[Federal Register Volume 59, Number 130 (Friday, July 8, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-16456]


[[Page Unknown]]

[Federal Register: July 8, 1994]


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DEPARTMENT OF THE TREASURY
Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8552]
RIN 1545-AL80

 

Intercompany Transfer Pricing Regulations Under Section 482

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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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 Secs. 1.482-OT 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 sufficiently 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, Sec. 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 Sec. 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 Sec. 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 Sec. 1.482-2 in the 1968 
regulations. Specifically, Sec. 1.482-3T governs transfers of tangible 
property, Sec. 1.482-4T governs transfers of intangible property, and 
Sec. 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 Sec. 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, Sec. 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 
Sec. 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 the 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 Sec. 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, Sec. 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 
(Sec. 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 
Sec. 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 (Sec. 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 Sec. 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 (Sec. 1.482-
1(a)(2)) is unchanged from the 1993 regulations.
    The provision regarding the taxpayer's use of section 482 
(Sec. 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 Sec. 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, Sec. 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 Sec. 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, 
Sec. 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 Sec. 1.482-6(c)(3), but would have little 
effect on an analysis under the CUT method.
    Finally, Sec. 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 Sec. 1.482-1T(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 Sec. 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 Sec. 1.482-1(d)(2) and its 
counterpart in the 1993 regulations (Sec. 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: Sec. 1.482-1T (c)(3)(iii) and (d)(3)(ii). The final 
regulations consolidate the discussion of these provisions into 
Sec. 1.482-1(d)(3)(ii) and make some clarifying changes.
    The discussion of risk in Sec. 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 (Sec. 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 Sec. 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, Sec. 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, 
Sec. 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, Sec. 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 Sec. 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 Sec. 1.482-
1(d)(3).
    Section 1.482-1(e) describes the arm's length range. This provision 
corresponds to Sec. 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, Sec. 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 Sec. 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 
Sec. 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, Sec. 1.482-1(e)(2)(iii)(B) provides that if the standards 
of Sec. 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 Sec. 1.482-1(e)(2)(iii)(A), the comparables under Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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, Sec. 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 Sec. 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, 
Sec. 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 Sec. 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, Sec. 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 Sec. 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 (Sec. 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 
Sec. 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 Sec. 1.482-1(h)(1), 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 Secs. 1.482-1(h)(2) (iii) and (iv), relating to the 
deferred income method of accounting. A foreign legal restriction is 
generally defined under Sec. 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 
Sec. 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 
Sec. 1.461-1(a)(4).
    Section 1.482-1(h)(3) provides a coordination rule for section 936 
that is identical to Sec. 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 Sec. 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 
Sec. 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, 
Sec. 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 Secs. 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 Sec. 1.482-1(c) (Best method rule).
    Section 1.482-3(b) describes the CUP method. Consistent with the 
best method rule, Sec. 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, Sec. 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 Sec. 1.482-1(d) 
must be considered, Sec. 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 Sec. 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 Sec. 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 
Sec. 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 Sec. 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 Secs. 1.482-3 and 1.482-4. While 
in such a case the transaction may be evaluated under Sec. 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 Sec. 1.482-3 to determine the arm's length consideration for the 
tangible property transferred and Sec. 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 Sec. 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 Sec. 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, Sec. 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 Sec. 1.482-1(c).
    Section 1.482-4(c)(2)(ii) emphasizes that, although all the factors 
described in Sec. 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 
Sec. 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, Sec. 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 Sec. 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 
Sec. 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, Sec. 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 Sec. 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 Sec. 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 Sec. 1.482-4(f)(2)(ii) (B) or (C) are satisfied.
    Finally, Sec. 1.482-4(f)(2)(ii)(E) provides that if the 
requirements of either Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Secs. 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 Sec. 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, Sec. 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 
Sec. 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, Sec. 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, Sec. 1.482-5(c)(2)(ii) provides that, while all the 
comparability factors described in Sec. 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 Sec. 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, Sec. 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, Sec. 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, Sec. 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, Sec. 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 Sec. 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 Secs. 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, Sec. 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 
Sec. 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.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entries for ``Sec. 1.482-1T'', ``Sec. 1.482-2T'', 
``Sec. 1.482-3T'', ``Sec. 1.482-4T'', ``Sec. 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. * * *


Secs. 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:


Sec. 1.482-0  Outline of regulations under 482.

