ABD Limited is a South African telecommunications company with subsidiaries worldwide. These subsidiaries are operating companies, with local shareholders, but having ABD as a significant shareholder. ABD licences its intellectual property to these operating companies (referred to as Opcos) in return for which they pay ABD a royalty. The present case involves the royalty payments made by fourteen of the Opcos to ABD during the periods 2009 to 2012. ABD charged all of them the same royalty rate of 1% for the right to use its intellectual property. In 2011 ABD retained the services of a consultancy to advise it on what royalty it should charge its various Opcos.The consultancy procured research on the subject and then, informed by that, came up with the recommendation that a royalty of 1% could be justified. The tax authorities (SARS) found that a 1% royalty rate was not at arms-length and issued an assessment where the royalty rate had instead been determined to be 3%. Judgment of the Court The Court ruled in favour of ABD Limited and set aside the assessment. Excerpt “I conclude that the Cyprus CUP serves as a comparable internal CUP. The royalty in that agreement was 1%. On that basis the royalty of 1% charged by ABD to the other Opcos constitutes a reasonable arm’s length royalty. That being the case there was no factual justification for the Commissioner to have adjusted the royalty in terms of the then section 31 of the Income Tax Act. The appeal succeeds. It is not necessary for this reason to consider the several other administrative law grounds and accounting issues raised by ABD in its appeal. I appreciate that the outcome of this case will be of great disappointment to SARS which put into it extensive resources to create a precedent in this seldom litigated field of tax law. But this not only meant it running contrary to the opinions and approach of its initial expert (which meant effectively dispensing with his views without explanation and engaging a new expert) but fighting a case where there appeared to be no rationale for the taxpayer to have any motive to shortchange the South African fiscus as I mentioned earlier in this decision.” Click here for translation ...

The tax authorities had issued a notice of assessment which disallowed tax deductions for royalties paid by R…Cash & C…, S.A. to its Polish parent company, O…Mark Sp. Z.o.o. R… Cash & C…, S.A. appealed to the Administrative Court, which later annulled the assessment. The tax authorities then filed an appeal with the Administrative Court of Appeal. Judgement of the Court The Court of Appeal revoked the judgement issued by the administrative court and decided in favour of the tax authorities. Extracts “It is clear from the evidence in the case file that the applicant has succeeded in demonstrating that the agreement to transfer rights is not based on effective competition, in the context of identical operations carried out by independent entities. The studies presented by the challenger do not succeed in overturning this assertion, since, as is clear from the evidence (12), they relate to operations and market segments other than the one at issue in the case. The provision for the payment of royalties for the transfer of the brands, together with the unpaid provision of management and promotion services for the brands in question by the applicant, prove that there has been a situation that deviates from full competition, with the allocation of income in a tax jurisdiction other than the State of source, without any apparent justification. The application of the profit splitting method (Article 9 of Ministerial Order 1446-C/2001 of 21 December 2001) does not deserve censure. Intangible assets are at stake, so invoking the comparability of transactions, in cases such as the present one, does not make it possible to understand the relationships established between the companies involved. It should also be noted that the Polish company receiving the royalties has minimal staff costs, and that brand amortisation costs account for 97.72% of its operating costs. As a result, the obligations arising for the defendant from the licence agreement in question are unjustified. In view of the demonstration of the deviation from the terms of an arm’s length transaction, it can be seen that the taxpayer’s declaratory obligations (articles 13 to 16 of Ministerial Order 1446-C/2001, of 21.12.200) have not been complied with, as there is a lack of elements that would justify the necessary adjustment. Therefore, the correction under examination does not deserve to be repaired and should be confirmed in the legal order. By ruling differently, the judgement under appeal was an error of judgement and should therefore be replaced by a decision dismissing the challenge.” Click here for English translation. Click here for other translation ...

