Material difference in comparables’ accounting for stock-based compensation. (i) The facts are the same as in paragraph (i) of Example 3. (ii) Stock options are granted to the employees of Taxpayer that engage in the relevant business activity. Assume that, as determined under a method in accordance with U.S. generally accepted accounting principles, the fair value of such stock options attributable to employees’ performance of the relevant business activity is 500 for the taxable year. Taxpayer includes salaries, fringe benefits, and all other compensation of these employees (including the stock option fair value) in “total services costs,” as defined in paragraph (j) of this section, and deducts these amounts in determining “reported operating profit” (within the meaning of § 1.482-5(d)(5)) for the taxable year under examination. (iii) Stock options are granted to the employees of Companies A, B, C, and D. Companies A and B expense the stock options for financial accounting purposes in accordance with U.S. generally accepted accounting principles. Companies C and D do not expense the stock options for financial accounting purposes. Under a method in accordance with U.S. generally accepted accounting principles, however, Companies C and D disclose the fair value of these options in their financial statements. The utilization and accounting treatment of options are depicted in the following table: Salary and other non-option compensation Stock options fair value Stock options expensed Taxpayer 1,000 500 500 Company A 7,000 2,000 2,000 Company B 4,300 250 250 Company C 12,000 4,500 0 Company D 15,000 2,000 0 (iv) A material difference in accounting for stock-based compensation (within the meaning of § 1.482-7T(d)(3)(i)) exists. Analysis indicates that this difference would materially affect the measure of the arm’s length result under paragraph (f) of this section. In evaluating the comparable operating profits of the tested party, the Commissioner includes in total services costs Taxpayer’s total compensation costs of 1,500 (including stock option fair value of 500). In considering whether an adjustment is necessary to improve comparability under §§ 1.482-1(d)(2) and 1.482-5(c)(2)(iv), the Commissioner recognizes that the total employee compensation (including stock options provided by Taxpayer and Companies A, B, C, and D) provides a reliable basis for comparison. Because Companies A and B expense stock-based compensation for financial accounting purposes, whereas Companies C and D do not, an adjustment to the comparables’ operating profit is necessary. In computing the net cost plus PLI, the Commissioner uses the financial-accounting data of Companies A and B, as reported. The Commissioner increases the total services costs of Companies C and D by amounts equal to the fair value of their respective stock options, and reduces the operating profits of Companies C and D accordingly. (v) The adjustments described in paragraph (iv) of this Example 6 are depicted in the following table. For purposes of illustration, the unadjusted data of Companies A and B are also included. Salaries and other non-option compensation Stock options fair value Total services costs (A) Operating profit (B) Net cost plus PLI (B/A) (percent) Per financial statements: Company A 7,000 2,000 27,000 4,000 14.80 Company B 4,300 250 12,750 2,250 17.65 As adjusted: Company C 12,000 4,500 40,500 6,500 16.05 Company D 15,000 2,000 29,000 5,000 17.24 ...

Non-material difference in utilization of stock-based compensation. (i) The facts are the same as in paragraph (i) of Example 3. (ii) Stock options are granted to the employees of Taxpayer that engage in the relevant business activity. Assume that, as determined under a method in accordance with U.S. generally accepted accounting principles, the fair value of such stock options attributable to the employees’ performance of the relevant business activity is 50 for the taxable year. Taxpayer includes salaries, fringe benefits, and all other compensation of these employees (including the stock option fair value) in “total services costs,” as defined in paragraph (j) of this section, and deducts these amounts in determining “reported operating profit” within the meaning of § 1.482-5(d)(5), for the taxable year under examination. (iii) Stock options are granted to the employees of Companies A, B, C, and D, but none of these companies expense stock options for financial accounting purposes. Under a method in accordance with U.S. generally accepted accounting principles, however, Companies A, B, C, and D disclose the fair value of the stock options for financial accounting purposes. The utilization and treatment of employee stock options is summarized in the following table: Salaries and other non-option compensation Stock options fair value Stock options expensed Taxpayer 1,000 50 50 Company A 7,000 100 0 Company B 4,300 40 0 Company C 12,000 130 0 Company D 15,000 75 0 (iv) Analysis of the data reported by Companies A, B, C, and D indicates that an adjustment for differences in utilization of stock-based compensation would not have a material effect on the determination of an arm’s length result. Salaries and other non-option compensation Stock options fair value Total services costs (A) Operating profit (B) Net cost plus PLI (B/A) (percent) Per financial statements: Company A 7,000 100 25,000 6,000 24.00 Company B 4,300 40 12,500 2,500 20.00 Company C 12,000 130 36,000 11,000 30.56 Company D 15,000 75 27,000 7,000 25.93 As adjusted: Company A 7,000 100 25,100 5,900 23.51 Company B 4,300 40 12,540 2,460 19.62 Company C 12,000 130 36,130 10,870 30.09 Company D 15,000 75 27,075 6,925 25.58 (v) Under the circumstances, the difference in utilization of stock-based compensation would not materially affect the determination of the arm’s length result under this paragraph (f). Accordingly, in calculating the net cost plus PLI, no comparability adjustment is made to the data of Companies A, B, C, or D pursuant to §§ 1.482-1(d)(2) and 1.482-5(c)(2)(iv) ...

