[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: 26CFR1.482-2A]

[Page 671-681]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.482-2A  Determination of taxable income in specific situations.

    (a)-(c) For applicable rules, see Sec. 1.482-2T (a) through (c).
    (d) Transfer or use of intangible property--(1) In general. (i) 
Except as otherwise provided in subparagraph (4) of this paragraph, 
where intangible property or an interest therein is transferred, sold, 
assigned, loaned, or otherwise made available in any manner by one 
member of a group of controlled entities (referred to in this paragraph 
as the transferor) to another member of the group (referred to in this 
paragraph as the transferee) for other than an arm's length 
consideration, the district director may make appropriate allocations to 
reflect an arm's length consideration for such property or its use. 
Subparagraph (2) of this paragraph provides rules for determining the 
form an amount of an appropriate allocation, subparagraph (3) of this 
paragraph provides a definition of ``intangible property'', and 
subparagraph (4) of this paragraph provides rules with respect to 
certain cost-sharing arrangements in connection with the development of 
intangible property. For purposes of this paragraph, an interest in 
intangible property may take the form of the right to use such property.

[[Page 672]]

    (ii)(a) In the absence of a bona fide cost-sharing arrangement (as 
defined in subparagraph (4) of this paragraph), where one member of a 
group of related entities undertakes the development of intangible 
property as a developer within the meaning of (c) of this subdivision, 
no allocation with respect to such development activity shall be made 
under the rules of this paragraph or any other paragraph of this section 
(except as provided in (b) of this subdivision) until such time as any 
property developed, or any interest therein, is or is deemed to be 
transferred, sold, assigned, loaned, or otherwise made available in any 
manner by the developer to a related entity in a transfer subject to the 
rules of this paragraph. Where a member of the group other than the 
developer acquires an interest in the property developed by virtue of 
obtaining a patent or copyright, or by any other means, the developer 
shall be deemed to have transferred such interest in such property to 
the acquiring member in a transaction subject to the rules of this 
paragraph. For example, if one member of a group (the developer) 
undertakes to develop a new patentable product and the costs of 
development are incurred by that entity over a period of 3 years, no 
allocation with respect to that entity's activity shall be made during 
such period. The amount of any allocation that may be appropriate at the 
expiration of such development period when, for example, the patent on 
the product is transferred, or deemed transferred, to a related entity 
for other than an arm's length consideration, shall be determined in 
accordance with the rules of this paragraph.
    (b) Where one member of a group renders assistance in the form of 
loans, services, or the use of tangible or intangible property to a 
developer in connection with an attempt to develop intangible property, 
the amount of any allocation that may be appropriate with respect to 
such assistance shall be determined in accordance with the rules of the 
appropriate paragraph or paragraphs of this section. Thus, where one 
entity allows a related entity, which is the developer, to use tangible 
property, such as laboratory equipment, in connection with the 
development of intangible property, the amount of any allocation that 
may be appropriate with respect to such use shall be determined in 
accordance with the rules of paragraph (c) of this section. In the event 
that the district director does not exercise his discretion to make 
allocations with respect to the assistance rendered to the developer, 
the value of the assistance shall be allowed as a set-off against any 
allocation that the district director may make under this paragraph as a 
result of the transfer of the intangible property to the entity 
rendering the assistance.
    (c) The determination as to which member of a group of related 
entities is a developer and which members of the group are rendering 
assistance to the developer in connection with its development 
activities shall be based upon all the facts and circumstances of the 
individual case. Of all the facts and circumstances to be taken into 
account in making this determination, greatest weight shall be given to 
the relative amounts of all the direct and indirect costs of development 
and the corresponding risks of development borne by the various members 
of the group, and the relative values of the use of any intangible 
property of members of the group which is made available without 
adequate consideration for use in connection with the development 
activity, which property is likely to contribute to a substantial extent 
in the production of intangible property. For this purpose, the risk to 
be borne with respect to development activity is the possibility that 
such activity will not result in the production of intangible property 
or that the intangible property produced will not be of sufficient value 
to allow for the recovery of the costs of developing it. A member will 
not be considered to have borne the costs and corresponding risks of 
development unless such member is committed to bearing such costs in 
advance of, or contemporaneously with, their incurrence and without 
regard to the success of the project. Other factors that may be relevant 
in determining which member of the group is the developer include the 
location of the development activity, the capabilities of the various 
members to carry on

