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 § 1.482-4(c)(2)(ii) ...

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 ...

(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 ...

(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: License Royalty 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 ...

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 ...

(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 ...

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

See § 1.482-1(e)(2) for the determination of an arm’s length range ...

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 § 1.482-1(c) (Best method rule) ...

In evaluating the comparability of the circumstances of the controlled and uncontrolled transactions, although all of the factors described in § 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 ...

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 § 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 ...

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The degree of comparability between controlled and uncontrolled transactions is determined by applying the comparability provisions of § 1.482-1(d). Although all of the factors described in § 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 ...

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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 ...

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 § 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 ...

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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) ...

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 ...

Medtronic had used the comparable uncontrolled transactions (CUT) method to determine the arm’s length royalty rates received from its manufacturing subsidiary in Puerto Rico for use of IP under an inter-group license agreement. The tax authorities found that Medtronic left too much profit in Puerto Rico. Using a “modified CPM” the IRS concluded that at arm’s length 90 percent of Medtronic’s “devices and leads” profit should have been allocated to the US parent and only 10 percent to the operations in Puerto Rico. Medtronic brought the case to the Tax Court. The Tax Court applied its own analysis and concluded that the Pacesetter agreement was the best CUT to calculate the arm’s length result for license payments. This decision from the Tax Court was then appealed by the IRS to the Court of Appeals. In 2018, the Court of Appeal found that the Tax Court’s factual findings had been insufficient. The Court of Appeals stated taht: “The Tax Court determined that the Pacesetter agreement was an appropriate comparable uncontrolled transaction (CUT) because it involved similar intangible property and had similar circumstances regarding licensing. We conclude that the Tax Court’s factual findings are insufficient to enable us to conduct an evaluation of that determination.” The Tax Court did not provide (1) sufficient detail as to whether the circumstances between Siemens Pacesetter, Inc. (Pacesetter), and Medtronic US were comparable to the licensing agreement between Medtronic US and Medtronic Puerto Rico (MPROC) and whether the Pacesetter agreement was one created in the ordinary course of business; (2) an analysis of the degree of comparability of the Pacesetter agreement’s contractual terms and those of the MPROC’s licensing agreement; (3) an evaluation of how the different treatment of intangibles affected the comparability of the Pacesetter agreement and the MPROC licensing agreement; and (4) the amount of risk and product liability expense that should be allocated between Medtronic US and MPROC. According to the Court of Appeal these findings were “… essential to its review of the Tax Court’s determination that the Pacesetter agreement was a CUT, as well as necessary to its determination whether the Tax Court applied the best transfer pricing method for calculating an arm’s length result or whether it made proper adjustments under its chosen method“. Hence, the case was remanded to the Tax Court for further considerations. Opinion of the US Tax Court Following the re-trial, the Tax Court concluded that the taxpayer did not meet its burden to show that its allocation under the CUT method and its proposed unspecified method satisfied the arm’s length standard. “Increasing the wholesale royalty rate to 48.8% results in an overall profit split of 68.72% to Medtronic US/Med USA and 31.28% profit split to MPROC and a R&D profits split of 62.34% to Medtronic US and 37.66% to MPROC. The resulting profit split reflects the importance of the patents as well as the role played by MPROC. The profit split is more reasonable than the profit split of 56.8% to Medtronic US/Med USA and 43.2% to MPROC resulting from petitioner’s unspecified method with a 50–50 allocation. According to respondent’s expert Becker, MPROC had incurred costs of 14.8% of retail prices. The evidence does not support a profit split which allocates 43.2% of the profits to MPROC when it has only 14.8% of the operating cost.” “We conclude that wholesale royalty rate is 48.8% for both leads and devices, and the royalty rate is the same for both years in issue. According to the regulations 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. Treas. Reg. § 1.482-4(d). Under the best method rule, 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 method of getting an arm’s-length result. Id. § 1.482-1(c)(1). We have concluded previously that petitioner’s CUT method, petitioner’s proposed unspecified method, the Court’s adjusted CUT method in Medtronic I, respondent’s CPM, and respondent’s modified CPM do not result in an arm’s-length royalty rate and are not the best method. Only petitioner suggested a new method, its proposed unspecified method; however, for reasons previously explained, that method needed adjustment for the result to be arm’s length. “Our adjustments consider that the MPROC licenses are valuable and earn higher profits than the licenses covered by the Pacesetter agreement. We also looked at the ROA in the Heimert analysis and from the evidence cannot determine what the proper ROA should be. The criticisms each party had of the other’s methods were factored into our adjustment. Respondent’s expert Becker testified that you may not like the logic of a method but ultimately the answer is fine. Because neither petitioner’s proposed CUT method nor respondent’s modified CPM was the best method, our goal was to find the right answer. The facts in this case are unique because of the complexity of the devices and leads, and we believe that our adjustment is necessary for us to bridge the gap between the parties’ methods. A wholesale royalty rate of 48.8% for both devices significantly bridges the gap between the parties. Petitioner’s expert witness Putnam proposed a CUT which resulted in a blended wholesale royalty rate of 21.8%; whereas respondent’s expert Heimert’s original CPM analysis resulted in a blended wholesale royalty rate of 67.7%. In Medtronic I we concluded that the blended wholesale royalty rate was 38%, and after further trial, we conclude that the wholesale royalty rate is 48.8%, which we believe is the right answer.” Click here for other translation ...