During the years in issue, 1975 through 1981, the worldwide operations of Perkin-Elmer (P-E) and its subsidiaries were organized into five operating groups, each of which was responsible for the research, manufacturing, sales, and servicing of its products. The five product areas were analytical instruments, optical systems, computer systems, flame spray equipment and materials, and military avionics. P-E and PECC entered into a General Licensing Agreement dated as of October 1, 1970, by the terms of which P-E granted PECC an exclusive right to manufacture in Puerto Rico and a nonexclusive right to use and sell worldwide the instruments and accessories to be identified in specific licenses. P-E also agreed to furnish PECC with all design and manufacturing information, including any then still to be developed, associated with any licensed products. PECC agreed to pay royalties on the products based upon the “Net Sales Price”, defined as “the net amount billed and payable for *** [licensed products] excluding import duties, insurance, transportation costs, taxes which are separately billed and normal trade discounts.” In practice, P-E and PECC interpreted this definition to mean the amount PECC billed P-E rather than the amount P-E billed upon resale. The specified term of this agreement was until the expiration of the last license entered into pursuant to the agreement. Following an audit the tax authorities issued an assessment of additional income taxes related to controlled transactions between the above parties. The issues presently before the Tax Court for decision were: [1) Whether the tax authorities’s allocations of gross income to P-E under section 482 were arbitrary, capricious, or unreasonable; (2) whether the prices FE paid for finished products to a wholly owned subsidiary operating in Puerto Rico were arm’s-length amounts; (3) whether the prices the subsidiary paid to P-E for parts that went into the finished products were arm’s-length amounts; (4) whether the royalties the subsidiary paid to P-E on sales of the finished products to P-E were arm’s-length amounts; and (5) for prices or royalties that were not arm’s length, what the arm’s-length amounts are ...

BAUSCH & LOMB Inc (B&L Inc) and its subsidiaries were engaged in the manufacture, marketing and sale of soft contact lenses and related products in the United States and abroad. B&L Ireland was organized on February 1, 1980, under the laws of the Republic of Ireland as a third tier, wholly owned subsidiary of petitioner. B&L Ireland was organized for valid business reasons and to take advantage of certain tax and other incentives offered by the Republic of Ireland. Pursuant to an agreement dated January 1, 1981, petitioner granted to B&L Ireland a nonexclusive license to use its patented and unpatented manufacturing technology to manufacture soft contact lenses in Ireland and a nonexclusive license to use certain of its trademarks in the sale of soft contact lenses produced through use of the licensed technology worldwide. In return, B&L Ireland agreed to pay B&L Inc. a royalty equal to five percent of sales. In 1981 and 1982, B&L Ireland engaged in the manufacture and sale of soft contact lenses in the Republic of Ireland. All of B&L Ireland’s sales were made either to B&L Inc or certain of B&L Inc’s wholly owned foreign sales affiliates at a price of $7.50 per lens. The tax authorities determined that the $7.50 sales price did not constitute an arm’s-length consideration for the soft contact lenses sold by B&L Ireland to B&L Inc. Furthermore the authorities determined that, the royalty contained in the January 1, 1981 license agreement did not constitute an arm’s-length consideration for the use by B&L Ireland of B&L Inc’s intangibles. Opinion of the Tax Court A. Determination of Arm’s-Length Prices Between B&L Inc and B&L Ireland for Soft Contact Lenses “… The market price for any product will be equal to the price at which the least efficient producer whose production is necessary to satisfy demand is willing to sell. During 1981 and 1982, the lathing methods were still the predominant production technologies employed in the soft contact lens industry. American Hydron, an affiliate of NPDC and a strong competitor in the contact lens market, was able to produce 466,348 and 762, 379 soft contact lenses using the lathing method in 1981 and 1982, for $6.18 and $6.46 per unit, respectively. It is questionable whether any of B&L Ireland’s competitors, save B&L, could profitably have sold soft contact lenses during the period in issue for less than the $7.50 charged by B&L Ireland. The fact that B&L Ireland could, through its possession of superior production technology, undercut the market and sell at a lower price is irrelevant. Petitioners have shown that the $7.50 they paid for lenses was a ‘market price‘ and have thus ‘earned the right to be free from a section 482 reallocation.