    This section contains major captions for Secs. 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.
    (2) Authority to make allocations.
    (3) Taxpayer's use of section 482.
(b) Arm's length standard.
    (1) In general.
    (2) Arm's length methods.
    (i) Methods.
    (ii) Selection of category of method applicable to transaction.
(c) Best method rule.
    (1) In general.
    (2) Determining the best method.
    (i) Comparability.
    (ii) Data and assumptions.
    (A) Completeness and accuracy of data.
    (B) Reliability of assumptions.
    (C) Sensitivity of results to deficiencies in data and 
assumptions.
    (iii) Confirmation of results by another method.
(d) Comparability.
    (1) In general.
    (2) Standard of comparability.
    (3) Factors for determining comparability.
    (i) Functional analysis.
    (ii) Contractual terms.
    (A) In general.
    (B) Identifying contractual terms.
    (1) Written agreement.
    (2) No written agreement.
    (C) Examples.
    (iii) Risk.
    (A) In general.
    (B) Identification of party that bears risk.
    (C) Examples.
    (iv) Economic conditions.
    (v) Property or services.
    (4) Special circumstances.
    (i) Market share strategy.
    (ii) Different geographic markets.
    (A) In general.
    (B) Example.
    (C) Location savings.
    (D) Example.
    (iii) Transactions ordinarily not accepted as comparables.
    (A) In general.
    (B) Examples.
(e) Arm's length range.
    (1) In general.
    (2) Determination of arm's length range.
    (i) Single method.
    (ii) Selection of comparables.
    (iii) Comparables included in arm's length range.
    (A) In general.
    (B) Adjustment of range to increase reliability.
    (C) Interquartile range.
    (3) Adjustment if taxpayer's results are outside arm's length 
range.
    (4) Arm's length range not prerequisite to allocation.
    (5) Examples.
(f) Scope of review.
    (1) In general.
    (i) Intent to evade or avoid tax not a prerequisite.
    (ii) Realization of income not a prerequisite.
    (A) In general.
    (B) Example.
    (iii) Nonrecognition provisions may not bar allocation.
    (A) In general.
    (B) Example.
    (iv) Consolidated returns.
    (2) Rules relating to determination of true taxable income.
    (i) Aggregation of transactions.
    (A) In general.
    (B) Examples.
    (ii) Allocation based on taxpayer's actual transactions.
    (A) In general.
    (B) Example.
    (iii) Multiple year data.
    (A) In general.
    (B) Circumstances warranting consideration of multiple year 
data.
    (C) Comparable effect over comparable period.
    (D) Applications of methods using multiple year averages.
    (E) Examples.
    (iv) Product lines and statistical techniques.
    (v) Allocations apply to results, not methods.
    (A) In general.
    (B) Example.
(g) Collateral adjustments with respect to allocations under section 
482.
    (1) In general.
    (2) Correlative allocations.
    (i) In general.
    (ii) Manner of carrying out correlative allocation.
    (iii) Events triggering correlative allocation.
    (iv) Examples.
    (3) Adjustments to conform accounts to reflect section 482 
allocations.
    (i) In general.
    (ii) Example.
    (4) Setoffs.
    (i) In general.
    (ii) Requirements.
    (iii) Examples.
(h) Special rules.
    (1) Small taxpayer safe harbor [Reserved].
    (2) Effect of foreign legal restrictions.
    (i) In general.
    (ii) Applicable legal restrictions.
    (iii) Requirement for electing the deferred income method of 
accounting.
    (iv) Deferred income method of accounting.
    (v) Examples.
    (3) Coordination with section 936.
    (i) Cost sharing under section 936.
    (ii) Use of terms.
(i) Definitions.
(j) Effective dates.

Section 1.482-2  Determination of taxable income in specific 
situations.

