying the best method rule. These considerations are couched in terms of reliability rather than accuracy.

 In deciding which of two or more methods provides the most reliable measure of an arm's length result, section 1.482-1(c)(2) provides that there are two primary factors to consider: comparability and the quality of data and assumptions. In addition, as under the 1993 regulations, in some cases it may be relevant to consider whether the results of a particular method are consistent with the results under another method.

 Section 1.482-1(c)(2)(i) discusses the role of comparability under the best method rule. Although the results of identical transactions between unrelated parties under identical circumstances provide the most objective basis for determining the true taxable income of a controlled taxpayer, it rarely is possible to locate uncontrolled transactions with this degree of similarity to the controlled transactions. Therefore, the regulations contemplate use of uncontrolled transactions that are comparable, rather than identical, to the controlled transaction.

 In most cases there will be more than one potential comparable uncontrolled transaction to which the controlled transaction may be compared, and it will be possible to apply more than one method. In such cases it is necessary to evaluate the relative degree of comparability of each such uncontrolled transaction under the comparability criteria relevant to the application of the method; the method that employs the uncontrolled comparables with the highest degree of comparability to the controlled transaction is more reliable than methods that employ uncontrolled comparables with a lesser degree of comparability, assuming data and assumptions of equal quality. Methods relying on uncontrolled transactions with the highest degree of comparability are preferred because, as the degree of comparability is improved, the number of differences that could render the analysis unreliable is reduced. Adjustments can and should be made for any differences if the reliability of the analysis is improved by making the adjustment. Under this approach, the comparable uncontrolled price and comparable uncontrolled transaction methods ordinarily will provide the most reliable measure of true taxable income when they can be applied to closely comparable uncontrolled transactions, because such analyses can be expected to achieve a higher degree of comparability than other methods.

 In determining which method provides the highest degree of comparability, it is necessary to consider the comparability factors discussed in section 1.482-1(d) (Comparability). In addition, it is necessary to consider further guidance on comparability set out under each method, as certain differences have a greater effect on comparability under some methods than under others. Finally, the reliability of data and assumptions, discussed below, will affect the ability to determine the degree of comparability between an uncontrolled transaction and the controlled transaction.

 Section 1.482-1(c)(2)(ii) discusses data and assumptions, which constitute the second factor that must be considered in applying the best method rule. This provision is divided into three components: completeness and accuracy of data, reliability of assumptions, and sensitivity of results to deficiencies in data and assumptions.

 Completeness and accuracy of data defines the ability to identify and quantify material differences. When data regarding a controlled or uncontrolled transaction is relatively incomplete, it is more difficult to determine if there are material differences between the transactions. Thus, the fact that no material difference between an uncontrolled and a controlled transaction has been identified does not necessarily mean that the two transactions are highly comparable unless the data on both transactions is sufficiently comprehensive that it is possible to conclude that it is unlikely that any such differences exist. In addition, the completeness and accuracy of data will affect the ability to reliably estimate the effect of a material difference once such a difference is identified. Thus, merely identifying and adjusting for the effect of a material difference does not render the controlled and uncontrolled transactions highly comparable unless the data on both transactions is sufficiently complete and accurate that the difference has a definite and reasonably ascertainable effect.

 Another factor that affects the reliability of an analysis is the reliability of the assumptions upon which the analysis is based. All methods rely on assumptions. For instance, adjustments for differences in payment terms reflect the assumption that such differences would have an effect on price at arm's length. While this assumption is relatively sound, other assumptions may be less reliable. In particular, assumptions under the profit split method (such as the assumption that the value of intangible assets is related to the cost of development) may not always be as reliable as the assumptions under methods that rely more closely on direct market indicators.

 After assessing the completeness and accuracy of data and the reliability of the assumptions upon which the analysis is based, section 1.482-1(c)(2)(ii)(C) provides that it is necessary to determine the effect that any deficiencies in the data and assumptions have on the reliability of the result. Some deficiencies will be more important than others. Thus, a difference in risks borne might be expected to affect all methods to some extent. Further, some deficiencies will have a more adverse impact on some methods than on other methods, because different methods rely more heavily on different types of comparability. Thus, an inability to reliably allocate research and development expenses would have a serious effect on the reliability of a residual profit split under section 1.482-6(c)(3), but would have little effect on an analysis under the CUT method.

 Finally, section 1.482-1(c)(2)(iii) provides that in some cases it may be relevant to consider whether the results obtained under a method are consistent with the results obtained under another method. This situation will arise when, after considering the comparability and the quality of the data and assumptions under two different methods (or under two different applications of the same method), it is not possible to determine which of the competing analyses provides a more reliable measure of an arm's length result. In such a case, it may be relevant to compare the results with the result obtained under a third method (or, given two applications of a single method, a third application of that method).

 Section 1.482-1(d) provides general guidance for determining comparability. General guidance on comparability is provided in this section of the regulations because the factors described are relevant under all the methods. This provision is substantially similar to the guidance provided in section 1.482-IT(c) of the 1993 regulations. It provides that in determining the degree of comparability between a controlled and uncontrolled transaction, the functions, contractual terms, risks, economic conditions, and property or services in the two transactions must be compared.

 Section 1.482-1(d)(2) provides that for two transactions to be considered comparable, they need not be identical, but must be sufficiently similar that the uncontrolled transaction provides a reliable measure of an arm's length result. Further, if there are material differences between the transactions, adjustments must be made to account for such differences if the effect of the differences can be ascertained with sufficient accuracy to improve the reliability of the results. A "material difference" is defined as a difference that would materially affect price or profit. Thus, adjustments for differences that would have only a de minimis or minor effect on price or profit are not required (although such adjustments will tend to increase the reliability of the result). Further, the extent (i.e., the number and magnitude) and reliability of any adjustments will affect the reliability of the result. The number and magnitude of adjustments affects reliability because as the number or magnitude of adjustments increases, the potential for error also increases. Although the standard of comparability under section 1.482-1(d)(2) creates the possibility that there may be a material difference between the controlled and uncontrolled transactions for which an adjustment has not been made, this only would occur if an adjustment was not possible and no better analysis could be employed.

 There are several differences between section 1.482-1(d)(2) and its counterpart in the 1993 regulations (section 1.482-1T(c)(2)(i)). First, in response to comments, the definition of comparability in the final regulations contemplates the use of so-called "inexact" comparables under all methods. The 1993 regulations only contemplated the use of such analyses under the CPM. Of course, inexact comparables only will be used if the best method rule indicates that these analyses provide the most reliable measure of an arm's length result.

 A second difference between the final and 1993 regulations is the standard for making adjustments. The 1993 regulations provided that adjustments "may" be made to account for material differences if such differences have a "definite and reasonably ascertainable effect" on prices or profits, and that if such differences can be reflected by such adjustments, the result constitutes an arm's length result for the controlled transaction. This language therefore seemed to preclude adjustments when the effect of the difference did not have a definite and reasonably ascertainable effect. Interpreted literally, this standard could prevent adjustments that, although not perfectly precise, nonetheless would improve the reliability of the analysis.

 Accordingly, the final regulations provide that adjustments for material differences should be made to the extent that they improve the reliability of a result. In some cases it may be possible to make adjustments that improve reliability even though the difference for which the adjustment is made does not have a "definite and reasonably ascertainable" effect on price or profit. Such adjustments nevertheless should be made. The provision adds that the extent and reliability of the adjustments will affect the reliability of the result in relation to the reliability of applications of other methods.

 A third important difference between the 1993 regulations and the final regulations is the definition of the minimum level of comparability. The 1993 regulations provided that an uncontrolled comparable could be used to determine an arm's length result only if it provided a "reasonable and reliable benchmark." This phrase has been replaced by the phrase "a reliable measure" of an arm's length result. To some readers the word "benchmark" indicated that unadjusted industry averages could serve as the basis for adjustments. This concern was most evident with respect to the comments received with respect to the CPM.

 Section 1.482-1(d)(3) discusses the five factors that affect comparability: functions, contractual terms, risks, economic conditions and property or services. Of these factors, the discussions of functions, economic conditions and property or services are substantially similar to the discussions of these factors in the 1993 regulations. The discussions of contractual terms and risks differ in some respects from the discussions of these factors in the 1993 regulations.

 Contractual terms were covered in two provisions of the 1993 regulations: section 1.482-1T(c)(3)(iii) and (d)(3)(ii). The final regulations consolidate the discussion of these provisions into section 1.482-1(d)(3)(ii) and make some clarifying changes.

 The discussion of risk in section 1.482-1(d)(3)(iii), particularly as it relates to identifying the party that bears a risk, is somewhat different from its predecessor in the 1993 regulations (section 1.482-1T(c)(3)(ii)). In general, the determination of which party bears a risk will be made in accordance with the provisions of section 1.482-1(d)(3)(ii)(B) (Identifying contractual terms). Thus, to the extent that taxpayers allocate risks by contract and their conduct is consistent with such contract, their allocation of risk will be respected, unless the contract is executed after the impact of the risk is known or knowable. In cases where the allocation of risk is not clear from the parties' contractual arrangements, several factors may be particularly relevant to determine which party bore the risk. These factors include whether the parties' conduct is consistent over time; which controlled taxpayer would ultimately bear the consequences of a risk; and the extent to which each taxpayer controls any activities that influence the outcome of a particular risk. The rules on documentation of risks contained in the 1993 regulations has been revised because some readers thought they implied that the district director could arbitrarily allocate risks in the absence of express documentation allocating the risk.

 Section 1.482-1(d)(4) sets forth rules for certain special circumstances affecting comparability. First, section 1.482-1(d)(4)(i) describes the extent to which market share strategies will be respected in determining an arm's length result for a controlled transaction. As under the 1993 regulations, these strategies may be recognized in certain situations in which a company is attempting to gain entry into a market or to increase market share. In such circumstances the amount charged in the controlled transaction, or the expenses borne by a controlled taxpayer, may for a short time differ from what normally would be observed at arm's length. The reference in the 1993 regulations to using such strategies to meet competition in an existing market has not been included in the final regulations because companies in competitive markets are routinely faced with the problem of meeting competition, which is reflected in a normal arm's length price.

 A market share strategy will be respected only if certain conditions are satisfied. These conditions are that the costs incurred to implement the strategy are borne by the controlled taxpayer that would derive the benefits from engaging in the strategy (and there is a reasonable likelihood that the strategy will bear fruit), the strategy is pursued for a reasonable period of time given the industry in question, and the strategy and related matters are documented before the strategy was implemented. The taxpayer must provide documentation establishing that it has satisfied these conditions. These conditions and the documentation requirement are similar to those imposed under the 1993 regulations. In addition, a market share strategy "will be taken into account only if it can be shown that an uncontrolled taxpayer engaged in a comparable strategy under comparable circumstances for a comparable period of time. . . ." This requirement ensures that the strategy is consistent with the behavior of parties operating at arm's length. It does not, however, require that the taxpayer locate a comparable uncontrolled transaction that would satisfy the standards of the cup method in order to take advantage of this rule. The critical component of this requirement is that there be evidence that uncontrolled taxpayers engage in similar behavior under comparable circumstances. A taxpayer could, for example, satisfy this requirement by providing evidence of an uncontrolled taxpayer in a different industry engaging in such a strategy, given evidence that the circumstances otherwise were comparable.

 Section 1.482-1(d)(4)(ii) addresses certain issues presented by differences in geographic markets. This section generally conforms to the analogous provision in the 1993 regulations by providing that while it is permissible to derive uncontrolled comparables from geographic markets that are different from the market in which the controlled transaction occurred, adjustments must be made to the extent possible to reflect the effect of any differences between the markets, and the failure to accurately adjust for such differences will affect the reliability of the analysis under the best method rule. In addition, section 1.482-1(d)(4)(ii)(C) provides that "location savings" from operating in a low-cost jurisdiction must be allocated among controlled taxpayers consistent with the allocation of such savings that would occur between unrelated parties, taking into account the competitive conditions in the low-cost market. As a result, some or all of the location savings might inure to the benefit of the other party to the controlled transaction.

 Finally, section 1.482-1(d)(4)(iii) describes certain transactions that are not ordinarily accepted as comparables. Transactions not in the ordinary course of business, and transactions arranged with a principal purpose of establishing an arm's length result, ordinarily will not constitute comparable transactions for purposes of section 482. This provision is generally consistent with section 1.482-1T(c)(4)(iii), except that the reference to "isolated transactions" has been deleted, as most transactions involving intangible property may be viewed as isolated. In addition, the statement that transfers of tangibles should be significant in number and amount in order to constitute comparables has also been deleted. Transfers of some property may be few in volume, but nonetheless be in the ordinary course of business and provide a useful basis for determining an arm's length result. Moreover, even large differences in volume are not per se bars to the use of a potential comparable. Rather, such differences should be taken into account as comparability factors under section 1.482-1(d)(3).

 Section 1.482-1(e) describes the arm's length range. This provision corresponds to section 1.482-1T(d)(2)(i) of the 1993 regulations. As under the 1993 regulations, the arm's length range is derived from two or more uncontrolled transactions. Under the 1993 regulations the range included all valid applications of a particular method. A modified rule has been included in the final regulations to reflect the possible use of inexact comparables under all of the methods. Given this relaxed standard of comparability, it would be inappropriate to derive a range from a mix of exact and inexact comparables, because to do so would accord the same weight to results with potentially widely varying degrees of reliability. Therefore, section 1.482-1(e)(2)(i) provides that the range is derived from two or more uncontrolled transactions "of similar comparability and reliability."

 Section 1.482-1(e)(2)(ii) expands upon this rule, providing that uncontrolled comparables with significantly lower levels of comparability and reliability than others will be disregarded. Thus, it is necessary in every case in which more than one uncontrolled transaction is available to compare the relative levels of comparability and reliability of the uncontrolled transactions, and to discard those uncontrolled transactions that do not have approximately the same level of comparability and reliability as the most comparable and reliable of the uncontrolled transactions.

 Under section 1.482-1(e)(2)(iii), the arm's length range will be established in one of two ways, depending upon the extent to which material differences between the uncontrolled comparables and the controlled transaction can be identified, and the reliability of adjustments made to account for such differences. First, under section 1.482-1(e)(2)(iii)(A), the arm's length range will consist of the results of all the uncontrolled comparables (i.e., all the uncontrolled comparables of similar comparability and reliability) if certain requirements are met. These requirements are that every identified material difference have a definite and reasonably ascertainable effect on prices or profits; that appropriate adjustments for such differences be made; and that the data be sufficiently complete that it is likely that there are no unidentified material differences. Given equal degrees of high comparability, it is impossible to conclude which of the uncontrolled comparables provides a more reliable measure of an arm's length result, and it is inappropriate to draw distinctions between them by excluding some from the range. Therefore all the results are included in the arm's length range.

 Second, section 1.482-1(e)(2)(iii)(B) provides that if the standards of section 1.482-1(e)(2)(iii)(A) are not met, then the reliability of the analysis must be enhanced, if possible, by applying valid statistical techniques to the uncontrolled comparables that are of similar comparability and reliability. In this case the range generally consists of the interquartile range, i.e., the 25th to the 75th percentile of the results derived from the uncontrolled comparables, or an equivalent range determined pursuant to other valid statistical methods corresponding to a level of confidence equal to that provided by the interquartile range. Finally, this section reemphasizes that all adjustments for material differences that improve the reliability of the result must be made to the extent possible. Section 1.482-1(e)(2)(iii)(C) provides guidance for determining the interquartile range.

 The 1993 regulations contemplated the use of statistical techniques to derive the arm's length range only under the CPM. The use of these techniques has been extended to all methods under the final regulations to reflect the fact that the standards of comparability have been relaxed to permit the use of inexact comparables.

 Unlike the uncontrolled comparables used in establishing the range under section 1.482-1(e)(2)(iii)(A), the comparables under section 1.482-1(e)(2)(iii)(B) have, or may have, material differences for which adjustments have not been made. The justification for including all the results in the arm's length range under section 1.482-1(e)(2)(iii)(A) is that all the uncontrolled comparables are of approximately equal comparability, and it is inappropriate to draw distinctions between them by excluding some from the range. This is not true, however, of the comparables used to derive the arm's length range under section 1.482-1(e)(2)(iii)(B). Although these comparables will appear to be of equal comparability, the presence of either unidentified material differences or identified material differences that do not have a definite and reasonably ascertainable effect, means that they are actually unlikely to be equally comparable. Therefore, to include all the results in the arm's length range under section 1.482-1(e)(2)(iii)(B) would mean that uncontrolled comparables of differing degrees of comparability and reliability would be included in the range, violating the rule set forth in section 1.482-1(e)(2)(ii) (Selection of comparables). If results of varying degrees of comparability and reliability were included in the range, the analysis would be distorted, because results with different degrees of comparability and reliability would be accorded equal weight.

 Since it is impossible to directly identify and quantify these material differences, the regulations require that they be taken into account indirectly through the use of a statistical range. Results that differ widely from one another have significant, unaccounted for, differences. Therefore when it is highly probable that the uncontrolled comparables are not of roughly equal comparability (it being impossible to identify all material differences), it is reasonable to assume that the results diverging significantly from the norm are not comparable to the controlled taxpayer.

 If results fall outside the arm's length range, section 1.482-1(e)(3) provides that the district director may make adjustments so that the taxpayer's result falls at any point within the range. When the interquartile range is used, this point generally will be the median of the results. In other cases, this point will normally be the mean of the results.

 Section 1.482-1(e)(4) states that the district director may properly propose an adjustment based on a single comparable uncontrolled price. However, if the taxpayer subsequently demonstrates that its results are within a range established by additional equally comparable transactions, no allocation will be made.

 Section 1.482-1(f) sets forth several rules relating to the scope of review under section 482 that correspond closely to rules provided under section 1.482-1T(d) of the 1993 regulations. This section provides that a section 482 allocation may be made whenever the taxable income of a controlled taxpayer differs from an arm's length amount. Further, section 1.482-1(f)(1)(i) provides that the discretion of the district director to utilize section 482 is not limited to cases in which the taxpayer intentionally distorted its taxable income. Section 1.482-1(f)(1)(ii) provides that the district director may make an allocation even if the ultimate income anticipated from a series of transactions is not realized. Sections 1.482-1(f)(1)(iii) and (iv) relate to the interaction between section 482 and the nonrecognition and consolidated return provisions, respectively. They are consistent with guidance set forth in the 1968 and 1993 regulations.

 Section 1.482-1(f)(2) contains rules relating to the determination of true taxable income. These rules are substantially similar to rules set forth in section 1.482-1T(d)(3) of the 1993 regulations. Section 1.482-1(f)(2)(i) provides that multiple transactions (generally within the same product grouping) may be aggregated when they are so interrelated that it is necessary to view them as a whole. Section 1.482-1(f)(2)(ii) 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 had been structured differently. The district director may, however, consider the alternatives that were available to the taxpayer in determining whether the terms of the controlled transactions would be acceptable to an uncontrolled taxpayer faced with similar alternatives. Adjustments should be made in such cases to reflect material differences between the alternative and the controlled transactions. As under the 1993 regulations, this authority to examine alternatives is limited to the determination of an arm's length price, and does not permit the district director to treat a controlled transaction as if it actually had been structured differently.

 Section 1.482-1(f)(2)(iii) provides that the results of controlled transactions ordinarily will be compared with the results of uncontrolled taxpayers derived from the same period as the controlled transactions. Data from different years may be used, however, under certain conditions. If data from other years is employed, such data should be compared to the controlled taxpayer's results from the same years. Data from multiple years also may be relevant for purposes of certain enumerated provisions, including analysis of risk, market share strategy, periodic adjustments, and the CPM. Section 1.482-1(f)(2)(iii)(C) provides that results from other years may be examined to determine if the same economic conditions that caused the taxpayer's result also caused the uncontrolled taxpayer's result. For example, in determining whether a loss from a controlled transaction is within an arm's length range based upon losses realized by uncontrolled taxpayers, it may be relevant to consider data from other taxable years to determine whether the same conditions that caused the controlled taxpayer's loss had a similar effect on the controlled taxpayer.

 Section 1.482-1(f)(2)(iii)(D) provides that if the application of a method is based on a multiple year analysis, the district director may make an adjustment if the taxpayer's average result for the period is outside the range of average results derived from uncontrolled comparables for the same period. Comparison of multiple year averages may provide a more accurate reflection of a taxpayer's transfer pricing practices over a period than an analysis based on a single year and reduces the effect of short-term variations that may be unrelated to transfer pricing. The determination of whether the taxpayer is within the arm's length range is based on a comparison of the taxpayer's average result for the relevant years to the results of the uncontrolled comparables over the same period, which indicates whether the taxpayer had similar results over a similar period. An adjustment ordinarily will be equal to the difference, if any, between the taxpayer's result for the taxable year and the mid-point (generally the median) of the uncontrolled comparables' results for the taxable year. However, an adjustment will be made only to the extent that it would move the controlled taxpayer's multiple year average closer to the arm's length range for the multiple year period or to any point within such range. Thus, for example, if a method is applied to a U.S. taxpayer, and the taxpayer's average result for the multiple year period is below the arm's length range of average results derived from uncontrolled comparables for the same period, an adjustment may be made that is equal to the difference between the controlled taxpayer's result for the taxable year and the mid-point of the results of the uncontrolled comparables for that year. However, the adjustment would not be made to the extent that the adjustment would cause the taxpayer to have an average result for the multiple year period that exceeds any point within the arm's length range derived from the average results of the uncontrolled comparables.

 Section 1.482-1(f)(2)(iv) permits evaluation of product lines and statistical groupings in a manner analogous to that permitted under the 1968 and 1993 regulations. Finally, section 1.482-1(f)(2)(v) follows the 1993 regulations in providing 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. In other words, the focus of this evaluation is the result achieved rather than the method employed in reaching that result.

 Section 1.482-1(g) provides procedural rules relating to collateral adjustments. Such adjustments include correlative allocations, conforming adjustments, and set-offs. Section 1.482-1(g)(2) provides rules regarding correlative allocations that are generally similar to the rules provided under the 1968 and 1993 regulations.

 Section 1.482-1(g)(3) provides that appropriate adjustments must be made to conform a taxpayer's accounts to reflect allocations under section 482. Such adjustments may include the treatment of an allocated amount as a dividend or a capital contribution. In other cases, pursuant to applicable revenue procedures (see, e.g., Rev. Proc. 65-17), amounts may be repaid without further income tax consequences.

 Section 1.482-1(g)(4) provides rules relating to setoffs that are similar to the rules provided under the 1993 regulations and the 1968 regulations. Several requirements are imposed on taxpayers that claim setoffs. First, as in the 1993 regulations, the taxpayer must establish that the transaction that is the basis of the set-off was not at arm's length. Second, the taxpayer must document all adjustments resulting from the proposed set-off. Finally, the taxpayer must notify the district director of any claimed set-off within 30 days after the earlier of the date of a letter by which the district director transmits an examination report notifying the taxpayer of proposed adjustments or the date of the issuance of the notice of deficiency. This requirement corresponds to section 1.482-1A(d)(3) of the 1968 regulations.

 In addition to set-offs arising from transactions between the controlled taxpayers that were the parties to the transaction giving rise to the original allocation, the temporary regulations permitted set-offs arising from transactions between one of these controlled taxpayers and a third controlled taxpayer. In discussions with treaty partners it proved impossible to reach an acceptable consensus on this issue, and no such rule was included in the final regulations. Therefore, as under the 1968 regulations and in accordance with the practice of most treaty partners, set-offs are permitted only for transactions between the same two controlled taxpayers that were parties to the transactions giving rise to the original allocation.

 The 1993 regulations contained a provision on compensating adjustments that has not been included in the final regulations. The provision in the 1993 regulations (section 1.482-1T(e)(2)) imposed several restrictions on the ability of taxpayers to adjust reported results to reflect an arm's length result. This requirement was deleted because it was not appropriate to impose such restrictions given the penalties that could be imposed under section 6662(e) on taxpayers that fail to make such adjustments in certain circumstances. The final regulations therefore impose no restrictions on taxpayers' ability to report a result on their original tax return that differs from the result reflected in the taxpayer's books and records. However, as provided in section 1.482-1(a)(3), taxpayers may not use section 482 to decrease their taxable income on an amended return.

 Section 1.482-1(h) provides special rules relating to a small taxpayer safe harbor, foreign legal restrictions and coordination with section 936. Under section 1.482-1(h)(l), the small taxpayer safe harbor is reserved. The 1993 regulations contained a small taxpayer safe harbor that has not been included in the final regulations. This provision was never implemented because the IRS did not issue the profit level indicators required to apply the provisions of the safe harbor. There are three reasons why this provision was not included. First, treaty partners had expressed concern that the safe harbor might cause taxpayers to overreport their U.S. taxable income and underreport their foreign taxable income. They requested that the safe harbor provide that electing taxpayers be required to report an amount of profit in the United States that was less than that expected under a strict application of the arm's length standard. Such an approach was not acceptable. Second, it would have been necessary to add a number of anti-abuse provisions in order to eliminate the possibility of inappropriate use of the provision by large taxpayers. Commenters had already expressed concern that the existing restrictions were excessively complex and burdensome given the level of sophistication of its intended beneficiaries. The final concern was that both taxpayers and the IRS might give undue weight to the published measures of profitability in cases not governed by the safe harbor. It was not possible to address these problems consistently with the overall objective of alleviating the compliance burden for small taxpayers. Moreover, the concern regarding the compliance burden on small taxpayers has been addressed to some extent by the regulations under section 6662(e), which provide that one of the factors to be taken into account in determining whether a taxpayer reasonably applied a method to determine its transfer prices is the taxpayer's experience and knowledge. Comment is requested on alternative approaches to the small taxpayer safe harbor that would not suffer from the deficiencies noted above.

 The rules on foreign legal restrictions were originally issued in proposed form in the 1993 regulations. Section 1.482-1(h)(2) modifies and finalizes that provision. It provides that a foreign legal restriction will be taken into account to the extent that such restriction affects the results of transactions at arm's length. If there is no evidence that the restriction affected uncontrolled taxpayers the restriction will be disregarded in determining an arm's length result, and it will be taken into account only to the extent provided in sections 1.482-1(h)(2)(iii) and (iv), relating to the deferred income method of accounting. A foreign legal restriction is generally defined under section 1.482-1(h)(2)(ii) as a restriction that is publicly promulgated and generally applicable, not imposed as part of a commercial transaction between the taxpayer and the foreign government, with respect to which the taxpayer has exhausted all practicable legal remedies afforded under foreign law, expressly prevents the payment, in any form, of an arm's length amount within the meaning of section 482, and was not otherwise circumvented by the controlled taxpayers.

 Section 1.482-1(h)(2)(iii) provides that if a provision meets the definition of a 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.

 Section 1.482-1(h)(2)(iv) provides that if the requirements of section 1.482-1(h)(2)(iii) are satisfied, the amount subject to the restriction will be treated as deferrable until payment or receipt of the relevant item ceases to be prevented by the foreign legal restriction. Deductions and credits incurred in open years and that are chargeable against a deferred amount are subject to deferral under section 1.461-1(a)(4).

 Section 1.482-1(h)(3) provides a coordination rule for section 936 that is identical to section 1.482-1T(f)(3) of the 1993 regulations.

 Section 1.482-1(i) defines ten terms that are employed in the regulations. These are generally identical to their definitions under the 1993 regulations, with the following exceptions. The definition of trade or business under section 1.482-1(i)(2) clarifies that employment for compensation will constitute a separate trade or business from the employing trade or business. The definition of "controlled" in section 1.482-1(i)(4) has been modified. The definition in the 1993 regulations was misinterpreted to provide that a presumption of control arises only if income or deductions have been arbitrarily shifted "as a result of the actions of two or more taxpayers acting in concert or with a common goal or purpose." This phrase was added to the 1993 regulations as an example of the type of control that could be considered control for purposes of section 482. The definition has been amended to make clear that this addition is only an example. The definition of the term "controlled taxpayer" has been clarified to include the taxpayer that owns or controls other taxpayers.

 Section 1.482-1(j)(1) provides that these regulations generally are effective for taxable years beginning 90 days after publication in the Federal Register. Section 1.482-1(j)(2) provides that taxpayers may elect to apply these regulations retroactively to all open years (in which case they also must be applied to all subsequent years). Section 1.482-1(j)(3) provides that the last sentence of section 482 is generally effective for taxable years beginning after December 31, 1986, and this sentence, prior to the effective date of the final regulations, must be applied using any reasonable method not inconsistent with the statute (including these regulations). Finally, section 1.482-1(j)(4) provides that the final regulations will not apply to transfers made or licenses granted prior to November 17, 1985 (in the case of a foreign transferee) or August 17, 1986 (in the case of other transferees), unless the property was not in existence on the relevant date.

SECTION 1.482-2

 The regulations under section 1.482-2 have not been changed. Section 1.482-2(d), providing that guidance with respect to transfers of property is set forth in sections 1.482-3 through 1.482-6, is now part of the final regulations.

SECTION 1.482-3

 Section 1.482-3 provides rules for transfers of tangible property. Six methods are provided: the CUP method; the resale price method; the cost plus method; the CPM; the profit split method; and unspecified methods. The method that will be applied in a particular case will be selected in accordance with section 1.482-1(c)(Best method rule).

 Section 1.482-3(b) describes the CUP method. Consistent with the best method rule, section 1.482-3(b)(2)(ii) provides that the CUP method generally provides the most direct and reliable measure of an arm's length result if an uncontrolled transaction either has no differences from the controlled transaction or there are only minor differences that have a definite and reasonably ascertainable effect on price, and appropriate adjustments are made for such differences. Further, unlike the 1993 regulations, the CUP method potentially may be used when there are more than minor differences between the controlled and uncontrolled transactions, or when adjustments for minor differences cannot be made. In such cases, the method may be employed, but its reliability for purposes of the best method rule will be reduced.

 In determining comparability under this method, product similarity is the most important factor to consider. Indeed, section 1.482-3(b)(2)(ii) provides that if there are material product differences for which reliable adjustments cannot be made, this method ordinarily will not provide a reliable basis for determining an arm's length result. Comparability also will be reduced if either the uncontrolled taxpayer or the controlled taxpayer owns a trademark that is exploited in connection with the sale of the product. Minor differences in contractual terms and economic conditions also can have a material effect on price, so comparability under this method also depends on close similarity with respect to these factors.

 Although all the comparability factors described in section 1.482-1(d) must be considered, section 1.482-3(b)(2)(ii)(B) provides examples of several factors that may be particularly relevant to the application of the CUP method.

 Section 1.482-3(b)(2)(iii) provides that the data and assumptions used to apply the CUP method also will affect the reliability of the result. This method assumes that a very similar transaction between uncontrolled taxpayers is a reliable basis for determining the price that would have been agreed between the controlled taxpayers had they been dealing at arm's length. Given reasonably complete and accurate data, this assumption is usually very reliable.

 Section 1.482-3(b)(5) describes the use of indirect evidence derived from public exchanges or quotation media to establish a comparable uncontrolled price under this method. This provision had been added in response to comments that in some industries in which commodities are traded in large quantities, it is common for unrelated parties to set prices based upon publicly available prices or quotations. Since these quoted prices are not themselves transactional prices, but may be averages based upon actual transactions, they do not qualify as applications of the CUP method as that method is otherwise described in the regulations. This section has been added to permit use of such indicators in appropriate circumstances.

 Such indicators may be employed only if the data is widely and routinely used in the ordinary course of business in the industry to establish prices in uncontrolled transactions, the data is used in the same way by uncontrolled and controlled taxpayers, and adjustments are made for differences that affect price. Further, such indicators may not be employed under extraordinary market conditions.

 Section 1.482-3(c) describes the resale price method. It is generally similar to the resale price method provisions of the 1968 and 1993 regulations, although greater guidance has been provided on comparability factors to consider in applying the method, and the standards of comparability expressly permit use of "inexact comparables" under this method.

 The discussion of comparability considerations emphasizes that, although all the factors described in section 1.482-1(d)(3) must be considered, this method is particularly dependent on similarity of functions performed, risks borne, and contractual terms. Further, although close product similarity will tend to improve the reliability of the result, reliable application of the resale price method is less dependent on product similarity than the CUP method. The reliability of the analysis also would be reduced if the uncontrolled taxpayer sells goods that are significantly more (or less) valuable than the goods in the controlled transaction, or if either the uncontrolled taxpayer or the controlled taxpayer owns a trademark that is exploited in connection with the resale of the product. In addition, it may be necessary to consider certain factors, such as management efficiency and differences in business experience, that would normally have little effect on comparability under the CUP method.

 The final regulations do not include the statement that in the absence of comparable transactions, prevailing gross profit margins in the general industry may be appropriate. Although this statement was included in the 1968 and 1993 regulations, such a measure of an arm's length result would be contrary to the rule under section 1.482-1(d)(2) that unadjusted industry average returns cannot independently establish an arm's length result.

 Section 1.482-3(d) describes the cost plus method. It is generally similar to the cost plus method provisions of the 1968 and 1993 regulations, although additional guidance has been provided on comparability factors to consider in applying the method, the rules for computing the arm's length price and appropriate gross profit have been clarified, and the standards of comparability expressly permit use of "inexact comparables" under this method.

 As under the resale price method, the discussion of comparability considerations emphasizes that, although all the factors described in section 1.482-1(d)(3) must be considered, this method is particularly dependent on similarity of functions performed, risks borne, and contractual terms. Further, although close product similarity will tend to improve the reliability of the result, reliable application of the cost plus method is less dependent on product similarity than the CUP method. As under the resale price method, it may be necessary to consider certain factors, such as management efficiency and differences in business experience, that would normally have little effect on comparability under the CUP method.

 Section 1.482-3(d)(3)(iii)(B) emphasizes that in computing the gross profit markup, items such as inventory and cost allocation must be accounted for consistently.

 Section 1.482-3(e) provides that in addition to the methods specifically enumerated in section 1.482-3, unspecified methods may be employed. This provision differs from its counterpart in the 1993 regulations in two significant respects. First, in response to comments, the procedural requirements that the 1993 regulations imposed in connection with the use of an unspecified method by the taxpayer have been deleted.

 Second, guidance has been provided on considerations that should be taken into account in applying an unspecified method. Such methods should reflect the principle underlying the arm's length standard that uncontrolled taxpayers compare the terms of a transaction to their realistic alternatives to the transaction. Therefore, an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction. This guidance has been included because it is a principle that is consistent with all methods that apply the arm's length standard. For example, the CUP method identifies an alternative price at which the controlled taxpayer could have completed the controlled transaction. An example of the application of this principle is provided in which a bona fide offer is used to establish an arm's length price. Unspecified methods are not, however, limited to examination of potential transactions that did not occur. They should, in general, be based on actual transactions and other indicia derived from actual or potential market transactions.

 Section 1.482-3(f) provides rules coordinating the application of the tangible property rules with the rules governing transfers of intangible property. This provision provides more guidance than its predecessor in the 1993 regulations. It provides that in most cases the transfer of tangible property with a so-called "embedded intangible" will not be considered a transfer of the intangible if the purchaser does not acquire the right to exploit the intangible other than in connection with the resale of the tangible property. This provision responds to commenters who expressed concern that sales of branded products to controlled taxpayers for resale would routinely have to be evaluated under the provisions of both sections 1.482-3 and 1.482-4. While in such a case the transaction may be evaluated under section 1.482-3, the presence of the intangible will affect the analysis of comparability, because the value of the product may be increased by the presence of an embedded intangible.

 Finally, when a purchaser of a tangible product acquires the right to commercially exploit an embedded intangible, it may be necessary to apply section 1.482-3 to determine the arm's length consideration for the tangible property transferred and section 1.482-4 to determine the arm's length consideration for the embedded intangible. An example of this type of transaction could include the transfer of a machine incorporating a valuable manufacturing process that the purchaser will exploit in connection with the operation of the machine.

SECTION 1.482-4

 Section 1.482-4 provides rules with respect to the transfer of intangible property. Four methods are provided: the comparable uncontrolled transaction (CUT) method, the CPM, the profit split method, and unspecified methods. The method that will be applied in a particular case will be selected in accordance with section 1.482-1(c) (Best method rule).

 Section 1.482-4(b) provides a definition of intangible property that is similar to that provided in the 1968 regulations. It differs from the 1993 regulations in that the requirement that the property be "commercially transferrable" has been deleted. This language was not included in the definition because it was superfluous: if the property was not commercially transferrable, then it could not have been transferred in a controlled transaction. In addition, the reference to "other similar items" under section 1.482-4(b)(6) has been clarified to refer to items that derive their value from intellectual content or other intangible properties rather than physical attributes.