‘ United States Steel Corp. v. Commissioner, supra at 947. Finally, respondent argues that B&L COULD HAVE produced the contact lenses purchased from B&L Ireland itself at lesser cost. However, B&L DID NOT produce the lenses itself. The mere power to determine who in a controlled group will earn income cannot justify a section 482 allocation of the income from the entity who actually earned the income. Bush Hog Mfg. Co. v. Commissioner, 42 T.C. 713, 725 (1964); Polak’s Frutal Works, Inc. v. Commissioner, 21 T.C. 953, 976 (1954). B&L Ireland was the entity which actually produced the contact lenses. Respondent is limited to determining how the sales to B&L by B&L Ireland would have been priced had the parties been unrelated and negotiating at arm’s length. We have determined that the $7.50 charged was a market price. We thus conclude that respondent abused his discretion and acted arbitrarily and unreasonably in reallocating income between B&L and B&L Ireland based on use of a transfer price for contact lenses other than the $7.50 per lens actually used. When conditions for use of the comparable uncontrolled price method are present, use of that method to determine an arm’s-length price is mandated. Sec. 1.482-2(e)(1)(ii), Income Tax Regs. Therefore, we need not consider petitioner’s alternative position — that application of the resale price method supports the arm’s-length nature of the $7.50 transfer price. We note, however, that application of such method lends further support to the arm’s-length nature of B&L Ireland’s $7.50 sales price. Uncontrolled purchases and resales by American Optical, Southern, Bailey-Smith, and Mid-South indicate gross profit percentages of between 22 and 40 percent were common among soft contact lens distributors. This is confirmed by the testimony of Thomas Sloan, president of Southern, who testified that he tried to purchase lenses from manufacturers at prices which allowed Southern to maintain a reasonable profit margin of between 25 and 40 percent. Applying a 40- percent gross margin to B&L’s average realized price of $16.74 and $15.25 for domestic sales in 1981 and 1982, respectively, indicates a lens cost of $10.04 and $9.15, respectively — well above the $7.50 received by B&L Ireland for its lenses and also above the $8.12 cost to B&L when freight and duty are added.” B. Determination of Arm’s-Length Royalty Payable by B&L Ireland for use of B&L’s Intangibles “… Obviously, no independent party would enter into an agreement for the license of intangibles under circumstances in which the royalty charged would preclude any reasonable expectation of earning a profit through use of the intangibles. We therefore find respondent’s section 482 allocation with respect to the royalty to be arbitrary, capricious and unreasonable. Our rejection of the royalty rate advocated by respondent does not, however, require that we accept that proposed by petitioners. G.D. Searle v. Commissioner, 88 T.C. at 367. Both Dr. Arons and Dr. Plotkin testified that in their opinion a royalty of five percent of the transfer price charged for the contact lenses sold by B&L Ireland was inadequate as arm’s-length consideration. On brief, petitioners recalculated the royalty due from B&L Ireland based on five percent of the average realized price (ARP) of Irish-produced lenses, arriving at royalties of $1,072,522 and $3,050,028 for 1981 and 1982, respectively. This translates to a royalty of ...

BAUSCH & LOMB Inc (B&L Inc) and its subsidiaries were engaged in the manufacture, marketing and sale of soft contact lenses and related products in the United States and abroad. B&L Ireland was organized on February 1, 1980, under the laws of the Republic of Ireland as a third tier, wholly owned subsidiary of petitioner. B&L Ireland was organized for valid business reasons and to take advantage of certain tax and other incentives offered by the Republic of Ireland. Pursuant to an agreement dated January 1, 1981, petitioner granted to B&L Ireland a nonexclusive license to use its patented and unpatented manufacturing technology to manufacture soft contact lenses in Ireland and a nonexclusive license to use certain of its trademarks in the sale of soft contact lenses produced through use of the licensed technology worldwide. In return, B&L Ireland agreed to pay B&L Inc. a royalty equal to five percent of sales. In 1981 and 1982, B&L Ireland engaged in the manufacture and sale of soft contact lenses in the Republic of Ireland. All of B&L Ireland’s sales were made either to B&L Inc or certain of B&L Inc’s wholly owned foreign sales affiliates at a price of $7.50 per lens. The tax authorities determined that the $7.50 sales price did not constitute an arm’s-length consideration for the soft contact lenses