Introduction

Inter-company pricing embraces some basic concepts. Those principles emanate from virtues of corporate structures that have related ownership of entities. The dealings between related entities brings into play arms length standards applicable to related entities. (See TaxConnections, April 24, 2014, Introduction to Section 482 and International Financial Centers) These governing guidelines are promulgated by regulation particularly to conduit entities that provide sales, services, personal property, and intangible property entities that compliment global enterprise of a parent or subsidiary. This writing focuses upon the guidelines that establish the borders of intangible property.

The Service utilizes Section 482 in its arsenal to achieve arm’s length pricing standards with respect to intangible property. (1) In the process of determining such pricing standards of intangible property, three basic methods are used. These are as follows:

1. The comparable uncontrolled transaction method;
2. The comparable profits method; and
3. The profit split method.

A fourth method, unspecified methods, is individualized and directed to pricing of hybrid intangible property. It reflects a combination of tangible and intangible features. (2)

As importantly as the four methods enumerated is that there is an override in their application, that is, each must be guided within the general principles of what are known as the best method rule, (3) the comparability analysis doctrine, (4) and the doctrine of what is referred to as the arm’s length range. (5)

Background

An overview of past legislation provides an understanding of the mechanics of the allocations with respect to the transfer or sale of intangible property. Section 482 was amended in 1986. (6) The amendment specified a transfer or licensing of intangible property required the income in consideration for the intangible is to be commensurate with the income attributable to the intangible. (7)

The United States legislative branches demonstrated a concern that intangibles developed through research and development expenses provided deductibility. (8) Subsequent to the policy enabling the taxpayer to expense such costs, the profits were being exported to the detriment of the United States. It was believed that there should be an assurance these profit-generating intangibles should adequately compensate the United States when exiting its taxing jurisdiction. The desire is to have a taxpayer account for the economic reality that subsequent foreign income being generated from the use of the intangible was the fruit of research and development activities subsidized by the United States system of taxation.

This government position is exacerbated by the very nature of the concept of what an intangible is and methods employed to effect transfers of intellectual properties. This is the first identification of what constitutes an intangible. By concept, it is intangible in that it is not something measurable with certainty; it is conceptual in nature. Geographic areas, level of distribution, and influence of public recognition can affect the valuation attributable to intangible property. Attempting to measure the recognition value of a trademark by a certain populous segment, for instance, is illustrative of the elusive nature of valuation concepts and intangible property. To appreciate this uncertainty of valuation demanded of intangible transfers, it is useful to contrast the required methods with the traditional latitude accorded free enterprise.

The focus of these methods is to scrutinize intangibles transferred between members of a related group and the veracity of the arm’s length reflection in pricing. The nature of research and development of intangible properties lends itself to a division of function, coordinated at various stages. Some of these functions can be viewed as support functions such as advertising, financial management, production know-how, marketing research, production adaptations, and similar activities.

The shifting of these functions away from a controlled group is a method of breaking down an intangible Section 482 allocation. Intangible assets may take in the breadth of numerous support functions. It follows then that the isolation and analytical breakdown of each support function is a planning technique to produce appropriate allocations of income and transfer valuations. This function approach takes in the notion that intangibles are capable of transfer, even oral transfer, through training methods and other ambiguous means. Conceptually, thinking of the intangible as a bundle of assets compressed as one, the intricacy evolves from the integration of support functions among related group members. The Section 482 allocation becomes a process of discerning inter-company transfers of functional pieces of the intangible bundle.

Intangible Property Pricing Methods

The focus for the purpose of this writing is with respect to three basic methods recognized as determining appropriate consideration for the transfer. The method purpose is to assure income will be deemed commensurate with the value of the intangible. (9) One measure of value deemed commensurate with the income attributable to the intangible is the testing method of comparable uncontrolled transactions. This method seeks to evaluate standards of comparability; comparability of the intangible property and circumstances.

The comparable uncontrolled transaction method contemplates a consideration for the transfer of intangible property will be arm’s length if it is equal to the amount of consideration charged or incurred in a comparable uncontrolled transaction. (10) In utilizing this method, the factors considered most influential are access to relevant pricing, related financial information, and the existence of comparable active markets. Of particular significance are the contemporaneous transactions involving comparable property between uncontrolled taxpayers. (11)

These factors when present in an intangible transaction provide guidance because the comparable uncontrolled transaction method will ordinarily result in the most accurate measure of evidence of arm’s length consideration of a transfer. (12) A standard of comparability is established which is the objective. An uncontrolled transaction is comparable with a controlled transaction if it involves comparable intangible property and occurs under comparable circumstances. (13)

Intangible properties may be comparable in a controlled transfer to those in an uncontrolled transfer if both intangibles are of the same class of property and relate to the same type of products, processes, or know-how within the same general industry or market. (14) The intangibles in that setting must have similar profit potential. (15) This step is the first element using the comparable uncontrolled transaction method.