 Section 1.482-4(c) describes the CUT method. This method is similar but not identical to the CUT method under the 1993 regulations. The CUT method determines an arm's length royalty for an intangible by reference to uncontrolled transfers of comparable intangible property under comparable circumstances. An important comparability factor under this method is the profit potential of the intangibles in the controlled and uncontrolled transactions. In response to comments, the requirement that the profit potential of the intangibles transferred in the controlled and uncontrolled transactions be "substantially the same" has been relaxed to permit more frequent use of this method, as long as it provides the most reliable measure of an arm's length result under the best method rule. In addition, as under all methods, the discussion of the comparability factors under this method has been expanded.

 As under the 1993 regulations, section 1.482-4(c)(2)(ii) provides, consistent with the best method rule, that the CUT method generally provides the most direct and reliable measure of an arm's length result if the same intangible is transferred in the controlled and uncontrolled transactions, and there are, at most, only minor differences between the uncontrolled and the controlled transaction, these differences have a definite and reasonably ascertainable effect on price, and appropriate adjustments are made for such differences. The CUT method also may provide the most reliable measure of an arm's length result in other cases, as determined under the best method rule in section 1.482-1(c).

 Section 1.482-4(c)(2)(ii) emphasizes that, although all the factors described in section 1.482-1(d)(3) must be considered, this method is particularly dependent on similarity in terms of contractual arrangements and economic conditions. Further, this method cannot be applied unless the intangible property involved in the controlled and uncontrolled transactions is comparable within the meaning of section 1.482-4(c)(2)(iii)(B)(1).

 Section 1.482-4(c)(2)(iii)(B)(1) provides that two requirements must be satisfied in order for the intangible property involved in two transactions to be comparable. First, as under the 1993 regulations, the intangibles must be used in connection with similar products or processes within the same general industry or market. Second, the intangibles must have similar profit potential. As indicated, this requirement is not as strict as the profit potential requirement under the 1993 regulations. Additional guidance is provided concerning the analysis applied in determining whether the profit potential of two intangibles is similar within the meaning of this provision.

 In order to conclude that the profit potential of two intangibles is similar, it is necessary to have an acceptably reliable measure of the profit potential of the two intangibles. Profit potential is most reliably measured by direct calculations, based on reliable projections, of the net present value of the benefits to be realized through use of the intangible. While this information frequently will be available with respect to the controlled transaction, it normally will not be available with respect to an uncontrolled transaction unless one of the controlled taxpayers was a party to it. In recognition of this difficulty, the regulations provide that in certain cases it may be acceptable to refer to evidence other than projections to compare profit potential. Such indirect comparisons of profit potential will be most useful in cases where it is not possible to directly calculate the profit potential of the intangibles in either the controlled or uncontrolled transaction. An example of such a case could include a transfer of an intangible that relates to a component of an asset consisting of many components (such as an airplane or automobile). In such a case it would be difficult to reliably calculate the net present value of the profit attributable to the intangible that was transferred in the controlled transaction, because the profit attributable to the intangible will be difficult to isolate from the overall profit attributable to the final asset.

 As the profit potential increases, the importance of reliably measuring the profit potential also increases, because the effects of errors may increase as the overall profitability of the intangible increases. The reliability of indirect comparisons of profit potential therefore decreases as the profit potential in the controlled transaction increases. Consequently, given an indirect measure of profit potential, it might be concluded that the profit potential of the intangible property involved in the uncontrolled transaction might be similar to that of the controlled transaction within the meaning of this provision when the overall profitability of the intangibles is relatively small, but the profit potential might not be similar under the same circumstances if the overall profitability was much greater. The ultimate determination will depend on the facts and circumstances of each case.

 Finally, section 1.482-4(c)(2)(iii)(B)(2) provides that to apply the CUT method the circumstances involved in the controlled and uncontrolled transactions must be similar. This provision is substantially the same as its counterpart in the 1993 regulations.

 Section 1.482-4(d) provides a rule for the use of unspecified methods that is analogous to the rule on unspecified methods provided for tangible property under section 1.482-3(e). To the extent that a method relies on internal data rather than uncontrolled comparables, its reliability will be reduced. Reliability also will be affected by the reliability of the data and assumptions used to apply the method, including any projections.

 Section 1.482-4(e) provides a rule for coordination with the tangible property rules that is analogous to the rule provided under section 1.482-3(f).

 Section 1.482-4(f) provides special rules for transfers of intangible property. Section 1.482-4(f)(1) provides that when a controlled taxpayer pays nominal or no consideration for the right to exploit an intangible, and the transferor retains a substantial interest in the intangible, the arm's length consideration shall be in the form of a royalty, unless a different form is more appropriate.

 Section 1.482-4(f)(2) provides that if an intangible is transferred for a period in excess of one year, the consideration charged is generally subject to an 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.

 The 1993 regulations contained two exceptions to this rule. The final regulations retain these exceptions and add three additional exceptions in response to comments. First, section 1.482-4(f)(2)(ii)(A) provides that no periodic adjustments will be made if the consideration for the transfer of an intangible is determined to be an arm's length amount under the CUT method, and if the uncontrolled transaction that serves as the basis for the application of the CUT method involved the transfer of the same intangible under substantially the same circumstances as those of the controlled transaction. Thus, for example, the consideration for the transfer of an intangible to a controlled taxpayer in one country could be determined to be arm's length based on the transfer of the same intangible to an uncontrolled taxpayer in another country in which the relevant economic conditions were substantially similar to those in the first country. In such case no periodic adjustment would be made if the two transactions occurred under substantially similar circumstances.

 Section 1.482-4(f)(2)(ii)(B) provides an exception, based on the CUT method, that is similar to the exception provided in section 1.482-4T(e)(2)(ii)(A) of the 1993 regulations. Section 1.482-4(f)(2)(ii)(C) provides an exception based on other methods that is similar to the exception provided in section 1.482-4T(e)(2)(ii)(B) of the 1993 regulations. Both of these exceptions are substantially identical to their counterparts in the 1993 regulations with one modification. The rule requiring that the taxpayer's actual profits attributable to the intangible must be no less than 80 percent and no greater than 120 percent of the projected profits has been liberalized. In the 1993 regulations, the profits subject to this comparison were only the projected and actual profits for all open years. Under the final regulations, this comparison applies to all past years, which in many cases will be a longer period. By enlarging the pool of data that is taken into account for purposes of this comparison, it generally will be less likely that the taxpayer's actual profits will fall outside the band of projected profits based solely on timing variances, and therefore fewer periodic adjustments will be permitted under these provisions.

 Section 1.482-4(f)(2)(ii)(D) provides an additional exception from periodic adjustments for extraordinary events. It provides that no periodic adjustments will be made if the aggregate actual profits fall outside the permissible band of projected profits, but this variation from the projected results was due to extraordinary events that could not reasonably have been anticipated (such as natural or man-made disaster but does not include more routine events such as the failure of a market to develop as anticipated), and all the other requirements of either section 1.482-4(f)(2)(ii)(B) or (C) are satisfied.

 Finally, section 1.482-4(f)(2)(ii)(E) provides that if the requirements of either section 1.482-4(f)(2)(ii)(B) or (C) are satisfied for the five-year period beginning with the year in which substantial periodic consideration is first paid, no periodic adjustments will be made.

 Section 1.482-4(f)(3) provides rules regarding the ownership of intangible property. These rules are required to identify the controlled taxpayer that should recognize the income attributable to intangible property. The 1993 regulations provided that, for purposes of section 482, intangible property generally would be treated as owned by the controlled taxpayer that bore the greatest share of the costs of development. This rule was criticized by many commenters, principally because it disregarded legal ownership. The commenters asserted that disregarding legal ownership could be inconsistent with the arm's length standard. For instance, a controlled taxpayer that was treated as the owner of an intangible for section 482 purposes might not be the legal owner. At arm's length, the legal owner could transfer the rights to the intangible to another person irrespective of the developer's contribution to the development of the intangible. On the other hand, it would be unlikely that at arm's length an unrelated party would incur substantial costs adding value to an intangible that was owned by an unrelated party, unless there was some assurance that the party that incurred the expenses would receive the opportunity to reap the benefit attributable to the expenses.

 The final regulations recognize these criticisms and adopt a modified approach to the identification of the owner of an intangible that is more consistent with legal ownership. Under section 1.482-4(f)(3)(ii)(A), the legal owner of the right to exploit an intangible will be considered the owner for purposes of section 482. Legal ownership does not refer solely to the registered holder, of an intangible: ownership rights may be transferred by explicit or implicit agreement, and more than one party may be considered a legal owner of rights in the same intangible. For example, a license agreement would grant the licensee a set of rights in the intangible for the duration of the agreement, while the licensor would retain the residual rights to the intangible after the expiration of the agreement.

 Under section 1.482-4(f)(2)(ii)(B), ownership of intangible property that is not legally protected will be determined in a manner similar to that under the 1993 regulations, i.e., the owner generally will be the person that bore the greatest share of the costs of development.

 Section 1.482-4(f)(2)(iii) provides that allocations may be made with respect to assistance provided to the owner by other parties that assisted in the development of the intangible. Assistance does not include expenditures of a routine nature that an unrelated party dealing at arm's length would be expected to incur under similar circumstances. For instance, even in the absence of a license agreement transferring the right to exploit a trademark to an unrelated distributor, a distributor may be expected to incur a certain amount of advertising and other marketing expenses that could increase the value of the trademark. If an uncontrolled taxpayer would incur such expenses without express or implicit reimbursement by the owner of the intangible, then no allocation with respect to similar levels of expenses would be made under section 482 in the case of a distributor that is a member of the controlled group to which the legal owner of the trademark belongs. On the other hand, an allocation could be made if the expenses were greater than those that an unrelated party would have incurred without some form of compensation.

 Section 1.482-4(f)(4) provides that the arm's length consideration for the transfer of an intangible is not limited either by prevailing industry average royalty rates or the consideration paid in uncontrolled transactions that are not comparable to the controlled transaction.

 Section 1.482-4(f)(5) addresses lump sum payments. This issue was reserved in the 1993 regulations. The final regulations provide that lump sum payments are potentially subject to periodic adjustments to the same extent as license agreements providing for periodic royalty payments. For purposes of determining if the lump sum payment satisfies the arm's length standard and if periodic adjustments may be made, the lump sum must be treated as an advance payment of a stream of royalties over the life of the agreement. This "equivalent royalty amount" serves as the basis for determining if the consideration is arm's length. In addition, if a periodic adjustment is made pursuant to the provisions of section 1.482-4(f)(2), the royalty that was deemed to have been prepaid for the taxable year in question will be set off against the arm's length royalty determined for such year, and the difference will be treated as an additional payment in the year of the allocation that is of the same character as the initial lump sum payment.

SECTION 1.482-5

 Section 1.482-5 describes the comparable profits method. It is similar to section 1.482-5T of the 1993 regulations. The CPM may be used to determine the arm's length consideration for tangible and intangible property. The CPM relies on the general principle that similarly situated taxpayers will tend to earn similar returns over a reasonable period of time. The CPM determines the arm's length consideration for a controlled transaction by referring to objective measures of operating profit (profit level indicators) derived from uncontrolled taxpayers that engage in similar activities with other uncontrolled taxpayers under similar circumstances.

 Many commenters were concerned that the CPM could be applied in a manner that would be inconsistent with the arm's length standard. This concern was attributable to the fact that operating profit is normally affected by more factors than gross profit or price, which are the measures employed under the other methods provided in sections 1.482-3 and 1.482-4. The commenters were concerned that the CPM would be applied without taking these additional differences into account, and as a result the comparability achieved under the CPM would be weaker than the comparability required under other methods. The commenters believed that in such cases an analysis under the CPM would be suspect. Further, some commenters concluded that it was permissible under the 1993 regulations to apply the CPM without making adjustments for observed material differences, which led them to believe that the IRS would routinely apply the CPM in a manner that did not provide a reasonably reliable measure of an arm's length result. This concern was heightened by language in section 1.482-5T(a) of the 1993 regulations stating that the CPM would ordinarily provide an accurate measure of an arm's length result unless the tested party owned certain types of intangible property. Some commenters misinterpreted this language as indicating that the CPM was preferred to the results obtained under other methods, irrespective of the relative levels of comparability obtained under the potentially applicable methods and without regard to the operation of the best method rule.

 The final regulations make it clear that the CPM is subject to the same considerations as any other method. First, the language providing that the CPM "ordinarily will provide an accurate measure of an arm's length result" has been deleted.

 Second, and more importantly, the final regulations contain a much more extensive discussion of comparability considerations under the CPM than did the 1993 regulations. While it may be permissible to apply the CPM when there is (or may be) a material difference but it is not possible to make a reliable adjustment for such difference, application of the CPM in such a case only would be permissible if the other methods were less reliable than the CPM under the facts and circumstances.

 Given adequate data, methods that determine an arm's length price (e.g., the CUP method) or gross margin (e.g., the resale price method) generally achieve a higher degree of comparability than the CPM. Because the degree of comparability, including the extent and reliability of adjustments, determines the relative reliability of the result under the best method rule, the results of these methods will be selected unless the data necessary to apply them is relatively incomplete or unreliable. In this regard the CPM generally would be considered a method of last resort.

 This greater emphasis on comparability under the CPM is also reflected in the treatment of "valuable non-routine intangibles." The 1993 regulations indicated that the CPM ordinarily would not provide an accurate measure of an arm's length result if the tested party owned certain highly valuable intangibles because it was unlikely that it would be possible to locate uncontrolled taxpayers that possessed similar intangibles in connection with activities similar to those performed by the controlled taxpayer. In such a case the CPM could understate the income attributable to the assets of the controlled taxpayer. As a result of this concern, the 1993 regulations generally provided that the CPM should not be applied if the tested party owned "valuable non-routine intangibles" that it developed or that it acquired from third parties.

 The final regulations have taken a different approach to the problem of valuable non-routine intangibles. Due to the difficulty in adequately defining the term and the fact that it would be inappropriate to deny use of the CPM if a comparable uncontrolled taxpayer could be located that owned intangibles similar to those owned by the controlled taxpayer, the restriction contained in the 1993 regulations has been eliminated. In its place intangible property is expressly mentioned as a factor to consider in determining if an uncontrolled taxpayer is comparable to the controlled taxpayer. In most cases in which the controlled taxpayer owns intangible property of the type described in the 1993 regulations it will not be possible to locate an uncontrolled comparable that owns similarly valuable intangible property. The final regulations recognize, however, the possibility that a comparable uncontrolled taxpayer with such intangibles might be found; therefore they do not rule out the possibility of the CPM being applied under such facts.

 Section 1.482-5(b)(4) describes the profit level indicators that are used to evaluate operating profit. They include two types of measures: the rate of return on capital employed and financial ratios. In addition, section 1.482-5(b)(4)(iii) provides that other profit level indicators not specifically described in the regulations may be employed, provided that they provide the most reliable measure of an arm's length result within the meaning of the best method rule. Under this provision, any measure of profit based on objective measures of profitability derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances could be employed. Accordingly, profit level indicators based solely on a controlled taxpayer's internal data would not be included under this provision, as they are not objective measures of profitability derived from transactions between uncontrolled taxpayers.

 In determining an arm's length result under the CPM, the taxpayer's average reported operating profit for the year under review and the preceding two taxable years ordinarily will be compared to the average result of the uncontrolled comparables for the same period. Comparison of multiple year averages may provide a more accurate reflection of a taxpayer's transfer pricing practices over a period than an analysis based on a single year and reduces the effect of short-term variations in operating profit that may be unrelated to transfer pricing. If the taxpayer's average reported operating profit for this period falls outside the range of arm's length results determined pursuant to section 1.482-1(e)(2) (Determination of arm's length range), the district director may make an adjustment. In most cases, the adjustment will be made to the median of the uncontrolled comparables results for the taxable year. Adjustments under section 482 for prior years are taken into account in determining the tested party's average reported operating profit for a particular year if a final determination has been made with respect to such adjustments.

 In line with the greater emphasis on comparability under the final regulations, section 1.482-5(c) contains a discussion of comparability factors that is substantially more comprehensive than that contained in the 1993 regulations. Section 1.482-5(c)(2) describes a number of comparability factors that must be taken into account under the CPM. In particular, section 1.482-5(c)(2)(ii) provides that, while all the comparability factors described in section 1.482-1(d)(3) must be considered, comparability under the CPM is particularly dependent on resources employed and risks assumed. Further, since resources and risks are directly related to functions, functional comparability, while somewhat less important than under the resale price or cost plus methods, also is an important consideration under the CPM.

 Section 1.482-5(c)(2)(iii) provides that product comparability is not as important a consideration under the CPM as it is under the cost plus or resale price methods. Conversely, comparability under the CPM may be adversely affected by other factors that have little effect on comparability under the CUP method, such as management efficiency. Determining whether such differences exist may be difficult in some cases. As with any potential difference, the regulations provide that objective evidence, such as long-term sales or executive compensation trends, is required in order to ascertain whether such differences exist.

 Section 1.482-5(c)(2)(iv) provides that adjustments must be made for all material differences to the extent that such adjustments improve the reliability of the analysis. In a departure from the 1993 regulations, the final regulations provide that differences in non- interest bearing liabilities (such as accounts payable) that would materially affect operating profit generally should be reflected by adjustments to operating profit to reflect an imputed interest charge on each party's liability. Such differences are more appropriately reflected by adjustments to operating profits than by adjustments to operating assets.

 Section 1.482-5(c)(3)(ii) requires that all items that have a material affect on the profit level indicators be accounted for consistently, and if necessary to obtain this consistency, adjustments must be made. An additional factor that may affect reliability under the CPM is the ability to allocate costs and other items between the relevant business activity and the other activities of the controlled taxpayer or the uncontrolled taxpayers.

 The definitions of several items under section 1.482-5(d) are substantially similar to the definitions provided under the 1993 regulations.

SECTION 1.482-6

 Section 1.482-6 describes profit split methods. This provision, which was in proposed form under the 1993 regulations, has been finalized. Like the CPM, profit split methods may be applied to controlled transactions involving tangible or intangible property. The basic approach of a profit split method is to estimate an arm's length return by comparing the relative economic contributions that the parties make to the success of a venture, and dividing the returns from that venture between them on the basis of the relative value of such contributions. Two profit split methods are provided: the comparable profit split and the residual profit split. In addition to these two methods, the 1993 regulations proposed two other profit split methods: the capital employed allocation rule and other profit splits. These methods have not been included in the final regulations for the reasons set forth below.

 Under the 1993 regulations taxpayers were required to satisfy a number of requirements in order to employ a profit split method. Since a profit split method either wholly or in part relies on internal data rather than data derived from uncontrolled taxpayers, other methods ordinarily will provide more reliable measures of an arm's length result, and these restrictions were imposed in order to ensure that the profit split method was applied only in cases where it was likely to be the most reliable measure of an arm's length result. As noted previously, these restrictions were both procedural and substantive.

 Many commenters objected to these restrictions. They observed that, contrary to the best method rule, these restrictions could prevent taxpayers from employing a profit split method in cases where the method would be likely to provide the most accurate measure of an arm's length result. In response to these comments, and in accordance with the greater flexibility associated with the increased reliance on the best method rule, the final regulations have removed these restrictions. In particular, for reasons similar to those discussed above under the CPM, the requirements that a profit split method may be applied only if both controlled taxpayers own valuable non- routine intangible property and that the intangibles contribute significantly to the combined operating profit derived from the relevant business activity, have been deleted. Further, the requirement that the taxpayer must make a binding election to apply a profit split method also has been deleted. The concerns that these and other restrictions were intended to address (the possibility that a profit split method would be used when it did not provide the most reliable measure of an arm's length result) are addressed by the more prominent role played by the best method rule in selecting a method.

 Section 1.482-6(c)(2) describes the comparable profit split method. It is substantially similar to the comparable profit split rule set forth under the 1993 regulations. As with other methods described in the final regulations, the discussion of comparability factors under this method is more comprehensive than under the 1993 regulations. In addition, section 1.482-6(c)(2)(ii)(C) identifies several reliability considerations that are particularly pronounced under this method. These are reliability of cost and income allocation to the relevant business activity-and accounting consistency. Further, section 1.482-6(c)(2)(ii)(D) provides that if the data and assumptions with respect to one of the controlled taxpayers are significantly more reliable than for the other, a method relying solely on an analysis of the first controlled taxpayer may be more reliable than the profit split method.

 Section 1.482-6(c)(3) describes the residual profit split. Like the version of this method described in the 1993 regulations, the residual profit split determines an arm's length consideration in a two-step process. First, using other methods such as the CPM, market returns for routine functions are estimated and allocated to the parties that performed them. The remaining, residual amount then is allocated between the parties on the assumption that this residual is attributable to intangible property contributed to the activity by the controlled taxpayers. Based on this assumption, the residual is divided based on the estimate of the relative value of the parties' contributions of such property. Since fair market value of the intangible property usually will not be readily ascertainable, the regulations permit use of other measures of the relative values of intangible property, including capitalized intangible development expenses.

 The final regulations contain an extensive discussion of comparability and reliability considerations under this method. The comparability considerations relevant to the first step of the allocation are analogous to the considerations relevant under the method employed to determine this portion of the allocation (such as the CPM). Since the second step ordinarily will not be based on a market benchmark, the reliability of this method will tend to be reduced for purposes of the best method rule as the amount of the residual profit allocated pursuant to the second step increases.

 Under the best method rule, methods that determine an arm's length result based on the results of transactions between uncontrolled taxpayers are generally considered to be more reliable than methods (such as the residual profit split) that only rely on such transactions in part. Therefore, the results of the methods based solely on results of transactions between uncontrolled taxpayers will be selected under the best method rule unless the data necessary to apply them is relatively incomplete or unreliable. In this regard the residual profit split generally would be considered a method of last resort.

 Further, section 1.482-6(c)(3)(ii)(C) identifies several other factors that may reduce the reliability of this method. In addition to allocation of costs, income and assets, and accounting consistency, another factor to take into account under the residual profit split is the reliability of the estimate of the value of intangible property. The reliability of this method could be particularly adversely affected if capitalized costs of development are used to estimate the value of intangible property because such costs may bear no relation to market value, calculation of such costs may require allocation of indirect expenses between the relevant business activity and the controlled taxpayer's other lines of business, and capitalizing costs requires assumptions regarding the useful life of intangible property.

 Finally, section 1.482-6(c)(3)(ii)(D) provides that the analysis of both parties to the controlled transaction under this method may, to some extent, mitigate the reliability concerns attributable to the use of internal data in allocating the residual profit. However, as under the comparable profit split, other methods that analyze only one of the parties to the controlled transaction may be more reliable if the data and assumptions regarding one of the parties is more reliable than the data and assumptions regarding the other party.

 As indicated previously, the final regulations do not provide for the use of the capital employed allocation rule or other profit splits. The capital employed allocation rule generally could be applied only when the controlled taxpayers were subject to approximately equal levels of risk with respect to the relevant business activity. This requirement was imposed because the method allocated the same rate of return to all the assets employed in the relevant business activity. This result generally would be encountered under arm's length conditions only if the parties shared all profits in proportion to their risks. With one exception it has not been possible to describe a case in which it would be possible to conclude with certainty that two or more controlled taxpayers face equal levels of risk. The one case where it undoubtedly is true that the parties face equal levels of risk is where the parties agree ex ante to share costs and benefits proportionately. Since, absent a joint venture, such a scenario is encountered rarely, if ever, under arm's length conditions, and it describes a situation contemplated under the cost sharing regulations, the capital employed allocation rule has been deleted from the profit split provisions of the final regulations. Its possible role as a variant of the cost sharing provisions will be examined in connection with the revision of those provisions. Comments are requested as to its potential use as a variant of the cost sharing method.

 Finally, the use of other profit split methods is not discussed under section 1.482-6 because it was unnecessary to provide an express rule for use of other profit splits given the liberalized rules for use of unspecified methods under sections 1.482-3 and 1.482-4. Accordingly, a profit split method other than the comparable profit split method and the residual profit split will be considered to be an unspecified method.

 Section 1.482-7, relating to cost sharing, is not being finalized with these regulations. The temporary regulations, which incorporate the text of the 1968 regulations, continue to apply. However, final regulations based on the 1992 proposed regulations are anticipated in the near future.

 Finally, section 1.482-8 provides a number of examples illustrating the application of the best method rule under specific fact patterns. Like all the examples in these regulations, the examples under section 1.482-8 are provided solely for purposes of illustrating the principles contained in the text of the regulations, and are not themselves statements of principles not contained in the text. The conclusions reached in these examples are based on the assumed simplified facts of the examples, and should not be read as general conclusions.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has 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 Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Sim Seo, Office of Associate Chief Counsel (International). However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR Part 1

 Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

 Reporting and recordkeeping requirements.

Treasury Decision 8552

ADOPTION OF AMENDMENTS TO THE REGULATIONS

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

PART I -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entries for "Section 1.482-1T", "Section 1.482-2T", "Section 1.482-3T", "Section 1.482-4T", "Section 1.482-5T" and adding entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.482-1 also issued under 26 U.S.C. 482 and 936.

Section 1.482-2 also issued under 26 U.S.C. 482.

Section 1.482-3 also issued under 26 U.S.C. 482.

Section 1.482-4 also issued under 26 U.S.C. 482.

Section 1.482-5 also issued under 26 U.S.C. 482. * * *

SECTIONS 1.482-0T THROUGH 1.482-6T [REMOVED].

Par. 2. Sections 1.482-0T through 1.482-6T are removed.

Par. 3. Sections 1.482-0 through 1.482-6 and 1.482-8 are added to read as follows:

SECTION 1.482-0 OUTLINE OF REGULATIONS UNDER 482.

This section contains major captions for sections 1.482-1 through 1.482-8.

 SECTION 1.482-1 ALLOCATION OF INCOME AND DEDUCTIONS AMONG TAXPAYERS.

(a) IN GENERAL -- (1) PURPOSE AND SCOPE. The purpose of section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions, and to prevent the avoidance of taxes with respect to such transactions. Section 482 places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer. This section 1.482-1 sets forth general principles and guidelines to be followed under section 482. Section 1.482-2 provides rules for the determination of the true taxable income of controlled taxpayers in specific situations, including controlled transactions involving loans or advances, services, and property. Sections 1.482-3 through 1.482-6 elaborate on the rules that apply to controlled transactions involving property. Section 1.482-7T sets forth the cost sharing provisions. Finally, section 1.482-8 provides examples illustrating the application of the best method rule.

(2) AUTHORITY TO MAKE ALLOCATIONS. The district director may make allocations between or among the members of a controlled group if a controlled taxpayer has not reported its true taxable income. In such case, the district director may allocate income, deductions, credits, allowances, basis, or any other item or element affecting taxable income (referred to as allocations). The appropriate allocation may take the form of an increase or decrease in any relevant amount.

(3) TAXPAYER'S USE OF SECTION 482. If necessary to reflect an arm's length result, a controlled taxpayer may report on a timely filed U.S. income tax return (including extensions) the results of its controlled transactions based upon prices different from those actually charged. Except as provided in this paragraph, section 482 grants no other right to a controlled taxpayer to apply the provisions of section 482 at will or to compel the district director to apply such provisions. Therefore, no untimely or amended returns will be permitted to decrease taxable income based on allocations or other adjustments with respect to controlled transactions. See section 1.6662-6T(a)(2) or successor regulations.

(b) ARM'S LENGTH STANDARD -- (1) IN GENERAL. In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer. A controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm's length result). However, because identical transactions can rarely be located, whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances. See section 1.482-1(d)(2) (Standard of comparability). Evaluation of whether a controlled transaction produces an arm's length result is made pursuant to a method selected under the best method rule described in section 1.482-1(c).

(2) ARM'S LENGTH METHODS -- (i) METHODS. Sections 1.482-2 through 1.482-6 provide specific methods to be used to evaluate whether transactions between or among members of the controlled group satisfy the arm's length standard, and if they do not, to determine the arm's length result.

(ii) SELECTION OF CATEGORY OF METHOD APPLICABLE TO TRANSACTION. The methods listed in section 1.482-2 apply to different types of transactions, such as transfers of property, services, loans or advances, and rentals. Accordingly, the method or methods most appropriate to the calculation of arm's length results for controlled transactions must be selected, and different methods may be applied to interrelated transactions if such transactions are most reliably evaluated on a separate basis. For example, if services are provided in connection with the transfer of property, it may be appropriate to separately apply the methods applicable to services and property in order to determine an arm's length result. But see section 1.482-1(f)(2)(i) (Aggregation of transactions). In addition, other applicable provisions of the Code may affect the characterization of a transaction, and therefore affect the methods applicable under section 482. See for example section 467.

(c) BEST METHOD RULE -- (1) IN GENERAL. The arm's length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm's length result. Thus, there is no strict priority of methods, and no method will invariably be considered to be more reliable than others. An arm's length result may be determined under any method without establishing the inapplicability of another method, but if another method subsequently is shown to produce a more reliable measure of an arm's length result, such other method must be used. Similarly, if two or more applications of a single method provide inconsistent results, the arm's length result must be determined under the application that, under the facts and circumstances, provides the most reliable measure of an arm's length result. See section 1.482-8 for examples of the application of the best method rule.

(2) DETERMINING THE BEST METHOD. Data based on the results of transactions between unrelated parties provides the most objective basis for determining whether the results of a controlled transaction are arm's length. Thus, in determining which of two or more available methods (or applications of a single method) provides the most reliable measure of an arm's length result, the two primary factors to take into account are the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and the quality of the data and assumptions used in the analysis. In addition, in certain circumstances, it also may be relevant to consider whether the results of an analysis are consistent with the results of an analysis under another method. These factors are explained in paragraphs (c)(2)(i), (ii), and (iii) of this section.

(i) COMPARABILITY. The relative reliability of a method based on the results of transactions between unrelated parties depends on the degree of comparability between the controlled transaction or taxpayers and the uncontrolled comparables, taking into account the factors described in section 1.482-1(d)(3) (Factors for determining comparability), and after making adjustments for differences, as described in section 1.482-1(d)(2) (Standard of comparability). As the degree of comparability increases, the number and extent of potential differences that could render the analysis inaccurate is reduced. In addition, if adjustments are made to increase the degree of comparability, the number, magnitude, and reliability of those adjustments will affect the reliability of the results of the analysis. Thus, an analysis under the comparable uncontrolled price method will generally be more reliable than analyses obtained under other methods if the analysis is based on closely comparable uncontrolled transactions, because such an analysis can be expected to achieve a higher degree of comparability and be susceptible to fewer differences than analyses under other methods. See section 1.482-3(b)(2)(ii)(A). An analysis will be relatively less reliable, however, as the uncontrolled transactions become less comparable to the controlled transaction.

(ii) DATA AND ASSUMPTIONS. Whether a method provides the most reliable measure of an arm's length result also depends upon the completeness and accuracy of the underlying data, the reliability of the assumptions, and the sensitivity of the results to possible deficiencies in the data and assumptions. Such factors are particularly relevant in evaluating the degree of comparability between the controlled and uncontrolled transactions. These factors are discussed in paragraphs (c)(2)(ii)(A), (B), and (C) of this section.

(A) COMPLETENESS AND ACCURACY OF DATA. The completeness and accuracy of the data affects the ability to identify and quantify those factors that would affect the result under any particular method. For example, the completeness and accuracy of data will determine the extent to which it is possible to identify differences between the controlled and uncontrolled transactions, and the reliability of adjustments that are made to account for such differences. An analysis will be relatively more reliable as the completeness and accuracy of the data increases.

(B) RELIABILITY OF ASSUMPTIONS. All methods rely on certain assumptions. The reliability of the results derived from a method depends on the soundness of such assumptions. Some assumptions are relatively reliable. For example, adjustments for differences in payment terms between controlled and uncontrolled transactions may be based on the assumption that at arm's length such differences would lead to price differences that reflect the time value of money. Although selection of the appropriate interest rate to use in making such adjustments involves some judgement, the economic analysis on which the assumption is based is relatively sound. Other assumptions may be less reliable. For example, the residual profit split method may be based on the assumption that capitalized intangible development expenses reflect the relative value of the intangible property contributed by each party. Because the costs of developing an intangible may not be related to its market value, the soundness of this assumption will affect the reliability of the results derived from this method.

(C) SENSITIVITY OF RESULTS TO DEFICIENCIES IN DATA AND ASSUMPTIONS. Deficiencies in the data used or assumptions made may have a greater effect on some methods than others. In particular, the reliability of some methods is heavily dependent on the similarity of property or services involved in the controlled and uncontrolled transaction. For certain other methods, such as the resale price method, the analysis of the extent to which controlled and uncontrolled taxpayers undertake the same or similar functions, employ similar resources, and bear similar risks is particularly important. Finally, under other methods, such as the profit split method, defining the relevant business activity and appropriate allocation of costs, income, and assets may be of particular importance. Therefore, a difference between the controlled and uncontrolled transactions for which an accurate adjustment cannot be made may have a greater effect on the reliability of the results derived under one method than the results derived under another method. For example, differences in management efficiency may have a greater effect on a comparable profits method analysis than on a comparable uncontrolled price method analysis, while differences in product characteristics will ordinarily have a greater effect on a comparable uncontrolled price method analysis than on a comparable profits method analysis.

(iii) CONFIRMATION OF RESULTS BY ANOTHER METHOD. If two or more methods produce inconsistent results, the best method rule will be applied to select the method that provides the most reliable measure of an arm's length result. If the best method rule does not clearly indicate which method should be selected, an additional factor that may be taken into account in selecting a method is whether any of the competing methods produce results that are consistent with the results obtained from the appropriate application of another method. Further, in evaluating different applications of the same method, the fact that a second method (or another application of the first method) produces results that are consistent with one of the competing applications may be taken into account.

(d) COMPARABILITY -- (1) IN GENERAL. Whether a controlled transaction produces an arm's length result is generally evaluated by comparing the results of that transaction to results realized by uncontrolled taxpayers engaged in comparable transactions under comparable circumstances. For this purpose, the comparability of transactions and circumstances must be evaluated considering all factors that could affect prices or profits in arm's length dealings (comparability factors). While a specific comparability factor may be of particular importance in applying a method, each method requires analysis of all of the factors that affect comparability under that method. Such factors include the following --

(i) Functions;

(ii) Contractual terms;

(iii) Risks;

(iv) Economic conditions; and

(v) Property or services.

(2) STANDARD OF COMPARABILITY. In order to be considered comparable to a controlled transaction, an uncontrolled transaction need not be identical to the controlled transaction, but must be sufficiently similar that it provides a reliable measure of an arm's length result. If there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results. For purposes of this section, a material difference is one that would materially affect the measure of an arm's length result under the method being applied. If adjustments for material differences cannot be made, the uncontrolled transaction may be used as a measure of an arm's length result, but the reliability of the analysis will be reduced. Generally, such adjustments must be made to the results of the uncontrolled comparable and must be based on commercial practices, economic principles, or statistical analyses. The extent and reliability of any adjustments will affect the relative reliability of the analysis. See section 1.482-1(c)(1) (Best method rule). In any event, unadjusted industry average returns themselves cannot establish arm's length results.

(3) FACTORS FOR DETERMINING COMPARABILITY. The comparability factors listed in section 1.482-1(d)(1) are discussed in this section. Each of these factors must be considered in determining the degree of comparability between transactions or taxpayers and the extent to which comparability adjustments may be necessary. In addition, in certain cases involving special circumstances, the rules under paragraph (d)(4) of this section must be considered.

(i) FUNCTIONAL ANALYSIS. Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the functions performed, and associated resources employed, by the taxpayers in each transaction. This comparison is based on a functional analysis that identifies and compares the economically significant activities undertaken, or to be undertaken, by the taxpayers in both controlled and uncontrolled transactions. A functional analysis should also include consideration of the resources that are employed, or to be employed, in conjunction with the activities undertaken, including consideration of the type of assets used, such as plant and equipment, or the use of valuable intangibles. A functional analysis is not a pricing method and does not itself determine the arm's length result for the controlled transaction under review. Functions that may need to be accounted for in determining the comparability of two transactions include --

(A) Research and development;

(B) Product design and engineering;

(C) Manufacturing, production and process engineering;

(D) Product fabrication, extraction, and assembly;

(E) Purchasing and materials management;

(F) Marketing and distribution functions, including inventory management, warranty administration, and advertising activities;

(G) Transportation and warehousing; and

(H) Managerial, legal, accounting and finance, credit and collection, training, and personnel management services.