(a) Loans or advances.
    (1) Interest on bona fide indebtedness.
    (i) In general.
    (ii) Application of paragraph (a) of this section.
    (A) Interest on bona fide indebtedness.
    (B) Alleged indebtedness.
    (iii) Period for which interest shall be charged.
    (A) General rule.
    (B) Exception for certain intercompany transactions in the 
ordinary course of business.
    (C) Exception for trade or business of debtor member located 
outside the United States.
    (D) Exception for regular trade practice of creditor member or 
others in creditor's industry.
    (E) Exception for property purchased for resale in a foreign 
country.
    (1) General rule.
    (2) Interest-free period.
    (3) Average collection period.
    (4) Illustration.
    (iv) Payment; book entries.
    (2) Arm's length interest rate.
    (i) In general.
    (ii) Funds obtained at situs of borrower.
    (iii) Safe haven interest rates for certain loans and advances 
made after May 8, 1986.
    (A) Applicability.
    (1) General rule.
    (2) Grandfather rule for existing loans.
    (B) Safe haven interest rate based on applicable Federal rate.
    (C) Applicable Federal rate.
    (D) Lender in business of making loans.
    (E) Foreign currency loans.
    (3) Coordination with interest adjustments required under 
certain other Internal Revenue Code sections.
    (4) Examples.
(b) Performance of services for another.
    (1) General rule.
    (2) Benefit test.
    (3) Arm's length charge.
    (4) Costs or deductions to be taken into account.
    (5) Costs and deductions not to be taken into account.
    (6) Methods.
    (7) Certain services.
    (8) Services rendered in connection with the transfer of 
property.
(c) Use of tangible property.
    (1) General rule.
    (2) Arm's length charge.
    (i) In general.
    (ii) Safe haven rental charge.
    (iii) Subleases.
(d) Transfer of property.

Section 1.482-3  Methods to determine taxable income in connection 
with a transfer of tangible property.

(a) In general.
(b) Comparable uncontrolled price method.
    (1) In general.
    (2) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) In general.
    (B) Adjustments for differences between controlled and 
uncontrolled transactions.
    (iii) Data and assumptions.
    (3) Arm's length range.
    (4) Examples.
    (5) Indirect evidence of comparable uncontrolled transactions.
    (i) In general.
    (ii) Limitations.
    (iii) Examples.
(c) Resale price method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Applicable resale price.
    (iii) Appropriate gross profit.
    (iv) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between controlled and 
uncontrolled transactions.
    (D) Sales agent.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
(d) Cost plus method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Appropriate gross profit.
    (iii) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between controlled and 
uncontrolled transactions.
    (D) Purchasing agent.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
(e) Unspecified methods.
    (1) In general.
    (2) Example.
(f) Coordination with intangible property rules.

Section 1.482-4  Methods to determine taxable income in connection 
with a transfer of intangible property.

(a) In general.
(b) Definition of intangible.
(c) Comparable uncontrolled transaction method.
    (1) In general.
    (2) Comparability and reliability considerations.
    (i) In general.
    (ii) Reliability.
    (iii) Comparability.
    (A) In general.
    (B) Factors to be considered in determining comparability.
    (1) Comparable intangible property.
    (2) Comparable circumstances.
    (iv) Data and assumptions.
    (3) Arm's length range.
    (4) Examples.
(d) Unspecified methods.
    (1) In general.
    (2) Example.
(e) Coordination with tangible property rules.
(f) Special rules for transfers of intangible property.
    (1) Form of consideration.
    (2) Periodic adjustments.
    (i) General rule.
    (ii) Exceptions.
    (A) Transactions involving the same intangible.
    (B) Transactions involving comparable intangible.
    (C) Methods other than comparable uncontrolled transaction.
    (D) Extraordinary events.
    (E) Five-year period.
    (iii) Examples.
    (3) Ownership of intangible property.
    (i) In general.
    (ii) Identification of the owner.
    (A) Legally protected intangible property.
    (B) Intangible property that is not legally protected.
    (iii) Allocations with respect to assistance provided to the 
owner.
    (iv) Examples.
    (4) Consideration not artificially limited.
    (5) Lump sum payments.
    (i) In general.
    (ii) Exceptions.
    (iii) Example.

Section 1.482-5  Comparable profits method.

(a) In general.
(b) Determination of arm's length result.
    (1) In general.
    (2) Tested party.
    (i) In general.
    (ii) Adjustments for tested party.
    (3) Arm's length range.
    (4) Profit level indicators.
    (i) Rate of return on capital employed.
    (ii) Financial ratios.
    (iii) Other profit level indicators.
(c) Comparability and reliability considerations.
    (1) In general.
    (2) Comparability.
    (i) In general.
    (ii) Functional, risk and resource comparability.
    (iii) Other comparability factors.
    (iv) Adjustments for differences between tested party and the 
uncontrolled taxpayers.
    (3) Data and assumptions.
    (i) In general.
    (ii) Consistency in accounting.
    (iii) Allocations between the relevant business activity and 
other activities.
(d) Definitions.
(e) Examples.