The second aspect of comparable circumstances that is required in using this method is to combine certain facts of comparable intangible property in the evaluating process. Factors of comparable circumstance are at the essence of this tool. It provides insight necessary to draft agreements, particularly licensing agreements, in connection with offshore licensing companies.

Vital elements in the comparable circumstance are the terms of the transfer. (16) This includes the notion of the exploitation of the rights granted to the intangible, the exclusive or nonexclusive character of any rights granted, restriction on use, and limitations on the geographic areas where the rights may be exploited. (17) Of particular significance is the stage of intangible development. The state of development contemplates the status of government approvals, authorizations, and licensing. (18)

Of critical importance in the application of this method are the rights to receive periodic updates and improvements to the intangible as well as the uniqueness of the period during which it remains unique. This would include the degree and duration of protection afforded the property under the particular laws of different countries. (19) Important drafting techniques associated with agreements are considerations of the duration of a license, the contractual stipulations for other agreements, and rights of termination and renegotiation. (20)

Other relevant factors to comparability of circumstances are the economic and product liability risks assumed by the transferee and the existence and extent of collateral transactions or on going business relationships of the transferor and transferee. (21) The function to be performed by a transferor and transferee, including ancillary or subsidiary services, is relevant in making this determination when there are comparable circumstances to accompany a comparable intangible property in the process of using this method. (22)

The second basic method to measure arm’s length standards in a controlled transfer of intangible property is the comparable profits method. This is a method
making determinations by the consideration of focusing on objective measures of profitability. This includes measurement from profit indicators derived from uncontrolled taxpayers engaging in similar business activities with other uncontrolled taxpayers under comparable circumstances. (23)

This method relies on distinctions between tested and untested parties. A tested party is a party that is ordinarily a participant in a controlled transaction that does not use valuable, non-routine intangibles. These intangibles are types that have been acquired from an uncontrolled taxpayer and with respect to which it bears significant risks. They also are characterized by the fact they bear significant risks and possess the right to significant economic benefits. They are characterized by having been developed themselves. A tested party is not necessarily the taxpayer that the determination is sought upon. (24)

In the implementation of this comparison method, an arm’s length range or result is determined based upon profits of a tested party. Those profits of a tested party are those that it might have earned if its profit level indicators were an equivalent to those of an uncontrolled taxpayer. An applicable term to those profits would be constructive operating profits. (25) This method measures total return on the business activity of a tested party. Controlled and uncontrolled taxpayers with respect to this test are required only to be broadly similar. Significant product diversity and some functional diversity between controlled and uncontrolled transactions are acceptable. (26)

A taxpayer will be provided an arm’s length, safe harbor standard if the tested party’s reported operating profits have a range within constructive operating profits derived from comparable parties. Constructive operating profits are those profits calculated by applying profit level indicators derived from comparable parties. Those profits test a party’s financial data for a time period to which the profits level indicators are attributable. (27) Profit level indicators utilized in the process of determining this safe harbor are financial ratios measuring the relationships that exist between profits, cost incurred, and resources employed. (28)

Which profit level indicators are appropriate in a particular instance is original to the particular transaction. Various factors may be drawn upon to fit the transaction being evaluated. Samplings of profit level indicators significant in connection with this method are the nature of the activities of a tested party and the reliability of the available data. Also compelling with this method is the extent to which a particular profit level indicator is likely to produce a reasonable determination of the income that a tested party would have earned had it been dealing with an uncontrolled taxpayer in an arm’s length transaction. The underlying purpose is to keep it in the context and perspective of all the facts and circumstances of the particular case. (29)

The regulations issued by the Service suggest profit level indicators should be derived from a sufficient run of years. The run of years is necessary to provide measures of return that accrue to an uncontrolled taxpayer with risk characteristics similar to those of the test party. (30) One particular profit level indicator regarded as a reliable basis in the determination of operating profit comparisons of similarly controlled and uncontrolled taxpayers is the rate of return of capital employed.