(ii) CONTRACTUAL TERMS -- (A) IN GENERAL. Determining the degree of comparability between the controlled and uncontrolled transactions requires a comparison of the significant contractual terms that could affect the results of the two transactions. These terms include --

(1) The form of consideration charged or paid;

(2) Sales or purchase volume;

(3) The scope and terms of warranties provided;

(4) Rights to updates, revisions or modifications;

(5) The duration of relevant license, contract or other agreements, and termination or renegotiation rights;

(6) Collateral transactions or ongoing business relationships between the buyer and the seller, including arrangements for the provision of ancillary or subsidiary services; and

(7) Extension of credit and payment terms. Thus, for example, if the time for payment of the amount charged in a controlled transaction differs from the time for payment of the amount charged in an uncontrolled transaction, an adjustment to reflect the difference in payment terms should be made if such difference would have a material effect on price. Such comparability adjustment is required even if no interest would be allocated or imputed under section 1.482-2(a) or other applicable provisions of the Internal Revenue Code or regulations.

(B) IDENTIFYING CONTRACTUAL TERMS -- (1) Written agreement. The contractual terms, including the consequent allocation of risks, that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic substance of the underlying transactions. In evaluating economic substance, greatest weight will be given to the actual conduct of the parties, and the respective legal rights of the parties (see, for example, section 1.482-4(f)(3) (Ownership of intangible property)). If the contractual terms are inconsistent with the economic substance of the underlying transaction, the district director may disregard such terms and impute terms that are consistent with the economic substance of the transaction.

(2) NO WRITTEN AGREEMENT. In the absence of a written agreement, the district director may impute a contractual agreement between the controlled taxpayers consistent with the economic substance of the transaction. In determining the economic substance of the transaction, greatest weight will be given to the actual conduct of the parties and their respective legal rights (see, for example, section 1.482-4(f)(3) (Ownership of intangible property)). For example, if, without a written agreement, a controlled taxpayer operates at full capacity and regularly sells all of its output to another member of its controlled group, the district director may impute a purchasing contract from the course of conduct of the controlled taxpayers, and determine that the producer bears little risk that the buyer will fail to purchase its full output. Further, if an established industry convention or usage of trade assigns a risk or resolves an issue, that convention or usage will be followed if the conduct of the taxpayers is consistent with it. See UCC section 1-205. For example, unless otherwise agreed, payment generally is due at the time and place at which the buyer is to receive goods. See UCC section 2-310.

(C) EXAMPLES. The following examples illustrate this paragraph (d)(3)(ii).

EXAMPLE 1 -- DIFFERENCES IN VOLUME. USP, a United States agricultural exporter, regularly buys transportation services from FSub, its foreign subsidiary, to ship its products from the United States to overseas markets. Although FSub occasionally provides transportation services to URA, an unrelated domestic corporation, URA accounts for only 10% of the gross revenues of FSub, and the remaining 90% of FSub's gross revenues are attributable to FSub's transactions with USP. In determining the degree of comparability between FSub's uncontrolled transaction with URA and its controlled transaction with USP, the difference in volumes involved in the two transactions and the regularity with which these services are provided must be taken into account if such difference would have a material effect on the price charged. Inability to make reliable adjustments for these differences would affect the reliability of the results derived from the uncontrolled transaction as a measure of the arm's length result.

EXAMPLE 2 -- RELIABILITY OF ADJUSTMENT FOR DIFFERENCES IN VOLUME. (i) FS manufactures product XX and sells that product to its parent corporation, P. FS also sells product XX to uncontrolled taxpayers at a price of $100 per unit. Except for the volume of each transaction, the sales to P and to uncontrolled taxpayers take place under substantially the same economic conditions and contractual terms. In uncontrolled transactions, FS offers a 2% discount for quantities of 20 per order, and a 5% discount for quantities of 100 per order. If P purchases product XX in quantities of 60 per order, in the absence of other reliable information, it may reasonably be concluded that the arm's length price to P would be $100, less a discount of 3.5%.

(ii) If P purchases product XX in quantities of 1,000 per order, a reliable estimate of the appropriate volume discount must be based on proper economic or statistical analysis, not necessarily a linear extrapolation from the 2% and 5% catalog discounts applicable to sales of 20 and 100 units, respectively.

EXAMPLE 3 -- CONTRACTUAL TERM IMPUTED FROM ECONOMIC SUBSTANCE. (i) USD, a United States corporation, is the exclusive distributor of products manufactured by FP, its foreign parent. The FP products are sold under a tradename that is not known in the United States. USD does not have an agreement with FP for the use of FP's tradename. For Years 1 through 6, USD bears marketing expenses promoting FP's tradename in the United States that are substantially above the level of such expenses incurred by comparable distributors in uncontrolled transactions. FP does not directly or indirectly reimburse USD for its marketing expenses. By Year 7, the FP tradename has become very well known in the market and commands a price premium. At this time, USD becomes a commission agent for FP.

(ii) In determining USD's arm's length result for Year 7, the district director considers the economic substance of the arrangements between USD and FP throughout the course of their relationship. It is unlikely that at arm's length, USD would incur these above-normal expenses without some assurance it could derive a benefit from these expenses. In this case, these expenditures indicate a course of conduct that is consistent with an agreement under which USD received a long-term right to use the FP tradename in the United States. Such conduct is inconsistent with the contractual arrangements between FP and USD under which USD was merely a distributor, and later a commission agent, for FP. Therefore, the district director may impute an agreement between USD and FP under which USD will retain an appropriate portion of the price premium attributable to the FP tradename.

(iii) RISK -- (A) COMPARABILITY. Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the significant risks that could affect the prices that would be charged or paid, or the profit that would be earned, in the two transactions. Relevant risks to consider include --

(1) Market risks, including fluctuations in cost, demand, pricing, and inventory levels;

(2) Risks associated with the success or failure of research and development activities;

(3) Financial risks, including fluctuations in foreign currency rates of exchange and interest rates;

(4) Credit and collection risks;

(5) Product liability risks; and

(6) General business risks related to the ownership of property, plant, and equipment.

(B) IDENTIFICATION OF TAXPAYER THAT BEARS RISK. In general, the determination of which controlled taxpayer bears a particular risk will be made in accordance with the provisions of section 1.482-1(d)(3)(ii)(B) (Identifying contractual terms). Thus, the allocation of risks specified or implied by the taxpayer's contractual terms will generally be respected if it is consistent with the economic substance of the transaction. An allocation of risk between controlled taxpayers after the outcome of such risk is known or reasonably knowable lacks economic substance. In considering the economic substance of the transaction, the following facts are relevant --

(1) Whether the pattern of the controlled taxpayer's conduct over time is consistent with the purported allocation of risk between the controlled taxpayers; or where the pattern is changed, whether the relevant contractual arrangements have been modified accordingly;

(2) Whether a controlled taxpayer has the financial capacity to fund losses that might be expected to occur as the result of the assumption of a risk, or whether, at arm's length, another party to the controlled transaction would ultimately suffer the consequences of such losses; and

(3) The extent to which each controlled taxpayer exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. In arm's length dealings, parties ordinarily bear a greater share of those risks over which they have relatively more control.

(C) EXAMPLES. The following examples illustrate this paragraph (d)(3)(iii).

EXAMPLE 1. FD, the wholly-owned foreign distributor of USM, a U.S. manufacturer, buys widgets from USM under a written contract. Widgets are a generic electronic appliance. Under the terms of the contract, FD must buy and take title to 20,000 widgets for each of the five years of the contract at a price of $10 per widget. The widgets will be sold under FD's label, and FD must finance any marketing strategies to promote sales in the foreign market. There are no rebate or buy back provisions. FD has adequate financial capacity-to fund its obligations under the contract under any circumstances that could reasonably be expected to arise. In Years 1, 2 and 3, FD sold only 10,000 widgets at a price of $11 per unit. In Year 4, FD sold its entire inventory of widgets at a price of $25 per unit. Since the contractual terms allocating market risk were agreed to before the outcome of such risk was known or reasonably knowable, FD had the financial capacity to bear the market risk that it would be unable to sell all of the widgets it purchased currently, and its conduct was consistent over time, FD will be deemed to bear the risk.

EXAMPLE 2. The facts are the same as in Example 1, except that in Year 1 FD had only $100,000 in total capital, including loans. In subsequent years USM makes no additional contributions to the capital of FD, and FD is unable to obtain any capital through loans from an unrelated party. Nonetheless, USM continues to sell 20,000 widgets annually to FD under the terms of the contract, and USM extends credit to FD to enable it to finance the purchase. FD does not have the financial capacity in Years 1, 2 and 3 to finance the purchase of the widgets given that it could not sell most of the widgets it purchased during those years. Thus, notwithstanding the terms of the contract, USM and not FD assumed the market risk that a substantial portion of the widgets could not be sold, since in that event FD would not be able to pay USM for all of the widgets it purchased.

EXAMPLE 3. S, a Country X corporation, manufactures small motors that it sells to P, its U.S. parent. P incorporates the motors into various products and sells those products to uncontrolled customers in the United States. The contract price for the motors is expressed in U.S. dollars, effectively allocating the currency risk for these transactions to S for any currency fluctuations between the time the contract is signed and payment is made. As long as S has adequate financial capacity to bear this currency risk (including by hedging all or part of the risk) and the conduct of S and P is consistent with the terms of the contract (i.e., the contract price is not adjusted to reflect exchange rate movements), the agreement of the parties to allocate the exchange risk to S will be respected.

EXAMPLE 4. USSub is the wholly-owned U.S. subsidiary of FP, a foreign manufacturer. USSub acts as a distributor of goods manufactured by FP. FP and USSub execute an agreement providing that FP will bear any ordinary product liability costs arising from defects in the goods manufactured by FP. In practice, however, when ordinary product liability claims are sustained against USSub and FP, USSub pays the resulting damages. Therefore, the district director disregards the contractual arrangement regarding product liability costs between FP and USSub, and treats the risk as having been assumed by USSub.

(iv) ECONOMIC CONDITIONS. Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the significant economic conditions that could affect the prices that would be charged or paid, or the profit that would be earned in each of the transactions. These factors include --

(A) The similarity of geographic markets;

(B) The relative size of each market, and the extent of the overall economic development in each market;

(C) The level of the market (e.g., wholesale, retail, etc.);

(D) The relevant market shares for the products, properties, or services transferred or provided;

(E) The location-specific costs of the factors of production and distribution;

(F) The extent of competition in each market with regard to the property or services under review;

(G) The economic condition of the particular industry, including whether the market is in contraction or expansion; and

(H) The alternatives realistically available to the buyer and seller.

(v) PROPERTY OR SERVICES. Evaluating the degree of comparability between controlled and uncontrolled transactions requires a comparison of the property or services transferred in the transactions. This comparison may include any intangibles that are embedded in tangible property or services being transferred. The comparability of the embedded intangibles will be analyzed using the factors listed in section 1.482-4(c)(2)(iii)(B)(1) (Comparable intangible property). The relevance of product comparability in evaluating the relative reliability of the results will depend on the method applied. For guidance concerning the specific comparability considerations applicable to transfers of tangible and intangible property, see sections 1.482-3 through 1.482-6; see also section 1.482-3(f), dealing with the coordination of the intangible and tangible property rules.

(4) SPECIAL CIRCUMSTANCES -- (i) MARKET SHARE STRATEGY. In certain circumstances, taxpayers may adopt strategies to enter new markets or to increase a product's share of an existing market (market share strategy). Such a strategy would be reflected by temporarily increased market development expenses or resale prices that are temporarily lower than the prices charged for comparable products in the same market. Whether or not the strategy is reflected in the transfer price depends on which party to the controlled transaction bears the costs of the pricing strategy. In any case, the effect of a market share strategy on a controlled transaction will be taken into account only if it can be shown that an uncontrolled taxpayer engaged in a comparable strategy under comparable circumstances for a comparable period of time, and the taxpayer provides documentation that substantiates the following --

(A) The costs incurred to implement the market share strategy are borne by the controlled taxpayer that would obtain the future profits that result from the strategy, and there is a reasonable likelihood that the strategy will result in future profits that reflect an appropriate return in relation to the costs incurred to implement it;

(B) The market share strategy is pursued only for a period of time that is reasonable, taking into consideration the industry and product in question; and

(C) The market share strategy, the related costs and expected returns, and any agreement between the controlled taxpayers to share the related costs, were established before the strategy was implemented.

(ii) DIFFERENT GEOGRAPHIC MARKETS -- (A) IN GENERAL. Uncontrolled comparables ordinarily should be derived from the geographic market in which the controlled taxpayer operates, because there may be significant differences in economic conditions in different markets. If information from the same market is not available, an uncontrolled comparable derived from a different geographic market may be considered if adjustments are made to account for differences between the two markets. If information permitting adjustments for such differences is not available, then information derived from uncontrolled comparables in the most similar market for which reliable data is available may be used, but the extent of such differences may affect the reliability of the method for purposes of the best method rule. For this purpose, a geographic market is any geographic area in which the economic conditions for the relevant product or service are substantially the same, and may include multiple countries, depending on the economic conditions.

(B) EXAMPLE. The following example illustrates this paragraph (d)(4)(ii).

EXAMPLE. Manuco, a wholly-owned foreign subsidiary of P, a U.S. corporation, manufactures products in Country Z for sale to P. No uncontrolled transactions are located that would provide a reliable measure of the arm's length result under the comparable uncontrolled price method. The district director considers applying the cost plus method or the comparable profits method. Information on uncontrolled taxpayers performing comparable functions under comparable circumstances in the same geographic market is not available. Therefore, adjusted data from uncontrolled manufacturers in other markets may be considered in order to apply the cost plus method. In this case, comparable uncontrolled manufacturers are found in the United States. Accordingly, data from the comparable U.S. uncontrolled manufacturers, as adjusted to account for differences between the United States and Country Z's geographic market, is used to test the arm's length price paid by P to Manuco. However, the use of such data may affect the reliability of the results for purposes of the best method rule. See section 1.482-1(c).

(C) LOCATION SAVINGS. If an uncontrolled taxpayer operates in a different geographic market than the controlled taxpayer, adjustments may be necessary to account for significant differences in costs attributable to the geographic markets. These adjustments must be based on the effect such differences would have on the consideration charged or paid in the controlled transaction given the relative competitive positions of buyers and sellers in each market. Thus, for example, the fact that the total costs of operating in a controlled manufacturer's geographic market are less than the total costs of operating in other markets ordinarily justifies higher profits to the manufacturer only if the cost differences would increase the profits of comparable uncontrolled manufacturers operating at arm's length, given the competitive positions of buyers and sellers in that market.

(D) EXAMPLE. The following example illustrates the principles of this paragraph (d)(4)(ii)(C).

EXAMPLE. Couture, a U.S. apparel design corporation, contracts with Sewco, its wholly owned Country Y subsidiary, to manufacture its clothes. Costs of operating in Country Y are significantly lower than the operating costs in the United States. Although clothes with the Couture label sell for a premium price, the actual production of the clothes does not require significant specialized knowledge that could not be acquired by actual or potential competitors to Sewco at reasonable cost. Thus, Sewco's functions could be performed by several actual or potential competitors to Sewco in geographic markets that are similar to Country Y. Thus, the fact that production is less costly in Country Y will not, in and of itself, justify additional profits derived from lower operating costs in Country Y inuring to Sewco, because the competitive positions of the other actual or potential producers in similar geographic markets capable of performing the same functions at the same low costs indicate that at arm's length such profits would not be retained by Sewco.

(iii) Transactions ordinarily not accepted as comparables -- (A) IN GENERAL. Transactions ordinarily will not constitute reliable measures of an arm's length result for purposes of this section if --

(1) They are not made in the ordinary course of business; or

(2) One of the principal purposes of the uncontrolled transaction was to establish an arm's length result with respect to the controlled transaction.

(B) EXAMPLES. The following examples illustrate the principle of this paragraph (d)(4)(iii).

EXAMPLE 1 -- NOT IN THE ORDINARY COURSE OF BUSINESS. USP, a United States manufacturer of computer software, sells its products to FSub, its foreign distributor in country X. Compco, a United States competitor of USP, also sells its products in X through unrelated distributors. However, in the year under review, Compco is forced into bankruptcy, and Compco liquidates its inventory by selling all of its products to unrelated distributors in X for a liquidation price. Because the sale of its entire inventory was not a sale in the ordinary course of business, Compco's sale cannot be used as an uncontrolled comparable to determine USP's arm's length result from its controlled transaction.

EXAMPLE 2 -- PRINCIPAL PURPOSE OF ESTABLISHING AN ARM'S LENGTH RESULT. USP, a United States manufacturer of farm machinery, sells its products to FSub, its wholly-owned distributor in Country Y. USP, operating at nearly full capacity, sells 95% of its inventory to FSub. To make use of its excess capacity, and also to establish a comparable uncontrolled price for its transfer price to FSub, USP increases its production to full capacity. USP sells its excess inventory to Compco, an unrelated foreign distributor in Country X. Country X has approximately the same economic conditions as that of Country Y. Because one of the principal purposes of selling to Compco was to establish an arm's length price for its controlled transactions with FSub, USP's sale to Compco cannot be used as an uncontrolled comparable to determine USP's arm's length result from its controlled transaction.

(e) ARM'S LENGTH RANGE -- (1) IN GENERAL. In some cases, application of a pricing method will produce a single result that is the most reliable measure of an arm's length result. In other cases, application of a method may produce a number of results from which a range of reliable results may be derived. A taxpayer will not be subject to adjustment if its results fall within such range (arm's length range).

(2) DETERMINATION OF ARM'S LENGTH RANGE -- (i) SINGLE METHOD. The arm's length range is ordinarily determined by applying a single pricing method selected under the best method rule to two or more uncontrolled transactions of similar comparability and reliability. Use of more than one method may be appropriate for the purposes described in paragraph (c)(2)(iii) of this section (Best method rule).

(ii) SELECTION OF COMPARABLES. Uncontrolled comparables must be selected based upon the comparability criteria relevant to the method applied and must be sufficiently similar to the controlled transaction that they provide a reliable measure of an arm's length result. If material differences exist between the controlled and uncontrolled transactions, adjustments must be made to the results of the uncontrolled transaction if the effect of such differences on price or profits can be ascertained with sufficient accuracy to improve the reliability of the results. See section 1.482-1(d)(2) (Standard of comparability). The arm's length range will be derived only from those uncontrolled comparables that have, or through adjustments can be brought to, a similar level of comparability and reliability, and uncontrolled comparables that have a significantly lower level of comparability and reliability will not be used in establishing the arm's length range.

(iii) COMPARABLES INCLUDED IN ARM'S LENGTH RANGE -- (A) IN GENERAL. The arm's length range will consist of the results of all of the uncontrolled comparables that meet the following conditions: the information on the controlled transaction and the uncontrolled comparables is sufficiently complete that it is likely that all material differences have been identified, each such difference has a definite and reasonably ascertainable effect on price or profit, and an adjustment is made to eliminate the effect of each such difference.

(B) ADJUSTMENT OF RANGE TO INCREASE RELIABILITY. If there are no uncontrolled comparables described in paragraph (e)(2)(iii)(A) of this section, the arm's length range is derived from the results of all the uncontrolled comparables, selected pursuant to paragraph (e)(2)(ii) of this section, that achieve a similar level of comparability and reliability. In such cases the reliability of the analysis must be increased, where it is possible to do so, by adjusting the range through application of a valid statistical method to the results of all of the uncontrolled comparables so selected. The reliability of the analysis is increased when statistical methods are used to establish a range of results in which the limits of the range will be determined such that there is a 75 percent probability of a result falling above the lower end of the range and a 75 percent probability of a result falling below the upper end of the range. The interquartile range ordinarily provides an acceptable measure of this range; however a different statistical method may be applied if it provides a more reliable measure.

(C) INTERQUARTILE RANGE. For purposes of this section, the interquartile range is the range from the 25th to the 75th percentile of the results derived from the uncontrolled comparables. For this purpose, the 25th percentile is the lowest result derived from an uncontrolled comparable such that at least 25 percent of the results are at or below the value of that result. However, if exactly 25 percent of the results are at or below a result, then the 25th percentile is equal to the average of that result and the next higher result derived from the uncontrolled comparables. The 75th percentile is determined analogously.

(3) ADJUSTMENT IF TAXPAYER'S RESULTS ARE OUTSIDE ARM'S LENGTH RANGE. If the results of a controlled transaction fall outside the arm's length range, the district director may make allocations that adjust the controlled taxpayer's result to any point within the arm's length range. If the interquartile range is used to determine the arm's length range, such adjustment will ordinarily be to the median of all the results. The median is the 50th percentile of the results, which is determined in a manner analogous to that described in paragraph (e)(2)(iii)(C) of this section (Interquartile range). In other cases, an adjustment normally will be made to the arithmetic mean of all the results. See section 1.482-1(f)(2)(iii)(D) for determination of an adjustment when a controlled taxpayer's result for a multiple year period falls outside an arm's length range consisting of the average results of uncontrolled comparables over the same period.

(4) ARM'S LENGTH RANGE NOT PREREQUISITE TO ALLOCATION. The rules of this paragraph (e) do not require that the district director establish an arm's length range prior to making an allocation under section 482. Thus, for example, the district director may properly propose an allocation on the basis of a single comparable uncontrolled price if the comparable uncontrolled price method, as described in section 1.482-3(b), has been properly applied. However, if the taxpayer subsequently demonstrates that the results claimed on its income tax return are within the range established by additional equally reliable comparable uncontrolled prices in a manner consistent with the requirements set forth in section 1.482-1(e)(2)(iii), then no allocation will be made.

(5) EXAMPLES. The following examples illustrate the principles of this paragraph (e).

EXAMPLE 1 -- SELECTION OF COMPARABLES. (i) To evaluate the arm's length result of a controlled transaction between USSub, the United States taxpayer under review, and FP, its foreign parent, the district director considers applying the resale price method. The district director identifies ten potential uncontrolled transactions. The distributors in all ten uncontrolled transactions purchase and resell similar products and perform similar functions to those of USSub.

(ii) Data with respect to three of the uncontrolled transactions is very limited, and although some material differences can be identified and adjusted for, the level of comparability of these three uncontrolled comparables is significantly lower than that of the other seven. Further, of those seven, adjustments for the identified material differences can be reliably made for only four of the uncontrolled transactions. Therefore, pursuant to section 1.482-1(e)(2)(ii) only these four uncontrolled comparables may be used to establish an arm's length range.

EXAMPLE 2 -- ARM'S LENGTH RANGE CONSISTS OF ALL THE RESULTS. (i) The facts are the same as in EXAMPLE 1. Applying the resale price method to the four uncontrolled comparables, and making adjustments to the uncontrolled comparables pursuant to section 1.482-1(d)(2), the district director derives the following results:

 Comparable          Result ($ price)

EXAMPLE 3 -- ARM'S LENGTH RANGE LIMITED TO INTERQUARTILE RANGE. (i) The facts are the same as in EXAMPLE 2, except in this case there are some product and functional differences between the four uncontrolled comparables and USSub. However, the data is insufficiently complete to determine the effect of the differences. Applying the resale price method to the four uncontrolled comparables, and making adjustments to the uncontrolled comparables pursuant to section 1.482-1(d)(2), the district director derives the following results:

 Uncontrolled Comparable       Result ($ price)

EXAMPLE 4 -- ARM'S LENGTH RANGE LIMITED TO INTERQUARTILE RANGE. (i) To evaluate the arm's length result of controlled transactions between USP, a United States manufacturing company, and FSub, its foreign subsidiary, the district director considers applying the comparable profits method. The district director identifies 50 uncontrolled taxpayers within the same industry that potentially could be used to apply the method.

(ii) Further review indicates that only 20 of the uncontrolled manufacturers engage in activities requiring similar capital investments and technical know-how. Data with respect to five of the uncontrolled manufacturers is very limited, and although some material differences can be identified and adjusted for, the level of comparability of these five uncontrolled comparables is significantly lower than that of the other 15. In addition, for those five uncontrolled comparables it is not possible to accurately allocate costs between the business activity associated with the relevant transactions and other business activities. Therefore, pursuant to section 1.482-1(e)(2)(ii) only the other fifteen uncontrolled comparables may be used to establish an arm's length range.

(iii) Although the data for the fifteen remaining uncontrolled comparables is relatively complete and accurate, there is a significant possibility that some material differences may remain. The district director has determined, for example, that it is likely that there are material differences in the level of technical expertise or in management efficiency. Accordingly, if the comparable profits method is determined to be the best method pursuant to section 1.482-1(c), the arm's length range for the controlled transaction may be established only pursuant to paragraph (e)(2)(iii)(B) of this section.

(f) SCOPE OF REVIEW -- (1) IN GENERAL. The authority to determine true taxable income extends to any case in which either by inadvertence or design the taxable income, in whole or in part, of a controlled taxpayer is other than it would have been had the taxpayer, in the conduct of its affairs, been dealing at arm's length with an uncontrolled taxpayer.

(i) INTENT TO EVADE OR AVOID TAX NOT A PREREQUISITE. In making allocations under section 482, the district director is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction, or to the case of a device designed to reduce or avoid tax by shifting or distorting income, deductions, credits, or allowances.

(ii) REALIZATION OF INCOME NOT A PREREQUISITE -- (A) IN GENERAL. The district director may make an allocation under section 482 even if the income ultimately anticipated from a series of transactions has not been or is never realized. For example, if a controlled taxpayer sells a product at less than an arm's length price to a related taxpayer in one taxable year and the second controlled taxpayer resells the product to an unrelated party in the next taxable year, the district director may make an appropriate allocation to reflect an arm's length price for the sale of the product in the first taxable year, even though the second controlled taxpayer had not realized any gross income from the resale of the product in the first year. similarly, if a controlled taxpayer lends money to a related taxpayer in a taxable year, the district director may make an appropriate allocation to reflect an arm's length charge for interest during such taxable year even if the second controlled taxpayer does not realize income during such year. Finally, even if two controlled taxpayers realize an overall loss that is attributable to a particular controlled transaction, an allocation under section 482 is not precluded.

(B) EXAMPLE. The following example illustrates this paragraph (f)(1)(ii).

EXAMPLE. USSub is a U.S. subsidiary of FP, a foreign corporation. Parent manufactures product X and sells it to USSub. USSub functions as a distributor of product X to unrelated customers in the United States. The fact that FP may incur a loss on the manufacture and sale of product X does not by itself establish that USSub, dealing with FP at arm's length, also would incur a loss. An independent distributor acting at arm's length with its supplier would in many circumstances be expected to earn a profit without regard to the level of profit earned by the supplier.

(iii) NONRECOGNITION PROVISIONS MAY NOT BAR ALLOCATION -- (A) IN GENERAL. If necessary to prevent the avoidance of taxes or to clearly reflect income, the district director may make an allocation under section 482 with respect to transactions that otherwise qualify for nonrecognition of gain or loss under applicable provisions of the Internal Revenue Code (such as section 351 or 1031).

(B) EXAMPLE. The following example illustrates this paragraph (f)(1)(iii).

EXAMPLE. (i) In Year 1 USP, a United States corporation, bought 100 shares of UR, an unrelated corporation, for $100,000. In Year 2, when the value of the UR stock had decreased to $40,000, USP contributed all 100 shares of UR stock to its wholly-owned subsidiary in exchange for subsidiary's capital stock. In Year 3, the subsidiary sold all of the UR stock for $40,000 to an unrelated buyer, and on its U.S. income tax return, claimed a loss of $60,000 attributable to the sale of the UR stock. USP and its subsidiary do not file a consolidated return.

(ii) In determining the true taxable income of the subsidiary, the district director may disallow the loss of $60,000 on the ground that the loss was incurred by USP. National Securities Corp. v Commissioner, 137 F.2d 600 (3rd Cir. 1943), cert. denied, 320 U.S. 794 (1943).

(iv) CONSOLIDATED RETURNS. Section 482 and the regulations thereunder apply to all controlled taxpayers, whether the controlled taxpayer files a separate or consolidated U.S. income tax return. If a controlled taxpayer files a separate return, its true separate taxable income will be determined. If a controlled taxpayer is a party to a consolidated return, the true consolidated taxable income of the affiliated group and the true separate taxable income of the controlled taxpayer must be determined consistently with the principles of a consolidated return.

(2) RULES RELATING TO DETERMINATION OF TRUE TAXABLE INCOME. The following rules must be taken into account in determining the true taxable income of a controlled taxpayer.

(i) AGGREGATION OF TRANSACTIONS -- (A) IN GENERAL. The combined effect of two or more separate transactions (whether before, during, or after the taxable year under review) may be considered, if such transactions, taken as a whole, are so interrelated that consideration of multiple transactions is the most reliable means of determining 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 section 1.6038A-3(c)(7)(vii).

(B) EXAMPLES. The following examples illustrate this paragraph (f)(2)(i).

EXAMPLE 1. P enters into a license agreement with S1, its subsidiary, that permits S1 to use a proprietary manufacturing process and to sell the output from this process throughout a specified region. S1 uses the manufacturing process and sells its output to S2, another subsidiary of P, which in turn resells the output to uncontrolled parties in the specified region. In evaluating the arm's length character of the royalty paid by S1 to P, it may be appropriate to 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 sale to uncontrolled parties of the products produced by S1.

EXAMPLE 2. S1, S2, and S3 are Country Z subsidiaries of U.S. manufacturer P. S1 is the exclusive Country Z distributor of computers manufactured by P. S2 provides marketing services in connection with sales of P computers in Country Z, and in this regard uses significant marketing intangibles provided by P. S3 administers the warranty program with respect to P computers in Country Z, including maintenance and repair services. In evaluating the arm's length character of the transfer price paid by S1 to P, of the fees paid by S2 to P for the use of P marketing intangibles, and of the service fees earned by S2 and S3, it may be appropriate to consider the combined effects of these separate transactions because they are so interrelated that they are most reliably analyzed on an aggregated basis.

EXAMPLE 3. The facts are the same as in Example 2. In addition, U1, U2, and U3 are uncontrolled taxpayers that carry out functions comparable to those of S1, S2, and S3, respectively, with respect to computers produced by unrelated manufacturers. R1, R2, and R3 are a controlled group of taxpayers (unrelated to the P controlled group) that also carry out functions comparable to those of S1, S2, and S3 with respect to computers produced by their common parent. Prices charged to uncontrolled customers of the R group differ from the prices charged to customers of U1, U2, and U3. In determining whether the transactions of U1, U2, and U3, or the transactions of R1, R2, and R3 would provide a more reliable measure of the arm's length result, it is determined that the interrelated R group transactions are more reliable than the wholly independent transactions of U1, U2, and U3, given the interrelationship of the P group transactions.

EXAMPLE 4. P enters into a license agreement with S1 that permits S1 to use a propriety process for manufacturing product X and to sell product X to uncontrolled parties throughout a specified region. P also sells to S1 product Y which is manufactured by P in the United States, and which is unrelated to product X. Product Y is resold by S1 to uncontrolled parties in the specified region. In evaluating the arm's length character of the royalty paid by S1 to P for the use of the manufacturing process for product X, and the transfer prices charged for unrelated product Y, it would not be appropriate to consider the combined effects of these separate and unrelated transactions.

(ii) ALLOCATION BASED ON TAXPAYER'S ACTUAL TRANSACTIONS -- (A) IN GENERAL. The district director will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance. However, the district director may consider the alternatives available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances. In such cases the district director may adjust the consideration charged in the controlled transaction based on the cost or profit of an alternative as adjusted to account for material differences between the alternative and the controlled transaction, but will not restructure the transaction as if the alternative had been adopted by the taxpayer. See section 1.482-1(d)(3) (Factors for determining comparability, Contractual terms and Risk); sections 1.482-3(e) and 1.482-4(d) (Unspecified methods).

(B) EXAMPLE. The following example illustrates this paragraph (f)(2)(ii).

EXAMPLE. P and S are controlled taxpayers. P enters into a license agreement with S that permits S to use a proprietary process for manufacturing product X. Using its sales and marketing employees, S sells product X to related and unrelated customers outside the United States. If the license agreement between P and S has economic substance, the district director ordinarily will not restructure the taxpayer's transaction to treat P as if it had elected to exploit directly the manufacturing process. However, the fact that P could have manufactured product X may be taken into account under section 1.482-4(d) in determining the arm's length consideration for the controlled transaction. For an example of such an analysis, see Example in section 1.482-4(d)(2).

(iii) MULTIPLE YEAR DATA -- (A) IN GENERAL. The results of a controlled transaction ordinarily will be compared with the results of uncontrolled comparables occurring in the taxable year under review. It may be appropriate, however, to consider data relating to the uncontrolled comparables or the controlled taxpayer for one or more years before or after the year under review. If data relating to uncontrolled comparables from multiple years is used, data relating to the controlled taxpayer for the same years ordinarily must be considered. However, if such data is not available, reliable data from other years, as adjusted under paragraph (d)(2) (Standard of comparability) of this section may be used.

(B) CIRCUMSTANCES WARRANTING CONSIDERATION OF MULTIPLE YEAR DATA. The extent to which it is appropriate to consider multiple-year data depends on the method being applied and the issue being addressed. Circumstances that may warrant consideration of data from multiple years include the extent to which complete and accurate data is available for the taxable year under review, the effect of business cycles in the controlled taxpayer's industry, or the effects of life cycles of the product or intangible being examined. Data from one or more years before or after the taxable year under review must ordinarily be considered for purposes of applying the provisions of section 1.482-1(d)(3)(iii) (Risk), section 1.482-1(d)(4)(i) (Market share strategy), section 1.482-4(f)(2) (Periodic adjustments), and section 1.482-5 (Comparable profits method). On the other hand, multiple-year data ordinarily will not be considered for purposes of applying the comparable uncontrolled price method (except to the extent that risk or market share strategy issues are present).

(C) COMPARABLE EFFECT OVER COMPARABLE PERIOD. Data from multiple years may be considered to determine whether the same economic conditions that caused the controlled taxpayer's results had a comparable effect over a comparable period of time on the uncontrolled comparables that establish the arm's length range. For example, given that uncontrolled taxpayers enter into transactions with the ultimate expectation of earning a profit, persistent losses among controlled taxpayers may be an indication of non-arm's length dealings. Thus, if a controlled taxpayer that realizes a loss with respect to a controlled transaction seeks to demonstrate that the loss is within the arm's length range, the district director may take into account data from taxable years other than the taxable year of the transaction to determine whether the loss was attributable to arm's length dealings. The rule of this paragraph (f)(2)(iii)(C) is illustrated by Example 3 of paragraph (f)(2)(iii)(E) of this section.

(D) APPLICATIONS OF METHODS USING MULTIPLE YEAR AVERAGES. If a comparison of a controlled taxpayer's average result over a multiple year period with the average results of uncontrolled comparables over the same period would reduce the effect of short-term variations that may be unrelated to transfer pricing, it may be appropriate to establish a range derived from the average results of uncontrolled comparables over a multiple year period to determine if an adjustment should be made. In such a case the district director may make an adjustment if the controlled taxpayer's average result for the multiple year period is not within such range. Such a range must be determined in accordance with section 1.482-1(e) (Arm's length range). An adjustment in such a case ordinarily will be equal to the difference, if any, between the controlled taxpayer's result for the taxable year and the mid-point of the uncontrolled comparables' results for that year. If the interquartile range is used to determine the range of average results for the multiple year period, such adjustment will ordinarily be made to the median of all the results of the uncontrolled comparables for the taxable year. See Example 2 of section 1.482-5(e). In other cases, the adjustment normally will be made to the arithmetic mean of all the results of the uncontrolled comparables for the taxable year. However, an adjustment will be made only to the extent that it would move the controlled taxpayer's multiple year average closer to the arm's length range for the multiple year period or to any point within such range. In determining a controlled taxpayer's average result for a multiple year period, adjustments made under this section for prior years will be taken into account only if such adjustments have been finally determined, as described in section 1.482-1(g)(2)(iii). See Example 3 of section 1.482-5(e).

(E) EXAMPLES. The following examples, in which S and P are controlled taxpayers, illustrate this paragraph (f)(2)(iii). Examples 1 and 4 also illustrate the principle of the arm's length range of paragraph (e) of this section.