[[Page 673]]

the project independently, and the degree of control over the project 
exercised by the various members.
    (d) The principles of this subdivision (ii) may be illustrated by 
the following examples in which it is assumed that X and Y are corporate 
members of the same group:

    Example (1). X, at the request of Y, undertakes to develop a new 
machine which will function effectively in the climate in which Y's 
factory is located. Y agrees to bear all the direct and indirect costs 
of the project whether or not X successfully develops the machine. 
Assume that X does not make any of its own intangible property available 
for use in connection with the project. The machine is successfully 
developed and Y obtains possession of the intangible property necessary 
to produce such machine. Based on the facts and circumstances as stated, 
Y shall be considered to be the developer of the intangible property 
and, therefore, Y shall not be treated as having obtained the property 
in a transfer subject to the rules of this paragraph. Any amount which 
may be allocable with respect to the assistance rendered by X shall be 
determined in accordance with the rules of (b) of this subdivision.
    Example (2). Assume the same facts as in example (1) except that Y 
agrees to reimburse X for its costs only in the event that the property 
is successfully developed. In such case X is the developer and Y is 
deemed to have received the property in a transfer subject to the rules 
of this paragraph. Therefore, the district director may make an 
allocation to reflect an arm's length consideration for such property.
    Example (3). In 1967 X undertakes to develop product M in its 
research and development department. X incurs direct and indirect costs 
of $1 million per year in connection with the project in 1967, 1968, and 
1969. In connection with the project, X employs the formula for compound 
N, which it owns, and which is likely to contribute substantially to the 
success of the project. The value of the use of the formula for compound 
N in connection with this project is $750,000. In 1968, 4 chemists 
employed by Y spend 6 months working on the project in X's laboratory. 
The salary and other expenses connected with the chemists' employment 
for that period ($100,000) are paid by Y, for which no charge is made to 
X. In 1969, product M is perfected and Y obtains patents thereon. X is 
considered to be the developer of product M since, among other things, 
it bore the greatest relative share of the costs and risks incurred in 
connection with this project and made available intangible property 
(formula for compound N) which was likely to contribute substantially in 
the development of product M. Accordingly, no allocation with respect to 
X's development activity should be made before 1969. The property is 
deemed to have been transferred to Y at that time by virtue of the fact 
that Y obtained the patent rights to product M. In such case the 
district director may make an allocation to reflect an arm's length 
consideration for such transfer. In the event that the district director 
makes such an allocation and he has not made or does not make an 
allocation for 1968 with respect to the services of the chemists in 
accordance with the principles of paragraph (b) of this section, the 
value of the assistance shall be allowed as a set-off against the amount 
of the allocation reflecting an arm's length consideration for the 
transfer of the intangible property.

    (2) Arm's length consideration. (i) An arm's length consideration 
shall be in a form which is consistent with the form which would be 
adopted in transactions between unrelated parties under the same 
circumstances. To the extent appropriate, an arm's length consideration 
may take any one or more of the following forms:
    (a) Royalties based on the transferee's output, sales, profits, or 
any other measure;
    (b) Lump-sum payments; or
    (c) Any other form, including reciprocal licensing rights, which 
might reasonably have been adopted by unrelated parties under the 
circumstances, provided that the parties can establish that such form 
was adopted pursuant to an arrangement which in fact existed between 
them.

However, where the transferee pays nominal or no consideration for the 
property or interest therein and where the transferor has retained a 
substantial interest in the property, an allocation shall be presumed 
not to take the form of a lump-sum payment.
    (ii) In determining the amount of an arm's length consideration, the 
standard to be applied is the amount that would have been paid by an 
unrelated party for the same intangible property under the same 
circumstances. Where there have been transfers by the transferor to 
unrelated parties involving the same or similar intangible property 
under the same or similar circumstances the amount of the consideration 
for such transfers shall generally be the best indication of an arm's 
length consideration.