Material difference in utilization of stock-based compensation. (i) The facts are the same as in paragraph (i) of Example 3. (ii) No stock options are granted to the employees of Taxpayer that engage in the relevant business activity. Thus, no deduction for stock options is made in determining “reported operating profit” (within the meaning of § 1.482-5(d)(5)) for the taxable year under examination. (iii) Stock options are granted to the employees of Companies A, B, C, and D, but none of these companies expense stock options for financial accounting purposes. Under a method in accordance with U.S. generally accepted accounting principles, however, Companies A, B, C, and D disclose the fair value of the stock options for financial accounting purposes. The utilization and treatment of employee stock options is summarized in the following table: Salaries and other non-option compensation Stock options fair value Stock options expensed Taxpayer 1,000 0 N/A Company A 7,000 2,000 0 Company B 4,300 250 0 Company C 12,000 4,500 0 Company D 15,000 2,000 0 (iv) A material difference in the utilization of stock-based compensation (within the meaning of § 1.482-7T(d)(3)(i)) exists. Analysis indicates that these differences would materially affect the measure of an arm’s length result under this paragraph (f). In evaluating the comparable operating profits of the tested party, the Commissioner uses Taxpayer’s total services costs, which include total compensation costs of 1,000. In considering whether an adjustment is necessary to improve comparability under §§ 1.482-1(d)(2) and 1.482-5(c)(2)(iv), the Commissioner recognizes that the total compensation provided to employees of Taxpayer is comparable to the total compensation provided to employees of Companies A, B, C, and D. Because Companies A, B, C, and D do not expense stock-based compensation for financial accounting purposes, their reported operating profits must be adjusted in order to improve comparability with the tested party. The Commissioner increases each comparable’s total services costs, and also reduces its reported operating profit, by the fair value of the stock-based compensation incurred by the comparable company. (v) The adjustments to the data of Companies A, B, C, and D described in paragraph (iv) of this Example 4 are summarized in the following table: Salaries and other non-option compensation Stock options fair value Total services costs (A) Operating profit (B) Net cost plus PLI (B/A) (Percent) Per financial statements: Company A 7,000 2,000 25,000 6,000 24.00 Company B 4,300 250 12,500 2,500 20.00 Company C 12,000 4,500 36,000 11,000 30.56 Company D 15,000 2,000 27,000 7,000 25.93 As adjusted: Company A 7,000 2,000 27,000 4,000 14.81 Company B 4,300 250 12,750 2,250 17.65 Company C 12,000 4,500 40,500 6,500 16.05 Company D 15,000 2,000 29,000 5,000 17.24 ...