EXAMPLE 1. P sold product Z to S for $60 per unit in 1995. Applying the resale price method to data from uncontrolled comparables for the same year establishes an arm's length range of prices for the controlled transaction from $52 to $59 per unit. Since the price charged in the controlled transaction falls outside the range, the district director would ordinarily make an allocation under section 482. However, in this case there are cyclical factors that affect the results of the uncontrolled comparables (and that of the controlled transaction) that cannot be adequately accounted for by specific adjustments to the data for 1995. Therefore, the district director considers results over multiple years to account for these factors. Under these circumstances, it is appropriate to average the results of the uncontrolled comparables over the years 1993, 1994, and 1995 to determine an arm's length range. The averaged results establish an arm's length range of $56 to $58 per unit. For consistency, the results of the controlled taxpayers must also be averaged over the same years. The average price in the controlled transaction over the three years is $57. Because the controlled transfer price of product Z falls within the arm's length range, the district director makes no allocation.

EXAMPLE 2. (i) FP, a Country X corporation, designs and manufactures machinery in Country X. FP's costs are incurred in Country X currency. USSub is the exclusive distributor of FP's machinery in the United States. The price of the machinery sold by FP to USSub is expressed in Country X currency. Thus, USSub bears all of the currency risk associated with fluctuations in the exchange rate between the time the contract is signed and the payment is made. The prices charged by FP to USSub for 1995 are under examination. In that year, the value of the dollar depreciated against the currency of Country X, and as a result, USSub's gross margin was only 8%.

(ii) UD is an uncontrolled distributor of similar machinery that performs distribution functions substantially the same as those performed by USSub, except that UD purchases and resells machinery in transactions where both the purchase and resale prices are denominated in U.S. dollars. Thus, UD had no currency exchange risk. UD's gross margin in 1995 was 10%. UD's average gross margin for the period 1990 to 1998 has been 12%.

(iii) In determining whether the price charged by FP to USSub in 1995 was arm's length, the district director may consider USSub's average gross margin for an appropriate period before and after 1995 to determine whether USSub's average gross margin during the period was sufficiently greater than UD's average gross margin during the same period such that USSub was sufficiently compensated for the currency risk it bore throughout the period. See section 1.482-1(d)(3)(iii) (Risk).

EXAMPLE 3. FP manufactures product X in Country M and sells it to USSub, which distributes X in the United States. USSub realizes losses with respect to the controlled transactions in each of five consecutive taxable years. In each of the five consecutive years a different uncontrolled comparable realized a loss with respect to comparable transactions equal to or greater than USSub's loss. Pursuant to paragraph (f)(3)(iii)(C) of this section, the district director examines whether the uncontrolled comparables realized similar losses over a comparable period of time, and finds that each of the five comparables realized losses in only one of the five years, and their average result over the five-year period was a profit. Based on this data, the district director may conclude that the controlled taxpayer's results are not within the arm's length range over the five year period, since the economic conditions that resulted in the controlled taxpayer's loss did not have a comparable effect over a comparable period of time on the uncontrolled comparables.

EXAMPLE 4. (i) USP, a U.S. corporation, manufactures product Y in the United States and sells it to FSub, which acts as USP's exclusive distributor of product Y in Country N. The resale price method described in section 1.482-3(c) is used to evaluate whether the transfer price charged by USP to FSub for the 1994 taxable year for product Y was arm's length. For the period 1992 through 1994, FSub had a gross profit margin for each year of 13%. A, B, C and D are uncontrolled distributors of products that compete directly with product Y in country N. After making appropriate adjustments in accordance with sections 1.482-1(d)(2) and 1.482-3(c), the gross profit margins for A, B, C, and D are as follows:

              1992      1993      1994     Average

(iv) PRODUCT LINES AND STATISTICAL TECHNIQUES. The methods described in sections 1.482-2 through 1.482-6 are generally stated in terms of individual transactions. However, because a taxpayer may have controlled transactions involving many different products, or many separate transactions involving the same product, it may be impractical to analyze every individual transaction to determine its arm's length price. In such cases, it is permissible to evaluate the arm's length results by applying the appropriate methods to the overall results for product lines or other groupings. In addition, the arm's length results of all related party transactions entered into by a controlled taxpayer may be evaluated by employing sampling and other valid statistical techniques.

(v) ALLOCATIONS APPLY TO RESULTS, NOT METHODS -- (A) IN GENERAL. In evaluating whether the result of a controlled transaction is arm's length, it is not necessary for the district director to determine whether the method or procedure that a controlled taxpayer employs to set the terms for its controlled transactions corresponds to the method or procedure that might have been used by a taxpayer dealing at arm's length with an uncontrolled taxpayer. Rather, the district director will evaluate the result achieved rather than the method the taxpayer used to determine its prices.

(B) EXAMPLE. The following example illustrates this paragraph (f)(2)(v).

EXAMPLE. (i) FS is a foreign subsidiary of P, a U.S. corporation. P manufactures and sells household appliances. FS operates as P's exclusive distributor in Europe. P annually establishes the price for each of its appliances sold to FS as part of its annual budgeting, production allocation and scheduling, and performance evaluation processes. FS's aggregate gross margin earned in its distribution business is 18%.

(ii) ED is an uncontrolled European distributor of competing household appliances. After adjusting for minor differences in the level of inventory, volume of sales, and warranty programs conducted by FS and ED, ED's aggregate gross margin is also 18%. Thus, the district director may conclude that the aggregate prices charged by P for its appliances sold to FS are arm's length, without determining whether the budgeting, production, and performance evaluation processes of P are similar to such processes used by ED.

(g) COLLATERAL ADJUSTMENTS WITH RESPECT TO ALLOCATIONS UNDER SECTION 482 -- (1) IN GENERAL. The district director will take into account appropriate collateral adjustments with respect to allocations under section 482. Appropriate collateral adjustments may include correlative allocations, conforming adjustments, and setoffs, as described in this paragraph (g).

(2) CORRELATIVE ALLOCATIONS -- (i) IN GENERAL. When the district director makes an allocation under section 482 (referred to in this paragraph (g)(2) as the primary allocation), appropriate correlative allocations will also be made with respect to any other member of the group affected by the allocation. Thus, if the district director makes an allocation of income, the district director will not only increase the income of one member of the group, but correspondingly decrease the income of the other member. In addition, where appropriate, the district director may make such further correlative allocations as may be required by the initial correlative allocation.

(ii) MANNER OF CARRYING OUT CORRELATIVE ALLOCATION. The district director will furnish to the taxpayer with respect to which the primary allocation is made a written statement of the amount and nature of the correlative allocation. The correlative allocation must be reflected in the documentation of the other member of the group that is maintained for U.S. tax purposes, without regard to whether it affects the U.S. income tax liability of the other member for any open year. In some circumstances the allocation will have an immediate U.S. tax effect, by changing the taxable income computation of the other member (or the taxable income computation of a shareholder of the other member, for example, under the provisions of subpart F of the Internal Revenue Code). Alternatively, the correlative allocation may not be reflected on any U.S. tax return until a later year, for example when a dividend is paid.

(iii) EVENTS TRIGGERING CORRELATIVE ALLOCATION. For purposes of this paragraph (g)(2), a primary allocation will not be considered to have been made (and therefore, correlative allocations are not required to be made) until the date of a final determination with respect to the allocation under section 482. For this purpose, a final determination includes --

(A) Assessment of tax following execution by the taxpayer of a Form 870 (Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment) with respect to such allocation;

(B) Acceptance of a Form 870-AD (Offer of Waiver of Restriction on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment);

(C) Payment of the deficiency;

(D) Stipulation in the Tax Court of the United States; or

(E) Final determination of tax liability by offer-in-compromise, closing agreement, or final resolution (determined under the principles of section 7481) of a judicial proceeding.

(iv) EXAMPLES. The following examples illustrate this paragraph (g)(2). In each example, X and Y are members of the same group of controlled taxpayers and each regularly computes its income on a calendar year basis.

EXAMPLE 1. (i) In 1996, Y, a U.S. corporation, rents a building owned by X, also a U.S. corporation. In 1998 the district director determines that Y did not pay an arm's length rental charge. The district director proposes to increase X's income to reflect an arm's length rental charge. X consents to the assessment reflecting such adjustment by executing Form 870, a Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment. The assessment of the tax with respect to the adjustment is made in 1998. Thus, the primary allocation, as defined in paragraph (g)(2)(i) of this section, is considered to have been made in 1998.

(ii) The adjustment made to X's income under section 482 requires a correlative allocation with respect to Y's income. The district director notifies X in writing of the amount and nature of the adjustment made with respect to Y. Y had net operating losses in 1993, 1994, 1995, 1996, and 1997. Although a correlative adjustment will not have an effect on Y's U.S. income tax liability for 1996, an adjustment increasing Y's net operating loss for 1996 will be made for purposes of determining Y's U.S. income tax liability for 1998 or a later taxable year to which the increased net operating loss may be carried.

EXAMPLE 2. (i) In 1995, X, a U.S. construction company, provided engineering services to Y, a U.S. corporation, in the construction of Y's factory. In 1997, the district director determines that the fees paid by Y to X for its services were not arm's length and proposes to make an adjustment to the income of X. X consents to an assessment reflecting such adjustment by executing Form 870. An assessment of the tax with respect to such adjustment is made in 1997. The district director notifies X in writing of the amount and nature of the adjustment to be made with respect to Y.

(ii) The fees paid by Y for X's engineering services properly constitute a capital expenditure. Y does not place the factory into service until 1998. Therefore, a correlative adjustment increasing Y's basis in the factory does not affect Y's U.S. income tax liability for 1997. However, the correlative adjustment must be made in the books and records maintained by Y for its U.S. income tax purposes and such adjustment will be taken into account in computing Y's allowable depreciation or gain or loss on a subsequent disposition of the factory.

EXAMPLE 3. In 1995, X, a U.S. corporation, makes a loan to Y, its foreign subsidiary not engaged in a U.S. trade or business. In 1997, the district director, upon determining that the interest charged on the loan was not arm's length, proposes to adjust X's income to reflect an arm's length interest rate. X consents to an assessment reflecting such allocation by executing Form 870, and an assessment of the tax with respect to the section 482 allocation is made in 1997. The district director notifies X in writing of the amount and nature of the correlative allocation to be made with respect to Y. Although the correlative adjustment does not have an effect on Y's U.S. income tax liability, the adjustment must be reflected in the documentation of Y that is maintained for U.S. tax purposes. Thus, the adjustment must be reflected in the determination of the amount of Y's earnings and profits for 1995 and subsequent years, and the adjustment must be made to the extent it has an effect on any person's U.S. income tax liability for any taxable year.

(3) ADJUSTMENTS TO CONFORM ACCOUNTS TO REFLECT SECTION 482 ALLOCATIONS -- (i) IN GENERAL. Appropriate adjustments must be made to conform a taxpayer's accounts to reflect allocations made under section 482. Such adjustments may include the treatment of an allocated amount as a dividend or a capital contribution (as appropriate), or, in appropriate cases, pursuant to such applicable revenue procedures as may be provided by the Commissioner (see section 601.601(d)(2) of this chapter), repayment of the allocated amount without further income tax consequences.

(ii) EXAMPLE. The following example illustrates the principles of this paragraph (g)(3).

EXAMPLE -- CONFORMING CASH ACCOUNTS. USD, a United States corporation, buys Product from its foreign parent, FP. In reviewing USD's income tax return, the district director determines that the arm's length price would have increased USD's taxable income by $5 million. The district director accordingly adjusts USD's income to reflect its true taxable income.

To conform its cash accounts to reflect the section 482 allocation made by the district director, USD applies for relief under Rev. Proc. 65-17, 1965-1 C.B. 833 (see section 601.601(d)(2)(ii)(b) of this chapter), to treat the $5 million adjustment as an account receivable from FP, due as of the last day of the year of the transaction, with interest accruing therefrom.

(4) SETOFFS -- (i) IN GENERAL. If an allocation is made under section 482 with respect to a transaction between controlled taxpayers, the district director will also take into account the effect of any other non-arm's length transaction between the same controlled taxpayers in the same taxable year which will result in a setoff against the original section 482 allocation. Such setoff, however, will be taken into account only if the requirements of section 1.482-1(g)(4)(ii) are satisfied. If the effect of the setoff is to change the characterization or source of the income or deductions, or otherwise distort taxable income, in such a manner as to affect the U.S. tax liability of any member, adjustments will be made to reflect the correct amount of each category of income or deductions. For purposes of this setoff provision, the term arm's length refers to the amount defined in paragraph (b) (Arm's length standard) of this section, without regard to the rules in section 1.482-2 under which certain charges are deemed to be equal to arm's length.

(ii) REQUIREMENTS. The district director will take a setoff into account only if the taxpayer --

(A) Establishes that the transaction that is the basis of the setoff was not at arm's length and the amount of the appropriate arm's length charge;

(B) Documents, pursuant to paragraph (g)(2) of this section, all correlative adjustments resulting from the proposed setoff; and

(C) Notifies the district director of the basis of any claimed setoff within 30 days after the earlier of the date of a letter by which the district director transmits an examination report notifying the taxpayer of proposed adjustments or the date of the issuance of the notice of deficiency.

(iii) EXAMPLES. The following examples illustrate this paragraph (g)(4).

EXAMPLE 1. P, a U.S. corporation, renders services to S, its foreign subsidiary in Country Y, in connection with the construction of S's factory. An arm's length charge for such services determined under section 1.482-2(b) would be $100,000. During the same taxable year P makes available to S the use of a machine to be used in the construction of the factory, and the arm's length rental value of the machine is $25,000. P bills S $125,000 for the services, but does not charge S for the use of the machine. No allocation will be made with respect to the undercharge for the machine if P notifies the district director of the basis of the claimed setoff within 30 days after the date of the letter from the district director transmitting the examination report notifying P of the proposed adjustment, establishes that the excess amount charged for services was equal to an arm's length charge for the use of the machine and that the taxable income and income tax liabilities of P are not distorted, and documents the correlative allocations resulting from the proposed setoff.

EXAMPLE 2. The facts are the same as in Example 1, except that, if P had reported $25,000 as rental income and $25,000 less as service income, it would have been subject to the tax on personal holding companies. Allocations will be made to reflect the correct amounts of rental income and service income.

(h) SPECIAL RULES -- (1) SMALL TAXPAYER SAFE HARBOR. [Reserved]

(2) EFFECT OF FOREIGN LEGAL RESTRICTIONS -- (i) IN GENERAL. The district director will take into account the effect of a foreign legal restriction to the extent that such restriction affects the results of transactions at arm's length. Thus, a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time. In the absence of evidence indicating the effect of the foreign legal restriction on uncontrolled taxpayers, the restriction will be taken into account only to the extent provided in paragraphs (h)(2)(iii) and (iv) of this section (Deferred income method of accounting).

(ii) APPLICABLE LEGAL RESTRICTIONS. Foreign legal restrictions (whether temporary or permanent) will be taken into account for purposes of this paragraph (h)(2) only if, and so long as, the conditions set forth in paragraphs (h)(2)(ii)(A) through (D) of this section are met.

(A) The restrictions are publicly promulgated, generally applicable to all similarly situated persons (both controlled and uncontrolled), and not imposed as part of a commercial transaction between the taxpayer and the foreign sovereign;

(B) The taxpayer (or other member of the controlled group with respect to which the restrictions apply) has exhausted all remedies prescribed by foreign law or practice for obtaining a waiver of such restrictions (other than remedies that would have a negligible prospect of success if pursued);

(C) The restrictions expressly prevented the payment or receipt, in any form, of part or all of the arm's length amount that would otherwise be required under section 482 (for example, a restriction that applies only to the deductibility of an expense for tax purposes is not a restriction on payment or receipt for this purpose); and

(D) The related parties subject to the restriction did not engage in any arrangement with controlled or uncontrolled parties that had the effect of circumventing the restriction, and have not otherwise violated the restriction in any material respect.

(iii) REQUIREMENT FOR ELECTING THE DEFERRED INCOME METHOD OF ACCOUNTING. If a foreign legal restriction prevents the payment or receipt of part or all of the arm's length amount that is due with respect to a controlled transaction, the restricted amount may be treated as deferrable if the following requirements are met --

(A) The controlled taxpayer establishes to the satisfaction of the district director that the payment or receipt of the arm's length amount was prevented because of a foreign legal restriction and circumstances described in paragraph (h)(2)(ii) of this section; and

(B) The controlled taxpayer whose U.S. tax liability may be affected by the foreign legal restriction elects the deferred income method of accounting, as described in paragraph (h)(2)(iv) of this section, on a written statement attached to a timely U.S. income tax return (or an amended return) filed before the IRS first contacts any member of the controlled group concerning an examination of the return for the taxable year to which the foreign legal restriction applies. A written statement furnished by a taxpayer subject to the Coordinated Examination Program will be considered an amended return for purposes of this paragraph (h)(2)(iii)(B) if it satisfies the requirements of a qualified amended return for purposes of section 1.6664-2(c)(3) as set forth in those regulations or as the Commissioner may prescribe by applicable revenue procedures. The election statement must identify the affected transactions, the parties to the transactions, and the applicable foreign legal restrictions.

(iv) DEFERRED INCOME METHOD OF ACCOUNTING. If the requirements of paragraph (h)(2)(ii) of this section are satisfied, any portion of the arm's length amount, the payment or receipt of which is prevented because of applicable foreign legal restrictions, will be treated as deferrable until payment or receipt of the relevant item ceases to be prevented by the foreign legal restriction. For purposes of the deferred income method of accounting under this paragraph (h)(2)(iv), deductions (including the cost or other basis of inventory and other assets sold or exchanged) and credits properly chargeable against any amount so deferred, are subject to deferral under the provisions of section 1.461-1(a)(4). In addition, income is deferrable under this deferred income method of accounting only to the extent that it exceeds the related deductions already claimed in open taxable years to which the foreign legal restriction applied.

(v) EXAMPLES. The following examples, in which Sub is a Country FC subsidiary of U.S. corporation, Parent, illustrate this paragraph (h)(2).

EXAMPLE 1. Parent licenses an intangible to Sub. FC law generally prohibits payments by any person within FC to recipients outside the country. The FC law meets the requirements of paragraph (h)(2)(ii) of this section. There is no evidence of unrelated parties entering into transactions under comparable circumstances for a comparable period of time, and the foreign legal restrictions will not be taken into account in determining the arm's length amount. The arm's length royalty rate for the use of the intangible property in the absence of the foreign restriction is 10% of Sub's sales in country FC. However, because the requirements of paragraph (h)(2)(ii) of this section are satisfied, Parent can elect the deferred income method of accounting by attaching to its timely filed U.S. income tax return a written statement that satisfies the requirements of paragraph (h)(2)(iii)(B) of this section.

EXAMPLE 2. (i) The facts are the same as in EXAMPLE 1, except that Sub, although it makes no royalty payment to Parent, arranges with an unrelated intermediary to make payments equal to an arm's length amount on its behalf to Parent.

(ii) The district director makes an allocation of royalty income to Parent, based on the arm's length royalty rate of 10%. Further, the district director determines that because the arrangement with the third party had the effect of circumventing the FC law, the requirements of paragraph (h)(2)(ii)(D) of this section are not satisfied. Thus, Parent could not validly elect the deferred income method of accounting, and the allocation of royalty income cannot be treated as deferrable. In appropriate circumstances, the district director may permit the amount of the distribution to be treated as payment by Sub of the royalty allocated to Parent, under the provisions of section 1.482-1(g) (Collateral adjustments).

EXAMPLE 3. The facts are the same as in EXAMPLE 1, except that the laws of FC do not prevent distributions from corporations to their shareholders. Sub distributes an amount equal to 8% of its sales in country FC. Because the laws of FC did not expressly prevent all forms of payment from Sub to Parent, Parent cannot validly elect the deferred income method of accounting with respect to any of the arm's length royalty amount. In appropriate circumstances, the district director may permit the 8% that was distributed to be treated as payment by Sub of the royalty allocated to Parent, under the provisions of section 1.482-1(g) (Collateral adjustments).

EXAMPLE 4. The facts are the same as in EXAMPLE 1, except that Country FC law permits the payment of a royalty, but limits the amount to 5% of sales, and Sub pays the 5% royalty to Parent. Parent demonstrates the existence of a comparable uncontrolled transaction for purposes of the comparable uncontrolled transaction method in which an uncontrolled party accepted a royalty rate of 5%. Given the evidence of the comparable uncontrolled transaction, the 5% royalty rate is determined to be the arm's length royalty rate.

(3) COORDINATION WITH SECTION 936 -- (i) COST SHARING UNDER SECTION 936. If a possessions corporation makes an election under section 936(h)(5)(C)(i)(I), the corporation must make a section 936 cost sharing payment that is at least equal to the payment that would be required under section 482 if the electing corporation were a foreign corporation. In determining the payment that would be required under section 482 for this purpose, the provisions of sections 1.482-1 and 1.482-4 will be applied, and to the extent relevant to the valuation of intangibles, sections 1.482-5 and 1.482-6 will be applied. The provisions of section 936(h)(5)(C)(i)(II) (Effect of Election -- electing corporation treated as owner of intangible property) do not apply until the payment that would be required under section 482 has been determined.

(ii) USE OF TERMS. A cost sharing payment, for the purposes of section 936(h)(5)(C)(i)(I), is calculated using the provisions of section 936 and the regulations thereunder and the provisions of this paragraph (h)(3). The provisions relating to cost sharing under section 482 do not apply to payments made pursuant to an election under section 936(h)(5)(C)(i)(I). Similarly, a profit split payment, for the purposes of section 936(h)(5)(C)(ii)(I), is calculated using the provisions of section 936 and the regulations thereunder, not section 482 and the regulations thereunder.

(i) DEFINITIONS. The definitions set forth in paragraphs (i)(1) through (10) of this section apply to sections 1.482-1 through 1.482-8.

(1) ORGANIZATION includes an organization of any kind, whether a sole proprietorship, a partnership, a trust, an estate, an association, or a corporation (as each is defined or understood in the Internal Revenue Code or the regulations thereunder), irrespective of the place of organization, operation, or conduct of the trade or business, and regardless of whether it is a domestic or foreign organization, whether it is an exempt organization, or whether it is a member of an affiliated group that files a consolidated U.S. income tax return, or a member of an affiliated group that does not file a consolidated U.S. income tax return.

(2) TRADE or BUSINESS includes a trade or business activity of any kind, regardless of whether or where organized, whether owned individually or otherwise, and regardless of the place of operation. Employment for compensation will constitute a separate trade or business from the employing trade or business.

(3) TAXPAYER means any person, organization, trade or business, whether or not subject to any internal revenue tax.

(4) CONTROLLED includes any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted.

(5) CONTROLLED TAXPAYER means any one of two or more taxpayers owned or controlled directly or indirectly by the same interests, and includes the taxpayer that owns or controls the other taxpayers. UNCONTROLLED TAXPAYER means any one of two or more taxpayers not owned or controlled directly or indirectly by the same interests.

(6) GROUP, CONTROLLED GROUP, and GROUP OF CONTROLLED TAXPAYERS mean the taxpayers owned or controlled directly or indirectly by the same interests.

(7) TRANSACTION means any sale, assignment, lease, license, loan, advance, contribution, or any other transfer of any interest in or a right to use any property (whether tangible or intangible, real or personal) or money, however such transaction is effected, and whether or not the terms of such transaction are formally documented. A transaction also includes the performance of any services for the benefit of, or on behalf of, another taxpayer.

(8) CONTROLLED TRANSACTION or CONTROLLED TRANSFER means any transaction or transfer between two or more members of the same group of controlled taxpayers. The term UNCONTROLLED TRANSACTION means any transaction between two or more taxpayers that are not members of the same group of controlled taxpayers.

(9) TRUE TAXABLE INCOME means, in the case of a controlled taxpayer, the taxable income that would have resulted had it dealt with the other member or members of the group at arm's length. It does not mean the taxable income resulting to the controlled taxpayer by reason of the particular contract, transaction, or arrangement the controlled taxpayer chose to make (even though such contract, transaction, or arrangement is legally binding upon the parties thereto).

(10) UNCONTROLLED COMPARABLE means the uncontrolled transaction or uncontrolled taxpayer that is compared with a controlled transaction or taxpayer under any applicable pricing methodology. Thus, for example, under the comparable profits method, an uncontrolled comparable is any uncontrolled taxpayer from which data is used to establish a comparable operating profit.

(j) EFFECTIVE dates -- (1) These regulations are generally effective for taxable years beginning after [INSERT DATE THAT IS 90 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

(2) Taxpayers may elect to apply retroactively all of the provisions of these regulations for any open taxable year. Such election will be effective for the year of the election and all subsequent taxable years.

(3) Although these regulations are generally effective for taxable years as stated, the final sentence of section 482 (requiring that the income with respect to transfers or licenses of intangible property be commensurate with the income attributable to the intangible) is generally effective for taxable years beginning after December 31, 1986. For the period prior to the effective date of these regulations, the final sentence of section 482 must be applied using any reasonable method not inconsistent with the statute. The IRS considers a method that applies these regulations or their general principles to be a reasonable method.

(4) These regulations will not apply with respect to transfers made or licenses granted to foreign persons before November 17, 1985, or before August 17, 1986, for transfers or licenses to others. Nevertheless, they will apply with respect to transfers or licenses before such dates if, with respect to property transferred pursuant to an earlier and continuing transfer agreement, such property was not in existence or owned by the taxpayer on such date.

SECTION 1.482-2 DETERMINATION OF TAXABLE INCOME IN SPECIFIC SITUATIONS. (a) LOANS OR ADVANCES -- (1) INTEREST ON BONA FIDE INDEBTEDNESS -- (i) IN GENERAL. Where one member of a group of controlled entities makes a loan or advance directly or indirectly to, or otherwise becomes a creditor of, another member of such group and either charges no interest, or charges interest at a rate which is not equal to an arm's length rate of interest (as defined in paragraph (a)(2) of this section) with respect to such loan or advance, the district director may make appropriate allocations to reflect an arm's length rate of interest for the use of such loan or advance.

(ii) APPLICATION OF PARAGRAPH (a) OF THIS SECTION -- (A) INTEREST ON BONA FIDE INDEBTEDNESS. Paragraph (e) of this section applies only to determine the appropriateness of the rate of interest charged on the principal amount of a bona fide indebtedness between members of a group of controlled entities, including --

(1) Loans or advances of money or other consideration (whether or not evidenced by a written instrument); and

(2) Indebtedness arising in the ordinary course of business from sales, leases, or the rendition of services by or between members of the group, or any other similar extension of credit.

(B) ALLEGED INDEBTEDNESS. This paragraph (e) does not apply to so much of an alleged indebtedness which is not in fact a bona fide indebtedness, even if the stated rate of interest thereon would be within the safe haven rates prescribed in paragraph (a)(2)(iii) of this section. For example, paragraph (a) of this section does not apply to payments with respect to all or a portion of such alleged indebtedness where in fact all or a portion of an alleged indebtedness is a contribution to the capital of a corporation or a distribution by a corporation with respect to its shares. Similarly, this paragraph (a) does not apply to payments with respect to an alleged purchase-money debt instrument given in consideration for an alleged sale of property between two controlled entities where in fact the transaction constitutes a lease of the property. Payments made with respect to alleged indebtedness (including alleged stated interest thereon) shall be treated according to their substance. See section 1.482-2(a)(3)(i).

(iii) PERIOD FOR WHICH INTEREST SHALL BE CHARGED -- (A) GENERAL RULE. This paragraph (a)(1)(iii) is effective for indebtedness arising after June 30, 1988. See section 1.482-2(a)(3)(26 CFR Part 1 edition revised as of April 1, 1988) for indebtedness arising before July 1, 1988. Except as otherwise provided in paragraphs (a)(1)(iii)(B) through (E) of this section, the period for which interest shall be charged with respect to a bona fide indebtedness between controlled entities begins on the day after the day the indebtedness arises and ends on the day the indebtedness is satisfied (whether by payment, offset, cancellation, or otherwise). Paragraphs (a)(1)(iii)(B) through (E) of this section provide certain alternative periods during which interest is not required to be charged on certain indebtedness. These exceptions apply only to indebtedness described in paragraph (a)(1)(ii)(A)(2) of this section (relating to indebtedness incurred in the ordinary course of business from sales, services, etc., between members of the group) and not evidenced by a written instrument requiring the payment of interest. Such amounts are hereinafter referred to as intercompany trade receivables. The period for which interest is not required to be charged on intercompany trade receivables under this paragraph (a)(1)(iii) is called the interest-free period. In general, an intercompany trade receivable arises at the time economic performance occurs (within the meaning of section 461(h) and the regulations thereunder) with respect to the underlying transaction between controlled entities. For purposes of this paragraph (a)(1)(iii), the term United States includes any possession of the United States, and the term foreign country excludes any possession of the United States.

(B) EXCEPTION FOR CERTAIN INTERCOMPANY TRANSACTIONS IN THE ORDINARY COURSE OF BUSINESS. Interest is not required to be charged on an intercompany trade receivable until the first day of the third calendar month following the month in which the intercompany trade receivable arises.

(C) EXCEPTION FOR TRADE OR BUSINESS OF DEBTOR MEMBER LOCATED OUTSIDE THE UNITED STATES. In the case of an intercompany trade receivable arising from a transaction in the ordinary course of a trade or business which is actively conducted outside the United States by the debtor member, interest is not required to be charged until the first day of the fourth calendar month following the month in which such intercompany trade receivable arises.

(D) EXCEPTION FOR REGULAR TRADE PRACTICE OF CREDITOR MEMBER OR OTHERS IN CREDITOR'S INDUSTRY. If the creditor member or unrelated persons in the creditor member's industry, as a regular trade practice, allow unrelated parties a longer period without charging interest than that described in paragraph (a)(1)(iii)(B) or (C) of this section (whichever is applicable) with respect to transactions which are similar to transactions that give rise to intercompany trade receivables, such longer interest-free period shall be allowed with respect to a comparable amount of intercompany trade receivables.

(E) EXCEPTION FOR PROPERTY PURCHASED FOR RESALE IN A FOREIGN COUNTRY -- (1) GENERAL RULE. If in the ordinary course of business one member of the group (related purchaser) purchases property from another member of the group (related seller) for resale to unrelated persons located in a particular foreign country, the related purchaser and the related seller may use as the interest-free period for the intercompany trade receivables arising during the related seller's taxable year from the purchase of such property within the same product group an interest-free period equal the sum of --

(i) The number of days in the related purchaser's average collection period (as determined under paragraph (a)(1)(iii)(E)(2) of this section) for sales of property within the same product group sold in the ordinary course of business to unrelated persons located in the same foreign country; plus

(ii) Ten (10) calendar days.

(2) INTEREST-FREE PERIOD. The interest-free period under this paragraph (a)(1)(iii)(E), however, shall in no event exceed 183 days. The related purchaser does not have to conduct business outside the United States in order to be eligible to use the interest-free period of this paragraph (a)(1)(iii)(E). The interest-free period under this paragraph (a)(1)(iii)(E) shall not apply to intercompany trade receivables attributable to property which is manufactured, produced, or constructed (within the meaning of section 1.954-3(a)(4)) by the related purchaser. For purposes of this paragraph (a)(1)(iii)(E) a product group includes all products within the same three-digit Standard Industrial Classification (sic) Code (as prepared by the Statistical Policy Division of the Office of Management and Budget, Executive Office of the President.)

(3) AVERAGE COLLECTION PERIOD. An average collection period for purposes of this paragraph (a)(1)(iii)(E) is determined as follows --

(i) STEP 1. Determine total sales (less returns and allowances) by the related purchaser in the product group to unrelated persons located in the same foreign country during the related purchaser's last taxable year ending on or before the first day of the related seller's taxable year in which the intercompany trade receivable arises.

(ii) STEP 2. Determine the related purchaser's average month-end accounts receivable balance with respect to sales described in paragraph (a)(1)(iii)(E)(2)(i) of this section for the related purchaser's last taxable year ending on or before the first day of the related seller's taxable year in which the intercompany trade receivable arises.

(iii) STEP 3. Compute a receivables turnover rate by dividing the total sales amount described in paragraph (a)(1)(iii)(E)(2)(i) of this section by the average receivables balance described in paragraph (a)(1)(iii)(E)(2)(ii) of this section.

(iv) STEP 4. Divide the receivables turnover rate determined under paragraph (a)(1)(iii)(E)(2)(iii) of this section into 365, and round the result to the nearest whole number to determine the number of days in the average collection period.

(v) OTHER CONSIDERATIONS. If the related purchaser makes sales in more than one foreign country, or sells property in more than one product group in any foreign country, separate computations of an average collection period, by product group within each country, are required. If the related purchaser resells fungible property in more than one foreign country and the intercompany trade receivables arising from the related party purchase of such fungible property cannot reasonably be identified with resales in particular foreign countries, then solely for the purpose of assigning an interest-free period to such intercompany trade receivables under this paragraph (a)(1)(iii)(E), an amount of each such intercompany trade receivable shall be treated as allocable to a particular foreign country in the same proportion that the related purchaser's sales of such fungible property in such foreign country during the period described in paragraph (a)(1)(iii)(E)(2)(i) of this section bears to the related purchaser's sales of all such fungible property in all such foreign countries during such period. An interest-free period under this paragraph (a)(1)(iii)(E) shall not apply to any intercompany trade receivables arising in a taxable year of the related seller if the related purchaser made no sales described in paragraph (a)(1)(iii)(E)(2)(i) of this section from which the appropriate interest-free period may be determined.

(4) ILLUSTRATION. The interest-free period provided under paragraph (a)(1)(iii)(E) of this section may be illustrated by the following example:

EXAMPLE -- (i) FACTS. X and Y use the calendar year as the taxable year and are members of the same group of controlled entities within the meaning of section 482. For Y's 1988 calendar taxable year X and Y intend to use the interest-free period determined under this paragraph (a)(1)(iii)(E) for intercompany trade receivables attributable to X's purchases of certain products from Y for resale by X in the ordinary course of business to unrelated persons in country Z. For its 1987 calendar taxable year all of X's sales in country Z were of products within a single product group based upon a three-digit SIC code, were not manufactured, produced, or constructed (within the meaning of section 1.954-3(a)(4)) by X, and were sold in the ordinary course of X's trade or business to unrelated persons located only in country Z. These sales and the month-end accounts receivable balances (for such sales and for such sales uncollected from prior months) are as follows:

 Month               Sales                     Accounts Receivable

 Receivables    = $6,200,000   =  2.21

(iv) PAYMENT; BOOK ENTRIES -- (A) Except as otherwise provided in this paragraph (a)(1)(iv), in determining the period of time for which an amount owed by one member of the group to another member is outstanding, payments or other credits to an account are considered to be applied against the earliest amount outstanding, that is, payments or credits are applied against amounts in a first-in, first- out (FIFO) order. Thus, tracing payments to individual intercompany trade receivables is generally not required in order to determine whether a particular intercompany trade receivable has been paid within the applicable interest-free period determined under paragraph (a)(1)(iii) of this section. The application of this paragraph (a)(1)(iv)(A) may be illustrated by the following example:

EXAMPLE -- (i) FACTS. X and Y are members of a group of controlled entities within the meaning of section 482. Assume that the balance of intercompany trade receivables owed by X to Y on June 1 is $100, and that all of the $100 balance represents amounts incurred by X to Y during the month of May. During the month of June X incurs an additional $200 of intercompany trade receivables to Y. Assume that on July 15, $60 is properly credited against X's intercompany account to Y, and that $240 is properly credited against the intercompany account on August 31. Assume that under paragraph (a)(1)(iii)(B) of this section interest must be charged on X's intercompany trade receivables to Y beginning with the first day of the third calendar month following the month the intercompany trade receivables arise, and that no alternative interest-free period applies. Thus, the interest-free period for intercompany trade receivables incurred during the month of May ends on July 31, and the interest-free period for intercompany trade receivables incurred during the month of June ends on August 31.

(ii) APPLICATION OF PAYMENTS. Using a FIFO payment order, the aggregate payments of $300 are applied first to the opening June balance, and then to the additional amounts incurred during the month of June. With respect to X's June opening balance of $100, no interest is required to be accrued on $60 of such balance paid by X on July 15, because such portion was paid within its interest-free period. Interest for 31 days, from August 1 to August 31 inclusive, is required to be accrued on the $40 portion of the opening balance not paid until August 31. No interest is required to be accrued on the $200 of intercompany trade receivables X incurred to Y during June because the $240 credited on August 31, after eliminating the $40 of indebtedness remaining from periods before June, also eliminated the $200 incurred by X during June prior to the end of the interest-free period for that amount. The amount of interest incurred by X to Y on the $40 amount during August creates bona fide indebtedness between controlled entities and is subject to the provisions of paragraph (a)(1)(iii)(A) of this section without regard to any of the exceptions contained in paragraphs (a)(1)(iii)(B) through (E).