[[Page 674]]

    (iii) Where a sufficiently similar transaction involving an 
unrelated party cannot be found, the following factors, to the extent 
appropriate (depending upon the type of intangible property and the form 
of the transfer), may be considered in arriving at the amount of the 
arm's length consideration:
    (a) The prevailing rates in the same industry or for similar 
property,
    (b) The offers of competing transferors or the bids of competing 
transferees,
    (c) The terms of the transfer, including limitations on the 
geographic area covered and the exclusive or nonexclusive character of 
any rights granted,
    (d) The uniqueness of the property and the period for which it is 
likely to remain unique,
    (e) The degree and duration of protection afforded to the property 
under the laws of the relevant countries.
    (f) Value of services rendered by the transferor to the transferee 
in connection with the transfer within the meaning of paragraph (b)(8) 
of this section,
    (g) Prospective profits to be realized or costs to be saved by the 
transferee through its use or subsequent transfer of the property,
    (h) The capital investment and starting up expenses required of the 
transferee,
    (i) The next subdivision is (j),
    (j) The availability of substitutes for the property transferred,
    (k) The arm's length rates and prices paid by unrelated parties 
where the property is resold or sublicensed to such parties,
    (l) The costs incurred by the transferor in developing the property, 
and
    (m) Any other fact or circumstance which unrelated parties would 
have been likely to consider in determining the amount of an arm's 
length consideration for the property.
    (3) Definition of intangible property. (i) Solely for the purposes 
of this section, intangible property shall consist of the items 
described in subdivision (ii) of this subparagraph, provided that such 
items have substantial value independent of the services of individual 
persons.
    (ii) The items referred to in subdivision (i) of this subparagraph 
are as follows:
    (a) Patents, inventions, formulas, processes, designs, patterns, and 
other similar items;
    (b) Copyrights, literary, musical, or artistic compositions, and 
other similar items;
    (c) Trademarks, trade names, brand names, and other similar items;
    (d) Franchises, licenses, contracts, and other similar items;
    (e) Methods, programs, systems, procedures, campaigns, surveys, 
studies, forecasts, estimates, customer lists, technical data, and other 
similar items.
    (4) Sharing of costs and risks. Where a member of a group of 
controlled entities acquires an interest in intangible property as a 
participating party in a bona fide cost sharing arrangement with respect 
to the development of such intangible property, the district director 
shall not make allocations with respect to such acquisition except as 
may be appropriate to reflect each participant's arm's length share of 
the costs and risks of developing the property. A bona fide cost sharing 
arrangement is an agreement, in writing, between two or more members of 
a group of controlled entities providing for the sharing of the costs 
and risks of developing intangible property in return for a specified 
interest in the intangible property that may be produced. In order for 
the arrangement to qualify as a bona fide arrangement, it must reflect 
an effort in good faith by the participating members to bear their 
respective shares of all the costs and risks of development on an arm's 
length basis. In order for the sharing of costs and risk to be 
considered on an arm's length basis, the terms and conditions must be 
comparable to those which would have been adopted by unrelated parties 
similarly situated had they entered into such an arrangement. If an oral 
cost sharing arrangement, entered into prior to April 16, 1968, and 
continued in effect after that date, is otherwise in compliance with the 
standards prescribed in this subparagraph, it shall constitute a bona 
fide cost sharing arrangement if it is

[[Page 675]]