Material difference in accounting for stock-based compensation. (i) Taxpayer, a U.S. corporation the stock of which is publicly traded, performs controlled services for its wholly-owned subsidiaries. The arm’s length price of these controlled services is evaluated under the comparable profits method for services in paragraph (f) of this section by reference to the net cost plus profit level indicator (PLI). Taxpayer is the tested party under paragraph (f)(2)(i) of this section. The Commissioner identifies the most narrowly identifiable business activity of the tested party for which data are available that incorporate the controlled transaction (the relevant business activity). The Commissioner also identifies four uncontrolled domestic service providers, Companies A, B, C, and D, each of which performs exclusively activities similar to the relevant business activity of Taxpayer that is subject to analysis under paragraph (f) of this section. The stock of Companies A, B, C, and D is publicly traded on a U.S. stock exchange. Assume that Taxpayer makes an election to apply these regulations to earlier taxable years. (ii) Stock options are granted to the employees of Taxpayer that engage in the relevant business activity. Assume that, as determined under a method in accordance with U.S. generally accepted accounting principles, the fair value of such stock options attributable to the employees’ performance of the relevant business activity is 500 for the taxable year in question. In evaluating the controlled services, Taxpayer includes salaries, fringe benefits, and related compensation of these employees in “total services costs,” as defined in paragraph (j) of this section. Taxpayer does not include any amount attributable to stock options in total services costs, nor does it deduct that amount in determining ”reported operating profit” within the meaning of § 1.482-5(d)(5), for the year under examination. (iii) Stock options are granted to the employees of Companies A, B, C, and D. Under a fair value method in accordance with U.S. generally accepted accounting principles, the comparables include in total compensation the value of the stock options attributable to the employees’ performance of the relevant business activity for the annual financial reporting period, and treat this amount as an expense in determining operating profit for financial accounting purposes. The treatment of employee stock options is summarized in the following table: Salaries and other non-option compensation Stock options fair value Stock options expensed Taxpayer 1,000 500 0 Company A 7,000 2,000 2,000 Company B 4,300 250 250 Company C 12,000 4,500 4,500 Company D 15,000 2,000 2,000 (iv) A material difference in accounting for stock-based compensation (within the meaning of § 1.482-7T(d)(3)(i)) exists. Analysis indicates that this difference would materially affect the measure of an arm’s length result under this paragraph (f). In making an adjustment to improve comparability under §§ 1.482-1(d)(2) and 1.482-5(c)(2)(iv), the Commissioner includes in total services costs of the tested party the total compensation costs of 1,500 (including stock option fair value). In addition, the Commissioner calculates the net cost plus PLI by reference to the financial-accounting data of Companies A, B, C, and D, which take into account compensatory stock options ...

Application of the operating profit to total services costs profit level indicator. (i) Company A is a foreign subsidiary of Company B, a U.S. corporation. Company B is under examination for its year 1 taxable year. Company B renders management consulting services to Company A. Company B’s consulting function includes analyzing Company A’s operations, benchmarking Company A’s financial performance against companies in the same industry, and to the extent necessary, developing a strategy to improve Company A’s operational performance. The accounting records of Company B allow reliable identification of the total services costs of the consulting staff associated with the management consulting services rendered to Company A. Company A reimburses Company B for its costs associated with rendering the consulting services, with no markup. (ii) Based on all the facts and circumstances, it is determined that the comparable profits method will provide the most reliable measure of an arm’s length result. Company B is selected as the tested party, and its rendering of management consulting services is identified as the relevant business activity. Data are available from ten domestic companies that operate in the industry segment involving management consulting and that perform activities comparable to the relevant business activity of Company B. These comparables include entities that primarily perform management consulting services for uncontrolled parties. The comparables incur similar risks as Company B incurs in performing the consulting services and do not make use of valuable intangible property or special processes. (iii) Based on the available financial data of the comparables, it cannot be determined whether the comparables report their costs for financial accounting purposes in the same manner as Company B reports its costs in the relevant business activity. The available financial data for the comparables report only an aggregate figure for costs of goods sold and operating expenses, and do not segment the underlying services costs. Due to this limitation, the ratio of operating profits to total services costs is determined to be the most appropriate profit level indicator. (iv) For the taxable years 1 through 3, Company B shows the following results for the services performed for Company A: Year 1 Year 2 Year 3 Average Revenues 1,200,000 1,100,000 1,300,000 1,200,000 Cost of Goods Sold 100,000 100,000 N/A 66,667 Operating Expenses 1,100,000 1,000,000 1,300,000 1,133,333 Operating Profit 0 0 0 0 (v) After adjustments have been made to account for identified material differences between the relevant business activity of Company B and the comparables, the average ratio for the taxable years 1 through 3 of operating profit to total services costs is calculated for each of the uncontrolled service providers. Applying each ratio to Company B’s average total services costs from the relevant business activity for the taxable years 1 through 3 would lead to the following comparable operating profit (COP) for the services rendered by Company B: Uncontrolled service provider OP/Total service costs (percent) Company B COP Company 1 15.75 $189,000 Company 2 15.00 180,000 Company 3 14.00 168,000 Company 4 13.30 159,600 Company 5 12.00 144,000 Company 6 11.30 135,600 Company 7 11.25 135,000 Company 8 11.18 134,160 Company 9 11.11 133,320 Company 10 10.75 129,000 (vi) The available data are not sufficiently complete to conclude that it is likely that all material differences between the relevant business activity of Company B and the comparables have been identified. Therefore, an arm’s length range can be established only pursuant to § 1.482-1(e)(2)(iii)(B). The arm’s length range is established by reference to the interquartile range of the results as calculated under § 1.482-1(e)(2)(iii)(C), which consists of the results ranging from $168,000 to $134,160. Company B’s reported average operating profit of zero ($0) falls outside this range. Therefore, an allocation may be appropriate. (vii) Because Company B reported income of zero, to determine the amount, if any, of the allocation, Company B’s reported operating profit for year 3 is compared to the comparable operating profits derived from the comparables’ results for year 3. The ratio of operating profit to total services costs in year 3 is calculated for each of the comparables and applied to Company B’s year 3 total services costs to derive the following results: Uncontrolled service provider OP/Total service costs (for year 3) (percent) Company B COP Company 1 15.00 $195,000 Company 2 14.75 191,750 Company 3 14.00 182,000 Company 4 13.50 175,500 Company 5 12.30 159,900 Company 6 11.05 143,650 Company 7 11.03 143,390 Company 8 11.00 143,000 Company 9 10.50 136,500 Company 10 10.25 133,250 (viii) Based on these results, the median of the comparable operating profits for year 3 is $151,775. Therefore, Company B’s income for year 3 is increased by $151,775, the difference between Company B’s reported operating profit for year 3 of zero and the median of the comparable operating profits for year 3 ...