Section 1.482-6  Profit split method.

(a) In general.
(b) Appropriate share of profits and losses.
(c) Application.
    (1) In general.
    (2) Comparable profit split.
    (i) In general.
    (ii) Comparability and reliability considerations.
    (A) In general.
    (B) Comparability.
    (1) In general.
    (2) Adjustments for differences between the controlled and 
uncontrolled taxpayers.
    (C) Data and assumptions.
    (D) Other factors affecting reliability.
    (3) Residual profit split.
    (i) In general.
    (A) Allocate income to routine contributions.
    (B) Allocate residual profit.
    (ii) Comparability and reliability considerations.
    (A) In general.
    (B) Comparability.
    (C) Data and assumptions.
    (D) Other factors affecting reliability.
    (iii) Example.

Section 1.482-7T  Sharing of costs and risks.

Section 1.482-8  Examples of the best method rule.

(a) In general.
(b) Examples.


Sec. 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 Sec. 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, 
Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 1.482-1(d)(3) (Factors for determining 
comparability), and after making adjustments for differences, as 
described in Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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, 
Sec. 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, Sec. 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 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 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 Sec. 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 
Sec. 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 
Secs. 1.482-3 through 1.482-6; see also Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 1.482- 1(d)(2), the 
district director derives the following results: 

------------------------------------------------------------------------
                                                                 Result 
                         Comparable                             (price) 
------------------------------------------------------------------------
1............................................................     $44.00
2............................................................      45.00
3............................................................      45.00
4............................................................     45.50 
------------------------------------------------------------------------

    (ii) The district director determines that data regarding the 
four uncontrolled transactions is sufficiently complete and accurate 
so 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 
appropriate adjustments were made for such differences. Accordingly, 
if the resale price method is determined to be the best method 
pursuant to Sec. 1.482-1(c), the arm's length range for the 
controlled transaction will consist of the results of all of the 
uncontrolled comparables, pursuant to paragraph (e)(2)(iii)(A) of 
this section. Thus, the arm's length range in this case would be the 
range from $44 to $45.50.
    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 Sec. 1.482-1(d)(2), the district director derives the 
following results: 

------------------------------------------------------------------------
                                                                 Result 
                   Uncontrolled comparable                      (price) 
------------------------------------------------------------------------
1............................................................     $42.00
2............................................................      44.00
3............................................................      45.00
4............................................................     47.50 
------------------------------------------------------------------------

    (ii) It cannot be established in this case that all material 
differences are likely to have been identified and reliable 
adjustments made for those differences. Accordingly, if the resale 
price method is determined to be the best method pursuant to 
Sec. 1.482-1(c), the arm's length range for the controlled 
transaction must be established pursuant to paragraph (e)(2)(iii)(B) 
of this section. In this case, the district director uses the 
interquartile range to determine the arm's length range, which is 
the range from $43 to $46.25. If USSub's price falls outside this 
range, the district director may make an allocation. In this case 
that allocation would be to the median of the results, or $44.50.
    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 Sec. 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 Sec. 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 Sec. 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 Sec. 1.482-1(d)(3) 
(Factors for determining comparability, Contractual terms and Risk); 
Secs. 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 Sec. 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 Sec. 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 
Sec. 1.482-1(d)(3)(iii) (Risk), Sec. 1.482-1(d)(4)(i) (Market share 
strategy), Sec. 1.482-4(f)(2) (Periodic adjustments), and Sec. 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 Sec. 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 Sec. 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 Sec. 1.482-1(g)(2)(iii). 
See Example 3 of Sec. 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 Sec. 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 Sec. 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 Secs. 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
------------------------------------------------------------------------
A...................................       13        3        8     8.00
B...................................       11       13        2     8.67
7C..................................        4        7       13     8.00
7D..................................        7        9        6     7.33
------------------------------------------------------------------------

    (ii) Applying the provisions of Sec. 1.482-1(e), the district 
director determines that the arm's length range of the average gross 
profit margins is between 7.33 and 8.67. The district director 
concludes that FSub's average gross margin of 13% is not within the 
arm's length range, despite the fact that C's gross profit margin 
for 1994 was also 13%, since the economic conditions that caused S's 
result did not have a comparable effect over a comparable period of 
time on the results of C or the other uncontrolled comparables. In 
this case, the district director makes an allocation equivalent to 
adjusting FSub's gross profit margin for 1994 from 13% to the mean 
of the uncontrolled comparables' results for 1994 (7.25%).


