[Code of Federal Regulations]
[Title 26, Volume 6]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.482-1]

[Page 576-598]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
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

[[Page 577]]

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 applicable to taxable years 
beginning on or after October 6, 1994, and before January 1, 1996. 
Section 1.482-7 sets forth the cost sharing provisions applicable to 
taxable years beginning on or after January 1, 1996. 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. Section 1.482-7 provides the specific method to be used 
to evaluate whether a qualified cost sharing arrangement produces 
results consistent with an 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.

[[Page 578]]

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. See Sec. 1.482-7 for the applicable method in the 
case of a qualified cost sharing arrangement.
    (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

[[Page 579]]

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

[[Page 580]]

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.

[[Page 581]]

    (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.

[[Page 582]]

    (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

[[Page 583]]

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 Sec. Sec. 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

[[Page 584]]

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

[[Page 585]]

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

[[Page 586]]

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

[[Page 587]]

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

[[Page 588]]

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

[[Page 589]]

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); Sec. Sec. 
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).


[[Page 590]]


    (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

[[Page 591]]

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 Sec. Sec. 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

[[Page 592]]

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 Sec. Sec. 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

[[Page 593]]

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.


[[Page 594]]


    (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

[[Page 595]]

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,

[[Page 596]]

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 Sec. Sec. 1.482-1 and 
1.482-4 will be applied, and to the extent relevant to the valuation of 
intangibles, Sec. Sec. 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 Sec. Sec. 1.482-1 through 1.482-
8.

[[Page 597]]

    (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

[[Page 598]]

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.
    (5) The last sentences of paragraphs (b)(2)(i) and (c)(1) of this 
section and of paragraph (c)(2)(iv) of Sec. 1.482-5 apply for taxable 
years beginning on or after August 26, 2003.

[T.D. 8552, 59 FR 34990, July 8, 1994, as amended by T.D. 9088, 68 FR 
51177, Aug. 26, 2003]