(B) Notwithstanding the first-in, first-out payment application rule described in paragraph (a)(1)(iv)(A) of this section, the taxpayer may apply payments or credits against amounts owed in some other order on its books in accordance with an agreement or understanding of the related parties if the taxpayer can demonstrate that either it or others in its industry, as a regular trade practice, enter into such agreements or understandings in the case of similar balances with unrelated parties.

(2) ARM'S LENGTH INTEREST RATE -- (i) IN GENERAL. For purposes of section 482 and paragraph (a) of this section, an arm's length rate of interest shall be a rate of interest which was charged, or would have been charged, at the time the indebtedness arose, in independent transactions with or between unrelated parties under similar circumstances. All relevant factors shall be considered, including the principal amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties.

(ii) FUNDS OBTAINED AT SITUS OF BORROWER. Notwithstanding the other provisions of paragraph (a)(2) of this section, if the loan or advance represents the proceeds of a loan obtained by the lender at the situs of the borrower, the arm's length rate for any taxable year shall be equal to the rate actually paid by the lender increased by an amount which reflects the costs or deductions incurred by the lender in borrowing such amounts and making such loans, unless the taxpayer establishes a more appropriate rate under the standards set forth in paragraph (a)(2)(i) of this section.

(iii) SAFE HAVEN INTEREST RATES FOR CERTAIN LOANS AND ADVANCES MADE AFTER MAY 28, 1986 -- (A) APPLICABILITY -- (1) GENERAL RULE. Except as otherwise provided in paragraph (a)(2) of this section, paragraph (a)(2)(iii)(B) applies with respect to the rate of interest charged and to the amount of interest paid or accrued in any taxable year --

(1) Under a term loan or advance between members of a group of controlled entities where (except as provided in paragraph (a)(2)(iii)(A)(2)(11) of this section) the loan or advance is entered into after May 8, 1986; and

(ii) After May 8, 1986 under a demand loan or advance between such controlled entities.

(2) GRANDFATHER RULE FOR EXISTING LOANS. The safe haven rates prescribed in paragraph (a)(2)(iii)(B) of this section shall not apply, and the safe haven rates prescribed in section 1.482-2(a)(2)(iii) (26 CFR part 1 edition revised as of April 1, 1985), shall apply to --

(i) Term loans or advances made before May 9, 1986; and

(ii) Term loans or advances made before August 7, 1986, pursuant to a binding written contract entered into before May 9, 1986.

(B) SAFE HAVEN INTEREST RATE BASED ON APPLICABLE FEDERAL RATE. Except as otherwise provided in this paragraph (a)(2), in the case of a loan or advance between members of a group of controlled entities, an arm's length rate of interest referred to in paragraph (a)(2)(i) of this section shall be for purposes of chapter 1 of the Internal Revenue Code --

(1) The rate of interest actually charged if that rate is -- (1) Not less than 100 percent of the applicable Federal rate (lower limit); and

(ii) Not greater than 130 percent of the applicable Federal rate (upper limit); or

(2) If either no interest is charged or if the rate of interest charged is less than the lower limit, then an arm's length rate of interest shall be equal to the lower limit, compounded semiannually; or

(3) If the rate of interest charged is greater than the upper limit, then an arm's length rate of interest shall be equal to the upper limit, compounded semiannually, unless the taxpayer establishes a more appropriate compound rate of interest under paragraph (a)(2)(i) of this section. However, if the compound rate of interest actually charged is greater than the upper limit and less than the rate determined under paragraph (a)(2)(i) of this section, or if the compound rate actually charged is less than the lower limit and greater than the rate determined under paragraph (a)(2)(i) of this section, then the compound rate actually charged shall be deemed to be an arm's length rate under paragraph (a)(2)(i). In the case of any sale-leaseback described in section 1274(e), the lower limit shall be 110 percent of the applicable Federal rate, compounded semiannually.

(C) Applicable Federal rate. For purposes of paragraph (a)(2)(iii)(B) of this section, the term applicable Federal rate means, in the case of a loan or advance to which this section applies and having a term of --

(1) Not over 3 years, the Federal short-term rate;

(2) Over 3 years but not over 9 years, the Federal mid-term rate; or

(3) Over 9 years, the Federal long-term rate, as determined under section 1274(d) in effect on the date such loan or advance is made. In the case of any sale or exchange between controlled entities, the lower limit shall be the lowest of the applicable Federal rates in effect for any month in the 3-calendar- month period ending with the first calendar month in which there is a binding written contract in effect for such sale or exchange (lowest 3-month rate, as defined in section 1274(d)(2)). In the case of a demand loan or advance to which this section applies, the applicable Federal rate means the Federal short-term rate determined under section 1274(d) (determined without regard to the lowest 3-month short term rate determined under section 1274(d)(2)) in effect for each day on which any amount of such loan or advance (including unpaid accrued interest determined under paragraph (a)(2) of this section) is outstanding.

(D) LENDER IN BUSINESS OF MAKING LOANS. If the lender in a loan or advance transaction to which paragraph (a)(2) of this section applies is regularly engaged in the trade or business of making loans or advances to unrelated parties, the safe haven rates prescribed in paragraph (a)(2)(iii)(B) of this section shall not apply, and the arm's length interest rate to be used shall be determined under the standards described in paragraph (a)(2)(i) of this section, including reference to the interest rates charged in such trade or business by the lender on loans or advances of a similar type made to unrelated parties at and about the time the loan or advance to which paragraph (a)(2) of this section applies was made.

(E) FOREIGN CURRENCY LOANS. The safe haven interest rates prescribed in paragraph (a)(2)(iii)(B) of this section do not apply to any loan or advance the principal or interest of which is expressed in a currency other than U.S. dollars.

(3) COORDINATION WITH INTEREST ADJUSTMENTS REQUIRED UNDER CERTAIN OTHER CODE SECTIONS. If the stated rate of interest on the stated principal amount of a loan or advance between controlled entities is subject to adjustment under section 482 and is also subject to adjustment under any other section of the Internal Revenue Code (for example, section 467, 483, 1274 or 7872), section 482 and paragraph (a) of this section may be applied to such loan or advance in addition to such other Internal Revenue Code section. After the enactment of the Tax Reform Act of 1964, Pub. L. 98-369, and the enactment of Pub. L. 99-121, such other Internal Revenue Code sections include sections 467, 483, 1274 and 7872. The order in which the different provisions shall be applied is as follows --

(i) First, the substance of the transaction shall be determined; for this purpose, all the relevant facts and circumstances shall be considered and any law or rule of law (assignment of income, step transaction, etc.) may apply. Only the rate of interest with respect to the stated principal amount of the bona fide indebtedness (within the meaning of paragraph (a)(1) of this section), if any, shall be subject to adjustment under section 482, paragraph (a) of this section, and any other Internal Revenue Code section.

(ii) Second, the other Internal Revenue Code section shall be applied to the loan or advance to determine whether any amount other than stated interest is to be treated as interest, and if so, to determine such amount according to the provisions of such other Internal Revenue Code section.

(iii) Third, whether or not the other Internal Revenue Code section applies to adjust the amounts treated as interest under such loan or advance, section 482 and paragraph (a) of this section may then be applied by the district director to determine whether the rate of interest charged on the loan or advance, as adjusted by any other Code section, is greater or less than an arm's length rate of interest, and if so, to make appropriate allocations to reflect an arm's length rate of interest.

(iv) Fourth, section 482 and paragraphs (b) through (e) of this section, if applicable, may be applied by the district director to make any appropriate allocations, other than an interest rate adjustment, to reflect an arm's length transaction based upon the principal amount of the loan or advance and the interest rate as adjusted under paragraph (a)(3)(i), (ii) or (iii) of this section. For example, assume that two commonly controlled taxpayers enter into a deferred payment sale of tangible property and no interest is provided, and assume also that section 483 is applied to treat a portion of the stated sales price as interest, thereby reducing the stated sales price. If after this recharacterization of a portion of the stated sales price as interest, the recomputed sales price does not reflect an arm's length sales price under the principles of paragraph (e) of this section, the district director may make other appropriate allocations (other than an interest rate adjustment) to reflect an arm's length sales price.

(4) EXAMPLES. The principles of paragraph (a)(3) of this section may be illustrated by the following examples:

EXAMPLE 1. An individual, A, transfers $20,000 to a corporation controlled by A in exchange for the corporation's note which bears adequate stated interest. The district director recharacterizes the transaction as a contribution to the capital of the corporation in exchange for preferred stock. Under paragraph (a)(3)(i) of this section, section 1.482-2(a) does not apply to the transaction because there is no bona fide indebtedness.

EXAMPLE 2. B, an individual, is an employee of Z corporation, and is also the controlling shareholder of Z. Z makes a term loan of $15,000 to B at a rate of interest that is less than the applicable Federal rate. In this instance the other operative Code section is section 7872. Under section 7872(b), the difference between the amount loaned and the present value of all payments due under the loan using a discount rate equal to 100 percent of the applicable Federal rate is treated as an amount of cash transferred from the corporation to B and the loan is treated as having original issue discount equal to such amount. Under paragraph (a)(3)(iii) of this section, section 482 and paragraph (a) of this section may also be applied by the district director to determine if the rate of interest charged on this $15,000 loan (100 percent of the AFR, compounded semiannually, as adjusted by section 7872) is an arm's length rate of interest. Because the rate of interest on the loan, as adjusted by section 7872, is within the safe haven range of 100-130 percent of the AFR, compounded semiannually, no further interest rate adjustments under section 482 and paragraph (a) of this section will be made to this loan.

EXAMPLE 3. The facts are the same as in Example 2 except that the amount lent by Z to B is $9,000, and that amount is the aggregate outstanding amount of loans between Z and B. Under the $10,000 de minimis exception of section 7872(c)(3), no adjustment for interest will be made to this $9,000 loan under section 7872. Under paragraph (a)(3)(iii) of this section, the district director may apply section 482 and paragraph (a) of this section to this $9,000 loan to determine whether the rate of interest charged is less than an arm's length rate of interest, and if so, to make appropriate allocations to reflect an arm's length rate of interest.

EXAMPLE 4. X and Y are commonly controlled taxpayers. At a time when the applicable Federal rate is 12 percent, compounded semiannually, X sells property to Y in exchange for a note with a stated rate of interest of 18 percent, compounded semiannually. Assume that the other applicable Code section to the transaction is section 483. Section 483 does not apply to this transaction because, under section 483(d), there is no total unstated interest under the contract using the test rate of interest equal to 100 percent of the applicable Federal rate. Under paragraph (a)(3)(iii) of this section, section 482 and paragraph (a) of this section may be applied by the district director to determine whether the rate of interest under the note is excessive, that is, to determine whether the 18 percent stated interest rate under the note exceeds an arm's length rate of interest.

EXAMPLE 5. Assume that A and B are commonly controlled taxpayers and that the applicable Federal rate is 10 percent, compounded semiannually. On June 30, 1986, A sells property to B and receives in exchange B's purchase-money note in the amount of $2,000,000. The stated interest rate on the note is 9%, compounded semiannually, and the stated redemption price at maturity on the note is $2,000,000. Assume that the other applicable Code section to this transaction is section 1274. As provided in section 1274A(a) and (b), the discount rate for purposes of section 1274 will be nine percent, compounded semiannually, because the stated principal amount of B's note does not exceed $2,800,000. Section 1274 does not apply to this transaction because there is adequate stated interest on the debt instrument using a discount rate equal to 9%, compounded semiannually, and the stated redemption price at maturity does not exceed the stated principal amount. Under paragraph (a)(3)(iii) of this section, the district director may apply section 482 and paragraph (a) of this section to this $2,000,000 note to determine whether the 9% rate of interest charged is less than an arm's length rate of interest, and if so, to make appropriate allocations to reflect an arm's length rate of interest.

(b) PERFORMANCE OF SERVICES FOR ANOTHER -- (1) GENERAL RULE. Where one member of a group of controlled entities performs marketing, managerial, administrative, technical, or other services for the benefit of, or on behalf of another member of the group without charge, or at a charge which is not equal to an arm's length charge as defined in paragraph (b)(3) of this section, the district director may make appropriate allocations to reflect an arm's length charge for such services.

(2) BENEFIT TEST -- (i) Allocations may be made to reflect arm's length charges with respect to services undertaken for the joint benefit of the members of a group of controlled entities, as well as with respect to services performed by one member of the group exclusively for the benefit of another member of the group. Any allocations made shall be consistent with the relative benefits intended from the services, based upon the facts known at the time the services were rendered, and shall be made even if the potential benefits anticipated are not realized. No allocations shall be made if the probable benefits to the other members were so indirect or remote that unrelated parties would not have charged for such services. In general, allocations may be made if the service, at the time it was performed, related to the carrying on of an activity by another member or was intended to benefit another member, either in the member's overall operations or in its day-to-day activities. The principles of this paragraph (b)(2)(i) may be illustrated by the following examples in each of which it is assumed that X and Y are corporate members of the same group of controlled entities:

EXAMPLE 1. X's International Division engages in a wide range of sales promotion activities. Although most of these activities are undertaken exclusively for the benefit of X's international operations, some are intended to jointly benefit both X and Y and others are undertaken exclusively for the benefit of Y. The district director may make an allocation to reflect an arm's length charge with respect to the activities undertaken for the joint benefit of X and Y consistent with the relative benefits intended as well as with respect to the services performed exclusively for the benefit of Y.

EXAMPLE 2. X operates an international airline, and Y owns and operates hotels in several cities which are serviced by X. X, in conjunction with its advertising of the airline, often pictures Y's hotels and mentions Y's name. Although such advertising was primarily intended to benefit X's airline operations, it was reasonable to anticipate that there would be substantial benefits to Y resulting from patronage by travelers who responded to X's advertising. Since an unrelated hotel operator would have been charged for such advertising, the district director may make an appropriate allocation to reflect an arm's length charge consistent with the relative benefits intended.

EXAMPLE 3. Assume the same facts as in EXAMPLE 2 except that X's advertising neither mentions nor pictures Y's hotels. Although it is reasonable to anticipate that increased air travel attributable to X's advertising will result in some benefit to Y due to increased patronage by air travelers, the district director will not make an allocation with respect to such advertising since the probable benefit to Y was so indirect and remote that an unrelated hotel operator would not have been charged for such advertising.

(ii) Allocations will generally not be made if the service is merely a duplication of a service which the related party has independently performed or is performing for itself. In this connection, the ability to independently perform the service (in terms of qualification and availability of personnel) shall be taken into account. The principles of this paragraph (b)(2)(ii) may be illustrated by the following examples, in each of which it is assumed that X and Y are corporate members of the same group of controlled entities:

EXAMPLE 1. At the request of Y, the financial staff of X makes an analysis to determine the amount and source of the borrowing needs of Y. Y does not have personnel qualified to make the analysis, and it does not undertake the same analysis. The district director may make an appropriate allocation to reflect an arm's length charge for such analysis.

EXAMPLE 2. Y, which has a qualified financial staff, makes an analysis to determine the amount and source of its borrowing needs. Its report, recommending a loan from a bank, is submitted to X. X's financial staff reviews the analysis to determine whether X should advise Y to reconsider its plan. No allocation should be made with respect to X's review.

(3) ARM'S LENGTH CHARGE. For the purpose of this paragraph an arm's length charge for services rendered shall be the amount which was charged or would have been charged for the same or similar services in independent transactions with or between unrelated parties under similar circumstances considering all relevant facts. However, except in the case of services which are an integral part of the business activity of either the member rendering the services or the member receiving the benefit of the services (as described in paragraph (b)(7) of this section) the arm's length charge shall be deemed equal to the costs or deductions incurred with respect to such services by the member or members rendering such services unless the taxpayer establishes a more appropriate charge under the standards set forth in the first sentence of this subparagraph. Where costs or deductions are a factor in applying the provisions of this paragraph adequate books and records must be maintained by taxpayers to permit verification of such costs or deductions by the Internal Revenue Service.

(4) COSTS OR DEDUCTIONS TO BE TAKEN INTO ACCOUNT -- (i) Where the amount of an arm's length charge for services is determined with reference to the costs or deductions incurred with respect to such services, it is necessary to take into account on some reasonable or basis all the costs or deductions which are directly or indirectly related to the service performed.

(ii) Direct costs or deductions are those identified specifically with a particular service. These include, but are not limited to, costs or deductions for compensation, bonuses, and travel expenses attributable to employees directly engaged in performing such services, for material and supplies directly consumed in rendering such services, and for other costs such as the cost of overseas cables in connection with such services.

(iii) Indirect costs or deductions are those which are not specifically identified with a particular activity or service but which relate to the direct costs referred to in paragraph (b)(4)(ii) of this section. Indirect costs or deductions generally include costs or deductions with respect to utilities, occupancy, supervisory and clerical compensation, and other overhead burden of the department incurring the direct costs or deductions referred to in paragraph (b)(4)(ii) of this section. Indirect costs or deductions also generally include an appropriate share of the costs or deductions relating to supporting departments and other applicable general and administrative expenses to the extent reasonably allocable to a particular service or activity. Thus, for example, if a domestic corporation's advertising department performs services for the direct benefit of a foreign subsidiary, in addition to direct costs of such department, such as salaries of employees and fees paid to advertising agencies or consultants, which are attributable to such foreign advertising, indirect costs must be taken into account on some reasonable basis in determining the amount of costs or deductions with respect to which the arm's length charge to the foreign subsidiary is to be determined. These generally include depreciation, rent, property taxes, other costs of occupancy, and other overhead costs of the advertising department itself, and allocations of costs from other departments which service the advertising department, such as the personnel, accounting, payroll, and maintenance departments, and other applicable general and administrative expenses including compensation of top management.

(5) COSTS AND DEDUCTIONS NOT TO BE TAKEN INTO ACCOUNT. Costs or deductions of the member rendering the services which are not to be taken into account in determining the amount of an arm's length charge for services include --

(i) Interest expense on indebtedness not incurred specifically for the benefit of another member of the group;

(ii) Expenses associated with the issuance of stock and maintenance of shareholder relations; and

(iii) Expenses of compliance with regulations or policies imposed upon the member rendering the services by its government which are not directly related to the service in question.

(6) METHODS -- (i) Where an arm's length charge for services rendered is determined with reference to costs or deductions, and a member has allocated and apportioned costs or deductions to reflect arm's length charges by employing in a consistent manner a method of allocation and apportionment which is reasonable and in keeping with sound accounting practice, such method will not be disturbed. If the member has not employed a method of allocation and apportionment which is reasonable and in keeping with sound accounting practice, the method of allocating and apportioning costs or deductions for the purpose of determining the amount of arm's length charges shall be based on the particular circumstances involved.

(ii) The methods of allocation and apportionment referred to in this paragraph (b)(6) are applicable both in allocating and apportioning indirect costs to a particular activity or service (see paragraph (b)(4)(iii) of this section) and in allocating and apportioning the total costs (direct and indirect) of a particular activity or service where such activity or service is undertaken for the joint benefit of two or more members of a group (see paragraph (b)(2)(i) of this section). While the use of one or more bases may be appropriate under the circumstances, in establishing the method of allocation and apportionment, appropriate consideration should be given to all bases and factors, including, for example, total expenses, asset size, sales, manufacturing expenses, payroll, space utilized, and time spent. The costs incurred by supporting departments may be apportioned to other departments on the basis of reasonable overall estimates, or such costs may be reflected in the other departments' costs by means of application of reasonable departmental overhead rates Allocations and apportionments of costs or deductions must be made on the basis of the full cost as opposed to the incremental cost. Thus, if an electronic data processing machine, which is rented by the taxpayer, is used for the joint benefit of itself and other members of a controlled group, the determination of the arm's length charge to each member must be made with reference to the full rent and cost of operating the machine by each member, even if the additional use of the machine for the benefit of the other members did not increase the cost to the taxpayer.

(iii) Practices actually employed to apportion costs or expenses in connection with the preparation of statements and analyses for the use of management, creditors, minority shareholders, joint venturers, clients, customers, potential investors, or other parties or agencies in interest shall be considered by the district director. Similarly, in determining the extent to which allocations are to be made to or from foreign members of a controlled group, practices employed by the domestic members of a controlled group in apportioning costs between themselves shall also be considered if the relationships with the foreign members of the group are comparable to the relationships between the domestic members of the group. For example, if, for purposes of reporting to public stockholders or to a governmental agency, a corporation apportions the costs attributable to its executive officers among the domestic members of a controlled group on a reasonable and consistent basis, and such officers exercise comparable control over foreign members of such group, such domestic apportionment practice will be taken into consideration in determining the amount of allocations to be made to the foreign members.

(7) CERTAIN SERVICES. An arm's length charge shall not be deemed equal to costs or deductions with respect to services which are an integral part of the business activity of either the member rendering the services (referred to in this paragraph (b) as the renderer) or the member receiving the benefit of the services (referred to in this paragraph (b) as the recipient). Paragraphs (b)(7)(i) through (b)(7)(iv) of this section describe those situations in which services shall be considered an integral part of the business activity of a member of a group of controlled entities.

(i) Services are an integral part of the business activity of a member of a controlled group where either the renderer or the recipient is engaged in the trade or business of rendering similar services to one or more unrelated parties.

(ii)(A) Services are an integral part of the business activity of a member of a controlled group where the renderer renders services to one or more related parties as one of its principal activities. Except in the case of services which constitute a manufacturing, production, extraction, or construction activity, it will be presumed that the renderer does not render services to related parties as one of its principal activities if the cost of services of the renderer attributable to the rendition of services for the taxable year to related parties do not exceed 25 percent of the total costs or deductions of the renderer for the taxable year. Where the cost of services rendered to related parties is in excess of 25 percent of the total costs or deductions of the renderer for the taxable year or where the 25-percent test does not apply, the determination of whether the rendition of such services is one of the principal activities of the renderer will be based on the facts and circumstances of each particular case. Such facts and circumstances may include the time devoted to the rendition of the services, the relative cost of the services, the regularity with which the services are rendered, the amount of capital investment, the risk of loss involved, and whether the services are in the nature of supporting services or independent of the other activities of the renderer.

(B) For purposes of the 25-percent test provided in this paragraph (b)(7)(ii), the cost of services rendered to related parties shall include all costs or deductions directly or indirectly related to the rendition of such services including the cost of services which constitute a manufacturing, production, extraction, or construction activity; and the total costs or deductions of the renderer for the taxable year shall exclude amounts properly reflected in the cost of goods sold of the renderer. Where any of the costs or deductions of the renderer do not reflect arm's length consideration and no adjustment is made under any provision of the Internal Revenue Code to reflect arm's length consideration, the 25-percent test will not apply if, had an arm's length charge been made, the costs or deductions attributable to the renderer's rendition of services to related entities would exceed 25 percent of the total costs or deductions of the renderer for the taxable year.

(C) For purposes of the 25-percent test in this paragraph (b)(7)(ii), a consolidated group (as defined in this paragraph (b)(7)(ii)(C)) may, at the option of the taxpayer, be considered as the renderer where one or more members of the consolidated group render services for the benefit of or on behalf of a related party which is not a member of the consolidated group. In such case, the cost of services rendered by members of the consolidated group to any related parties not members of the consolidated group, as well as the total costs or deductions of the members of the consolidated group, shall be considered in the aggregate to determine if such services constitute a principal activity of the renderer. Where a consolidated group is considered the renderer in accordance with this paragraph (b)(7)(ii)(C), the costs or deductions referred to in this paragraph (b)(7)(ii) shall not include costs or deductions paid or accrued to any member of the consolidated group. In addition to the preceding provisions of this paragraph (b)(7)(ii)(C), if part or all of the services rendered by a member of a consolidated group to any related party not a member of the consolidated group are similar to services rendered by any other member of the consolidated group to unrelated parties as part of a trade or business, the 25-percent test in this paragraph (b)(7)(ii) shall be applied with respect to such similar services without regard to this subdivision (c). For purposes of this paragraph (b)(7)(ii)(C), the term consolidated group means all members of a group of controlled entities created or organized within a single country and subjected to an income tax by such country on the basis of their combined income.

(iii) Services are an integral part of the business activity of a member of a controlled group where the renderer is peculiarly capable of rendering the services and such services are a principal element in the operations of the recipient. The renderer is peculiarly capable of rendering the services where the renderer, in connection with the rendition of such services, makes use of a particularly advantageous situation or circumstance such as by utilization of special skills and reputation, utilization of an influential relationship with customers, or utilization of its intangible property (as defined in section 1.482-4(b)). However, the renderer will not be considered peculiarly capable of rendering services unless the value of the services is substantially in excess of the costs or deductions of the renderer attributable to such services.

(iv) Services are an integral part of the business activity of a member of a controlled group where the recipient has received the benefit of a substantial amount of services from one or more related parties during its taxable year. For purposes of this subdivision, services rendered by one or more related parties shall be considered substantial in amount if the total costs or deductions of the related party or parties rendering services to the recipient during its taxable year which are directly or indirectly related to such services exceed an amount equal to 25 percent of the total costs or deductions of the recipient during its taxable year. For purposes of the preceding sentence, the total costs or deductions of the recipient shall include the renderers' costs or deductions directly or indirectly related to the rendition of such services and shall exclude any amounts paid or accrued to the renderers by the recipient for such services and shall also exclude any amounts paid or accrued for materials the cost of which is properly reflected in the cost of goods sold of the recipient. At the option of the taxpayer, where the taxpayer establishes that the amount of the total costs or deductions of a recipient for the recipient's taxable year are abnormally low due to the commencement or cessation of an operation by the recipient, or other unusual circumstances of a nonrecurring nature, the costs or deductions referred to in the preceding two sentences shall be the total of such amount for the 3-year period immediately preceding the close of the taxable year of the recipient (or for the first 3 years of operation of the recipient if the recipient had been in operation for less than 3 years as of the close of the taxable year in which the services in issue were rendered).

(v) The principles of paragraphs (b)(7)(i) through (iv) of this section may be illustrated by the following examples:

EXAMPLE 1. Y is engaged in the business of selling merchandise and X, an entity related to Y, is a printing company regularly engaged in printing and mailing advertising literature for unrelated parties. X also prints circulars advertising Y's products, mails the circulars to potential customers of Y, and in addition, performs the art work involved in the preparation of the circulars. Since the printing, mailing, and art work services rendered by X to Y are similar to the printing and mailing services rendered by X as X's trade or business, the services rendered to Y are an integral part of the business activity of X as described in subdivision (i) of this subparagraph.

EXAMPLE 2. V, W, X, and Y are members of the same group of controlled entities. Each member of the group files a separate income tax return. X renders wrecking services to V, W, and Y, and, in addition, sells building materials to unrelated parties. The total costs or deductions incurred by X for the taxable year (exclusive of amounts properly reflected in the cost of goods sold of X) are $4 million. The total costs or deductions of X for the taxable year which are directly or indirectly related to the services rendered to V, W, and Y are $650,000. Since $650,000 is less than 25 percent of the total costs or deductions of X (exclusive of amounts properly reflected in the cost of goods sold of X) for the taxable year ($4,000,000 * 25% = $1,000,000), the services rendered by X to V, W, and Y will not be considered one of X's principal activities within the meaning of subdivision (ii) of this subparagraph.

EXAMPLE 3. Assume the same facts as in EXAMPLE 2, except that the total costs or deductions of X for the taxable year which are directly or indirectly related to the services rendered to V, W, and Y are $1,800,000. Assume in addition, that there is a high risk of loss involved in the rendition of the wrecking services by X, that X has a large investment in the wrecking equipment, and that a substantial amount of X's time is devoted to the rendition of wrecking services to V, W, and Y. Since $1,800,000 is greater than 25 percent of the total costs or deductions of X for the taxable year (exclusive of amounts properly reflected in the cost of goods sold of X), i.e., $1 million, the services rendered by X to V, W, and Y will not be automatically excluded from classification as one of the principal activities of X as in EXAMPLE 2, and consideration must be given to the facts and circumstances of the particular case. Based on the facts and circumstances in this case, X would be considered to render wrecking services to related parties as one of its principal activities. Thus, the wrecking services are an integral part of the business activity of X as described in paragraph (b)(7)(ii) of this section.

EXAMPLE 4. Z is a domestic corporation and has several foreign subsidiaries. Z and X, a domestic subsidiary of Z, have exercised the privilege granted under section 1501 to file a consolidated return and, therefore, constitute a CONSOLIDATED GROUP within the meaning of paragraph (b)(7)(ii)(C) of this section. Pursuant to paragraph (b)(7)(ii)(C) of this section, the taxpayer treats X and Z as the renderer. The sole function of X is to provide accounting, billing, communication, and travel services to the foreign subsidiaries of Z. Z also provides some other services for the benefit of its foreign subsidiaries. The total costs or deductions of X and Z related to the services rendered for the benefit of the foreign subsidiaries is $750,000. Of that amount, $710,000 represents the costs of X, which are X's total operating costs. The total costs or deductions of X and Z for the taxable year with respect to their operations (exclusive of amounts properly reflected in the cost of goods sold of X and Z) is $6,500,000. Since the total costs or deductions related to the services rendered to the foreign subsidiaries ($750,000) is less than 25 percent of the total costs or deductions of X and Z (exclusive of amounts properly reflected in the costs of goods sold of X or Z) in the aggregate ($6,500,000 * 25% = $1,625,000), the services rendered by X and Z to the foreign subsidiaries will not be considered one of the principal activities of X and Z within the meaning of paragraph (b)7)(ii) of this section.

EXAMPLE 5. Assume the same facts as in Example 4, except that all the communication services rendered for the benefit of the foreign subsidiaries are rendered by X and that Z renders communication services to unrelated parties as part of its trade or business. X is regularly engaged in rendering communication services to foreign subsidiaries and devotes a substantial amount of its time to this activity. The costs or deductions of X related to the rendition of the communication services to the foreign subsidiaries are $355,000. By application of the paragraph (b)(7)(ii)(C) of this section, the services provided by X and Z to related entities other than the communication services will not be considered one of the principal activities of X and Z. However, since Z renders communication services to unrelated parties as a part of its trade or business, the communication services rendered by X to the foreign subsidiaries will be subject to the provisions of paragraph (b)(7)(ii) of this section without regard to paragraph (b)(7)(ii)(C) of this section. Since the costs or deductions of X related to the rendition of the communication services ($355,000) are in excess of 25 percent of the total costs or deductions of X (exclusive of amounts properly reflected in the cost of goods sold of X) for the taxable year ($710,000 * 25% = $177,500), the determination of whether X renders the communication services as one of its principal activities will depend on the particular facts and circumstances. The given facts and circumstances indicate that X renders the communication services as one of its principal activities.

EXAMPLE 6. X and Y are members of the same group of controlled entities. Y produces and sells product D. As a part of the production process, Y sends materials to X who converts the materials into component parts. This conversion activity constitutes only a portion of X's operations. X then ships the component parts back to Y who assembles them (along with other components) into the finished product for sale to unrelated parties. Since the services rendered by X to Y constitute a manufacturing activity, the 25-percent test in paragraph (b)(7)(ii) of this section does not apply.

EXAMPLE 7. X and Y are members of the same group of controlled entities. X manufactures product D for distribution and sale in the United States, Canada, and Mexico. Y manufactures product D for distribution and sale in South and Central America. Due to a breakdown of machinery, Y is forced to cease its manufacturing operations for a 1-month period. In order to meet demand for product D during the shutdown period, Y sends partially finished goods to X. X, for that period, completes the manufacture of product D for Y and ships the finished product back to Y. The costs or deductions of X related to the manufacturing services rendered to Y are $750,000. The total costs or deductions of X are $24,000,000. Since the services in issue constitute a manufacturing activity, the 25-percent test in paragraph (b)(7)(ii) of this section does not apply. However, under these facts and circumstances, i.e., the insubstantiality of the services rendered to Y in relation to X's total operations, the lack of regularity with which the services are rendered, and the short duration for which the services are rendered, X's rendition of manufacturing services to Y is not considered one of X's principal activities within the meaning of paragraph (b)(7)(ii) of this section.

EXAMPLE 8. Assume the same facts as in EXAMPLE 7, except that, instead of temporarily ceasing operations, Y requests assistance from X in correcting the defects in the manufacturing equipment. In response, X sends a team of engineers to discover and correct the defects without the necessity of a shutdown. Although the services performed by the engineers were related to a manufacturing activity, the services are essentially supporting in nature and, therefore, do not constitute a manufacturing, production, extraction, or construction activity. Thus, the 25-percent test in paragraph (b)(7)(ii) of this section applies.

EXAMPLE 9. X is a domestic manufacturing corporation. Y, a foreign subsidiary of X, has decided to construct a plant in Country A. In connection with the construction of Y's plant, X draws up the architectural plans for the plant, arranges the financing of the construction, negotiates with various Government authorities in Country A, invites bids from unrelated parties for several phases of construction, and negotiates, on Y's behalf, the contracts with unrelated parties who are retained to carry out certain phases of the construction. Although the unrelated parties retained by X for Y perform the physical construction, the aggregate services performed by X for Y are such that they, in themselves, constitute a construction activity. Thus, the 25-percent test in paragraph (b)(7)(ii) of this section does not apply with respect to such services.

EXAMPLE 10. X and Y are members of the same group of controlled entities. X is a finance company engaged in financing automobile loans. In connection with such loans it requires the borrower to have life insurance in the amount of the loan. Although X's borrowers are not required to take out life insurance from any particular insurance company, at the same time that the loan agreement is being finalized, X's employees suggest that the borrower take out life insurance from Y, which is an agency for life insurance companies. Since there would be a delay in the processing of the loan if some other company were selected by the borrower, almost all of X's borrowers take out life insurance through Y. Because of this utilization of its influential relationship with its borrowers, X is peculiarly capable of rendering selling services to Y and, since a substantial amount of Y's business is derived from X's borrowers, such selling services are a principal element in the operation of Y's insurance business. In addition, the value of the services is substantially in excess of the costs incurred by X. Thus, the selling services rendered by X to Y are an integral part of the business activity of a member of the controlled group as described in paragraph (b)(7)(iii) of this section.

EXAMPLE 11. X and Y are members of the same group of controlled entities. Y is a manufacturer of product E. In past years product E has not always operated properly because of imperfections present in the finished product. X owns an exclusive patented process by which such imperfections can be detected and removed prior to sale of the product, thereby greatly increasing the marketability of the product. In connection with its manufacturing operations Y sends its products to X for inspection which involves utilization of the patented process. The inspection of Y's products by X is not one of the principal activities of X. However, X is peculiarly capable of rendering the inspection services to Y because of its utilization of the patented process. Since this inspection greatly increases the marketability of product E it is extremely valuable. Such value is substantially in excess of the cost incurred by X in rendition of such services. Because of the impact of the inspection on sales, such services are a principal element in the operations of Y. Thus, the inspection services rendered by X to Y are an integral part of the business activity of a member of the controlled group as described in paragraph (b)(7)(iii) of this section.

EXAMPLE 12. Assume the same facts as in EXAMPLE 11 except that Y owns the patented process for detecting the imperfections. Y, however, does not have the facilities to implement the inspection process. Therefore, Y sends its products to X for inspection which involves utilization of the patented process owned by Y. Since Y owns the patent, X is not peculiarly capable of rendering the inspection services to Y within the meaning of paragraph (b)(7)(iii) of this section.

EXAMPLE 13. Assume the same facts as in EXAMPLE 12 except that X and Y both own interests in the patented process as a result of having developed the process pursuant to a bona fide cost sharing plan (within the meaning of paragraph (d)(4) of this section). Since Y owns the requisite interest in the patent, X is not peculiarly capable of rendering the inspection services to Y within the meaning of paragraph (b)(7)(iii) of this section.

EXAMPLE 14. X and Y are members of the same group of controlled entities. X is a large manufacturing concern. X's accounting department has, for many years, maintained the financial records of Y, a distributor of X's products. Although X is able to render these accounting services more efficiently than others due to its thorough familiarity with the operations of Y, X is not peculiarly capable of rendering the accounting services to Y because such familiarity does not, in and of itself, constitute a particularly advantageous situation or circumstance within the meaning of paragraph (b)(7)(iii) of this section. Furthermore, under these circumstances, the accounting services are supporting in nature and, therefore, do not constitute a principal element in the operations of Y. Thus, the accounting services rendered by X to Y are not an integral part of the business activity of either X or Y within the meaning of paragraph (b)(7)(iii) of this section.