reduced to writing prior to January 1, 1969.
    (e) Sales of tangible property--(1) In general. (i) Where one member 
of a group of controlled entities (referred to in this paragraph as the 
``seller'') sells or otherwise disposes of tangible property to another 
member of such group (referred to in this paragraph as the ``buyer'') at 
other than an arm's length price (such a sale being referred to in this 
paragraph as a ``controlled sale''), the district director may make 
appropriate allocations between the seller and the buyer to reflect an 
arm's length price for such sale or disposition. An arm's length price 
is the price that an unrelated party would have paid under the same 
circumstances for the property involved in the controlled sale. Since 
unrelated parties normally sell products at a profit, an arm's length 
price normally involves a profit to the seller.
    (ii) Subparagraphs (2), (3), and (4) of this paragraph describe 
three methods of determining an arm's-length price and the standards for 
applying each method. They are, respectively, the comparable 
uncontrolled price method, the resale price method, and the cost-plus 
method. In addition, a special rule is provided in subdivision (v) of 
this subparagraph for use (notwithstanding any other provision of this 
subdivision) in determining an arm's-length price for an ore or mineral. 
If there are comparable uncontrolled sales as defined in subparagraph 
(2) of this paragraph, the comparable uncontrolled price method must be 
utilized because it is the method likely to result in the most accurate 
estimate of an arm's-length price (for the reason that it is based upon 
the price actually paid by unrelated parties for the same or similar 
products). If there are no comparable uncontrolled sales, then the 
resale price method must be utilized if the standards for its 
application are met because it is the method likely to result in the 
next most accurate estimate in such instances (for the reason that, in 
such instances, the arm's-length price determined under such method is 
based more directly upon actual arm's-length transactions than is the 
cost-plus method). A typical situation where the resale price method may 
be required is where a manufacturer sells products to a related 
distributor which, without further processing, resells the products in 
uncontrolled transactions. If all the standards for the mandatory 
application of the resale price method are not satisfied, then, as 
provided in subparagraph (3)(iii) of this paragraph, either that method 
or the cost-plus method may be used, depending upon which method is more 
feasible and is likely to result in a more accurate estimate of an 
arm's-length price. A typical situation where the cost-plus method may 
be appropriate is where a manufacturer sells products to a related 
entity which performs substantial manufacturing, assembly, or other 
processing of the product or adds significant value by reason of its 
utilization of its intangible property prior to resale in uncontrolled 
transactions.
    (iii) Where the standards for applying one of the three methods of 
pricing described in subdivision (ii) of this subparagraph are met, such 
method must, for the purposes of this paragraph, be utilized unless the 
taxpayer can establish that, considering all the facts and 
circumstances, some method of pricing other than those described in 
subdivision (ii) of this subparagraph is clearly more appropriate. Where 
none of the three methods of pricing described in subdivision (ii) of 
this subparagraph can reasonably be applied under the facts and 
circumstances as they exist in a particular case, some appropriate 
method of pricing other than those described in subdivision (ii) of this 
subparagraph, or variations on such methods, can be used.
    (iv) The methods of determining arm's length prices described in 
this section are stated in terms of their application to individual 
sales of property. However, because of the possibility that a taxpayer 
may make controlled sales of many different products, or many separate 
sales of the same product, it may be impractical to analyze every sale 
for the purposes of determining the arm's length price. It is therefore 
permissible to determine or verify arm's length prices by applying the 
appropriate methods of pricing to product lines or other groupings where 
it is impractical to ascertain an arm's length price for each product or

[[Page 676]]

sale. In addition, the district director may determine or verify the 
arm's length price of all sales to a related entity by employing 
reasonable statistical sampling techniques.
    (v) The price for a mineral product which is sold at the stage at 
which mining or extraction ends shall be determined under the provisions 
of Sec. Sec. 1.613-3 and 1.613-4.
    (2) Comparable uncontrolled price method. (i) Under the method of 
pricing described as the ``comparable uncontrolled price method'', the 
arm's length price of a controlled sale is equal to the price paid in 
comparable uncontrolled sales, adjusted as provided in subdivision (ii) 
of this subparagraph.
    (ii) ``Uncontrolled sales'' are sales in which the seller and the 
buyer are not members of the same controlled group. These include (a) 
sales made by a member of the controlled group to an unrelated party, 
(b) sales made to a member of the controlled group by an unrelated 
party, and (c) sales made in which the parties are not members of the 
controlled group and are not related to each other. However, 
uncontrolled sales do not include sales at unrealistic prices, as for 
example where a member makes uncontrolled sales in small quantities at a 
price designed to justify a nonarm's length price on a large volume of 
controlled sales. Uncontrolled sales are considered comparable to 
controlled sales if the physical property and circumstances involved in 
the uncontrolled sales are identical to the physical property and 
circumstances involved in the controlled sales, or if such properties 
and circumstances are so nearly identical that any differences either 
have no effect on price, or such differences can be reflected by a 
reasonable number of adjustments to the price of uncontrolled sales. For 
this purpose, differences can be reflected by adjusting prices only 
where such differences have a definite and reasonably ascertainable 
effect on price. If the differences can be reflected by such adjustment, 
then the price of the uncontrolled sale as adjusted constitutes the 
comparable uncontrolled sale price. Some of the differences which may 
affect the price of property are differences in the quality of the 
product, terms of sale, intangible property associated with the sale, 
time of sale, and the level of the market and the geographic market in 
which the sale takes place. Whether and to what extent differences in 
the various properties and circumstances affect price, and whether 
differences render sales noncomparable, depends upon the particular 
circumstances and property involved. The principles of this subdivision 
may be illustrated by the following examples, in each of which it is 
assumed that X makes both controlled and uncontrolled sales of the 
identical property:

    Example (1). Assume that the circumstances surrounding the 
controlled and the uncontrolled sales are identical, except for the fact 
that the controlled sales price is a delivered price and the 
uncontrolled sales are made f.o.b. X's factory. Since differences in 
terms of transportation and insurance generally have a definite and 
reasonably ascertainable effect on price, such differences do not 
normally render the uncontrolled sales noncomparable to the controlled 
sales.
    Example (2). Assume that the circumstances surrounding the 
controlled and uncontrolled sales are identical, except for the fact 
that X affixes its valuable trademark in the controlled sales, and does 
not affix its trademark in uncontrolled sales. Since the effects on 
price of differences in intangible property associated with the sale of 
tangible property, such as trademarks, are normally not reasonably 
ascertainable, such differences would normally render the uncontrolled 
sales noncomparable.
    Example (3). Assume that the circumstances surrounding the 
controlled and uncontrolled sales are identical, except for the fact 
that X, a manufacturer of business machines, makes certain minor 
modifications in the physical properties of the machines to satisfy 
safety specifications or other specific requirements of a customer in 
controlled sales, and does not make these modifications in uncontrolled 
sales. Since minor physical differences in the product generally have a 
definite and reasonably ascertainable effect on prices, such differences 
do not normally render the uncontrolled sales noncomparable to the 
controlled sales.

    (iii) Where there are two or more comparable uncontrolled sales 
susceptible of adjustment as defined in subdivision (ii) of this 
subparagraph, the comparable uncontrolled sale or sales requiring the 
fewest and simplest adjustments provided in subdivision (ii) of this 
subparagraph should generally

[[Page 677]]

be selected. Thus, for example, if a taxpayer makes comparable 
uncontrolled sales of a particular product which differ from the 
controlled sale only with respect to the terms of delivery, and makes 
other comparable uncontrolled sales of the product which differ from the 
controlled sale with respect to both terms of delivery and terms of 
payment, the comparable uncontrolled sales differing only with respect 
to terms of delivery should be selected as the comparable uncontrolled 
sale.
    (iv) One of the circumstances which may affect the price of property 
is the fact that the seller may desire to make sales at less than a 
normal profit for the primary purpose of establishing or maintaining a 
market for his products. Thus, a seller may be willing to reduce the 
price of a product, for a time, in order to introduce his product into 
an area or in order to meet competition. However, controlled sales may 
be priced in such a manner only if such price would have been charged in 
an uncontrolled sale under comparable circumstances. Such fact may be 
demonstrated by showing that the buyer in the controlled sale made 
corresponding reductions in the resale price to uncontrolled purchasers, 
or that such buyer engaged in substantially greater sales promotion 
activities with respect to the product involved in the controlled sale 
than with respect to other products. For example, assume X, a 
manufacturer of batteries, commences to sell car batteries to Y, a 
subsidiary of X, for resale in a new market. In its existing markets X's 
batteries sell to independent retailers at $20 per unit, and X sells 
them to wholesalers at $17 per unit. Y also sells X's batteries to 
independent retailers at $20 per unit. X's batteries are not known in 
the new market in which Y is operating. In order to engage competitively 
in the new market Y incurs selling and advertising costs substantially 
higher than those incurred for its sales of other products. Under these 
circumstances X may sell to Y, for a time, at less than $17 to take into 
account the increased selling and advertising activities of Y in 
penetrating and establishing the new market. This may be done even 
though it may result in a transfer price from X to Y which is below X's 
full costs of manufacturing the product.
    (3) Resale price method. (i) Under the pricing method described as 
the ``resale price method'', the arm's length price of a controlled sale 
is equal to the applicable resale price (as defined in subdivision (iv) 
or (v) of this subparagraph), reduced by an appropriate markup, and 
adjusted as provided in subdivision (ix) of this subparagraph. An 
appropriate markup is computed by multiplying the applicable resale 
price by the appropriate markup percentage as defined in subdivision 
(vi) of this subparagraph. Thus, where one member of a group of 
controlled entities sells property to another member which resells the 
property in uncontrolled sales, if the applicable resale price of the 
property involved in the uncontrolled sale is $100 and the appropriate 
markup percentage for resales by the buyer is 20 percent, the arm's 
length price of the controlled sale is $80 ($100 minus 20 percent x 
$100), adjusted as provided in subdivision (ix) of this subparagraph.
    (ii) The resale price method must be used to compute an arm's length 
price of a controlled sale if all the following circumstances exist:
    (a) There are no comparable uncontrolled sales as defined in 
subparagraph (2) of this paragraph.
    (b) An applicable resale price, as defined in subdivision (iv) or 
(v) of this subparagraph, is available with respect to resales made 
within a reasonable time before or after the time of the controlled 
sale.
    (c) The buyer (reseller) has not added more than an insubstantial 
amount to the value of the property by physically altering the product 
before resale. For this purpose packaging, repacking, labeling, or minor 
assembly of property does not constitute physical alteration.
    (d) The buyer (reseller) has not added more than an insubstantial 
amount to the value of the property by the use of intangible property. 
See Sec. 1.482-2(d)(3) for the definition of intangible property.
    (iii) Notwithstanding the fact that one or both of the requirements 
of subdivision (ii) (c) or (d) of this subparagraph may not be met, the 
resale price method may be used if such method is