    (iv) Product lines and statistical techniques. The methods 
described in Secs. 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 Sec. 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. (i) 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.
    (ii) 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 
Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 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 Sec. 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 Sec. 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 Secs. 1.482-1 and 
1.482-4 will be applied, and to the extent relevant to the valuation of 
intangibles, Secs. 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 Secs. 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) The regulations in this are generally 
effective for taxable years beginning after October 6, 1994

    (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.


Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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: 

------------------------------------------------------------------------
                                                             Accounts   
                   Month                        Sales       receivable  
------------------------------------------------------------------------
Jan. 1987..................................     $500,000      $2,835,850
Feb........................................      600,000       2,840,300
Mar........................................      450,000       2,850,670
Apr........................................      550,000       2,825,700
May........................................      650,000       2,809,360
June.......................................      525,000       2,803,200
July.......................................      400,000       2,825,850
Aug........................................      425,000       2,796,240
Sept.......................................      475,000       2,839,390
Oct........................................      525,000       2,650,550
Nov........................................      450,000       2,775,450
Dec. 1987..................................      650,000       2,812,600
                                            ----------------------------
      Totals...............................    6,200,000      33,665,160
------------------------------------------------------------------------

    (ii) Average collection period. X's total sales within the same 
product group to unrelated persons within country Z for the period 
are $6,200,000. The average receivables balance for the period is 
$2,805,430 ($33,665,160/12). The average collection period in whole 
days is determined as follows:

TR08JY94.000


TR08JY94.001

    (iii) Interest-free period. Accordingly, for intercompany trade 
receivables incurred by X during Y's 1988 calendar taxable year 
attributable to the purchase of property from Y for resale to 
unrelated persons located in country Z and included in the product 
group, X may use an interest-free period of 175 days (165 days in 
the average collection period plus 10 days, but not in excess of a 
maximum of 183 days). All other intercompany trade receivables 
incurred by X are subject to the interest-free periods described in 
paragraphs (a)(1)(iii) (B), (C), or (D), whichever are applicable. 
If X makes sales in other foreign countries in addition to country Z 
or makes sales of property in more than one product group in any 
foreign country, separate computations of X's average collection 
period, by product group within each country, are required in order 
for X and Y to determine an interest-free period for such product 
groups in such foreign countries under this paragraph 
(a)(1)(iii)(E).

    (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 8, 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--
    (i) 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)(ii) 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 Sec. 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--
    (i) 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 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 does 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 Sec. 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:                                                 
  Billing................................................  $50,000      
  Shipping...............................................  250,000      
  Accounting.............................................  150,000      
  Other..................................................  200,000      
Services provided by Z:                                                 
  Selling................................................  500,000      
                                                          --------------
Total Costs                                                1,150,000    
                                                                        

    (ii) Since the total costs or deductions of X and Z related to 
the rendition of services to Y exceed the amount equal to 25 percent 
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 ($1,150,000  
[$1,600,000 + $1,150,000] = 41.8%), the services rendered by X and Z 
to Y are substantial within the meaning of paragraph (b)(7)(iv) of 
this section. Thus, the services rendered by X and Z to Y are an 
integral part of the business activity of Y as described in 
paragraph (b)(7)(iv) of this section.

    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 Secs. 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 Sec. 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 
same 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 Secs. 1.482-3 
through 1.482-6.