EXAMPLE 15. (i) Corporations X, Y, and Z are members of the same group of controlled entities. X is a manufacturer, and Y and Z are distributors of X's products. X provides a variety of services to Y including billing, shipping, accounting, and other general and administrative services. During Y's taxable year, on several occasions, Z renders selling and other promotional services to Y. None of the services rendered to Y constitute one of the principal activities of any of the renderers within the meaning of paragraph (b)(7)(ii) of this section. Y's total costs and deductions for Y's taxable year (exclusive of amounts paid to X and Z for services rendered and amounts paid for goods purchased for resale) are $1,600,000. The total direct and indirect costs of X and Z for services rendered to Y during Y's taxable year are as follows:

     Services provided by X:

EXAMPLE 16. Assume the same facts as in EXAMPLE 15, except that the taxpayer establishes that, due to a major change in the operations of Y, Y's total costs or deductions for Y's taxable year were abnormally low. Y has always used the calendar year as its taxable year. Y's total costs and deductions for the 2 years immediately preceding the taxable year in issue (exclusive of amounts paid to X and Z for services rendered and amounts paid for goods purchased for resale) were $6 million and $6,200,000 respectively. The total direct and indirect costs of X and Z for services rendered to Y were $1,150,000 for each of the 3 years. Applying the same formula to the costs or deductions for the 3 years immediately preceding the close of the taxable year in issue, the costs or deductions of X and Z related to the rendition of services to Y (3 * $1,150,000 = $3,450,000) amount to 20 percent of the sum of the total costs or deductions of Y (exclusive of amounts paid to X and Z for the services rendered and amounts paid for goods purchased for resale) plus the total costs or deductions of X and Z related to the rendition of services to Y ($3,450,000 + [$1,600,000 + $6,000,000 + $6,200,000 + $3,450,000] = 20%). If the taxpayer chooses to use the 3-year period, the services rendered by X and Z to Y are not substantial within the meaning of paragraph (b)(7)(iv) of this section. Thus, the services will not be an integral part of the business activity of a member of the controlled group as described in paragraph (b)(7)(iv) of this section.

(8) SERVICES RENDERED IN CONNECTION WITH THE TRANSFER OF PROPERTY. Where tangible or intangible property is transferred, sold, assigned, loaned, leased, or otherwise made available in any manner by one member of a group to another member of the group and services are rendered by the transferor to the transferee in connection with the transfer, the amount of any allocation that may be appropriate with respect to such transfer shall be determined in accordance with the rules of paragraph (c) of this section, or sections 1.482-3 or 1.482-4, whichever is appropriate and a separate allocation with respect to such services under this paragraph shall not be made. Services are rendered in connection with the transfer of property where such services are merely ancillary and subsidiary to the transfer of the property or to the commencement of effective use of the property by the transferee. Whether or not services are merely ancillary and subsidiary to a property transfer is a question of fact. Ancillary and subsidiary services could be performed, for example, in promoting the transaction by demonstrating and explaining the use of the property, or by assisting in the effective starting-up of the property transferred, or by performing under a guarantee relating to such effective starting-up. Thus, where an employee of one member of a group, acting under the instructions of his employer, reveals a valuable secret process owned by his employer to a related entity, and at the same time supervises the integration of such process into the manufacturing operation of the related entity, such services could be considered to be rendered in connection with the transfer, and, if so considered, shall not be the basis for a separate allocation. However, if the employee continues to render services to the related entity by supervising the manufacturing operation after the secret process has been effectively integrated into such operation, a separate allocation with respect to such additional services may be made in accordance with the rules of this paragraph.

(c) USE OF TANGIBLE PROPERTY -- (1) GENERAL RULE. Where possession, use, or occupancy of tangible property owned or leased by one member of a group of controlled entities (referred to in this paragraph as the owner) is transferred by lease or other arrangement to another member of such group (referred to in this paragraph as the user) without charge or at a charge which is not equal to an arm's length rental charge (as defined in paragraph (c)(2)(i) of this section) the district director may make appropriate allocations to properly reflect such arm's length charge. Where possession, use, or occupancy of only a portion of such property is transferred, the determination of the arm's length charge and the allocation shall be made with reference to the portion transferred.

(2) ARM'S LENGTH CHARGE -- (i) IN GENERAL. For purposes of paragraph (c) of this section, an arm's length rental charge shall be the amount of rent which was charged, or would have been charged for the use of the same or similar property, during the time it was in use, in independent transactions with or between unrelated parties under similar circumstances considering the period and location of the use, the owner's investment in the property or rent paid for the property, expenses of maintaining the property, the type of property involved, its condition, and all other relevant facts.

(ii) SAFE HAVEN RENTAL CHARGE. See section 1.482-2(c)(2)(ii) (26 CFR Part 1 revised as of April 1, 1985), for the determination of safe haven rental charges in the case of certain leases entered into before May 9, 1986, and for leases entered into before August 7, 1986, pursuant to a binding written contract entered into before May 9, 1986.

(iii) SUBLEASES -- (A) Except as provided in paragraph (c)(2)(iii)(B) of this section, where possession, use, or occupancy of tangible property, which is leased by the owner (lessee) from an unrelated party is transferred by sublease or other arrangement to the user, an arm's length rental charge shall be considered to be equal to all the deductions claimed by the owner (lessee) which are attributable to the property for the period such property is used by the user. Where only a portion of such property was transferred, any allocations shall be made with reference to the portion transferred. The deductions to be considered include the rent paid or accrued by the owner (lessee) during the period of use and all other deductions directly and indirectly connected with the property paid or accrued by the owner (lessee) during such period. Such deductions include deductions for maintenance and repair, utilities, management and other similar deductions.

(B) The provisions of paragraph (c)(2)(iii)(A) of this section shall not apply if either --

(1) The taxpayer establishes a more appropriate rental charge under the general rule set forth in paragraph (c)(2)(i) of this section; or

(2) During the taxable year, the owner (lessee) or the user was regularly engaged in the trade or business of renting property of the sane general type as the property in question to unrelated persons.

(d) TRANSFER OF PROPERTY. For rules governing allocations under section 482 to reflect an arm's length consideration for controlled transactions involving the transfer of property, see sections 1.482-3 through 1.482-6.

SECTION 1.482-3 METHODS TO DETERMINE TAXABLE INCOME IN CONNECTION WITH A TRANSFER OF TANGIBLE PROPERTY.

(a) IN GENERAL. The arm's length amount charged in a controlled transfer of tangible property must be determined under one of the six methods listed in this paragraph (a). Each of the methods must be applied in accordance with all of the provisions of section 1.482-1, including the best method rule of section 1.482-1(c), the comparability analysis of section 1.482-1(d), and the arm's length range of section 1.482-1(e). The methods are --

(1) The comparable uncontrolled price method, described in paragraph (b) of this section;

(2) The resale price method, described in paragraph (c) of this section;

(3) The cost plus method, described in paragraph (d) of this section;

(4) The comparable profits method, described in section 1.482-5;

(5) The profit split method, described in section 1.482-6; and

(6) unspecified methods, described in paragraph (e) of this section.

(b) COMPARABLE UNCONTROLLED PRICE METHOD -- (1) IN GENERAL. The comparable uncontrolled price method evaluates whether the amount charged in a controlled transaction is arm's length by reference to the amount charged in a comparable uncontrolled transaction.

(2) COMPARABILITY AND RELIABILITY CONSIDERATIONS -- (i) IN GENERAL. Whether results derived from applications of this method are the most reliable measure of the arm's length result must be determined using the factors described under the best method rule in section 1.482-1(c). The application of these factors under the comparable uncontrolled price method is discussed in paragraph (b)(2)(ii) and (iii) of this section.

(ii) COMPARABILITY -- (A) IN GENERAL. The degree of comparability between controlled and uncontrolled transactions is determined by applying the provisions of section 1.482-1(d). Although all of the factors described in section 1.482-1(d)(3) must be considered, similarity of products generally will have the greatest effect on comparability under this method. In addition, because even minor differences in contractual terms or economic conditions could materially affect the amount charged in an uncontrolled transaction, comparability under this method depends on close similarity with respect to these factors, or adjustments to account for any differences. The results derived from applying the comparable uncontrolled price method generally will be the most direct and reliable measure of an arm's length price for the controlled transaction if an uncontrolled transaction has no differences with the controlled transaction that would affect the price, or if there are only minor differences that have a definite and reasonably ascertainable effect on price and for which appropriate adjustments are made. If such adjustments cannot be made, or if there are more than minor differences between the controlled and uncontrolled transactions, the comparable uncontrolled price method may be used, but the reliability of the results as a measure of the arm's length price will be reduced. Further, if there are material product differences for which reliable adjustments cannot be made, this method ordinarily will not provide a reliable measure of an arm's length result.

(B) ADJUSTMENTS FOR DIFFERENCES BETWEEN CONTROLLED AND UNCONTROLLED TRANSACTIONS. If there are differences between the controlled and uncontrolled transactions that would affect price, adjustments should be made to the price of the uncontrolled transaction according to the comparability provisions of section 1.482-1(d)(2). Specific examples of the factors that may be particularly relevant to this method include --

(1) Quality of the product;

(2) Contractual terms, (e.g., scope and terms of warranties provided, sales or purchase volume, credit terms, transport terms);

(3) Level of the market (i.e., wholesale, retail, etc.);

(4) Geographic market in which the transaction takes place;

(5) Date of the transaction;

(6) Intangible property associated with the sale;

(7) Foreign currency risks; and

(8) Alternatives realistically available to the buyer and seller.

(iii) DATA AND ASSUMPTIONS. The reliability of the results derived from the comparable uncontrolled price method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply the method. See section 1.482-1(c) (Best method rule).

(3) ARM'S LENGTH RANGE. See section 1.482-1(e)(2) for the determination of an arm's length range.

(4) EXAMPLES. The principles of this paragraph (b) are illustrated by the following examples.

EXAMPLE 1 -- COMPARABLE SALES OF SAME PRODUCT. USM, a U.S. manufacturer, sells the same product to both controlled and uncontrolled distributors. The circumstances surrounding the controlled and uncontrolled transactions are substantially the same, except that the controlled sales price is a delivered price and the uncontrolled sales are made f.o.b. USM's factory. Differences in the contractual terms of transportation and insurance generally have a definite and reasonably ascertainable effect on price, and adjustments are made to the results of the uncontrolled transaction to account for such differences. No other material difference has been identified between the controlled and uncontrolled transactions. Because USM sells in both the controlled and uncontrolled transactions, it is likely that all material differences between the two transactions have been identified. In addition, because the comparable uncontrolled price method is applied to an uncontrolled comparable with no product differences, and there are only minor contractual differences that have a definite and reasonably ascertainable effect on price, the results of this application of the comparable uncontrolled price method will provide the most direct and reliable measure of an arm's length result. See section 1.482-3(b)(2)(ii)(A).

EXAMPLE 2 -- EFFECT OF TRADEMARK. The facts are the same as in Example 1, except that USM affixes its valuable trademark to the property sold in the controlled transactions, but does not affix its trademark to the property sold in the uncontrolled transactions. Under the facts of this case, the effect on price of the trademark is material and cannot be reliably estimated. Because there are material product differences for which reliable adjustments cannot be made, the comparable uncontrolled price method is unlikely to provide a reliable measure of the arm's length result. See section 1.482-3(b)(2)(ii)(A).

EXAMPLE 3 -- MINOR PRODUCT DIFFERENCES. The facts are the same as in Example 1, except that USM, which manufactures business machines, makes minor modifications to the physical properties of the machines to satisfy specific requirements of a customer in controlled sales, but does not make these modifications in uncontrolled sales. If the minor physical differences in the product have a material affect on prices, adjustments to account for these differences must be made to the results of the uncontrolled transactions according to the provisions of section 1.482-1(d)(2), and such adjusted results maybe used as a measure of the arm1s length result.

EXAMPLE 4--EFFECT OF GEOGRAPHIC DIFFERENCES. FM, a foreign specialty radio manufacturer, sells its radios to a controlled U.S. distributor, AM, that serves the West Coast of the United States. FM sells its radios to uncontrolled distributors to serve other regions in the United States. The product in the controlled and uncontrolled transactions is the same, and all other circumstances surrounding the controlled and uncontrolled transactions are substantially the same, other than the geographic differences. If the geographic differences are unlikely to have a material effect on price, or they have definite and reasonably ascertainable effects for which adjustments are made, then the adjusted results of the uncontrolled sales may be used under the comparable uncontrolled price method to establish an arm's length range pursuant to section 1.482-1(e)(iii)(A). If the effects of the geographic differences would be material but cannot be reliably ascertained, then the reliability of the results will be diminished. However, the comparable uncontrolled price method may still provide the most reliable measure of an arm's length result, pursuant to the best method rule of section 1.482-1(c), and, if so, an arm's length range may be established pursuant to section 1.482-1(e)(iii)(B).

(5) INDIRECT EVIDENCE OF COMPARABLE UNCONTROLLED TRANSACTIONS -- (1) IN GENERAL. A comparable uncontrolled price may be derived from data from public exchanges or quotation media, but only if the following requirements are met --

(A) The data is widely and routinely used in the ordinary course of business in the industry to negotiate prices for uncontrolled sales;

(B) The data derived from public exchanges or quotation media is used to set prices in the controlled transaction in the same way it is used by uncontrolled taxpayers in the industry; and

(C) The amount charged in the controlled transaction is adjusted to reflect differences in product quality and quantity, contractual terms, transportation costs, market conditions, risks borne, and other factors that affect the price that would be agreed to by uncontrolled taxpayers.

(ii) LIMITATION. Use of data from public exchanges or quotation media may not be appropriate under extraordinary market conditions.

(iii) EXAMPLES. The following examples illustrate this paragraph (b)(5).

EXAMPLE 1 -- USE OF QUOTATION MEDIUM. (i) On June 1, USOil, a United States corporation, enters into a contract to purchase crude oil from its foreign subsidiary, FS, in Country z. USOil and FS agree to base their sales price on the average of the prices published for that crude in a quotation medium in the five days before August 1, the date set for delivery. USOil and FS agree to adjust the price for the particular circumstances of their transactions, including the quantity of the crude sold, contractual terms, transportation costs, risks borne, and other factors that affect the price.

(ii) The quotation medium used by USOil and FS is widely and routinely used in the ordinary course of business in the industry to establish prices for uncontrolled sales. Because USOil and FS use the data to set their sales price in the same way that unrelated parties use the data from the quotation medium to set their sales prices, and appropriate adjustments were made to account for differences, the price derived from the quotation medium used by USOil and FS to set their transfer prices will be considered evidence of a comparable uncontrolled price.

EXAMPLE 2 -- EXTRAORDINARY MARKET CONDITIONS. The facts are the same as in Example 1, except that before USOil and FS enter into their contract, war breaks out in Countries X and Y, major oil producing countries, causing significant instability in world petroleum markets. As a result, given the significant instability in the price of oil, the prices listed on the quotation medium may not reflect a reliable measure of an arm's length result. See section 1.482-3(b)(5)(ii).

(c) RESALE PRICE METHOD -- (1) IN GENERAL. The resale price method evaluates whether the amount charged in a controlled transaction is arm's length by reference to the gross profit margin realized in comparable uncontrolled transactions. The resale price method measures the value of functionS performed, and is ordinarily used in cases involving the purchase and resale of tangible property in which the reseller has not added substantial value to the tangible goods by physically altering the goods before resale. For this purpose, packaging, repackaging, labelling, or minor assembly do not ordinarily constitute physical alteration. Further the resale price method is not ordinarily used in cases where the controlled taxpayer uses its intangible property to add substantial value to the tangible goods.

(2) DETERMINATION OF ARM'S LENGTH PRICE -- (i) IN GENERAL. The resale price method measures an arm's length price by subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction under review.

(ii) APPLICABLE RESALE PRICE. The applicable resale price is equal to either the resale price of the particular item of property involved or the price at which contemporaneous resales of the same property are made. If the property purchased in the controlled sale is resold to one or more related parties in a series of controlled sales before being resold in an uncontrolled sale, the applicable resale price is the price at which the property is resold to an uncontrolled party, or the price at which contemporaneous resales of the same property are made. In such case, the determination of the appropriate gross profit will take into account the functions of all members of the group participating in the series of controlled sales and final uncontrolled resales, as well as any other relevant factors described in section 1.482-1(d)(3).

(iii) APPROPRIATE GROSS PROFIT. The appropriate gross profit is computed by multiplying the applicable resale price by the gross profit margin (expressed as a percentage of total revenue derived from sales) earned in comparable uncontrolled transactions.

(iv) ARM'S LENGTH RANGE. See section 1.482-1(e)(2) for determination of the arm's length range.

(3) COMPARABILITY AND RELIABILITY CONSIDERATIONS -- (i) IN GENERAL. Whether results derived from applicationS of this method are the most reliable measure of the arm's length result must be determined using the factors described under the best method rule in section 1.482-1(c). The application of these factors under the resale price method is discussed in paragraphs (c)(3)(ii) and (iii) of this section.

(ii) COMPARABILITY -- (A) FUNCTIONAL COMPARABILITY. The degree of comparability between an uncontrolled transaction and a controlled transaction is determined by applying the comparability provisions of section 1.482-1(d). A reseller's gross profit provides compensation for the performance of resale functions related to the product or products under review, including an operating profit in return for the reseller's investment of capital and the assumption of risks. Therefore, although all of the factors described in section 1.482-1(d)(3) must be considered, comparability under this method is particularly dependent on similarity of functions performed, risks borne, and contractual terms, or adjustments to account for the effects of any such differences. If possible, appropriate gross profit margins should be derived from comparable uncontrolled purchases and resales of the reseller involved in the controlled sale, because similar characteristics are more likely to be found among different resales of property made by the same reseller than among sales made by other resellers. In the absence of comparable uncontrolled transactions involving the same reseller, an appropriate gross profit margin may be derived from comparable uncontrolled transactions of other resellers.

(B) OTHER COMPARABILITY FACTORS. Comparability under this method is less dependent on close physical similarity between the products transferred than under the comparable uncontrolled price method. For example, distributors of a wide variety of consumer durables might perform comparable distribution functions without regard to the specific durable goods distributed. Substantial differences in the products may, however, indicate significant functional differences between the controlled and uncontrolled taxpayers. Thus, it ordinarily would be expected that the controlled and uncontrolled transactions would involve the distribution of products of the same general type (e.g., consumer electronics). Furthermore, significant differences in the value of the distributed goods due, for example, to the value of a trademark, may also affect the reliability of the comparison. Finally, the reliability of profit measures based on gross profit may be adversely affected by factors that have less effect on prices. For example, gross profit may be affected by a variety of other factors, including cost structures (as reflected, for example, in the age of plant and equipment), business experience (such as whether the business is in a start-up phase or is mature), or management efficiency (as indicated, for example, by expanding or contracting sales or executive compensation over time). Accordingly, if material differences in these factors are identified based on objective evidence, the reliability of the analysis may be affected.

(C) ADJUSTMENTS FOR DIFFERENCES BETWEEN CONTROLLED AND UNCONTROLLED TRANSACTIONS. If there are material differences between the controlled and uncontrolled transactions that would affect the gross profit margin, adjustments should be made to the gross profit margin earned with respect to the uncontrolled transaction according to the comparability provisions of section 1.482-1(d)(2). For this purpose, consideration of operating expenses associated with functions performed and risks assumed may be necessary, because differences in functions performed are often reflected in operating expenses. If there are differences in functions performed, however, the effect on gross profit of such differences is not necessarily equal to the differences in the amount of related operating expenses. Specific examples of the factors that may be particularly relevant to this method include --

(1) Inventory levels and turnover rates, and corresponding risks, including any price protection programs offered by the manufacturer;

(2) Contractual terms (e.g., scope and terms of warranties provided, sales or purchase volume, credit terms, transport terms);

(3) Sales, marketing, advertising programs and services, (including promotional programs, rebates, and co-op advertising);

(4) The level of the market (e.g., wholesale, retail, etc.); and

(5) Foreign currency risks.

(D) SALES AGENT. If the controlled taxpayer is comparable to a sales agent that does not take title to goods or otherwise assume risks with respect to ownership of such goods, the commission earned by such sales agent, expressed as a percentage of the uncontrolled sales price of the goods involved, may be used as the comparable gross profit margin.

(iii) DATA AND ASSUMPTIONS -- (A) IN GENERAL. The reliability of the results derived from the resale price method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply this method. See section 1.482-1(c) (Best method rule).

(B) CONSISTENCY IN ACCOUNTING. The degree of consistency in accounting practices between the controlled transaction and the uncontrolled comparables that materially affect the gross profit margin affects the reliability of the result. Thus, for example, if differences in inventory and other cost accounting practices would materially affect the gross profit margin, the ability to make reliable adjustments for such differences would affect the reliability of the results. Further, the controlled transaction and the uncontrolled comparable should be consistent in the reporting of items (such as discounts, returns and allowances, rebates, transportation costs, insurance, and packaging) between cost of goods sold and operating expenses.

(4) EXAMPLES. The following examples illustrate the principles of this paragraph (c).

EXAMPLE 1. A controlled taxpayer sells property to another member of its controlled group that resells the property in uncontrolled sales. There are no changes in the beginning and ending inventory for the year under review. Information regarding an uncontrolled comparable is sufficiently complete to conclude that it is likely that all material differences between the controlled and uncontrolled transactions have been identified and adjusted for. If the applicable resale price of the property involved in the controlled sale is $100 and the appropriate gross profit margin is 20%, then an arm's length result of the controlled sale is a price of $80 ($100 minus (20% x $100)).

EXAMPLE 2. (i) S, a U.S. corporation, is the exclusive distributor for FP, its foreign parent. There are no changes in the beginning and ending inventory for the year under review. S's total reported cost of goods sold is $800, consisting of $600 for property purchased from FP and $200 of other costs of goods sold incurred to unrelated parties. S's applicable resale price and reported gross profit are as follows:

 Applicable resale price                 $1000

EXAMPLE 3. FP, a foreign manufacturer, sells Product to USSub, its U.S. subsidiary, which in turn sells Product to its domestic affiliate Sister. Sister sells Product to unrelated buyers. In this case, the applicable resale price is the price at which Sister sells Product in uncontrolled transactions. The determination of the appropriate gross profit margin for the sale from FP to USSub will take into account the functions performed by USSub and Sister, as well as other relevant factors described in section 1.482-1(d)(3).

EXAMPLE 4. (i) USSub, a U.S. corporation, is the exclusive distributor of widgets for its foreign parent. To determine whether the gross profit margin of 25% earned by USSub is an arm's length result, the district director considers applying the resale price method. There are several uncontrolled distributors that perform similar functions under similar circumstances in uncontrolled transactions. However, the uncontrolled distributors treat certain costs such as discounts and insurance as cost of goods sold, while USSub treats such costs as operating expenses. In such cases, accounting reclassifications, pursuant to section 1.482-3(c)(iii)(B), must be made to ensure consistent treatment of such material items. Inability to make such accounting reclassifications will decrease the reliability of the results of the uncontrolled transactions.

EXAMPLE 5. (i) USP, a U.S. corporation, manufactures Product X, an unbranded widget, and sells it to FSub, its wholly owned foreign subsidiary. FSub acts as a distributor of Product X in country M, and sells it to uncontrolled parties in that country. Uncontrolled distributors A, B, C, D, and E distribute competing products of approximately similar value in country M. All such products are unbranded.

(ii) Relatively complete data is available regarding the functions performed and risks borne by the uncontrolled distributors and the contractual terms under which they operate in the uncontrolled transactions. In addition, data is available to ensure accounting consistency between all of the uncontrolled distributors and FSub. Because the available data is sufficiently complete and accurate to conclude that it is likely that all material differences between the controlled and uncontrolled transactions have been identified, such differences have a definite and reasonably ascertainable effect, and reliable adjustments are made to account for such differences, the results of each of the uncontrolled distributors may be used to establish an arm's length range pursuant to section 1.482-1(e)(2)(iii)(A).

EXAMPLE 6. The facts are the same as EXAMPLE 5, except that sufficient data is not available to determine whether any of the uncontrolled distributors provide warranties or to determine the payment terms of the contracts. Because differences in these contractual terms could materially affect price or profits, the inability to determine whether these differences exist between the controlled and uncontrolled transactions diminishes the reliability of the results of the uncontrolled comparables. However, the reliability of the results may be enhanced by the application of a statistical method when establishing an arm's length range pursuant to section 1.482-1(e)(2)(iii)(B).

EXAMPLE 7. The facts are the same as in EXAMPLE 5, except that Product X is branded with a valuable trademark that is owned by P. A, B, and C distribute unbranded competing products, while D and E distribute products branded with other trademarks. D and E do not own any rights in the trademarks under which their products are sold. The value of the products that A, B, and C sold are not similar to the value of the products sold by S. The value of products sold by D and E, however, is similar to that of Product X. Although close product similarity is not as important for a reliable application of the resale price method as for the comparable uncontrolled price method, significant differences in the value of the products involved in the controlled and uncontrolled transactions may affect the reliability of the results. In addition, because in this case it is difficult to determine the effect the trademark will have on price or profits, reliable adjustments for the differences cannot be made. Because D and E have a higher level of comparability than A, B, and C with respect to S, pursuant to section 1.482-1(e)(2)(ii), only D and E may be included in an arm's length range.

(d) COST PLUS METHOD -- (1) IN GENERAL. The cost plus method evaluates whether the amount charged in a controlled transaction is arm's length by reference to the gross profit markup realized in comparable uncontrolled transactions. The cost plus method is ordinarily used in cases involving the manufacture, assembly, or other production of goods that are sold to related parties.

(2) DETERMINATION OF ARM'S LENGTH PRICE -- (i) IN GENERAL. The cost plus method measures an arm's length price by adding the appropriate gross profit to the controlled taxpayer's costs of producing the property involved in the controlled transaction.

(ii) APPROPRIATE GROSS PROFIT. The appropriate gross profit is computed by multiplying the controlled taxpayer's cost of producing the transferred property by the gross profit markup, expressed as a percentage of cost, earned in comparable uncontrolled transactions.

(iii) ARM'S LENGTH RANGE. See section 1.482-1(e)(2) for determination of an arm's length range.

(3) COMPARABILITY AND RELIABILITY CONSIDERATIONS -- (i) IN GENERAL. Whether results derived from the application of this method are the most reliable measure of the arm's length result must be determined using the factors described under the best method rule in section 1.482-1(c).

(ii) COMPARABILITY -- (A) FUNCTIONAL COMPARABILITY. The degree of comparability between controlled and uncontrolled transactions is determined by applying the comparability provisions of section 1.482-1(d). A producer's gross profit provides compensation for the performance of the production functions related to the product or products under review, including an operating profit for the producer's investment of capital and assumption of risks. Therefore, although all of the factors described in section 1.482-1(d)(3) must be considered, comparability under this method is particularly dependent on similarity of functions performed, risks borne, and contractual terms, or adjustments to account for the effects of any such differences. If possible, the appropriate gross profit markup should be derived from comparable uncontrolled transactions of the taxpayer involved in the controlled sale, because similar characteristics are more likely to be found among sales of property by the same producer than among sales by other producers. In the absence of such sales, an appropriate gross profit markup may be derived from comparable uncontrolled sales of other producers whether or not such producers are members of the same controlled group.

(B) OTHER COMPARABILITY FACTORS. Comparability under this method is less dependent on close physical similarity between the products transferred than under the comparable uncontrolled price method. Substantial differences in the products may, however, indicate significant functional differences between the controlled and uncontrolled taxpayers. Thus, it ordinarily would be expected that the controlled and uncontrolled transactions involve the production of goods within the same product categories. Furthermore, significant differences in the value of the products due, for example, to the value of a trademark, may also affect the reliability of the comparison. Finally, the reliability of profit measures based on gross profit may be adversely affected by factors that have less effect on prices. For example, gross profit may be affected by a variety of other factors, including cost structures (as reflected, for example, in the age of plant and equipment), business experience (such as whether the business is in a start-up phase or is mature), or management efficiency (as indicated, for example, by expanding or contracting sales or executive compensation over time). Accordingly, if material differences in these factors are identified based on objective evidence, the reliability of the analysis may be affected.

(C) ADJUSTMENTS FOR DIFFERENCES BETWEEN CONTROLLED AND UNCONTROLLED TRANSACTIONS. If there are material differences between the controlled and uncontrolled transactions that would affect the gross profit markup, adjustments should be made to the gross profit markup earned in the comparable uncontrolled transaction according to the provisions of section 1.482-1(d)(2). For this purpose, consideration of the operating expenses associated with the functions performed and risks assumed may be necessary, because differences in functions performed are often reflected in operating expenses. If there are differences in functions performed, however, the effect on gross profit of such differences is not necessarily equal to the differences in the amount of related operating expenses. Specific examples of the factors that may be particularly relevant to this method include -

(1) The complexity of manufacturing or assembly;

(2) Manufacturing, production, and process engineering;

(3) Procurement, purchasing, and inventory control activities;

(4) Testing functions;

(5) Selling, general, and administrative expenses;

(6) Foreign currency risks; and

(7) Contractual terms (e.g., scope and terms of warranties provided, sales or purchase volume, credit terms, transport terms).

(D) PURCHASING AGENT. If a controlled taxpayer is comparable to a purchasing agent that does not take title to property or otherwise assume risks with respect to ownership of such goods, the commission earned by such purchasing agent, expressed as a percentage of the purchase price of the goods, may be used as the appropriate gross profit markup.

(iii) DATA AND ASSUMPTIONS -- (A) IN GENERAL. The reliability of the results derived from the cost plus method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply this method. See section 1.482-1(c) (Best method rule).

(B) CONSISTENCY IN ACCOUNTING. The degree of consistency in accounting practices between the controlled transaction and the uncontrolled comparables that materially affect the gross profit margin affects the reliability of the result. Thus, for example, if differences in inventory and other cost accounting practices would materially affect the gross profit markup, the ability to make reliable adjustments for such differences would affect the reliability of the results. Further, the controlled transaction and the comparable uncontrolled transaction should be consistent in the reporting of costs between cost of goods sold and operating expenses. The term COST OF PRODUCING includes the cost of acquiring property that is held for resale.

(4) EXAMPLES. The following examples illustrate the principles of this paragraph (d).

EXAMPLE 1. (i) USP, a domestic manufacturer of computer components, sells its products to FS, its foreign distributor. UT1, UT2, and UT3 are domestic computer component manufacturers that sell to uncontrolled foreign purchasers.

(ii) Relatively complete data is available regarding the functions performed and risks borne by UT1, UT2, and UT3, and the contractual terms in the uncontrolled transactions. In addition, data is available to ensure accounting consistency between all of the uncontrolled manufacturers and USP. Because the available data is sufficiently complete to conclude that it is likely that all material differences between the controlled and uncontrolled transactions have been identified, the effect of the differences are definite and reasonably ascertainable, and reliable adjustments are made to account for the differences, an arm's length range can be established pursuant to section 1.482-1(e)(2)(iii)(A).

EXAMPLE 2. The facts are the same as in EXAMPLE 1, except that USP accounts for supervisory, general, and administrative costs as operating expenses, which are not allocated to its sales to FS. The gross profit markups of UT1, UT2, and UT3, however, reflect supervisory, general, and administrative expenses because they are accounted for as costs of goods sold. Accordingly, the gross profit markups of UT1, UT2, and UT3 must be adjusted as provided in paragraph (d)(3)(iii)(B) of this section to provide accounting consistency. If data is not sufficient to determine whether such accounting differences exist between the controlled and uncontrolled transactions, the reliability of the results will be decreased.

EXAMPLE 3. The facts are the same as in EXAMPLE 1, except that under its contract with FS, USP uses materials consigned by FS. UT1, UT2, and UT3, on the other hand, purchase their own materials, and their gross profit markups are determined by including the costs of materials. The fact that USP does not carry an inventory risk by purchasing its own materials while the uncontrolled producers carry inventory is a significant difference that may require an adjustment if the difference has a material effect on the gross profit markups of the uncontrolled producers. Inability to reasonably ascertain the effect of the difference on the gross profit markups will affect the reliability of the results of UT1, UT2, and UT3.

EXAMPLE 4. (i) FS, a foreign corporation, produces apparel for USP, its U.S. parent corporation. FS purchases its materials from unrelated suppliers and produces the apparel according to designs provided by USP. The district director identifies 10 uncontrolled foreign apparel producers that operate in the same geographic market and are similar in many respect to FS.

(ii) Relatively complete data is available regarding the functions performed and risks borne by the uncontrolled producers. In addition, data is sufficiently detailed to permit adjustments for differences in accounting practices. However, sufficient data is not available to determine whether it is likely that all material differences in contractual terms have been identified. For example, it is not possible to determine which parties in the uncontrolled transactions bear currency risks. Because differences in these contractual terms could materially affect price or profits, the inability to determine whether differences exist between the controlled and uncontrolled transactions will diminish the reliability of these results. Therefore, the reliability of the results of the uncontrolled transactions must be enhanced by the application of a statistical method in establishing an arm's length range pursuant to section 1.482-1(e)(2)(iii)(B).

(e) UNSPECIFIED METHODS -- (1) IN GENERAL. Methods not specified in paragraphs (a)(1), (2), (3), (4), and (5) of this section may be used to evaluate whether the amount charged in a controlled transaction is arm's length. Any method used under this paragraph (e) must be applied in accordance with the provisions of section 1.482-1. Consistent with the specified methods, an unspecified method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it. For example, the comparable uncontrolled price method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price to which the parties would have agreed had they resorted directly to a market alternative to the controlled transaction. Therefore, in establishing whether a controlled transaction achieved an arm's length result, an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction. As with any method, an unspecified method will not be applied unless it provides the most reliable measure of an arm's length result under the principles of the best method rule. See section 1.482-1(c). Therefore, in accordance with section 1.482-1(d) (Comparability), to the extent that a method relies on internal data rather than uncontrolled comparables, its reliability will be reduced. Similarly, the reliability of a method will be affected by the reliability of the data and assumptions used to apply the method, including any projections used.

(2) EXAMPLE. The following example illustrates an application of the principle of this paragraph (e).

EXAMPLE. Amcan, a U.S. company, produces unique vessels for storing and transporting toxic waste, toxicans, at its U.S. production facility. Amcan agrees by contract to supply its Canadian subsidiary, Cancan, with 4000 toxicans per year to serve the Canadian market for toxicans. Prior to entering into the contract with Cancan, Amcan had received a bona fide offer from an independent Canadian waste disposal company, Cando, to serve as the Canadian distributor for toxicans and to purchase a similar number of toxicans at a price of $5,000 each. If the circumstances and terms of the Cancan supply contract are sufficiently similar to those of the Cando offer, or sufficiently reliable adjustments can be made for differences between them, then the Cando offer price of $5,000 may provide reliable information indicating that an arm's length consideration under the Cancan contract will not be less than $5,000 per toxican.

(f) COORDINATION WITH INTANGIBLE PROPERTY RULES. The value of an item of tangible property may be affected by the value of intangible property, such as a trademark affixed to the tangible property (embedded intangible). Ordinarily, the transfer of tangible property with an embedded intangible will not be considered a transfer of such intangible if the controlled purchaser does not acquire any rights to exploit the intangible property other than rights relating to the resale of the tangible property under normal commercial practices. Pursuant to section 1.482-1(d)(3)(v), however, the embedded intangible must be accounted for in evaluating the comparability of the controlled transaction and uncontrolled comparables. For example, because product comparability has the greatest effect on an application of the comparable uncontrolled price method, trademarked tangible property may be insufficiently comparable to unbranded tangible property to permit a reliable application of the comparable uncontrolled price method. The effect of embedded intangibles on comparability will be determined under the principles of section 1.482-4. If the transfer of tangible property conveys to the recipient a right to exploit an embedded intangible (other than in connection with the resale of that item of tangible property), it may be necessary to determine the arm's length consideration for such intangible separately from the tangible property, applying methods appropriate to determining the arm's length result for a transfer of intangible property under section 1.482-4. For example, if the transfer of a machine conveys the right to exploit a manufacturing process incorporated in the machine, then the arm's length consideration for the transfer of that right must be determined separately under section 1.482-4.

SECTION 1.482-4 METHODS TO DETERMINE TAXABLE INCOME IN CONNECTION WITH A TRANSFER OF INTANGIBLE PROPERTY.

(a) IN GENERAL. The arm's length amount charged in a controlled transfer of intangible property must be determined under one of the four methods listed in this paragraph (a). Each of the methods must be applied in accordance with all of the provisions of section 1.482-1, including the best method rule of section 1.482-1(c), the comparability analysis of section 1.482-1(d), and the arm's length range of section 1.482-1(e). The arm's length consideration for the transfer of an intangible determined under this section must be commensurate with the income attributable to the intangible. See section 1.482-4(f)(2) (Periodic adjustments). The available methods are --

(1) The comparable uncontrolled transaction method, described in paragraph (c) of this section;

(2) The comparable profits method, described in section 1.482-5;

(3) The profit split method, described in section 1.482-6; and

(4) Unspecified methods described in paragraph (d) of this section.