Ratio of operating profit to total services costs as the appropriate profit level indicator. (i) A Country T parent firm, Company A, and its Country Y subsidiary, Company B, both engage in manufacturing as their principal business activity. Company A also performs certain advertising services for itself and its affiliates. In year 1, Company A renders advertising services to Company B. (ii) Based on the facts and circumstances, it is determined that the comparable profits method will provide the most reliable measure of an arm’s length result. Company A is selected as the tested party. No data are available for comparable independent manufacturing firms that render advertising services to third parties. Financial data are available, however, for ten independent firms that render similar advertising services as their principal business activity in Country X. The ten firms are determined to be comparable under § 1.482-5(c). Neither Company A nor the comparable companies use valuable intangible property in rendering the services. (iii) Based on the available financial data of the comparable companies, it cannot be determined whether these comparable companies report costs for financial accounting purposes in the same manner as the tested party. The publicly available financial data of the comparable companies segregate total services costs into cost of goods sold and sales, general and administrative costs, with no further segmentation of costs provided. Due to the limited information available regarding the cost accounting practices used by the comparable companies, the ratio of operating profits to total services costs is determined to be the most appropriate profit level indicator. This ratio includes total services costs to minimize the effect of any inconsistency in accounting practices between Company A and the comparable companies ...

The principles of this paragraph (f) are illustrated by the following examples: ...

Consistency in accounting practices between the relevant business activity of the tested party and the uncontrolled service providers is particularly important in determining the reliability of the results under this method, but less than in applying the cost of services plus method. Adjustments may be appropriate if materially different treatment is applied to particular cost items related to the relevant business activity of the tested party and the uncontrolled service providers. For example, adjustments may be appropriate where the tested party and the uncontrolled comparables use inconsistent approaches to classify similar expenses as “cost of goods sold” and “selling, general, and administrative expenses.” Although distinguishing between these two categories may be difficult, the distinction is less important to the extent that the ratio of operating profit to total services costs is used as the appropriate profit level indicator. Determining whether adjustments are necessary under these or similar circumstances requires thorough analysis of the functions performed and consideration of the cost accounting practices of the tested party and the uncontrolled comparables. Other adjustments as provided in § 1.482-5(c)(2)(iv) may also be necessary to increase the reliability of the results under this method ...