Sec. 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 Sec. 1.482-1, 
including the best method rule of Sec. 1.482-1(c), the comparability 
analysis of Sec. 1.482-1(d), and the arm's length range of Sec. 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 Sec. 1.482-5;
    (5) The profit split method, described in Sec. 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 Sec. 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 Sec. 1.482-1(d). Although all of the factors 
described in Sec. 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 Sec. 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 Sec. 1.482-1(c) (Best method 
rule).
    (3) Arm's length range. See Sec. 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 Sec. 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 
Sec. 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 effect on 
prices, adjustments to account for these differences must be made to 
the results of the uncontrolled transactions according to the 
provisions of Sec. 1.482- 1(d)(2), and such adjusted results may be 
used as a measure of the arm's 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 Sec. 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 Sec. 1.482-1(c), 
and, if so, an arm's length range may be established pursuant to 
Sec. 1.482-1(e)(iii)(B).

    (5) Indirect evidence of comparable uncontrolled transactions--(i) 
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 
Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 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 Sec. 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 Sec. 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 Sec. 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
Cost of goods sold:                                                     
    Cost of purchases from FP...................................     600
    Costs incurred to unrelated parties.........................     200
Reported gross profit...........................................    200 
                                                                        

    (ii) The district director determines that the appropriate gross 
profit margin is 25%. Therefore, S's appropriate gross profit is 
$250 (i.e., 25% of the applicable resale price of $1000). Because S 
is incurring costs of sales to unrelated parties, an arm's length 
price for property purchased from FP must be determined under a two-
step process. First, the appropriate gross profit ($250) is 
subtracted from the applicable resale price ($1000). The resulting 
amount ($750) is then reduced by the costs of sales incurred to 
unrelated parties ($200). Therefore, an arm's length price for S's 
cost of sales of FP's product in this case equals $550 (i.e., $750 
minus $200).

    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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 1.482-1(c). Therefore, in 
accordance with Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 1.482-4.


Sec. 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 Sec. 1.482-1, 
including the best method rule of Sec. 1.482-1(c), the comparability 
analysis of Sec. 1.482-1(d), and the arm's length range of Sec. 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 Sec. 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 Sec. 1.482-5;
    (3) The profit split method, described in Sec. 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 Sec. 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 Sec. 1.482-1(d). Although all 
of the factors described in Sec. 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 Sec. 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 Sec. 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 Sec. 1.482-1(c) (Best method 
rule).
    (3) Arm's length range. See Sec. 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 
                          License                                rate   
                                                              (percent) 
------------------------------------------------------------------------
 1..........................................................        1.0 
 2..........................................................        1.0 
 3..........................................................        1.25
4...........................................................        1.25
 5..........................................................        1.5 
 6..........................................................        1.5 
 7..........................................................        1.75
8...........................................................        2.0 
9...........................................................        2.0 
10..........................................................        2.0 
11..........................................................        2.25
12..........................................................        2.5 
 13.........................................................        2.5 
14..........................................................        2.75
 15.........................................................        3.0 
------------------------------------------------------------------------

    (viii) Although the uncontrolled comparables are clearly similar 
to the controlled transaction, it is likely that unidentified 
material differences exist between the uncontrolled comparables and 
the controlled transaction. Therefore, an appropriate statistical 
technique must be used to establish the arm's length range. In this 
case the district director uses the interquartile range to determine 
the arm's length range. Therefore, the arm's length range covers 
royalty rates from 1.25 to 2.5 percent, and an adjustment is 
warranted to the 3 percent royalty charged in the controlled 
transfer. The district director determines that the appropriate 
adjustment corresponds to a reduction in the royalty rate to 2.0 
percent, which is the median of the uncontrolled comparables.
     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 Sec. 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 Sec. 1.482-1(c). Therefore, in 
accordance with Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 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
------------------------------------------------------------------------
Year 1..................................             200             250
Year 2..................................             250             300
Year 3..................................             500             600
Year 4..................................             350             200
Year 5..................................             100             100
                                                                        
                                         -------------------------------
    Total...............................            1400            1450
------------------------------------------------------------------------

    (v) The total profits earned through Year 5 were not less than 
80% nor more than 120% of the profits that were projected when the 
license was entered into. If the district director determines that 
the other requirements of Sec. 1.482-4(f)(2)(ii)(C) were met, no 
adjustment will be made to the royalty rate between USdrug and 
Eurodrug for the license of Nosplit.
    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
------------------------------------------------------------------------
Year 1..................................             200             250
Year 2..................................             250             500
Year 3..................................             500             800
Year 4..................................             350             700
Year 5..................................             100             600
                                         -------------------------------
    Total...............................            1400            2850
------------------------------------------------------------------------