sold by B&L Ireland to B&L Inc. Furthermore the authorities determined that, the royalty contained in the January 1, 1981 license agreement did not constitute an arm’s-length consideration for the use by B&L Ireland of B&L Inc’s intangibles. Opinion of the Tax Court A. Determination of Arm’s-Length Prices Between B&L Inc and B&L Ireland for Soft Contact Lenses “… The market price for any product will be equal to the price at which the least efficient producer whose production is necessary to satisfy demand is willing to sell. During 1981 and 1982, the lathing methods were still the predominant production technologies employed in the soft contact lens industry. American Hydron, an affiliate of NPDC and a strong competitor in the contact lens market, was able to produce 466,348 and 762, 379 soft contact lenses using the lathing method in 1981 and 1982, for $6.18 and $6.46 per unit, respectively. It is questionable whether any of B&L Ireland’s competitors, save B&L, could profitably have sold soft contact lenses during the period in issue for less than the $7.50 charged by B&L Ireland. The fact that B&L Ireland could, through its possession of superior production technology, undercut the market and sell at a lower price is irrelevant. Petitioners have shown that the $7.50 they paid for lenses was a ‘market price‘ and have thus ‘earned the right to be free from a section 482 reallocation.‘ United States Steel Corp. v. Commissioner, supra at 947. Finally, respondent argues that B&L COULD HAVE produced the contact lenses purchased from B&L Ireland itself at lesser cost. However, B&L DID NOT produce the lenses itself. The mere power to determine who in a controlled group will earn income cannot justify a section 482 allocation of the income from the entity who actually earned the income. Bush Hog Mfg. Co. v. Commissioner, 42 T.C. 713, 725 (1964); Polak’s Frutal Works, Inc. v. Commissioner, 21 T.C. 953, 976 (1954). B&L Ireland was the entity which actually produced the contact lenses. Respondent is limited to determining how the sales to B&L by B&L Ireland would have been priced had the parties been unrelated and negotiating at arm’s length. We have determined that the $7.50 charged was a market price. We thus conclude that respondent abused his discretion and acted arbitrarily and unreasonably in reallocating income between B&L and B&L Ireland based on use of a transfer price for contact lenses other than the $7.50 per lens actually used. When conditions for use of the comparable uncontrolled price method are present, use of that method to determine an arm’s-length price is mandated. Sec. 1.482-2(e)(1)(ii), Income Tax Regs. Therefore, we need not consider petitioner’s alternative position — that application of the resale price method supports the arm’s-length nature of the $7.50 transfer price. We note, however, that application of such method lends further support to the arm’s-length nature of B&L Ireland’s $7.50 sales price. Uncontrolled purchases and resales by American Optical, Southern, Bailey-Smith, and Mid-South indicate gross profit percentages of between 22 and 40 percent were common among soft contact lens distributors. This is confirmed by the testimony of Thomas Sloan, president of Southern, who testified that he tried to purchase lenses from manufacturers at prices which allowed Southern to maintain a reasonable profit margin of between 25 and 40 percent. Applying a 40- percent gross margin to B&L’s average realized price of $16.74 and $15.25 for domestic sales in 1981 and 1982, respectively, indicates a lens cost of $10.04 and $9.15, respectively — well above the $7.50 received by B&L Ireland for its lenses and also above the $8.12 cost to B&L when freight and duty are added. B. Determination of Arm’s-Length Royalty Payable by B&L Ireland for use of B&L’s Intangibles “… Obviously, no independent party would enter into an agreement for the license of intangibles under circumstances in which the royalty charged would preclude any reasonable expectation of earning a profit through use of the intangibles. We therefore find respondent’s section 482 allocation with respect to the royalty to be arbitrary, capricious and unreasonable. Our rejection of the royalty rate advocated by respondent does not, however, require that we accept that proposed by petitioners. G.D. Searle v. Commissioner, 88 T.C. at 367. Both Dr. Arons and Dr. Plotkin testified that in their opinion a royalty of five percent of the transfer price charged for the contact lenses sold by B&L Ireland was inadequate as arm’s-length consideration. On brief, petitioners recalculated the royalty due from B&L Ireland based on five percent of the average realized price (ARP) of Irish-produced lenses, arriving at royalties of $1,072,522 and $3,050,028 for 1981 and 1982, respectively. This translates to a royalty of ...