(b) DEFINITION OF INTANGIBLE. For purposes of section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual --

(1) Patents, inventions, formulae, processes, designs, patterns, or know-how;

(2) Copyrights and literary, musical, or artistic compositions;

(3) Trademarks, trade names, or brand names;

(4) Franchises, licenses, or contracts;

(5) Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and

(6) Other similar items. For purposes of section 482, an item is considered similar to those listed in paragraph (b)(1) through (5) of this section if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.

(c) COMPARABLE UNCONTROLLED TRANSACTION METHOD -- (1) IN GENERAL. The comparable uncontrolled transaction method evaluates whether the amount charged for a controlled transfer of intangible property was arm's length by reference to the amount charged in a comparable uncontrolled transaction. The amount determined under this method may be adjusted as required by paragraph (f)(2) of this section (Periodic adjustments).

(2) COMPARABILITY AND RELIABILITY CONSIDERATIONS -- (i) IN GENERAL. Whether results derived from applications of this method are the most reliable measure of an arm's length result is determined using the factors described under the best method rule in section 1.482-1(c). The application of these factors under the comparable uncontrolled transaction method is discussed in paragraphs (c)(2)(ii), (iii), and (iv) of this section.

(ii) RELIABILITY. If an uncontrolled transaction involves the transfer of the same intangible under the same, or substantially the same, circumstances as the controlled transaction, the results derived from applying the comparable uncontrolled transaction method will generally be the most direct and reliable measure of the arm's length result for the controlled transfer of an intangible. Circumstances between the controlled and uncontrolled transactions will be considered substantially the same if there are at most only minor differences that have a definite and reasonably ascertainable effect on the amount charged and for which appropriate adjustments are made. If such uncontrolled transactions cannot be identified, uncontrolled transactions that involve the transfer of comparable intangibles under comparable circumstances may be used to apply this method, but the reliability of the analysis will be reduced.

(iii) COMPARABILITY -- (A) IN GENERAL. The degree of comparability between controlled and uncontrolled transactions is determined by applying the comparability provisions of section 1.482-1(d). Although all of the factors described in section 1.482-1(d)(3) must be considered, specific factors may be particularly relevant to this method. In particular, the application of this method requires that the controlled and uncontrolled transactions involve either the same intangible property or comparable intangible property, as defined in paragraph (c)(2)(iii)(B)(1) of this section. In addition, because differences in contractual terms, or the economic conditions in which transactions take place, could materially affect the amount charged, comparability under this method also depends on similarity with respect to these factors, or adjustments to account for material differences in such circumstances.

(B) FACTORS TO BE CONSIDERED IN DETERMINING COMPARABILITY -- (1) COMPARABLE INTANGIBLE PROPERTY. In order for the intangible property involved in an uncontrolled transaction to be considered comparable to the intangible property involved in the controlled transaction, both intangibles must --

(i) Be used in connection with similar products or processes within the same general industry or market; and

(ii) Have similar profit potential. The profit potential of an intangible is most reliably measured by directly calculating 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, considering the capital investment and start-up expenses required, the risks to be assumed, and other relevant considerations. The need to reliably measure profit potential increases in relation to both the total amount of potential profits and the potential rate of return on investment necessary to exploit the intangible. If the information necessary to directly calculate net present value of the benefits to be realized is unavailable, and the need to reliably measure profit potential is reduced because the potential profits are relatively small in terms of total amount and rate of return, comparison of profit potential may be based upon the factors referred to in paragraph (c)(2)(iii)(B)(2) of this section. See EXAMPLE 3 of section 1.482-4(c)(4). Finally, the reliability of a measure of profit potential is affected by the extent to which the profit attributable to the intangible can be isolated from the profit attributable to other factors, such as functions performed and other resources employed.

(2) COMPARABLE CIRCUMSTANCES. In evaluating the comparability of the circumstances of the controlled and uncontrolled transactions, although all of the factors described in section 1.482-1(d)(3) must be considered, specific factors that may be particularly relevant to this method include the following --

(i) The terms of the transfer, including the exploitation rights granted in the intangible, the exclusive or nonexclusive character of any rights granted, any restrictions on use, or any limitations on the geographic area in which the rights may be exploited;

(ii) The stage of development of the intangible (including, where appropriate, necessary governmental approvals, authorizations, or licenses) in the market in which the intangible is to be used;

(iii) Rights to receive updates, revisions, or modifications of the intangible;

(iv) The uniqueness of the property and the period for which it remains unique, including the degree and duration of protection afforded to the property under the laws of the relevant countries;

(v) The duration of the license, contract, or other agreement, and any termination or renegotiation rights;

(vi) Any economic and product liability risks to be assumed by the transferee;

(vii) The existence and extent of any collateral transactions or ongoing business relationships between the transferee and transferor; and

(viii) The functions to be performed by the transferor and transferee, including any ancillary or subsidiary services.

(iv) DATA AND ASSUMPTIONS. The reliability of the results derived from the comparable uncontrolled transaction method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply this method. See section 1.482-1(c) (Best method rule).

(3) ARM'S LENGTH RANGE. See section 1.482-1(e)(2) for the determination of an arm's length range.

(4) EXAMPLES. The following examples illustrate the principles of this paragraph (c).

EXAMPLE 1. (i) USpharm, a U.S. pharmaceutical company, develops a new drug Z that is a safe and effective treatment for the disease zeezee. Uspharm has obtained patents covering drug Z in the United States and in various foreign countries. Uspharm has also obtained the regulatory authorizations necessary to market drug Z in the United States and in foreign countries.

(ii) USpharm licenses its subsidiary in country X, Xpharm, to produce and sell drug Z in country X. At the same time, it licenses an unrelated company, Ydrug, to produce and sell drug Z in country Y, a neighboring country. Prior to licensing the drug, USpharm had obtained patent protection and regulatory approvals in both countries and both countries provide similar protection for intellectual property rights. Country X and country Y are similar countries in terms of population, per capita income and the incidence of disease zeezee. Consequently, drug Z is expected to sell in similar quantities and at similar prices in both countries. In addition, costs of producing and marketing drug Z in each country are expected to be approximately the same.

(iii) USpharm and Xpharm establish terms for the license of drug Z that are identical in every material respect, including royalty rate, to the terms established between Uspharm and Ydrug. In this case the district director determines that the royalty rate established in the Ydrug license agreement is a reliable measure of the arm's length royalty rate for the Xpharm license agreement.

EXAMPLE 2. The facts are the same as in EXAMPLE 1, except that the incidence of the disease zeezee in Country Y is much higher than in Country X. In this case, the profit potential from exploitation of the right to make and sell drug Z is likely to be much higher in country Y than it is in Country X. Consequently, the Ydrug license agreement is unlikely to provide a reliable measure of the arm's length royalty rate for the Xpharm license.

EXAMPLE 3 (i) FP, is a foreign company that designs, manufactures and sells industrial equipment. FP has developed proprietary components that are incorporated in its products. These components are important in the operation of FP's equipment and some of them have distinctive features, but other companies produce similar components and none of these components by itself accounts for a substantial part of the value of FP's products.

(ii) FP licenses its U.S. subsidiary, USSub, exclusive North American rights to use the patented technology for producing component X, a heat exchanger used for cooling operating mechanisms in industrial equipment. Component X incorporates proven technology that makes it somewhat more efficient than the heat exchangers commonly used in industrial equipment. FP also agrees to provide technical support to help adapt component X to USSub's products and to assist with initial production. Under the terms of the license agreement USSub pays FP a royalty equal to 3 percent of sales of USSub equipment incorporating component X.

(iii) FP does not license unrelated parties to use component X, but many similar components are transferred between uncontrolled taxpayers. Consequently, the district director decides to apply the comparable uncontrolled transaction method to evaluate whether the 3 percent royalty for component x is an arm's length royalty.

(iv) The district director uses a database of company documents filed with the Securities and Exchange Commission (SEC) to identify potentially comparable license agreements between uncontrolled taxpayers that are on file with the SEC. The district director identifies 40 license agreements that were entered into in the same year as the controlled transfer or in the prior or following year, and that relate to transfers of technology associated with industrial equipment that has similar applications to USSub's products. Further review of these uncontrolled agreements indicates that 25 of them involved components that have a similar level of technical sophistication as component x and could be expected to play a similar role in contributing to the total value of the final product.

(v) The district director makes a detailed review of the terms of each of the 25 uncontrolled agreements and finds that 15 of them are similar to the controlled agreement in that they all involve --

(A) The transfer of exclusive rights for the North American market;

(B) Products for which the market could be expected to be of a similar size to the market for the products into which USSub incorporates component X;

(C) The transfer of patented technology;

(D) Continuing technical support;

(E) Access to technical improvements;

(F) Technology of a similar age; and

(G) A similar duration of the agreement.

(vi) Based on these factors and the fact that none of the components to which these license agreements relate accounts for a substantial part of the value of the final products, the district director concludes that these fifteen intangibles have similar profit potential to the component X technology.

(vii) The 15 uncontrolled comparables produce the following royalty rates:

                          Royalty rate

EXAMPLE 4. (i) USdrug, a U.S. pharmaceutical company, has developed a new drug, Nosplit, that is useful in treating migraine headaches and produces no significant side effects. Nosplit replaces another drug, Lessplit, that USdrug had previously produced and marketed as a treatment for migraine headaches. A number of other drugs for treating migraine headaches are already on the market, but Nosplit can be expected rapidly to dominate the worldwide market for such treatments and to command a premium price since all other treatments produce side effects. Thus, USdrug projects that extraordinary profits will be derived from Nosplit in the U.S. market and other markets.

(ii) USdrug licenses its newly established European subsidiary, Eurodrug, the rights to produce and market Nosplit in the European market. In setting the royalty rate for this license, USdrug considers the royalty that it established previously when it licensed the right to produce and market Lessplit in the European market to an unrelated European pharmaceutical company. In many respects the two license agreements are closely comparable. The drugs were licensed at the same stage in their development and the agreements conveyed identical rights to the licensees. Moreover, there appear to have been no significant changes in the European market for migraine headache treatments since Lessplit was licensed. However, at the time that Lessplit was licensed there were several other similar drugs already on the market to which Lessplit was not in all cases superior. Consequently, the projected and actual Lessplit profits were substantially less than the projected Nosplit profits. Thus, USdrug concludes that the profit potential of Lessplit is not similar to the profit potential of Nosplit, and the Lessplit license agreement consequently is not a comparable uncontrolled transaction for purposes of this paragraph (c) in spite of the other indicia of comparability between the two intangibles.

(d) UNSPECIFIED METHODS -- (1) IN GENERAL. Methods not specified in paragraphs (a)(1), (2), and (3) of this section may be used to evaluate whether the amount charged in a controlled transaction is arm's length. Any method used under this paragraph (d) must be applied in accordance with the provisions of section 1.482-1. Consistent with the specified methods, an unspecified method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it. For example, the comparable uncontrolled transaction method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price the parties would have agreed to had they resorted directly to a market alternative to the controlled transaction. Therefore, in establishing whether a controlled transaction achieved an arm's length result, an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction. As with any method, an unspecified method will not be applied unless it provides the most reliable measure of an arm's length result under the principles of the best method rule. See section 1.482-1(c). Therefore, in accordance with section 1.482-1(d) (Comparability), to the extent that a method relies on internal data rather than uncontrolled comparables, its reliability will be reduced. Similarly, the reliability of a method will be affected by the reliability of the data and assumptions used to apply the method, including any projections used.

(2) EXAMPLE. The following example illustrates an application of the principle of this paragraph (d).

EXAMPLE. (i) USbond is a U.S. company that licenses to its foreign subsidiary, Eurobond, a proprietary process that permits the manufacture of Longbond, a long-lasting industrial adhesive, at a substantially lower cost than otherwise would be possible. Using the proprietary process, Eurobond manufactures Longbond and sells it to related and unrelated parties for the market price of $550 per ton. Under the terms of the license agreement, Eurobond pays USbond a royalty of $100 per ton of Longbond sold. USbond also manufactures and markets Longbond in the United States.

(ii) In evaluating whether the consideration paid for the transfer of the proprietary process to Eurobond was arm's length, the district director may consider, subject to the best method rule of section 1.482-1(c), USbond's alternative of producing and selling Longbond itself. Reasonably reliable estimates indicate that if USbond directly supplied Longbond to the European market, a selling price of $300 per ton would cover its costs and provide a reasonable profit for its functions, risks and investment of capital associated with the production of Longbond for the European market. Given that the market price of Longbond was $550 per ton, by licensing the proprietary process to Eurobond, USbond forgoes $250 per ton of profit over the profit that would be necessary to compensate it for the functions, risks and investment involved in supplying Longbond to the European market itself. Based on these facts, the district director concludes that a royalty of $100 for the proprietary process is not arm's length.

(e) COORDINATION WITH TANGIBLE PROPERTY RULES. See section 1.482-3(f) for the provisions regarding the coordination between the tangible property and intangible property rules.

(f) SPECIAL RULES FOR TRANSFERS OF INTANGIBLE PROPERTY -- (1) FORM OF CONSIDERATION. If a transferee of an intangible pays nominal or no consideration and the transferor has retained a substantial interest in the property, the arm's length consideration shall be in the form of a royalty, unless a different form is demonstrably more appropriate.

(2) PERIODIC ADJUSTMENTS -- (i) GENERAL RULE. If an intangible is transferred under an arrangement that covers more than one year, the consideration charged in each taxable year may be adjusted to ensure that it is commensurate with the income attributable to the intangible. Adjustments made pursuant to this paragraph (f)(2) shall be consistent with the arm's length standard and the provisions of section 1.482-1. In determining whether to make such adjustments in the taxable year under examination, the district director may consider all relevant facts and circumstances throughout the period the intangible is used. The determination in an earlier year that the amount charged for an intangible was an arm's length amount will not preclude the district director in a subsequent taxable year from making an adjustment to the amount charged for the intangible in the subsequent year. A periodic adjustment under the commensurate with income requirement of section 482 may be made in a subsequent taxable year without regard to whether the taxable year of the original transfer remains open for statute of limitation purposes. For exceptions to this rule see paragraph (f)(2)(ii) of this section.

(ii) EXCEPTIONS -- (A) TRANSACTIONS INVOLVING THE SAME INTANGIBLE. If the same intangible was transferred to an uncontrolled taxpayer under substantially the same circumstances as those of the controlled transaction; this transaction serves as the basis for the application of the comparable uncontrolled transaction method in the first taxable year in which substantial periodic consideration was required to be paid; and the amount paid in that year was an arm's length amount, then no allocation in a subsequent year will be made under paragraph (f)(2)(i) of this paragraph for a controlled transfer of intangible property.

(B) TRANSACTIONS INVOLVING COMPARABLE INTANGIBLE. If the arm's length result is derived from the application of the comparable uncontrolled transaction method based on the transfer of a comparable intangible under comparable circumstances to those of the controlled transaction, no allocation will be made under paragraph (f)(2)(i) of this section if each of the following facts is established --

(1) The controlled taxpayers entered into a written agreement (controlled agreement) that provided for an amount of consideration with respect to each taxable year subject to such agreement, such consideration was an arm's length amount for the first taxable year in which substantial periodic consideration was required to be paid under the agreement, and such agreement remained in effect for the taxable year under review;

(2) There is a written agreement setting forth the terms of the comparable uncontrolled transaction relied upon to establish the arm's length consideration (uncontrolled agreement), which contains no provisions that would permit any change to the amount of consideration, a renegotiation, or a termination of the agreement, in circumstances comparable to those of the controlled transaction in the taxable year under review (or that contains provisions permitting only specified, non-contingent, periodic changes to the amount of consideration);

(3) The controlled agreement is substantially similar to the uncontrolled agreement, with respect to the time period for which it is effective and the provisions described in paragraph (f)(2)(ii)(B)(2) of this section;

(4) The controlled agreement limits use of the intangible to a specified field or purpose in a manner that is consistent with industry practice and any such limitation in the uncontrolled agreement;

(5) There were no substantial changes in the functions performed by the controlled transferee after the controlled agreement was executed, except changes required by events that were not foreseeable; and

(6) The aggregate profits actually earned or the aggregate cost savings actually realized by the controlled taxpayer from the exploitation of the intangible in the year under examination, and all past years, are not less than 80% nor more than 120% of the prospective profits or cost savings that were foreseeable when the comparability of the uncontrolled agreement was established under paragraph (c)(2) of this section.

(C) METHODS OTHER THAN COMPARABLE UNCONTROLLED TRANSACTION. If the arm's length amount was determined under any method other than the comparable uncontrolled transaction method, no allocation will be made under paragraph (f)(2)(i) of this section if each of the following facts is established --

(1) The controlled taxpayers entered into a written agreement (controlled agreement) that provided for an amount of consideration with respect to each taxable year subject to such agreement, and such agreement remained in effect for the taxable year under review;

(2) The consideration called for in the controlled agreement was an arm's length amount for the first taxable year in which substantial periodic consideration was required to be paid, and relevant supporting documentation was prepared contemporaneously with the execution of the controlled agreement;

(3) There have been no substantial changes in the functions performed by the transferee since the controlled agreement was executed, except changes required by events that were not foreseeable; and

(4) The total profits actually earned or the total cost savings realized by the controlled transferee from the exploitation of the intangible in the year under examination, and all past years, are not less than 80% nor more than 120% of the prospective profits or cost savings that were foreseeable when the controlled agreement was entered into.

(D) EXTRAORDINARY EVENTS. No allocation will be made under paragraph (f)(2)(i) of this section if the following requirements are met --

(1) Due to extraordinary events that were beyond the control of the controlled taxpayers and that could not reasonably have been anticipated at the time the controlled agreement was entered into, the aggregate actual profits or aggregate cost savings realized by the taxpayer are less than 80% or more than 120% of the prospective profits or cost savings; and

(2) All of the requirements of paragraph (f)(2)(ii)(B) or (C) of this section are otherwise satisfied.

(E) FIVE-YEAR PERIOD. If the requirements of section 1.482-4(f)(2)(ii)(B) or (f)(2)(ii)(C) are met for each year of the five- year period beginning with the first year in which substantial periodic consideration was required to be paid, then no periodic adjustment will be made under paragraph (f)(2)(i) of this section in any subsequent year.

(iii) EXAMPLES. The following examples illustrate this paragraph (f)(2).

EXAMPLE 1. (i) USdrug, a U.S. pharmaceutical company, has developed a new drug, Nosplit, that is useful in treating migraine headaches and produces no significant side effects. A number of other drugs for treating migraine headaches are already on the market, but Nosplit can be expected rapidly to dominate the worldwide market for such treatments and to command a premium price since all other treatments produce side effects. Thus, USdrug projects that extraordinary profits will be derived from Nosplit in the U.S. and European markets.

(ii) USdrug licenses its newly established European subsidiary, Eurodrug, the rights to produce and market Nosplit for the European market for 5 years. In setting the royalty rate for this license, USdrug makes projections of the annual sales revenue and the annual profits to be derived from the exploitation of Nosplit by Eurodrug. Based on the projections, a royalty rate of 3.9% is established for the term of the license.

(iii) In Year 1, USdrug evaluates the royalty rate it received from Eurodrug. Given the high profit potential of Nosplit, USdrug is unable to locate any uncontrolled transactions dealing with licenses of comparable intangible property. USdrug therefore determines that the comparable uncontrolled transaction method will not provide a reliable measure of an arm's length royalty. However, applying the comparable profits method to Eurodrug, USdrug determines that a royalty rate of 3.9% will result in Eurodrug earning an arm's length return for its manufacturing and marketing functions.

(iv) In Year 5, the U.S. income tax return for USdrug is examined, and the district director must determine whether the royalty rate between USdrug and Eurodrug is commensurate with the income attributable to Nosplit. In making this determination, the district director considers whether any of the exceptions in section 1.482-4(f)(2)(ii) are applicable. In particular, the district director compares the profit projections attributable to Nosplit made by USdrug against the actual profits realized by Eurodrug. The projected and actual profits are as follows:

        Profit projections          Actual profits

EXAMPLE 2. (i) The facts are the same as in EXAMPLE 1, except that Eurodrug's actual profits earned were much higher than the projected profits, as follows:

               Profit Projections       Actual Profits

EXAMPLE 3. (i) FP, a foreign corporation, licenses to USS, its U.S. subsidiary, a new air-filtering process that permits manufacturing plants to meet new environmental standards. The license runs for a 10-year period, and the profit derived from the new process is projected to be $15 million per year, for an aggregate profit of $150 million.

(ii) The royalty rate for the license is based on a comparable uncontrolled transaction involving a comparable intangible under comparable circumstances. The requirements of paragraphs (f)(2)(ii)(B)(1) through (5) of this section have been met. Specifically, FP and USS have entered into a written agreement that provides for a royalty in each year of the license, the royalty rate is considered arm's length for the first taxable year in which a substantial royalty was required to be paid, the license limited the use of the process to a specified field, consistent with industry practice, and there are no substantial changes in the functions performed by USS after the license was entered into.

(iii) In examining Year 4 of the license, the district director determines that the aggregate actual profits earned by USS through Year 4 are $30 million, less than 80% of the projected profits of $60 million. However, USS establishes to the satisfaction of the district director that the aggregate actual profits from the process are less than 80% of the projected profits in Year 3 because an earthquake severely damaged USS's manufacturing plant. Because the difference between the projected profits and actual profits was due to an extraordinary event that was beyond the control of USS, and could not reasonably have been anticipated at the time the license was entered into, the requirement under section 1.482-4(f)(2)(ii)(D) has been met, and no adjustment under this section is made.

(3) OWNERSHIP OF INTANGIBLE PROPERTY -- (i) IN GENERAL. If the owner of the rights to exploit an intangible transfers such rights to a controlled taxpayer, the owner must receive an amount of consideration with respect to such transfer that is determined in accordance with the provisions of this section. If another controlled taxpayer provides assistance to the owner in connection with the development or enhancement of an intangible, such person may be entitled to receive consideration with respect to such assistance. See section 1.482-4(f)(3)(iii) (Allocations with respect to assistance provided to the owner). Because the right to exploit an intangible can be subdivided in various ways, a single intangible may have multiple owners for purposes of this paragraph (3)(i). Thus, for example, the owner of a trademark may license to another person the exclusive right to use that trademark in a specified geographic area for a specified period of time (while otherwise retaining the right to use the intangible). In such a case, both the licensee and the licensor will be considered owners for purposes of this paragraph (f)(3)(i), with respect to their respective exploitation rights.

(ii) IDENTIFICATION OF OWNER -- (A) LEGALLY PROTECTED INTANGIBLE PROPERTY. The legal owner of a right to exploit an intangible ordinarily will be considered the owner for purposes of this section. Legal ownership may be acquired by operation of law or by contract under which the legal owner transfers all or part of its rights to another. Further, the district director may impute an agreement to convey legal ownership if the conduct of the controlled taxpayers indicates the existence in substance of such an agreement. See section 1.482-1(d)(3)(ii)(B) (Identifying contractual terms).

(B) INTANGIBLE PROPERTY THAT IS NOT LEGALLY PROTECTED. In the case of intangible property that is not legally protected, the developer of the intangible will be considered the owner. Except as provided in section 1.482-7T, if two or more controlled taxpayers jointly develop an intangible, for purposes of section 482, only one of the controlled taxpayers will be regarded as the developer and owner of the intangible, and the other participating members will be regarded as assisters. Ordinarily, the developer is the controlled taxpayer that bore the largest portion of the direct and indirect costs of developing the intangible, including the provision, without adequate compensation, of property or services likely to contribute substantially to developing the intangible. A controlled taxpayer will be presumed not to have borne the costs of development if, pursuant to an agreement entered into before the success of the project is known, another person is obligated to reimburse the controlled taxpayer for its costs. If it cannot be determined which controlled taxpayer bore the largest portion of the costs of development, all other facts and circumstances will be taken into consideration, including the location of the development activities, the capability of each controlled taxpayer to carry on the project independently, the extent to which each controlled taxpayer controls the project, and the conduct of the controlled taxpayers.

(iii) ALLOCATIONS WITH RESPECT TO ASSISTANCE PROVIDED TO THE OWNER. Allocations may be made to reflect an arm's length consideration for assistance provided to the owner of an intangible in connection with the development or enhancement of the intangible. Such assistance may include loans, services, or the use of tangible or intangible property. Assistance does not, however, include expenditures of a routine nature that an unrelated party dealing at arm's length would be expected to incur under circumstances similar to those of the controlled taxpayer. The amount of any allocation required with respect to that assistance must be determined in accordance with the applicable rules under section 482.

(iv) EXAMPLES. The principles of this paragraph are illustrated by the following examples.

EXAMPLE 1. A, a member of a controlled group, allows B, another member of the controlled group and the owner of an intangible, to use tangible property, such as laboratory equipment, in connection with the development of the intangible. Any allocations with respect to the owner's use of the property will be determined under section 1.482-2(c).

EXAMPLE 2. FP, a foreign producer of cheese, markets the cheese in countries other than the United States under the tradename Fromage Frere. FP owns all the worldwide rights to this name. The name is widely known and is valuable outside the United States but is not known within the United States. In 1995, FP decides to enter the United States market and incorporates U.S. subsidiary, USSub, to be its U.S. distributor and to supervise the advertising and other marketing efforts that will be required to develop the name Fromage Frere in the United States. USSub incurs expenses that are not reimbursed by FP for developing the U.S. market for Fromage Frere. These expenses are comparable to the levels of expense incurred by independent distributors in the U.S. cheese industry when introducing a product in the U.S. market under a brand name owned by a foreign manufacturer. Since USSub would have been expected to incur these expenses if it were unrelated to FP, no allocation to USSub is made with respect to the market development activities performed by USSub.

EXAMPLE 3. The facts are the same as in EXAMPLE 2, except that the expenses incurred by USSub are significantly larger than the expenses incurred by independent distributors under similar circumstances. FP does not reimburse USSub for its expenses. The district director concludes based on this evidence that an unrelated party dealing at arm's length under similar circumstances would not have engaged in the same level of activity relating to the development of FP's marketing intangibles. The expenditures in excess of the level incurred by the independent distributors therefore are considered to be a service provided to FP that adds to the value of FP's trademark for Fromage Frere. Accordingly, the district director makes an allocation under section 482 for the fair market value of the services that USSub is considered to have performed for FP.

EXAMPLE 4. The facts are the same as in EXAMPLE 3, except that FP and USSub conclude a long term agreement under which USSub receives the exclusive right to distribute cheese in the United States under FP's trademark. USSub purchases cheese from FP at an arm's length price. Since USSub is the owner of the trademark under paragraph (f)(3)(ii)(A) of this section, and its conduct is consistent with that status, its activities related to the development of the trademark are not considered to be a service performed for the benefit of FP, and no allocation is made with respect to such activities.

(4) CONSIDERATION NOT ARTIFICIALLY LIMITED. The arm's length consideration for the controlled transfer of an intangible is not limited by the consideration paid in any uncontrolled transactions that do not meet the requirements of the comparable uncontrolled transaction method described in paragraph (c) of this section. Similarly, the arm's length consideration for an intangible is not limited by the prevailing rates of consideration paid for the use or transfer of intangibles within the same or similar industry.

(5) LUMP SUM PAYMENTS -- (i) IN GENERAL. If an intangible is transferred in a controlled transaction for a lump sum, that amount must be commensurate with the income attributable to the intangible. A lump sum is commensurate with income in a taxable year if the equivalent royalty amount for that taxable year is equal to an arm's length royalty. The equivalent royalty amount for a taxable year is the amount determined by treating the lump sum as an advance payment of a stream of royalties over the useful life of the intangible (or the period covered by an agreement, if shorter), taking into account the projected sales of the licensee as of the date of the transfer. Thus, determining the equivalent royalty amount requires a present value calculation based on the lump sum, an appropriate discount rate, and the projected sales over the relevant period. The equivalent royalty amount is subject to periodic adjustments under section 1.482-4(f)(2)(i) to the same extent as an actual royalty payment pursuant to a license agreement.

(ii) EXCEPTIONS. No periodic adjustment will be made under paragraph (f)(2)(i) of this section if any of the exceptions to periodic adjustments provided in paragraph (f)(2)(ii) of this section apply.

(iii) EXAMPLE. The following example illustrates the principle of this paragraph (f)(5).

EXAMPLE. CALCULATION OF THE EQUIVALENT ROYALTY AMOUNT. (i) FSub is the foreign subsidiary of USP, a U.S. company. USP licenses FSub the right to produce and sell the whopperchopper, a patented new kitchen appliance, for the foreign market. The license is for a period of five years, and payment takes the form of a single lump-sum charge of $500,000 that is paid at the beginning of the period.

(ii) The equivalent royalty amount for this license is determined by deriving an equivalent royalty rate equal to the lump-sum payment divided by the present discounted value of FSub's projected sales of whopperchoppers over the life of the license. Based on the riskiness of the whopperchopper business, an appropriate discount rate is determined to be 10 percent. Projected sales of whopperchoppers for each year of the license are as follows:

 Year                Projected Sales ($)

 Year       Projected Sales ($)     Equivalent royalty amount ($)

SECTION 1.482-5 COMPARABLE PROFITS METHOD.

(a) IN GENERAL. The comparable profits method evaluates whether the amount charged in a controlled transaction is arm's length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances.

(b) DETERMINATION OF ARM'S LENGTH RESULT -- (1) IN GENERAL. Under the comparable profits method, the determination of an arm's length result is based on the amount of operating profit that the tested party would have earned on related party transactions if its profit level indicator were equal to that of an uncontrolled comparable (comparable operating profit). Comparable operating profit is calculated by determining a profit level indicator for an uncontrolled comparable, and applying the profit level indicator to the financial data related to the tested party's most narrowly identifiable business activity for which data incorporating the controlled transaction is available (relevant business activity). To the extent possible, profit level indicators should be applied solely to the tested party's financial data that is related to controlled transactions. The tested party's reported operating profit is compared to the comparable operating profits derived from the profit level indicators of uncontrolled comparables to determine whether the reported operating profit represents an arm's length result.

(2) TESTED PARTY -- (i) IN GENERAL. For purposes of this section, the tested party will be the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data regarding uncontrolled comparables can be located. Consequently, in most cases the tested party will be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables.

(ii) ADJUSTMENTS FOR TESTED PARTY. The tested party's operating profit must first be adjusted to reflect all other allocations under section 482, other than adjustments pursuant to this section.

(3) ARM'S LENGTH RANGE. See section 1.482-1(e)(2) for the determination of the arm's length range. For purposes of the comparable profits method, the arm's length range will be established using comparable operating profits derived from a single profit level indicator.

(4) PROFIT LEVEL INDICATORS. Profit level indicators are ratios that measure relationships between profits and costs incurred or resources employed. A variety of profit level indicators can be calculated in any given case. Whether use of a particular profit level indicator is appropriate depends upon a number of factors, including the nature of the activities of the tested party, the reliability of the available data with respect to uncontrolled comparables, and the extent to which the profit level indicator is likely to produce a reliable measure of the income that the tested party would have earned had it dealt with controlled taxpayers at arm's length, taking into account all of the facts and circumstances. The profit level indicators should be derived from a sufficient number of years of data to reasonably measure returns that accrue to uncontrolled comparables. Generally, such a period should encompass at least the taxable year under review and the preceding two taxable years. This analysis must be applied in accordance with section 1.482-1(f)(2)(iii)(D). Profit level indicators that may provide a reliable basis for comparing operating profits of the tested party and uncontrolled comparables include the following --

(i) RATE OF RETURN ON CAPITAL EMPLOYED. The rate of return on capital employed is the ratio of operating profit to operating assets. The reliability of this profit level indicator increases as operating assets play a greater role in generating operating profits for both the tested party and the uncontrolled comparable. In addition, reliability under this profit level indicator depends on the extent to which the composition of the tested party's assets is similar to that of the uncontrolled comparable. Finally, difficulties in properly valuing operating assets will diminish the reliability of this profit level indicator.

(ii) FINANCIAL RATIOS. Financial ratios measure relationships between profit and costs or sales revenue. Since functional differences generally have a greater effect on the relationship between profit and costs or sales revenue than the relationship between profit and operating assets, financial ratios are more sensitive to functional differences than the rate of return on capital employed. Therefore, closer functional comparability normally is required under a financial ratio than under the rate of return on capital employed to achieve a similarly reliable measure of an arm's length result. Financial ratios that may be appropriate include the following --

(A) Ratio of operating profit to sales; and

(B) Ratio of gross profit to operating expenses. Reliability under this profit level indicator also depends on the extent to which the composition of the tested party's operating expenses is similar to that of the uncontrolled comparables.

(iii) OTHER PROFIT LEVEL INDICATORS. Other profit level indicators not described in this paragraph (b)(4) may be used if they provide reliable measures of the income that the tested party would have earned had it dealt with controlled taxpayers at arm's length. However, profit level indicators based solely on internal data may not be used under this paragraph (b)(4) because they are not objective measures of profitability derived from operations of uncontrolled taxpayers engaged in similar business activities under similar circumstances.

(c) COMPARABILITY AND RELIABILITY CONSIDERATIONS -- (1) IN GENERAL. Whether results derived from application of this method are the most reliable measure of the arm's length result must be determined using the factors described under the best method rule in section 1.482-1(c).

(2) COMPARABILITY -- (i) IN GENERAL. The degree of comparability between an uncontrolled taxpayer and the tested party is determined by applying the provisions of section 1.482-1(d)(2). The comparable profits method compares the profitability of the tested party, measured by a profit level indicator (generally based on operating profit), to the profitability of uncontrolled taxpayers in similar circumstances. As with all methods that rely on external market benchmarks, the greater the degree of comparability between the tested party and the uncontrolled taxpayer, the more reliable will be the results derived from the application of this method. The determination of the degree of comparability between the tested party and the uncontrolled taxpayer depends upon all the relevant facts and circumstances, including the relevant lines of business, the product or service markets involved, the asset composition employed (including the nature and quantity of tangible assets, intangible assets and working capital), the size and scope of operations, and the stage in a business or product cycle.

(ii) FUNCTIONAL, RISK AND RESOURCE COMPARABILITY. An operating profit represents a return for the investment of resources and assumption of risks. Therefore, although all of the factors described in section 1.482-1(d)(3) must be considered, comparability under this method is particularly dependent on resources employed and risks assumed. Moreover, because resources and risks usually are directly related to functions performed, it is also important to consider functions performed in determining the degree of comparability between the tested party and an uncontrolled taxpayer. The degree of functional comparability required to obtain a reliable result under the comparable profits method, however, is generally less than that required under the resale price or cost plus methods. For example, because differences in functions performed often are reflected in operating expenses, taxpayers performing different functions may have very different gross profit margins but earn similar levels of operating profit.

(iii) OTHER COMPARABILITY FACTORS. Other factors listed in section 1.482-1(d)(3) also may be particularly relevant under the comparable profits method. Because operating profit usually is less sensitive than gross profit to product differences, reliability under the comparable profits method is not as dependent on product similarity as the resale price or cost plus method. However, the reliability of profitability measures based on operating profit may be adversely affected by factors that have less effect on results under the comparable uncontrolled price, resale price, and cost plus methods. For example, operating profit may be affected by varying cost structures (as reflected, for example, in the age of plant and equipment), differences in business experience (such as whether the business is in a start-up phase or is mature), or differences in management efficiency (as indicated, for example, by objective evidence such as expanding or contracting sales or executive compensation over time). Accordingly, if material differences in these factors are identified based on objective evidence, the reliability of the analysis may be affected.

(iv) ADJUSTMENTS FOR THE DIFFERENCES BETWEEN THE TESTED PARTY AND THE UNCONTROLLED TAXPAYERS. If there are differences between the tested party and an uncontrolled comparable that would materially affect the profits determined under the relevant profit level indicator, adjustments should be made according to the comparability provisions of section 1.482-1(d)(2). In some cases, the assets of an uncontrolled comparable may need to be adjusted to achieve greater comparability between the tested party and the uncontrolled comparable. In such cases, the uncontrolled comparable's operating income attributable to those assets must also be adjusted before computing a profit level indicator in order to reflect the income and expense attributable to the adjusted assets. In certain cases it may also be appropriate to adjust the operating profit of the tested party and comparable parties. For example, where there are material differences in accounts payable among the comparable parties and the tested party, it will generally be appropriate to adjust the operating profit of each party by increasing it to reflect an imputed interest charge on each party's accounts payable.