    (ii) In examining USdrug's tax return for Year 5, the district 
director considers the actual profits realized by Eurodrug in Year 
5, and all past years. Accordingly, although Years 1 through 4 may 
be closed under the statute of limitations, for purposes of 
determining whether an adjustment should be made with respect to the 
royalty rate in Year 5 with respect to Nosplit, the district 
director aggregates the actual profits from those years with the 
profits of Year 5. However, the district director will make an 
adjustment, if any, only with respect to Year 5.
    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 Sec. 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 Sec. 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 
Sec. 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 
Sec. 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 
Sec. 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 Sec. 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:

------------------------------------------------------------------------
                                                             Projected  
                          Year                                 sales    
------------------------------------------------------------------------
1.......................................................      $2,500,000
2.......................................................       2,600,000
3.......................................................       2,700,000
4.......................................................       2,700,000
5.......................................................       2,750,000
------------------------------------------------------------------------

    (iii) Based on this information, the present discounted value of 
the projected whopperchopper sales is approximately $10 million, 
yielding an equivalent royalty rate of approximately 5%. Thus, the 
equivalent royalty amounts for each year are as follows: 

------------------------------------------------------------------------
                                                            Equivalent  
                  Year                       Projected    royalty amount
                                               sales                    
------------------------------------------------------------------------
1.......................................      $2,500,000        $125,000
2.......................................       2,600,000         130,000
3.......................................       2,700,000         135,000
4.......................................       2,700,000         135,000
5.......................................       2,750,000        137,500 
------------------------------------------------------------------------

    (iv) If in any of the five taxable years the equivalent royalty 
amount is determined not to be an arm's length amount, a periodic 
adjustment may be made pursuant to Sec. 1.482-4(f)(2)(i). The 
adjustment in such case would be equal to the difference between the 
equivalent royalty amount and the arm's length royalty in that 
taxable year.


Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 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 
Sec. 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 Sec. 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 Sec. 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  
------------------------------------------------------------------------
Sales..............      $00,000      $60,000      $00,000       $20,000
Cost of Goods Sold.      393,000      412,400      400,000       401,800
Operating Expenses.       80,000      110,000      104,600        98,200
Operating Profit...       27,000       37,600       (4,600)      20,000 
------------------------------------------------------------------------

    (iv) After adjustments have been made to account for identified 
material differences between USSub and the uncontrolled 
distributors, the average ratio of operating profit to sales is 
calculated for each of the uncontrolled distributors. Applying each 
ratio to USSub would lead to the following comparable operating 
profit (COP) for USSub: 

------------------------------------------------------------------------
                                                       OP/S    USSub COP
             Uncontrolled distributor               (percent)           
------------------------------------------------------------------------
A.................................................       1.7      $8,840
B.................................................       3.1      16,120
C.................................................       3.8      19,760
D.................................................       4.5      23,400
E.................................................       4.7      24,440
F.................................................       4.8      24,960
G.................................................       4.9      25,480
H.................................................       6.7      34,840
I.................................................       9.9      51,480
J.................................................      10.5     54,600 
------------------------------------------------------------------------

    (v) The data is not sufficiently complete to conclude that it is 
likely that all material differences between USSub and the 
uncontrolled distributors have been identified. Therefore, an arm's 
length range can be established only pursuant to Sec. 1.482- 
1(e)(2)(iii)(B). The district director measures the arm's length 
range by the interquartile range of results, which consists of the 
results ranging from $19,760 to $34,840. Although USSub's operating 
income for 1996 shows a loss of $4,600, the district director 
determines that no allocation should be made, because USSub's 
average reported operating profit of $20,000 is within this range.
    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  
------------------------------------------------------------------------
Sales.............     $500,000     $560,000      $500,000      $520,000
Cost of Good Sold.      370,000      460,000       400,000       410,000
Operating Expenses      110,000      110,000       110,000       110,000
Operating Profit..       20,000      (10,000)      (10,000)           0 
------------------------------------------------------------------------

    (ii) The interquartile range of comparable operating profits 
remains the same as derived in Example 1: $19,760 to $34,840. 
USSub's average operating profit for the years 1994 through 1996 
($0) falls outside this range. Therefore, the district director 
determines that an allocation may be appropriate.
    (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: 