In this case the IRS was of the opinion, that Medtronic erred in allocating the profit earned from its devises and leads between its businesses located in the United States and its device manufacturer in Puerto Rico. To determine the arm’s length price for Medtronic’s intercompany licensing agreements the comparable profits method was therefor applied by the IRS, rather than the comparable uncontrolled transaction (CUT) used by Medtronic. Medtronic brought the case to the Tax Court. The Tax Court applied its own valuation analysis and concluded that the Pacesetter agreement was the best CUT to calculate the arm’s length result for intangible property. This decision from the Tax Court was then appealed by the IRS to the Court of Appeals. The Court of Appeal found that the Tax Court’s factual findings were insufficient to enable the Court to conduct an evaluation of Tax Court’s determination. Specifically, the Tax Court failed to: address whether the circumstances of the Pacesetter settlement was comparable to the licensing agreements in this case, the degree of comparability of the contractual terms between the two situations, how the different treatment of intangibles affected the two agreements and the amount of risk and product liability expenses that should be allocated. Thus, the case has been remanded for further consideration ...

Amazon is an online retailer that sells products through Amazon.com and related websites. Amazon also sells third-party products for which it receives a commissions. In a series of transactions  in 2005 and 2006, Amazon US transferred intangibles to Amazon Europe, a newly established European HQ placed in Luxembourg. A Cost Sharing Arrangement (“CSA”), whereby Amazon US and Amazon Europe agreed to share costs of further research, development, and marketing in proportion to the benefits A License Agreement, whereby Amazon US granted Amazon Europe the right to Amazon US’s Technology IP An Assignment Agreement, whereby Amazon US granted Amazon Europe the right to Amazon US’s Marketing IP and Customer Lists. For these transfers Amazon Europe was required to make an upfront buy-in payment and annual payments according to the cost sharing arrangement for ongoing developments of the intangibles. In the valuation, Amazon had considered the intangibles to have a lifetime of 6 to 20 years. On that basis, the buy-in payment for pre-existing intangibles had been set to $254.5 million. The IRS disagreed with the valuation and calculated a buy-in payment of $3.5 billion, by applying a discounted cash-flow methodology to the expected cash flows from the European business. The IRS took the position, that the intangibles transferred to Amazon Europe had an indefinite useful life and had to be valued as integrated components of an ongoing business rather than separate assets. The case brought before the US Tax Court HAD two issues had to be decided: Amazon Europe’s buy-in payment with respect to the intangibles transferred; and The pool of cost, on which Amazon Europe ongoing cost sharing payments were to be calculated. The Courts decision on Amazon Europe’s buy-in payment IRS’s position of “indefinite useful life” in the valuation of the intangibles and the buy in payment was rejected by the court, and the comparable uncontrolled transaction (“CUT”) method applied by Amazon – after appropriate upward adjustments – was found to be the best method. The Courts decision on Cost Share Payments The Court found that Amazon’s method for allocating intangible development costs, after adjustments, was reasonable. US CSA regulations pre- and post 2009  US CSA regs in effect for 2005-2006 refer to the definition of intangibles set forth in section 1.482-4(b), Income Tax Regs. Here intangibles are defined to include five enumerated categories of assets, each of which has “substantial value independent of the services of any individual.” These include patents, inventions, copyrights, know-how, trademarks, trade names, and 20 other specified intangibles. The definition of intangibles in the pre 2009 CSA regs did not include value of workforce in place, going concern value, goodwill, and growth options, corporate resources or opportunities. In 2009 new CSA regs were introduced in the US where the concept of “platform contribution transaction” (PCT) applies. According to the new regs. there are no limit on the type of intangibles that must be compensated under a cost sharing arrangement. But these new US CSA regulations did not apply to the years 2005 – 2006 in the Amazon case. See also the US vs. Veritas case from 2009. 2019 UPDATE The 2017 decision of the Tax Court has later been appealed by the Commissioner of Internal Revenue ...

The IRS argued that Medtronic Inc failed to accurately account for the value of trade secrets and other intangibles owned by Medtronic Inc and used by Medtronic’s Puerto Rico manufacturing subsidiary in 2005 and 2006 when determening the royalty payments from the subsidiary. In 2016 the United States Tax Court found in favor of Medtronic, sustaining the use of the CUT method to analyze royalty payments. The Court also found that adjustments to the CUT were required. These included additional adjustments not initially applied by Medtronic Inc for know-how, profit potential and scope of product. The decision from the United States Tax Court has been appealed by the IRS in 2017 ...