This calculates a ratio of the relation between operating profit and operating assets. The rate of return on capital normally provides acceptable profit level indicators where a tested party has substantial fixed assets or working capital playing a significant role in generating profit. (31) Financial ratios that focus upon profit and costs or sales revenues are a company’s profit level indicators to the rate of return on capital employed. (32)

This comparable profits method contemplates circumstances where similarly controlled and uncontrolled taxpayers can be the subjects of comparable profit indicators. Because intangibles have the attribute of being difficult in similarity, this test allowing for subjective evaluation also envisions similar taxpayer comparisons, including risk similarities.

The comparable profits method can be contrasted with the comparable controlled transaction method. The comparable controlled transaction method contemplates comparable uncontrolled transactions. The comparable profits method seeks to draw guidelines from comparable business activities, requiring the controlled and uncontrolled taxpayer to be only broadly similar.

This method seeks to separate industry segments of the tested party. It permits latitude in product and functional diversity between controlled and uncontrolled transactions. Its application and calculations can be extremely complex. However, it serves as a very admirable guideline by evaluating each function of an intangible’s splinters to establish basic arm’s length pricing. One test evaluates consideration; the other, profitability.

With respect to the profit split method, its intention is to evaluate whether the combined operating profit or loss is arm’s length. It uses the standard of referring to the relative value of each controlled taxpayer’s contribution to the combined operating profit and loss.

Where combined profit and loss is used, it must be derived from the most narrowly identifiable business activity of the controlled taxpayers. The data used must be from controlled transactions that would be deemed relevant business activity. The relative value of each controlled taxpayer’s contribution to the success of the relevant business activity is to reflect the functions performed, risks assumed, and resources employed by each participant in the relevant business activity.

This type of allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers. This analysis should take into account that each participant is performing functions similar to those that various controlled taxpayers engage in during the course of relevant business activity. Profit under this method allocated to a particular member is not necessarily limited to the total operating profit of the group. It should not be assumed a combined operating profit or loss from the activity deemed to be a relevant business activity is to be shared equally or in any other arbitrary proportion. (33)

The allocation of profit and loss pursuant to the profit split method must be made in accordance with one of two methods; the comparable profit split or the residual profit split. (34) Using the comparable profit split, one combines operating profit of uncontrolled taxpayers with similar activities and transactions in relevant businesses. Each uncontrolled taxpayer’s percentage of the combined operating profit and loss is a part of the computation to combine profit and loss. (35)

On the other hand, the residual profit split method combines the operating profit or loss from the relevant business activity and allocates it between controlled taxpayers using a two-step process. (36) First there is an allocation of income to the controlled transactions in order to calculate a market return for its routine contributions to the relevant business activity. Routine contributions normally include contributions of tangible property, services, and intangibles usually owned by uncontrolled taxpayers engaged in similar activities. A functional analysis is required to specify those contributions and takes into account functions performed, risks assumed, and resources employed by the controlled taxpayers. (37)

The last method to determine arm’s length pricing standards between related parties with respect to intangible property is described by the Service as other methods. Inclusion of another method to establish safe harbor transfer pricing is intended to be utilized in instances where neither the comparable uncontrolled transaction method nor the comparable profit method provides adequate guidelines. (38)

What this method contemplates as a calculation is an alternative taxpayer’s concoction for circumstances quite different than what might have been predictable from previous experience. It permits the use of methods applied that are normally associated with tangible property transfers, taking into consideration a property transferred may possess the characteristics of intangible property as well as tangible property. It is a hybrid method of sorts. Restrictive conditions by the taxpayer must be abandoned if a maverick, hybrid method is adopted. (39)

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Footnotes
1. Treas. Reg. Section 1.482 – 4 (a) of the IRC of 1986 and as thereafter amended.
2. Treas. Reg. Section 1.482 –4(a) (1), (2), (3), and (4) of the IRC of 1986 and as thereafter amended.
3. Treas. Reg. Section 1.482 – 1(c) of the IRC of 1986 and as thereafter amended.
4. Treas. Reg. Section 1.482 – 1(d) of the IRC of 1986 and as thereafter amended.
5. Treas. Reg. Section 1.482 – 1(e) of the IRC of 1986 and as thereafter amended.
6. IRC Section 1231 (e) (1) of the Tax Reform Act of 1986.
7. IRC Section 482 (1986). For purposes of section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual –
(1) Patents, inventions, formulae, processes, designs, patterns, or know-how;
(2) Copyrights and literary, musical, or artistic compositions;
(3) Trademarks, trade names, or brand names;
(4) Franchises, licenses, or contracts;
(5) Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data.