------------------------------------------------------------------------
                                                         OP/S     USSub 
              Uncontrolled distributor                (percent)    COP  
------------------------------------------------------------------------
C...................................................       0.5    $2,500
D...................................................       1.5     7,500
E...................................................       2.0    10,000
A...................................................       1.6    13,000
F...................................................       2.8    14,000
B...................................................       2.9    14,500
J...................................................       3.0    15,000
I...................................................       4.4    22,000
H...................................................       6.9    34,500
G...................................................       7.4   37,000 
------------------------------------------------------------------------

    (iv) Based on these results, the median of the comparable 
operating profits for 1996 is $14,250. Therefore, USSub's income for 
1996 is increased by $24,250, the difference between USSub's 
reported operating profit for 1996 and the median of the comparable 
operating profits for 1996.
    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   
------------------------------------------------------------------------
Sales...........     $560,000      $500,000      $530,000      $530,000 
Cost of Good                                                            
 Sold...........      460,000       400,000       430,000       430,000 
Operating                                                               
 Expenses.......      110,000       110,000       110,000       110,000 
Operating Profit      (10,000)      (10,000)      (10,000)      (10,000) 
------------------------------------------------------------------------

    (ii) The interquartile range of comparable operating profits, 
based on average results from the uncontrolled comparables and 
average sales for USSub for the years 1995 through 1997, ranges from 
$15,500 to $30,000. In determining whether an allocation for the 
1997 taxable year may be made, the district director compares 
USSub's average reported operating profit for the years 1995 through 
1997 to the interquartile range of average comparable operating 
profits over this period. USSub's average reported operating profit 
is determined without regard to the adjustment made with respect to 
the 1996 taxable year. See Sec. 1.482-1(f)(2)(iii)(D). Therefore, 
USSub's average reported operating profit for the years 1995 through 
1997 is ($10,000). Because this amount of income falls outside the 
interquartile range, the district director determines that an 
allocation may be appropriate.
    (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 Sec. 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  
------------------------------------------------------------------------
Assets.............      $24,000      $25,000      $26,000       $25,000
Sales to MarkCo....       25,000       30,000       35,000        30,000
Cost of Goods Sold.        6,250        7,500        8,750         7,500
  Royalty to DevCo                                                      
   (5%)............        1,250        1,500        1,750         1,500
  Other............        5,000        6,000        7,000         6,000
Operating Expenses.        1,000        1,000        1,000         1,000
Operating Profit...       17,750       21,500       25,250       21,500 
------------------------------------------------------------------------

    (v) Applying the ratios of average operating profit to operating 
assets for the 1994 through 1996 taxable years derived from a group 
of similar uncontrolled comparables located in country M and N to 
ManuCo's average operating assets for the same period provides a set 
of comparable operating profits. The interquartile range for these 
average comparable operating profits is $3,000 to $4,500. ManuCo's 
average reported operating profit for the years 1994 through 1996 
($21,500) falls outside this range. Therefore, the district director 
determines that an allocation may be appropriate for the 1996 
taxable year.
    (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.


Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 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 Sec. 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 Sec. 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 Secs. 1.482-3, 1.482-4, and 1.482-5, the comparable profit split 
relies exclusively on external market benchmarks. As indicated in 
Sec. 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 Secs. 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 Sec. 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 Secs. 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 Sec. 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.


Sec. 1.482-8  Examples of the best method rule.

    In accordance with the best method rule of Sec. 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 Secs. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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:


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * * 

------------------------------------------------------------------------
                                                             Current OMB
    CFR part or section where identified and described       control No.
------------------------------------------------------------------------
                                                                        
                                  *****                                 
1.482-1T...................................................   D1545-1298
1.482-2....................................................    1545-0123
1.482-3T...................................................    1545-1298
1.482-4T...................................................    1545-1298
                                                                        
                                 *****                                  
------------------------------------------------------------------------

    2. Adding entries to the table in numerical order to read as 
follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * * 

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
                                                                        
                                  *****                                 
1.482-1....................................................    1545-1364
1.482-4....................................................    1545-1364
                                                                        
                                 *****                                  
------------------------------------------------------------------------

Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: June 27, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-16456 Filed 7-1-94; 3:59 pm]
BILLING CODE 4830-01-U