[[Page 678]]

more feasible and is likely to result in a more accurate determination 
of an arm's length price than the use of the cost plus method. Thus, 
even though one of the requirements of such subdivision is not 
satisfied, the resale price method may nevertheless be more appropriate 
than the cost plus method because the computations and evaluations 
required under the former method may be fewer and easier to make than 
under the latter method. In general, the resale price method is more 
appropriate when the functions performed by the seller are more 
extensive and more difficult to evaluate than the functions performed by 
the buyer (reseller). The principle of this subdivision may be 
illustrated by the following examples in each of which it is assumed 
that corporation X developed a valuable patent covering product M which 
it manufactures and sells to corporation Y in a controlled sale, and for 
which there is no comparable uncontrolled sale:

    Example (1). Corporation Y adds a component to product M and resells 
the assembled product in an uncontrolled sale within a reasonable time 
after the controlled sale of product M. Assume further that the addition 
of the component added more than an insubstantial amount to the value of 
product M, but that Y's function in purchasing the component and 
assembling the product prior to sale was subject to reasonably precise 
valuation. Although the controlled sale and resale does not meet the 
requirements of subdivision (ii)(c) of this subparagraph, the resale 
price method may be used under the circumstances because that method 
involves computations and evaluations which are fewer and easier to make 
than under the cost plus method. This is because X's use of a patent may 
be more difficult to evaluate in determining an appropriate gross profit 
percentage under the cost plus method, than is evaluation of Y's 
assembling function in determining the appropriate markup percentage 
under the resale price method.
    Example (2). Corporation Y resells product M in an uncontrolled sale 
within a reasonable time after the controlled sale after attaching its 
valuable trademark to it. Assume further that it can be demonstrated 
through comparison with other uncontrolled sales of Y that the addition 
of Y's trademark to a product usually adds 25 percent to the markup on 
its sales. On the other hand, the effect of X's use of its patent is 
difficult to evaluate in applying the cost plus method because no 
reasonable standard of comparison is available. Although the controlled 
sale and resale does not meet the requirements of subdivision (ii)(d) of 
this subparagraph, the resale price method may be used because that 
method involves computations and evaluation which are fewer and easier 
to make than under the cost plus method. That is because, under the 
circumstances, X's use of a patent is more difficult to evaluate in 
determining an appropriate gross profit percentage under the cost plus 
method, than is evaluation of the use of Y's trademark in determining 
the appropriate markup percentage under the resale price method.

    (iv) For the purposes of this subparagraph the ``applicable resale 
price'' is the price at which it is anticipated that property purchased 
in the controlled sale will be resold by the buyer in an uncontrolled 
sale. The ``applicable resale price'' will generally be equal to either 
the price at which current resales of the same property are being made 
or the resale price of the particular item of property involved.
    (v) Where the property purchased in the controlled sale is resold in 
another controlled sale, the ``applicable resale price'' is the price at 
which such property is finally resold in an uncontrolled sale, providing 
that the series of sales as a whole meets all the requirements of 
subdivision (ii) of this subparagraph or that the resale price method is 
used pursuant to subdivision (iii) of this subparagraph. In such case, 
the determination of the appropriate markup percentage shall take into 
account the function or functions performed by all members of the group 
participating in the series of sales and resales. Thus, if X sells a 
product to Y in a controlled sale, Y sells the product to Z in a 
controlled sale, and Z sells the product in an uncontrolled sale, the 
resale price method must be used if Y and Z together have not added more 
than an insubstantial amount to the value of the product through 
physical alteration or the application of intangible property, and the 
final resale occurs within a reasonable time of the sale from X to Y. In 
such case, the applicable resale price is the price at which Z sells the 
product in the uncontrolled sale, and the appropriate markup percentage 
shall take into account the functions performed by both Y and Z.
    (vi) For the purposes of this subparagraph, the appropriate markup 
percentage is equal to the percentage of

