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Tangible Property – Section 482 and International Financial Centers



Introduction

Corporate structures in global enterprise find the use of conduit offshore corporate entities a requisite to accommodate the anomalies inherent in maximizing efficiencies and cost savings. Common ownership of inter-related corporate structures encounter arms length pricing scrutiny. (See TaxConnections April 24, 2014, Introduction to Section 482 and International Financial Centers.)

Arm’s length standards of Section 482 are applicable to a transfer of tangible property rights in transactions when deemed between controlled entities. When the possession, use or occupancy of tangible property that is owned or leased by one member of a group of controlled entities is transferred by a lease or other arrangement to another member of the controlled structure, Section 482 principles are applicable. If a lease or similar type transfer of an interest is made between controlled members without any charge or at a charge not equal to an arm’s length consideration charge, an allocation can be made. The allocation is made to reflect an appropriate consideration attributable to acquired tangible rights. (1)

An arm’s length allocation is the amount of consideration that would be charged from the same or similar tangible property in a transaction that is independent when conducted between unrelated parties under similar circumstances. (2) The regulations allow for five specified methods in making a determination of an appropriate arm’s length charge for controlled transactions of tangible property and allow for unspecified methods. These methods are enumerated as the following:

A. Comparable uncontrolled price method;
B. Resale price method
C. Cost plus method
D. Comparable profits method
E. Profit Split-Method
F. Unspecified methods. (3)

Comparable Uncontrolled Price Method

The comparable uncontrolled price method is a method whose purpose is to determine the amount of consideration that would be paid in a comparable uncontrolled transaction. Similarity of products generally will have the greatest effect on comparability under this method. Because even minor differences in contractual terms or economic conditions could materially affect the amount charged in an uncontrolled transaction, comparability utilizing this method is aligned with close similarity with respect to these factors or adjustments to account for any differences.

Results that are derived from applying the comparable uncontrolled price method generally will be the most direct and reliable measure of an arm’s length price for the controlled transaction if an uncontrolled transaction has no differences with the controlled transaction that would affect the price or if there are only minor differences that have a definite and reasonably ascertainable effect on price. However where there exists material product differences for which reliable adjustments cannot be made, this method ordinarily will not provide a reliable measure of an arm’s length result. (4)

Resale Price Method

The resale price method, on the other hand, utilizes the gross profit margin realized in an analogy with a comparable uncontrolled transaction. This method measures the value of functions performed and is ordinarily used in cases involving the purchase and resale of tangible property in which the reseller has not added substantial value to the tangible goods by physically altering the goods before resale. Packaging, re-packaging, labeling, or minor assembly do not ordinarily constitute physical alteration. (5)

This method determines arm’s length standards by a calculation method that subtracts the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction. (6) The term applicable resale price is equal to either the resale price of the particular item of property involved or the price at which contemporaneous resales of the same property are made. Where property purchased in the controlled sale is resold to one or more related parties in a series of controlled sales before being resold in an uncontrolled sale, the applicable resale price is the price at which the property is resold to an uncontrolled party or the price at which contemporaneous re-sales of the same property are made. (7)

It is a particularly significant and complex test relating to Financial Centers Offshore and the manner in which it illustrates the interrelationship with Foreign Base Company Income and Subpart F Income treatment. These methods of determining taxable income and the application of Section 482 are in conjunction with and remain subject to the best method rule. (8)

Cost Plus Method

A third method in the determination of arm’s length character of pricing controlled transactions is the cost plus method. The focus of this method is the gross profit markup realized in comparable uncontrolled transactions. Its application is directed to manufacturing, assembly, or other production of goods sold to related parties. (9)

The arm’s length price for a controlled transfer is equal to the controlled taxpayer’s cost of producing the property. This amount is adjusted by adding to the cost of producing an amount multiplied by an appropriate gross profit markup. (10) The definition is key to the concept of this method. Appropriate gross profit markup is that which is equal to the gross profit earned in comparable uncontrolled transactions when expressed as a percentage of cost. (11) A producer’s gross profit provides compensation for the performance of the production functions related to the product or products under review, including an operating profit for the producer’s investment of capital and assumption of risks. (12)

Within the framework of this method, a taxpayers’ operating profit is entitled to be weighted with respect to the producer’s investment of capital and assumption of risks. Because the comparison is made as to controlled versus uncontrolled transactions in utilizing this method, adjustments for differences occurring as to operating expenses is appropriate in some scenarios. In doing so, a taxpayer is permitted to consider the operating expenses associated with functions performed and risks assumed. (13)

Important in concept, this method directs itself to the purchasing agent. In making controlled and uncontrolled transaction comparisons, the function of a purchasing agent has a factual significance embedded in the concept of whether title to the property does or does not vest in the agent. Where a purchasing agent earns a commission, it may constitute an appropriate gross profit markup. This rule will hold true even though title to the property does not vest in the purchasing agent in the transactional scheme.