(3) DATA AND ASSUMPTIONS -- (i) IN GENERAL. The reliability of the results derived from the comparable profits method is affected by the quality of the data and assumptions used to apply this method.

(ii) CONSISTENCY IN ACCOUNTING. The degree of consistency in accounting practices between the controlled transaction and the uncontrolled comparables that materially affect operating profit affects the reliability of the result. Thus, for example, if differences in inventory and other cost accounting practices would materially affect operating profit, the ability to make reliable adjustments for such differences would affect the reliability of the results.

(iii) ALLOCATIONS BETWEEN THE RELEVANT BUSINESS ACTIVITY AND OTHER ACTIVITIES. The reliability of the allocation of costs, income, and assets between the relevant business activity and other activities of the tested party or an uncontrolled comparable will affect the reliability of the determination of operating profit and profit level indicators. If it is not possible to allocate costs, income, and assets directly based on factual relationships, a reasonable allocation formula may be used. To the extent direct allocations are not made, the reliability of the results derived from the application of this method is reduced relative to the results of a method that requires fewer allocations of costs, income, and assets. Similarly, the reliability of the results derived from the application of this method is affected by the extent to which it is possible to apply the profit level indicator to the tested party's financial data that is related solely to the controlled transactions. For example, if the relevant business activity is the assembly of components purchased from both controlled and uncontrolled suppliers, it may not be possible to apply the profit level indicator solely to financial data related to the controlled transactions. In such a case, the reliability of the results derived from the application of this method will be reduced.

(d) DEFINITIONS. The definitions set forth in paragraphs (d)(1) through (6) of this section apply for purposes of this section.

(1) SALES REVENUE means the amount of the total receipts from sale of goods and provision of services, less returns and allowances. Accounting principles and conventions that are generally accepted in the trade or industry of the controlled taxpayer under review must be used.

(2) GROSS PROFIT means sales revenue less cost of goods sold.

(3) OPERATING EXPENSES includes all expenses not included in cost of goods sold except for interest expense, foreign income taxes (as defined in section 1.901-2(a)), domestic income taxes, and any other expenses not related to the operation of the relevant business activity. Operating expenses ordinarily include expenses associated with advertising, promotion, sales, marketing, warehousing and distribution, administration, and a reasonable allowance for depreciation and amortization.

(4) OPERATING PROFIT means gross profit less operating expenses. Operating profit includes all income derived from the business activity being evaluated by the comparable profits method, but does not include interest and dividends, income derived from activities not being tested by this method, or extraordinary gains and losses that do not relate to the continuing operations of the tested party.

(5) REPORTED OPERATING PROFIT means the operating profit of the tested party reflected on a timely filed U.S. income tax return. If the tested party files a U.S. income tax return, its operating profit is considered reflected on a U.S. income tax return if the calculation of taxable income on its return for the taxable year takes into account the income attributable to the controlled transaction under review. If the tested party does not file a U.S. income tax return, its operating profit is considered reflected on a U.S. income tax return in any taxable year for which income attributable to the controlled transaction under review affects the calculation of the U.S. taxable income of any other member of the same controlled group. If the comparable operating profit of the tested party is determined from profit level indicators derived from financial statements or other accounting records and reports of comparable parties, adjustments may be made to the reported operating profit of the tested party in order to account for material differences between the tested party's operating profit reported for U.S. income tax purposes and the tested party's operating profit for financial statement purposes. In addition, in accordance with section 1.482-1(f)(2)(iii)(D), adjustments under section 482 that are finally determined may be taken into account in determining reported operating profit.

(6) OPERATING ASSETS. The term operating assets means the value of all assets used in the relevant business activity of the tested party, including fixed assets and current assets (such as cash, cash equivalents, accounts receivable, and inventories). The term does not include investments in subsidiaries, excess cash, and portfolio investments. Operating assets may be measured by their net book value or by their fair market value, provided that the same method is consistently applied to the tested party and the comparable parties, and consistently applied from year to year. In addition, it may be necessary to take into account recent acquisitions, leased assets, intangibles, currency fluctuations, and other items that may not be explicitly recorded in the financial statements of the tested party or uncontrolled comparable. Finally, operating assets must be measured by the average of the values for the beginning of the year and the end of the year, unless substantial fluctuations in the value of operating assets during the year make this an inaccurate measure of the average value over the year. In such a case, a more accurate measure of the average value of operating assets must be applied.

(e) EXAMPLES. The following examples illustrate the application of this section.

EXAMPLE 1 -- TRANSFER OF TANGIBLE PROPERTY RESULTING IN NO ADJUSTMENT. (i) FP is a publicly traded foreign corporation with a U.S. subsidiary, USSub, that is under audit for its 1996 taxable year. FP manufactures a consumer product for worldwide distribution. USSub imports the assembled product and distributes it within the United States at the wholesale level under the FP name.

(ii) FP does not allow uncontrolled taxpayers to distribute the product. Similar products are produced by other companies but none of them is sold to uncontrolled taxpayers or to uncontrolled distributors.

(iii) Based on all the facts and circumstances, the district director determines that the comparable profits method will provide the most reliable measure of an arm's length result. USSub is selected as the tested party because it engages in activities that are less complex than those undertaken by FP. There is data from a number of independent operators of wholesale distribution businesses. These potential comparables are further narrowed to select companies in the same industry segment that perform similar functions and bear similar risks to USSub. An analysis of the information available on these taxpayers shows that the ratio of operating profit to sales is the most appropriate profit level indicator, and this ratio is relatively stable where at least three years are included in the average. For the taxable years 1994 through 1996, USSub shows the following results:

                         1994      1995      1996     Average

 Uncontrolled                            USSub

EXAMPLE 2 -- TRANSFER OF TANGIBLE PROPERTY RESULTING IN ADJUSTMENT. (i) The facts are the same as in EXAMPLE 1 except that USSub reported the following income and expenses:

                         1994      1995      1996     Average

(iii) To determine the amount, if any, of the allocation, the district director compares USSub's reported operating profit for 1996 to comparable operating profits derived from the uncontrolled distributors' results for 1996. The ratio of operating profit to sales in 1996 is calculated for each of the uncontrolled comparables and applied to USSub's 1996 sales to derive the following results:

 Uncontrolled                        USSub

EXAMPLE 3 -- MULTIPLE YEAR ANALYSIS. (i) The facts are the same as in EXAMPLE 2. In addition, the district director examines the taxpayer's results for the 1997 taxable year. As in EXAMPLE 2, the district director increases USSub's income for the 1996 taxable year by $24,250. The results for the 1997 taxable year, together with the 1995 and 1996 taxable years, are as follows:

                       1995      1996      1997       Average

(iii) To determine the amount, if any, of the allocation for the 1997 taxable year, the district director compares USSub's reported operating profit for 1997 to the median of the comparable operating profits derived from the uncontrolled distributors' results for 1997. The median of the comparable operating profits derived from the uncontrolled comparables results for the 1997 taxable year is $12,000. Based on this comparison, the district director increases USSub's 1997 taxable income by $22,000, the difference between the median of the comparable operating profits for the 1997 taxable year and USSub's reported operating profit of ($10,000) for the 1997 taxable year.

EXAMPLE 4 -- TRANSFER OF INTANGIBLE TO OFFSHORE MANUFACTURER. (i) DevCo is a U.S. developer, producer and marketer of widgets. DevCo develops a new "high tech widget" (htw) that is manufactured by its foreign subsidiary ManuCo located in Country H. ManuCo sells the htw to MarkCo (a U.S. subsidiary of DevCo) for distribution and marketing in the United States. The taxable year 1996 is under audit, and the district director examines whether the royalty rate of 5 percent paid by ManuCo to DevCo is an arm's length consideration for the htw technology.

(ii) Based on all the facts and circumstances, the district director determines that the comparable profits method will provide the most reliable measure of an arm's length result. ManuCo is selected as the tested party because it engages in relatively routine manufacturing activities, while DevCo engages in a variety of complex activities using unique and valuable intangibles. Finally, because ManuCo engages in manufacturing activities, it is determined that the ratio of operating profit to operating assets is an appropriate profit level indicator.

(iii) Uncontrolled taxpayers performing similar functions cannot be found in country H. It is determined that data available in countries M and N provides the best match of companies in a similar market performing similar functions and bearing similar risks. Such data is sufficiently complete to identify many of the material differences between ManuCo and the uncontrolled comparables, and to make adjustments to account for such differences. However, data is not sufficiently complete so that it is likely that no material differences remain. In particular, the differences in geographic markets might have materially affected the results of the various companies.

(iv) In a separate analysis, it is determined that the price that ManuCo charged to MarkCo for the htw's is an arm's length price under section 1.482-3(b). Therefore, ManuCo's financial data derived from its sales to MarkCo are reliable. ManuCo's financial data from 1994-1996 is as follows:

                          1994        1995         1996      Average

(vi) To determine the amount, if any, of the allocation for the 1996 taxable year, the district director compares ManuCo's reported operating profit for 1996 to the median of the comparable operating profits derived from the uncontrolled distributors' results for 1996. The median result for the uncontrolled comparables for 1996 is $3,750. Based on this comparison, the district director increases royalties that ManuCo paid by $21,500 (the difference between $25,250 and the median of the comparable operating profits, $3,750).

EXAMPLE 5 -- ADJUSTING OPERATING ASSETS AND OPERATING PROFIT FOR DIFFERENCES IN ACCOUNTS RECEIVABLE. (i) USM is a U.S. company that manufactures parts for industrial equipment and sells them to its foreign parent corporation. For purposes of applying the comparable profits method, 15 uncontrolled manufacturers that are similar to USM have been identified.

(ii) USM has a significantly lower level of accounts receivable than the uncontrolled manufacturers. Since the rate of return on capital employed is to be used as the profit level indicator, both operating assets and operating profits must be adjusted to account for this difference. Each uncontrolled comparable's operating assets is reduced by the amount (relative to sales) by which they exceed USM's accounts receivable. Each uncontrolled comparable's operating profit is adjusted by deducting imputed interest income on the excess accounts receivable. This imputed interest income is calculated by multiplying the uncontrolled comparable's excess accounts receivable by an interest rate appropriate for short-term debt.

EXAMPLE 6 -- ADJUSTING OPERATING PROFIT FOR DIFFERENCES IN ACCOUNTS PAYABLE. (i) USD is the U.S. subsidiary of a foreign corporation. USD purchases goods from its foreign parent and sells them in the U.S. market. For purposes of applying the comparable profits method, 10 uncontrolled distributors that are similar to USD have been identified.

(ii) There are significant differences in the level of accounts payable among the uncontrolled distributors and USD. To adjust for these differences, the district director increases the operating profit of the uncontrolled distributors and USD to reflect interest expense imputed to the accounts payable. The imputed interest expense for each company is calculated by multiplying the company's accounts payable by an interest rate appropriate for its short-term debt.

SECTION 1.482-6 PROFIT SPLIT METHOD.

(a) IN GENERAL. The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm's length by reference to the relative value of each controlled taxpayer's contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions (relevant business activity).

(b) APPROPRIATE SHARE OF PROFITS AND LOSSES. The relative value of each controlled taxpayer's contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the comparability provisions of section 1.482-1(d)(3). Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers engaged in the relevant business activity. The profit allocated to any particular member of a controlled group is not necessarily limited to the total operating profit of the group from the relevant business activity. For example, in a given year, one member of the group may earn a profit while another member incurs a loss. In addition, it may not be assumed that the combined operating profit or loss from the relevant business activity should be shared equally, or in any other arbitrary proportion. The specific method of allocation must be determined under paragraph (c) of this section.

(c) APPLICATION -- (1) IN GENERAL. The allocation of profit or loss under the profit split method must be made in accordance with one of the following allocation methods --

(i) The comparable profit split, described in paragraph (c)(2) of this section; or

(ii) The residual profit split, described in paragraph (c)(3) of this section.

(2) COMPARABLE PROFIT SPLIT -- (i) IN GENERAL. A comparable profit split is derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayers in the relevant business activity. Under this method, each uncontrolled taxpayer's percentage of the combined operating profit or loss is used to allocate the combined operating profit or loss of the relevant business activity.

(ii) COMPARABILITY AND RELIABILITY CONSIDERATIONS -- (A) IN GENERAL. Whether results derived from application of this method are the most reliable measure of the arm's length result is determined using the factors described under the best method rule in section 1.482-1(c).

(B) COMPARABILITY -- (1) IN GENERAL. The degree of comparability between the controlled and uncontrolled taxpayers is determined by applying the comparability provisions of section 1.482-1(d). The comparable profit split compares the division of operating profits among the controlled taxpayers to the division of operating profits among uncontrolled taxpayers engaged in similar activities under similar circumstances. Although all of the factors described in section 1.482-1(d)(3) must be considered, comparability under this method is particularly dependent on the considerations described under the comparable profits method in section 1.482-5(c)(2), because this method is based on a comparison of the operating profit of the controlled and uncontrolled taxpayers. In addition, because the contractual terms of the relationship among the participants in the relevant business activity will be a principal determinant of the allocation of functions and risks among them, comparability under this method also depends particularly on the degree of similarity of the contractual terms of the controlled and uncontrolled taxpayers. Finally, the comparable profit split may not be used if the combined operating profit (as a percentage of the combined assets) of the uncontrolled comparables varies significantly from that earned by the controlled taxpayers.

(2) ADJUSTMENTS FOR DIFFERENCES BETWEEN THE CONTROLLED AND UNCONTROLLED TAXPAYERS. If there are differences between the controlled and uncontrolled taxpayers that would materially affect the division of operating profit, adjustments must be made according to the provisions of section 1.482-1(d)(2).

(C) DATA AND ASSUMPTIONS. The reliability of the results derived from the comparable profit split is affected by the quality of the data and assumptions used to apply this method. In particular, the following factors must be considered --

(1) The reliability of the allocation of costs, income, and assets between the relevant business activity and the participants' other activities will affect the accuracy of the determination of combined operating profit and its allocation among the participants. If it is not possible to allocate costs, income, and assets directly based on factual relationships, a reasonable allocation formula may be used. To the extent direct allocations are not made, the reliability of the results derived from the application of this method is reduced relative to the results of a method that requires fewer allocations of costs, income, and assets. Similarly, the reliability of the results derived from the application of this method is affected by the extent to which it is possible to apply the method to the parties' financial data that is related solely to the controlled transactions. For example, if the relevant business activity is the assembly of components purchased from both controlled and uncontrolled suppliers, it may not be possible to apply the method solely to financial data related to the controlled transactions. In such a case, the reliability of the results derived from the application of this method will be reduced.

(2) The degree of consistency between the controlled and uncontrolled taxpayers in accounting practices that materially affect the items that determine the amount and allocation of operating profit affects the reliability of the result. Thus, for example, if differences in inventory and other cost accounting practices would materially affect operating profit, the ability to make reliable adjustments for such differences would affect the reliability of the results. Further, accounting consistency among the participants in the controlled transaction is required to ensure that the items determining the amount and allocation of operating profit are measured on a consistent basis.

(D) OTHER FACTORS AFFECTING RELIABILITY. Like the methods described in sections 1.482-3, 1.482-4, and 1.482-5, the comparable profit split relies exclusively on external market benchmarks. As indicated in section 1.482-1(c)(2)(i), as the degree of comparability between the controlled and uncontrolled transactions increases, the relative weight accorded the analysis under this method will increase. In addition, the reliability of the analysis under this method may be enhanced by the fact that all parties to the controlled transaction are evaluated under the comparable profit split. However, the reliability of the results of an analysis based on information from all parties to a transaction is affected by the reliability of the data and the assumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are significantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results.

(3) RESIDUAL PROFIT SPLIT -- (i) IN GENERAL. Under this method, the combined operating profit or loss from the relevant business activity is allocated between the controlled taxpayers following the two-step process set forth in paragraphs (c)(3)(i)(A) and (B) of this section.

(A) ALLOCATE INCOME TO ROUTINE CONTRIBUTIONS. The first step allocates operating income to each party to the controlled transactions to provide a market return for its routine contributions to the relevant business activity. Routine contributions are contributions of the same or a similar kind to those made by uncontrolled taxpayers involved in similar business activities for which it is possible to identify market returns. Routine contributions ordinarily include contributions of tangible property, services and intangibles that are generally owned by uncontrolled taxpayers engaged in similar activities. A functional analysis is required to identify these contributions according to the functions performed, risks assumed, and resources employed by each of the controlled taxpayers. Market returns for the routine contributions should be determined by reference to the returns achieved by uncontrolled taxpayers engaged in similar activities, consistent with the methods described in section 1.482-3, 1.482-4 and 1.482-5.

(B) ALLOCATE RESIDUAL PROFIT. The allocation of income to the controlled taxpayers' routine contributions will not reflect profits attributable to the controlled group's valuable intangible property where similar property is not owned by the uncontrolled taxpayers from which the market returns are derived. Thus, in cases where such intangibles are present there normally will be an unallocated residual profit after the allocation of income described in paragraph (c)(3)(i)(A) of this section. Under this second step, the residual profit generally should be divided among the controlled taxpayers based upon the relative value of their contributions of intangible property to the relevant business activity that was not accounted for as a routine contribution. The relative value of the intangible property contributed by each taxpayer may be measured by external market benchmarks that reflect the fair market value of such intangible property. Alternatively, the relative value of intangible contributions may be estimated by the capitalized cost of developing the intangibles and all related improvements and updates, less an appropriate amount of amortization based on the useful life of each intangible. Finally, if the intangible development expenditures of the parties are relatively constant over time and the useful life of the intangible property of all parties is approximately the same, the amount of actual expenditures in recent years may be used to estimate the relative value of intangible contributions. If the intangible property contributed by one of the controlled taxpayers is also used in other business activities (such as transactions with other controlled taxpayers), an appropriate allocation of the value of the intangibles must be made among all the business activities in which it is used.

(ii) COMPARABILITY AND RELIABILITY CONSIDERATIONS -- (A) IN GENERAL. Whether results derived from this method are the most reliable measure of the arm's length result is determined using the factors described under the best method rule in section 1.482-1(c). Thus, comparability and the quality of data and assumptions must be considered in determining whether this method provides the most reliable measure of an arm's length result. The application of these factors to the residual profit split is discussed in paragraph (c)(3)(ii)(B), (C), and (D) of this section.

(B) COMPARABILITY. The first step of the residual profit split relies on market benchmarks of profitability. Thus, the comparability considerations that are relevant for the first step of the residual profit split are those that are relevant for the methods that are used to determine market returns for the routine contributions. The second step of the residual profit split, however, may not rely so directly on market benchmarks. Thus, the reliability of the results under this method is reduced to the extent that the allocation of profits in the second step does not rely on market benchmarks.

(C) DATA AND ASSUMPTIONS. The reliability of the results derived from the residual profit split is affected by the quality of the data and assumptions used to apply this method. In particular, the following factors must be considered --

(1) The reliability of the allocation of costs, income, and assets as described in paragraph (c)(2)(ii)(C)(1);

(2) Accounting consistency as described in paragraph (c)(2)(ii)(C)(2) of this section;

(3) The reliability of the data used and the assumptions made in valuing the intangible property contributed by the participants. In particular, if capitalized costs of development are used to estimate the value of intangible property, the reliability of the results is reduced relative to the reliability of other methods that do not require such an estimate, for the following reasons. First, in any given case, the costs of developing the intangible may not be related to its market value. Second, the calculation of the capitalized costs of development may require the allocation of indirect costs between the relevant business activity and the controlled taxpayer's other activities, which may affect the reliability of the analysis. Finally, the calculation of costs may require assumptions regarding the useful life of the intangible property.

(D) OTHER FACTORS AFFECTING RELIABILITY. Like the methods described in sections 1.482-3, 1.482-4, and 1.482-5, the first step of the residual profit split relies exclusively on external market benchmarks. As indicated in section 1.482-1(c)(2)(i), as the degree of comparability between the controlled and uncontrolled transactions increases, the relative weight accorded the analysis under this method will increase. In addition, to the extent the allocation of profits in the second step is not based on external market benchmarks, the reliability of the analysis will be decreased in relation to an analysis under a method that relies on market benchmarks. Finally, the reliability of the analysis under this method may be enhanced by the fact that all parties to the controlled transaction are evaluated under the residual profit split. However, the reliability of the results of an analysis based on information from all parties to a transaction is affected by the reliability of the data and the assumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are significantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results.

(iii) EXAMPLE. The provisions of this paragraph (c)(3) are illustrated by the following example.

EXAMPLE -- APPLICATION OF RESIDUAL PROFIT SPLIT. (i) XYZ is a U.S. corporation that develops, manufactures and markets a line of products for police use in the United States. XYZ's research unit developed a bulletproof material for use in protective clothing and headgear (Nulon). XYZ obtains patent protection for the chemical formula for Nulon. Since its introduction in the U.S., Nulon has captured a substantial share of the U.S. market for bulletproof material.

(ii) XYZ licensed its European subsidiary, XYZ-Europe, to manufacture and market Nulon in Europe. XYZ-Europe is a well- established company that manufactures and markets XYZ products in Europe. XYZ-Europe has a research unit that adapts XYZ products for the defense market, as well as a well-developed marketing network that employs brand names that it developed.

(iii) XYZ-Europe's research unit alters Nulon to adapt it to military specifications and develops a high-intensity marketing campaign directed at the defense industry in several European countries. Beginning with the 1995 taxable year, XYZ- Europe manufactures and sells Nulon in Europe through its marketing network under one of its brand names.

(iv) For the 1995 taxable year, XYZ has no direct expenses associated with the license of Nulon to XYZ-Europe and incurs no expenses related to the marketing of Nulon in Europe. For the 1995 taxable year, XYZ-Europe's Nulon sales and pre-royalty expenses are $500 million and $300 million, respectively, resulting in net pre-royalty profit of $200 million related to the Nulon business. The operating assets employed in XYZ- Europe's Nulon business are $200 million. Given the facts and circumstances, the district director determines under the best method rule that a residual profit split will provide the most reliable measure of an arm's length result. Based on an examination of a sample of European companies performing functions similar to those of XYZ-Europe, the district director determines that an average market return on XYZ-Europe's operating assets in the Nulon business is 10 percent, resulting in a market return of $20 million (10% X $200 million) for XYZ- Europe's Nulon business, and a residual profit of $180 million.

(v) Since the first stage of the residual profit split allocated profits to XYZ-Europe's contributions other than those attributable to highly valuable intangible property, it is assumed that the residual profit of $180 million is attributable to the valuable intangibles related to Nulon, i.e., the European brand name for Nulon and the Nulon formula (including XYZ- Europe's modifications). To estimate the relative values of these intangibles, the district director compares the ratios of the capitalized value of expenditures as of 1995 on Nulon- related-research and development and marketing over the 1995 sales related to such expenditures.

(vi) Because XYZ's protective product research and development expenses support the worldwide protective product sales of the XYZ group, it is necessary to allocate such expenses among the worldwide business activities to which they relate. The district director determines that it is reasonable to allocate the value of these expenses based on worldwide protective product sales. Using information on the average useful life of its investments in protective product research and development, the district director capitalizes and amortizes XYZ's protective product research and development expenses. This analysis indicates that the capitalized research and development expenditures have a value of $0.20 per dollar of global protective product sales in 1995.

(vii) XYZ-Europe's expenditures on Nulon research and development and marketing support only its sales in Europe. Using information on the average useful life of XYZ-Europe's investments in marketing and research and development, the district director capitalizes and amortizes XYZ-Europe's expenditures and determines that they have a value in 1995 of $0.40 per dollar of XYZ-Europe's Nulon sales.

(viii) Thus, XYZ and XYZ-Europe together contributed $0.60 in capitalized intangible development expenses for each dollar of XYZ-Europe's protective product sales for 1995, of which XYZ contributed one-third (or $0.20 per dollar of sales). Accordingly, the district director determines that an arm's length royalty for the Nulon license for the 1995 taxable year is $60 million, i.e., one-third of XYZ-Europe's $180 million in residual Nulon profit.

SECTION 1.482-8 EXAMPLES OF THE BEST METHOD RULE

In accordance with the best method rule of section 1.482-1(c), a method may be applied in a particular case only if the comparability, quality of data, and reliability of assumptions under that method make it more reliable than any other available measure of the arm's length result. The following examples illustrate the comparative analysis required to apply this rule. As with all of the examples in these regulations, these examples are based on simplified facts, are provided solely for purposes of illustrating the type of analysis required under the relevant rule, and do not provide rules of general application. Thus, conclusions reached in these examples as to the relative reliability of methods are based on the assumed facts of the examples, and are not general conclusions concerning the relative reliability of any method.

EXAMPLE 1 -- PREFERENCE FOR COMPARABLE UNCONTROLLED PRICE METHOD. Company A is the U.S. distribution subsidiary of Company B, a foreign manufacturer of consumer electrical appliances. Company A purchases toaster ovens from Company B for resale in the U.S. market. To exploit other outlets for its toaster ovens, Company B also sells its toaster ovens to Company C, an unrelated U.S. distributor of toaster ovens. The products sold to Company A and Company C are identical in every respect and there are no material differences between the transactions. In this case application of the CUP method, using the sales of toaster ovens to Company C, generally will provide a more reliable measure of an arm's length result for the controlled sale of toaster ovens to Company A than the application of any other method. See sections 1.482-1(c)(2)(i) and -3(b)(2)(ii)(A).

EXAMPLE 2 -- RESALE PRICE METHOD PREFERRED TO COMPARABLE UNCONTROLLED PRICE METHOD. The facts are the same as in Example 1, except that the toaster ovens sold to Company A are of substantially higher quality than those sold to Company C and the effect on price of such quality differences cannot be accurately determined. In addition, in order to round out its line of consumer appliances Company A purchases blenders from unrelated parties for resale in the United States. The blenders are resold to substantially the same customers as the toaster ovens, have a similar resale value to the toaster ovens, and are purchased under similar terms and in similar volumes. The distribution functions performed by Company A appear to be similar for toaster ovens and blenders. Given the product differences between the toaster ovens, application of the resale price method using the purchases and resales of blenders as the uncontrolled comparables is likely to provide a more reliable measure of an arm's length result than application of the comparable uncontrolled price method using Company B's sales of toaster ovens to Company C.

EXAMPLE 3 -- RESALE PRICE METHOD PREFERRED TO COMPARABLE PROFITS METHOD. (i) The facts are the same as in EXAMPLE 2 except that Company A purchases all its products from Company B and Company B makes no uncontrolled sales into the United States. However, six uncontrolled U.S. distributors are identified that purchase a similar line of products from unrelated parties. The uncontrolled distributors purchase toaster ovens from unrelated parties, but there are significant differences in the characteristics of the toaster ovens, including the brandnames under which they are sold.

(ii) Under the facts of this case, reliable adjustments for the effect of the different brandnames cannot be made. Except for some differences in payment terms and inventory levels, the purchases and resales of toaster ovens by the three uncontrolled distributors are closely similar to the controlled purchases in terms of the markets in which they occur, the volume of the transactions, the marketing activities undertaken by the distributor, inventory levels, warranties, allocation of currency risk, and other relevant functions and risks. Reliable adjustments can be made for the differences in payment terms and inventory levels. In addition, sufficiently detailed accounting information is available to permit adjustments to be made for differences in accounting methods or in reporting of costs between cost of goods sold and operating expenses. There are no other material differences between the controlled and uncontrolled transactions.

(iii) Because reliable adjustments for the differences between the toaster ovens, including the trademarks under which they are sold, cannot be made, these uncontrolled transactions will not serve as reliable measures of an arm's length result under the comparable uncontrolled price method. There is, however, close functional similarity between the controlled and uncontrolled transactions and reliable adjustments have been made for material differences that would be likely to affect gross profit. Under these circumstances, the gross profit margins derived under the resale price method are less likely to be susceptible to any unidentified differences than the operating profit measures used under the comparable profits method. Therefore, given the close functional comparability between the controlled and uncontrolled transactions, and the high quality of the data, the resale price method achieves a higher degree of comparability and will provide a more reliable measure of an arm's length result. See section 1.482-1(c) (Best method rule).

EXAMPLE 4 -- COMPARABLE PROFITS METHOD PREFERRED TO RESALE PRICE METHOD. The facts are the same as in Example 3, except that the accounting information available for the uncontrolled comparables is not sufficiently detailed to ensure consistent reporting between cost of goods sold and operating expenses of material items such as discounts, insurance, warranty costs, and supervisory, general and administrative expenses. These expenses are significant in amount. Therefore, whether these expenses are treated as costs of goods sold or operating expenses would have a significant effect on gross margins. Because in this case reliable adjustments can not be made for such accounting differences, the reliability of the resale price method is significantly reduced. There is, however, close functional similarity between the controlled and uncontrolled transactions and reliable adjustments have been made for all material differences other than the potential accounting differences. Because the comparable profits method is not adversely affected by the potential accounting differences, under these circumstances the comparable profits method is likely to produce a more reliable measure of an arm's length result than the resale price method. See section 1.482-1(c) (Best method rule).

EXAMPLE 5 -- COST PLUS METHOD PREFERRED TO COMPARABLE PROFITS METHOD. (i) USS is a U.S. company that manufactures machine tool parts and sells them to its foreign parent corporation, FP. Four U.S. companies are identified that also manufacture various types of machine tool parts but sell them to uncontrolled purchasers.

(ii) Except for some differences in payment terms, the manufacture and sales of machine tool parts by the four uncontrolled companies are closely similar to the controlled transactions in terms of the functions performed and risks assumed. Reliable adjustments can be made for the differences in payment terms. In addition, sufficiently detailed accounting information is available to permit adjustments to be made for differences between the controlled transaction and the uncontrolled comparables in accounting methods and in the reporting of costs between cost of goods sold and operating expenses.

(iii) There is close functional similarity between the controlled and uncontrolled transactions and reliable adjustments can be made for material differences that would be likely to affect gross profit. Under these circumstances, the gross profit markups derived under the cost plus method are less likely to be susceptible to any unidentified differences than the operating profit measures used under the comparable profits method. Therefore, given the close functional comparability between the controlled and uncontrolled transactions, and the high quality of the data, the cost plus method achieves a higher degree of comparability and will provide a more reliable measure of an arm's length result. See section 1.482-1(c) (Best method rule).

EXAMPLE 6 -- COMPARABLE PROFITS METHOD PREFERRED TO COST PLUS METHOD. The facts are the same as in Example 5, except that there are significant differences between the controlled and uncontrolled transactions in terms of the types of parts and components manufactured and the complexity of the manufacturing process. The resulting functional differences are likely to materially affect gross profit margins, but it is not possible to identify the specific differences and reliably adjust for their effect on gross profit. Because these functional differences would be reflected in differences in operating expenses, the operating profit measures used under the comparable profits method implicitly reflect to some extent these functional differences. Therefore, because in this case the comparable profits method is less sensitive than the cost plus method to the potentially significant functional differences between the controlled and uncontrolled transactions, the comparable profits method is likely to produce a more reliable measure of an arm's length result than the cost plus method. See section 1.482-1(c) (Best method rule).

EXAMPLE 7 -- PREFERENCE FOR COMPARABLE UNCONTROLLED TRANSACTION METHOD. (i) USpharm, a U.S. pharmaceutical company, develops a new drug Z that is a safe and effective treatment for the disease zeezee. USpharm has obtained patents covering drug Z in the United States and in various foreign countries. USpharm has also obtained the regulatory authorizations necessary to market drug Z in the United States and in foreign countries.

(ii) USpharm licenses its subsidiary in country X, Xpharm, to produce and sell drug Z in country X. At the same time, it licenses an unrelated company, Ydrug, to produce and sell drug Z in country Y, a neighboring country. Prior to licensing the drug, USpharm had obtained patent protection and regulatory approvals in both countries and both countries provide similar protection for intellectual property rights. Country X and country Y are similar countries in terms of population, per capita income and the incidence of disease zeezee. Consequently, drug Z is expected to sell in similar quantities and at similar prices in both countries. In addition, costs of producing drug Z in each country are expected to be approximately the same.

(iii) USpharm and Xpharm establish terms for the license of drug Z that are identical in every material respect, including royalty rate, to the terms established between USpharm and Ydrug. In this case the district director determines that the royalty rate established in the Ydrug license agreement is a reliable measure of the arm's length royalty rate for the Xpharm license agreement. Given that the same property is transferred in the controlled and uncontrolled transactions, and that the circumstances under which the transactions occurred are substantially the same, in this case the comparable uncontrolled transaction method is likely to provide a more reliable measure of an arm's length result than any other method. See section 1.482-4(c)(2)(ii).

EXAMPLE 8 -- RESIDUAL PROFIT SPLIT METHOD PREFERRED TO OTHER METHODS. (i) USC is a U.S. company that develops, manufactures and sells communications equipment. EC is the European subsidiary of USC. EC is an established company that carries out extensive research and development activities and develops, manufactures and sells communications equipment in Europe. There are extensive transactions between USC and EC. USC licenses valuable technology it has developed to EC for use in the European market but EC also licenses valuable technology it has developed to USC. Each company uses components manufactured by the other in some of its products and purchases products from the other for resale in its own market.

(ii) Detailed accounting information is available for both USC and EC and adjustments can be made to achieve a high degree of consistency in accounting practices between them. Relatively reliable allocations of costs, income and assets can be made between the business activities that are related to the controlled transactions and those that are not. Relevant marketing and research and development expenditures can be identified and reasonable estimates of the useful life of the related intangibles are available so that the capitalized value of the intangible development expenses of USC and EC can be calculated. In this case there is no reason to believe that the relative value of these capitalized expenses is substantially different from the relative value of the intangible property of USC and EC. Furthermore, comparables are identified that could be used to estimate a market return for the routine contributions of USC and EC. Based on these facts, the residual profit split could provide a reliable measure of an arm's length result.

(iii) There are no uncontrolled transactions involving property that is sufficiently comparable to much of the tangible and intangible property transferred between USC and EC to permit use of the comparable uncontrolled price method or the comparable uncontrolled transaction method. Uncontrolled companies are identified in Europe and the United States that perform somewhat similar activities to USC and EC; however, the activities of none of these companies are as complex as those of USC and EC and they do not use similar levels of highly valuable intangible property that they have developed themselves. Under these circumstances, the uncontrolled companies may be useful in determining a market return for the routine contributions of USC and EC, but that return would not reflect the value of the intangible property employed by USC and EC. Thus, none of the uncontrolled companies is sufficiently similar so that reliable results would be obtained using the resale price, cost plus, or comparable profits methods. Moreover, no uncontrolled companies can be identified that engaged in sufficiently similar activities and transactions with each other to employ the comparable profit split method.

(iv) Given the difficulties in applying the other methods, the reliability of the internal data on USC and EC, and the fact that acceptable comparables are available for deriving a market return for the routine contributions of USC and EC, the residual profit split method is likely to provide the most reliable measure of an arm's length result in this case.

EXAMPLE 9 -- COMPARABLE PROFITS METHOD PREFERRED TO PROFIT SPLIT. (i) Company X is a large, complex U.S. company that carries out extensive research and development activities and manufactures and markets a variety of products. Company X has developed a new process by which compact disks can be fabricated at a fraction of the cost previously required. The process is expected to prove highly profitable, since there is a large market for compact disks. Company X establishes a new foreign subsidiary, Company Y, and licenses it the rights to use the process to fabricate compact disks for the foreign market as well as continuing technical support and improvements to the process. Company Y uses the process to fabricate compact disks which it supplies to related and unrelated parties.

(ii) The process licensed to Company Y is unique and highly valuable and no uncontrolled transfers of intangible property can be found that are sufficiently comparable to permit reliable application of the comparable uncontrolled transaction method. Company X is a large, complex company engaged in a variety of activities that owns unique and highly valuable intangible property. Consequently, no uncontrolled companies can be found that are similar to Company X. Furthermore, application of the profit split method in this case would involve the difficult and problematic tasks of allocating Company X's costs and assets between the relevant business activity and other activities and assigning a value to Company X's intangible contributions. On the other hand, Company Y performs relatively routine manufacturing and marketing activities and there are a number of similar uncontrolled companies. Thus, application of the comparable profits method using Company Y as the tested party is likely to produce a more reliable measure of an arm's length result than a profit split in this case.

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

Par. 4. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. Section 602.101 is amended by:

1. Removing the following entries from the table:

SECTION 602.101 OMB CONTROL NUMBERS.

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(c) * * *

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SECTION 602.101 OMB CONTROL NUMBERS.

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