[[Page 679]]

gross profit (expressed as a percentage of sales) earned by the buyer 
(reseller) or another party on the resale of property which is both 
purchased and resold in an uncontrolled transaction, which resale is 
most similar to the applicable resale of the property involved in the 
controlled sale. The following are the most important characteristics to 
be considered in determining the similarity of resales:
    (a) The type of property involved in the sales. For example: machine 
tools, men's furnishings, small household appliances.
    (b) The functions performed by the reseller with respect to the 
property. For example: packaging, labeling, delivering, maintenance of 
inventory, minor assembly, advertising, selling at wholesale, selling at 
retail, billing, maintenance of accounts receivable, and servicing.
    (c) The effect on price of any intangible property utilized by the 
reseller in connection with the property resold. For example: patents, 
trademarks, trade names.
    (d) The geographic market in which the functions are performed by 
the reseller.

In general, the similarity to be sought relates to the probable effect 
upon the markup percentage of any differences in such characteristics 
between the uncontrolled purchases and resales on the one hand and the 
controlled purchases and resales on the other hand. Thus, close physical 
similarity of the property involved in the sales compared is not 
required under the resale price method since a lack of close physical 
similarity is not necessarily indicative of dissimilar markup 
percentages.
    (vii) Whenever possible, markup percentages should be derived from 
uncontrolled purchases and resales of the buyer (reseller) involved in 
the controlled sale, because similar characteristics are more likely to 
be found among different resales of property made by the same reseller 
than among sales made by other resellers. In the absence of resales by 
the same buyer (reseller) which meet the standards of subdivision (vi) 
of this subparagraph, evidence of an appropriate markup percentage may 
be derived from resales by other resellers selling in the same or a 
similar market in which the controlled buyer (reseller) is selling 
providing such resellers perform comparable functions. Where the 
function performed by the reseller is similar to the function performed 
by a sales agent which does not take title, such sales agent will be 
considered a reseller for the purpose of determining an appropriate 
markup percentage under this subparagraph and the commission earned by 
such sales agent, expressed as a percentage of the sales price of the 
goods, may constitute the appropriate markup percentage. If the 
controlled buyer (reseller) is located in a foreign country and 
information on resales by other resellers in the same foreign market is 
not available, then markup percentages earned by United States resellers 
performing comparable functions may be used. In the absence of data on 
markup percentages of particular sales or groups of sales, the 
prevailing markup percentage in the particular industry involved may be 
appropriate.
    (viii) In calculating the markup percentage earned on uncontrolled 
purchases and resales, and in applying such percentage to the applicable 
resale price to determine the appropriate markup, the same elements 
which enter into the computation of the sales price and the costs of 
goods sold of the property involved in the comparable uncontrolled 
purchases and resales should enter into such computation in the case of 
the property involved in the controlled purchases and resales. Thus, if 
freight-in and packaging expense are elements of the cost of goods sold 
in comparable uncontrolled purchases, then such elements should also be 
taken into account in computing the cost of goods sold of the controlled 
purchase. Similarly, if the comparable markup percentage is based upon 
net sales (after reduction for returns and allowances) of uncontrolled 
resellers, such percentage must be applied to net sales of the buyer 
(reseller).
    (ix) In determining an arm's length price appropriate adjustment 
must be made to reflect any material differences between the 
uncontrolled purchases and resales used as the basis for the calculation 
of the appropriate markup percentage and the resales of

[[Page 680]]

property involved in the controlled sale. The differences referred to in 
this subdivision are those differences in functions or circumstances 
which have a definite and reasonably ascertainable effect on price. The 
principles of this subdivision may be illustrated by the following 
example:

    Example. Assume that X and Y are members of the same group of 
controlled entities and that Y purchases electric mixers from X and 
electric toasters from uncontrolled entities. Y performs substantially 
similar functions with respect to resales of both the mixers and the 
toasters, except that it does not warrant the toasters, but does provide 
a 90-day warranty for the mixers. Y normally earns a gross profit on 
toasters of 20 percent of gross selling price. The 20-percent gross 
profit on the resale of toasters is an appropriate markup percentage, 
but the price of the controlled sale computed with reference to such 
rate must be adjusted to reflect the difference in terms (the warranty).