For purposes of Section 482, an item is considered similar to those listed … if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.

8. H. R. Rep. 426, 99th Cong. 2nd Sess. (1986).
9. Treas. Reg. Section 1.482 – 4 (a) of the IRC of 1986 and as thereafter amended.
10. Treas. Reg. Section 1.482 – 4 (c) (1) of the IRC of 1986 and as thereafter amended.
11. Treas. Reg. Section 1.482 – 4 (c) (2)(i),(ii), and (iii) of the IRC of 1986 and as thereafter amended.
12. Treas. Reg. Section 1.482 – 4 (c) (2) (ii) of the IRC of 1986 and as thereafter amended.
13. Id. at 12.
14. Treas. Reg. Section 1.482 – 4 (c) (2) (iii) (A) of the IRC of 1986 and as thereafter amended.
15. Treas. Reg. Section 1.482 – 4 (c) (2) (iii) (B)(1)(ii) of the IRC of 1986 and as thereafter amended.
16. Treas. Reg. Section 1.482 – 4 (c) (2) (iii) (B) (2) (i) of the IRC of 1986 and as thereafter amended.
17. Id. at 16.
18. Treas. Reg. Section 1.482 – 4(c)(2)(iii)(2)(ii) of the IRC of 1986 and as thereafter amended.
19. Treas. Reg. Section 1.482 – 4(c (2) (iii) (B) (2) (iv) of the IRC of 1986 and as thereafter amended.
20. Treas. Reg. Section 1.482 – 4 (c) (2) (iii) (B) (2) (v) of the IRC of 1986 and as thereafter amended. A contract can rise to the level of an intangible. See generally, Hospital Corp. of America v. Commissioner, 81 T. C. 520 (1983); Shell Oil Co. No. 3767-8T (T. C. Filed Feb. 19, 1981), judgment entered for taxpayer by stipulation. U.S. v. Stafford, 727 F. 2d 1043 (11th Cir. 1984), rev’d F. Supp. 311 (M.D. Ga. 1982); I. E. DuPont de Nemours & Co. , 471 F. 2d 1211 (Ct. Cl. 1973).
21. Treas. Reg. Section 1.482 – 4 (c) (2) of the IRC of 1986 and as thereafter amended.
22. Id. at 21.
23. Treas. Reg. Section 1.482 – 5 (a) of the IRC of 1986 and as thereafter amended.
24. Treas. Reg. Section 1.482 – 5 (b) (2) (i) and (ii) of the IRC of 1986 and as thereafter amended.
25. Treas. Reg. Section 1.482 – 5 (c) (2) (i) of the IRC of 1986 and as thereafter amended.
26. Treas. Reg. Section 1.482 – 5 (c) (2) (ii) of the IRC of 1986 and as thereafter amended.
27. Treas. Reg. Section 1.482 – 5 (b) (4) of the IRC of 1986 and as thereafter amended.
28. Treas. Reg. Section 1.482 – 5 (b) (4) (ii) of the IRC of 1986 and as thereafter amended.
29. Treas. Reg. Section 1.482 – 5 (c) (2) of the IRC of 1986 and as thereafter amended
30. Treas. Reg. Section 1.482 – 5 (b) (4) of the IRC of 1986 and as thereafter amended.
31. Treas. Reg. Section 1.482 – 5 (b) (4) (i) of the IRC of 1986 and as thereafter amended.
32. Treas. Reg. Section 1.482 – 5 (b) (4) (ii) of the IRC of 1986 and as thereafter amended.
33. Treas. Reg. Section 1.482 – 6 (a) and (b) of the IRC of 1986 and as thereafter amended.
34. Treas. Reg. Section 1.482 – 6 (c) of the IRC of 1986 and as thereafter amended.
35. Treas. Reg. Section 1.482 – 6 (c) (2) (i) of the IRC of 1986 and as thereafter amended
36. Treas. Reg. Section 1.482 – 6 (c) (3) (i) of the IRC of 1986 and as thereafter amended.
37. Treas. Reg. Section 1.482 – 6 (c) (3) (i) (A) of the IRC of 1986 and as thereafter amended.
38. Treas. Reg. Section 1.482 – 3 (e) of the IRC of 1986 and as thereafter amended.
39. Treas. Reg. Section 1.482 – 3 (f) of the IRC of 1986 and as thereafter amended.

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In accordance with Circular 230 Disclosure