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 § 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) ...

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 § 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 ...

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: Uncontrolled distributor OP/S (percent) USSub 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 ...

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 $500,000 $560,000 $500,000 $520,000 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: Uncontrolled distributor OP/S (percent) USSub COP 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 § 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 ...

When applying a cost plus, resale price or transactional net margin method as described in Chapter II, it is necessary to choose the party to the transaction for which a financial indicator (mark-up on costs, gross margin, or net profit indicator) is tested. The choice of the tested party should be consistent with the functional analysis of the transaction. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e. it will most often be the one that has the less complex functional analysis ...

When applying a cost plus, resale price or transactional net margin method as described in Chapter II, it is necessary to choose the party to the transaction for which a financial indicator (mark-up on costs, gross margin, or net profit indicator) is tested. The choice of the tested party should be consistent with the functional analysis of the transaction. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e. it will most often be the one that has the less complex functional analysis ...