    (4) Cost plus method. (i) Under the pricing method described as the 
``cost plus method'', the arm's length price of a controlled sale of 
property shall be computed by adding to the cost of producing such 
property (as computed in subdivision (ii) of this subparagraph), an 
amount which is equal to such cost multiplied by the appropriate gross 
profit percentage (as computed in subdivision (iii) of this 
subparagraph), plus or minus any adjustments as provided in subdivision 
(v) of this subparagraph.
    (ii) For the purposes of this subparagraph, the cost of producing 
the property involved in the controlled sale, and the costs which enter 
into the computation of the appropriate gross profit percentage shall be 
computed in a consistent manner in accordance with sound accounting 
practices for allocating or apportioning costs, which neither favors nor 
burdens controlled sales in comparison with uncontrolled sales. Thus, if 
the costs used in computing the appropriate gross profit percentage are 
comprised of the full cost of goods sold, including direct and indirect 
costs, then the cost of producing the property involved in the 
controlled sales must be comprised of the full cost of goods sold, 
including direct and indirect costs. On the other hand, if the costs 
used in computing the appropriate gross profit percentage are comprised 
only of direct costs, the cost of producing the property involved in the 
controlled sale must be comprised only of direct costs. The term ``cost 
of producing'', as used in this subparagraph, includes the cost of 
acquiring property which is held for resale.
    (iii) For the purposes of this subparagraph, the appropriate gross 
profit percentage is equal to the gross profit percentage (expressed as 
a percentage of cost) earned by the seller or another party on the 
uncontrolled sale or sales of property which are most similar to the 
controlled sale in question. The following are the most important 
characteristics to be considered in determining the similarity of the 
uncontrolled sale or sales:
    (a) The type of property involved in the sales. For example: machine 
tools, men's furnishings, small household appliances.
    (b) The functions performed by the seller with respect to the 
property sold. For example: contract manufacturing, product assembly, 
selling activity, processing, servicing, delivering.
    (c) The effect of any intangible property used by the seller in 
connection with the property sold. For example: patents, trademarks, 
trade names.
    (d) The geographic market in which the functions are performed by 
the seller. In general, the similarity to be sought relates to the 
probable effect upon the margin of gross profit of any differences in 
such characteristics between the uncontrolled sales and the controlled 
sale. Thus, close physical similarity of the property involved in the 
sales compared is not required under the cost plus method since a lack 
of close physical similarity is not necessarily indicative of dissimilar 
profit margins. See subparagraph (2)(iv) of this paragraph, relating to 
sales made at less than a normal profit for the primary purpose of 
establishing or maintaining a market.
    (iv) Whenever possible, gross profit percentages should be derived 
from uncontrolled sales made by the seller involved in the controlled 
sale, because similar characteristics are more likely to be found among 
sales of property made by the same seller than among sales made by other 
sellers. In the absence of such sales, evidence of an appropriate gross 
profit percentage may

[[Page 681]]

be derived from similar uncontrolled sales by other sellers whether or 
not such sellers are members of the controlled group. Where the function 
performed by the seller is similar to the function performed by a 
purchasing agent which does not take title, such purchasing agent will 
be considered a seller for the purpose of determining an appropriate 
gross profit percentage under this subparagraph and the commission 
earned by such purchasing agent, expressed as a percentage of the 
purchase price of the goods, may constitute the appropriate gross profit 
percentage. In the absence of data on gross profit percentages of 
particular sales or groups of sales which are similar to the controlled 
sale, the prevailing gross profit percentages in the particular industry 
involved may be appropriate.
    (v) Where the most similar sale or sales from which the appropriate 
gross profit percentage is derived differ in any material respect from 
the controlled sale, the arm's length price which is computed by 
applying such percentage must be adjusted to reflect such differences to 
the extent such differences would warrant an adjustment of price in 
uncontrolled transactions. The differences referred to in this 
subdivision are those differences which have a definite and reasonably 
ascertainable effect on price.

(Sec. 385 and 7805 of the Internal Revenue Code of 1954 (83 Stat. 613 
and 68A Stat. 917; 26 U.S.C. 385 and 7805))

[T.D. 6952, 33 FR 5849, Apr. 16, 1968]

    Editorial Note: For Federal Register citations affecting Sec. 
1.482-2A, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and on GPO Access.