This can be of immense benefit in structuring offshore sales companies when the issue of where title vests becomes critical and decisive. If a controlled taxpayer is comparable to a purchasing agent that does not take title to property or otherwise assume risks with respect to ownership of such goods, the commission earned by such purchasing agent, expressed as a percentage of the purchase price of the goods, may be used as the appropriate gross profit markup. (14)

Comparable Profits Method

The comparable profits method is another means to evaluate arm’s length transactions of controlled entities within comparable business activity. This method seeks to determine a standard through the use of comparing amounts of profits a taxpayer would earn if its profit level indicators were equivalent to those of the uncontrolled taxpayers or constructive operating profit comparisons. (15)

The comparable profits method is based upon the amount of operating profit that the tested party would have earned on related party transactions if its profit level indicator were equal to that of an uncontrolled comparable, that is comparable operating profit. Comparable operating profit is calculated by determining a profit level indicator. The profit level indicator is one for an uncontrolled comparable. It is then applied to the profit level indicator with respect to financial data is available; the relevant business activity aspect approach. To the extent possible, profit level indicators are to be applied solely to the tested party’s financial data that is related to controlled transactions. The tested party’s reported operating profit is used to compare it to the comparable operating profits derived from the profit level indicators of uncontrolled comparables to determine whether the reported operating profit represents an arm’s length result. (16)

Because of the type of comparisons of total return on business activities, adjustments are often made to the profit level indicators of the industry being compared. It is usual to require accounting reclassifications to produce a more accurate and consistent determination of what the operating profit is to the level of investment. (17)

Certain material items that are components of the profit level indicators are adjusted to provide a measuring method having consistency of comparability. Adjustments are required to more accurately reflect the actual operating profits earned and operating assets employed by the comparable parties. These adjustments account for material differences between controlled and uncontrolled transactions. The respective taxpayers assume these adjustments as to functions performed and risks (18)

Profit Split Method

The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to a combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions or what is referred to as relevant business activity.

A controlled transaction will be considered arm’s length pursuant to this analysis if the tested party’s reported operating profits are within an arm’s length range. This range consists of parameters of constructive operating profits derived from comparable parties. Constructive operating profits make use of the term profit level indicators in establishing the means of creating this method. Profit level indicators are financial ratios whose function is to measure the relationships between profits, costs incurred, and resources employed. (19)

The relative value used in the application of the profit split method must be determined in a manner reflecting the functions performed, risks assumed, and the resources employed by each participant in the relevant business activity. This allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers where each is performing functions similar to those of the controlled taxpayers engaged in the relevant business activity. (20)

Unspecified Methods

Lastly, the method termed, unspecified methods, is actually a reference that an unspecified method may be used other than those enumerated. By using another method in accordance with this treasury guideline, an unspecified method is to be applied with the underlying concept. An unspecified method is to take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to the transaction. It should only be utilized when none of the other methods accurately reflects an appropriate analysis. (21)

An unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction. As with any method, an unspecified method will not be applied unless it provides the most reliable measure of an arm’s length result under the principles of the best method rule. The reliability of an unspecified method will be affected by the reliability of the data and assumptions used to apply the method, including any projections used. (22)

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Footnotes
1. Treas. Reg. Section 1.482 – 1 (a) (2) of the IRC of 1986 and as thereafter amended.
2. Treas. Reg. Section 1.482 – 1 (b) (2) of the IRC of 1986 and as thereafter amended.
3. Treas. Reg. Section 1.482 – 3 (a) of the IRC of 1986 and as thereafter amended.
4 Treas. Reg. Section 1.482 – 3 (b) (2) (ii) of the IRC of 1986 and as thereafter amended.
5. Treas. Reg. Section 1.482 – 3 (c) (1) of the IRC of 1986 and as thereafter amended.
6. Treas. Reg. Section 1.482 – 3 (c) (2) of the IRC of 1986 and as thereafter amended.
7 . Treas. Reg. Section 1.482 – 3 (c) (2) (ii) of the IRC of 1986 and as thereafter amended.
8. Treas. Reg. Section 1.482 – 3 (a) of the IRC of 1986 and as thereafter amended.
9. Treas. Reg. Section 1.482 – 3 (d) (1) of the IRC of 1986 and as thereafter amended.
10. Treas. Reg. Section 1.482 – 3 (d) (2) of the IRC of 1986 and as thereafter amended.
11. Treas. Reg. Section 1.482 – 3 (d) (2) (ii) of the IRC of 1986 and as thereafter amended.
12. Treas. Reg. Section 1.482 – 3 (d) (3) (ii) (A) of the IRC of 1986 and as thereafter amended.
13. Treas. Reg. Section 1.482 – 3 (d) (3) (ii) (A) and (C) of the IRC of 1986 and as thereafter amended.
14. Treas. Reg. Section 1.482 -3 (d) (3) (ii) (D) of the IRC of 1986 and as thereafter amended. See PPG Industries, Inc. v. Commissioner, 79-2 USTC 9633 (Ct. of Cl. 1979)
15. Treas. Reg. Section 1.482 – 5 (a) of the IRC of 1986 and as thereafter amended. See, CIR v. First Security Bank of Utah, 405 U. S. 394, 92 Sup. Ct. 1085 (1972).
16. Treas. Reg. Section 1.482 – 5(b) of the IRC of 1986 and as thereafter amended.
17. Treas. Reg. Section 1.482 – 5 (c) (2) (i), (ii), (iii) and (iv) of the IRC of 1986 and as thereafter amended.
18. Id. at 17.
19. Treas. Reg. Section 1.482 – 6 of the IRC of 1986 and as thereafter amended.
20. Treas. Reg. Section 1.482 – 6 of the IRC of 1986 and as thereafter amended.
21. Treas. Reg. Section 1.482 – 3 (e) of the IRC of 1986 and as thereafter amended.
22. Id. at 21.

In accordance with Circular 230 Disclosure

 

William Richards is a Sole Practitioner in Orlando, Florida, USA 32626. Attorney at Law, Legal Advisor. 1978 – Present

PUBLICATIONS: International Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2012, 378 pages. The Handbook of Offshore Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2004, 266 pages; Offshore Financial Centers and Tax Havens, Archives of Tulane Law Library, Tulane Law School, Tulane University, New Orleans, Louisiana, Copyright, 1996, 512 Pages.

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