What Are The US’s Transfer Pricing Methodologies and Rules?

Comparing the various transfer pricing methodologies available under US and Dutch laws, this series of articles examines and identifies which country’s body of law appears to be more substantive (i.e., provides more guidance for the taxpayers and tax authorities of that country) than does the body of law of the other country. My intention, however, is not to expressly conclude—or by implication, suggest—that one country’s law concerning transfer pricing is superior to the other. Rather, my intention is for these articles to serve as a useful resource for both US and Dutch tax professionals. Specifically, it is my hope that tax professionals from these two nations can utilize these articles in order to obtain a better understanding of what law is available to their counterparts as well as what their counterparts must adhere to and satisfy when negotiating a bilateral or multilateral advance pricing agreement with their respective taxing authority.

Transfer pricing laws have been established by taxing authorities in order to ensure that related business entities are charging the same price in controlled transactions as independent parties would in similar, uncontrolled circumstances. This is known as the arm’s-length standard. In order to determine whether a controlled transaction between related parties is arm’s-length, the best method rule needs to be employed. The various transfer pricing methodologies which serve as the foundation of the best method rule are the focus of these articles.

Transfer pricing can involve:
1. goods;
2. services; and
3. intangibles.

A transaction between controlled entities (see infra) can include one or more of these three components.

Relevant sections of US and Dutch law (including the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2022), see infra) typically cover all three of these components. However, as services and intangibles can often raise certain unique issues, both nations reserve certain sections of controlling statutory and administrative law for controlled transactions involving services and intangibles. The treatment of intangibles in transfer pricing situations can be, in certain situations, particularly complicated.

What Does the Term “Transfer Pricing” Mean?

The term “Transfer Pricing” refers to the price which is paid in transactions between related parties.

For purposes of this article, the terms “Parties” and “Entities” refer to business organizations. The word “Related” means the parties are either connected to one another by a common parent (horizontal and vertical relationship) or one of the parties is, in fact, the parent of the other party (vertical relationship).

“Transactions” may involve the following:

1. tangible property;
2. intangible property (including, but not limited to, patents, trademarks, goodwill, and copyrights);
3. services; and
4. financing.

Why Is Transfer Pricing Important?

Essentially, the price one related party charges another related party in a transaction will be a factor (albeit, perhaps a small factor) in determining whether a profit or a loss will be attributable to each party in a given tax year. Transfer pricing becomes an issue in cross-border taxation because tax laws and, more importantly, tax rates, vary by country. Multinational firms have been known to attempt to utilize transfer pricing in order to obtain the lowest possible effective tax rate in a particular transaction for a particular taxpayer.

For example, Parent Corporation (P) is incorporated in Country X and controls both Subsidiary No. 1 (S1) and Subsidiary No. 2 (S2). S1 and S2 are incorporated and have their headquarters in Country A and Country B, respectively. Country A’s effective corporate tax rate is 25%;Country B’s effective corporate tax rate is 29%. If S2 sells tangible products to S1 at a price which does not reflect an arm’s-length, market price (i.e., S2 sells at a lower price), two things happen. First, S1’s cost savings are increased, thereby increasing its profitability in the country with the lower of the two effective corporate tax rates. Second, S2’s sales and/or revenues are lower (due to the lower price it received in the transaction), thereby decreasing its profitability in the country with the higher of the two effective tax rates.

The governments of many nations consider this type of transaction to be tax avoidance. The Netherlands has: (1) implemented legislation under Article 8b of the Corporate Income Tax Act of 1969 (CITA) to address perceived transfer price issues; and (2) adopted non-binding OECD Guidelines as well as other legislation. The US has adopted §482 of Title 26 of the US Code as well as related Treasury regulations to address perceived transfer price issues (see infra).

Section 482 of the US Tax Code

26 U.S.C. §482: Allocation of Income and Deductions Among Taxpayers
This statute simply empowers the Secretary of the Treasury with the ability to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among related corporate entities in order to: (1) prevent the evasion of taxes; or (2) otherwise ensure that the gross income of any related corporate entity is clearly reflected.

The 1968 Treasury regulations were subsequently revised 26 years later, and these regulations stand as the current version of the Service’s interpretation of the Tax Code.

26 C.F.R. §1.482-1: Allocation of Income and Deductions Among Taxpayers
Section 482 of the Treasury regulations places a controlled taxpayer on a tax parity with an uncontrolled taxpayer. 26 C.F.R. §1.482-1(a)(1).

A controlled taxpayer, in this context, is any one of two or more taxpayers owned or controlled directly or indirectly by the same interest. 26 C.F.R. §1.482-1(i)(5). Examples of relation are: (1) parent/branch; (2) parent/subsidiary; (3) branch/branch, both of which have a common parent; (4) branch/subsidiary, both of which have a common parent; and (5) subsidiary/subsidiary, both of which have a common parent.

An uncontrolled taxpayer, in this context, is any one of two or more taxpayers that are not owned or controlled by the same interest. 26 C.F.R. §1.482-1(i)(5). In this situation, the law assumes that the two parties are engaged in an arm’s-length transaction which would fall under accepted industry standards.

Treasury regulations under 26 C.F.R. §1.482-1 provides that when 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 (unrelated) taxpayer. 26 C.F.R. §1.482-1(b)(1).

This regulation establishes that a controlled transaction meets the arm’s-length standard if the results of the transaction are consistent with the results which would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (i.e., arm’s-length results). 26 C.F.R. §1.482-1(b)(1).

However, it is noteworthy the Treasury regulations recognize that identical transactions can rarely be identified. Therefore, the question of whether a transaction produces an arm’s-length result generally will be determined by the results of comparable transactions under comparable circumstances. 26 C.F.R. §1.482-1(b)(1).

The arm’s-length result of a controlled transaction must be determined under the best method rule which, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. There is no strict priority of methods; no one method will be considered to be more reliable than any others. 26 C.F.R. §1.482-1(c)(1). Different types of methods are set forth in the Treasury regulations discussed below (see infra).

In determining which of two or more available methods (or applications of a single method) provide the most reliable measure of an arm’s-length result, the primary elements to consider are: (1) the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparable; and (2) the quality of the data and assumptions used in the analysis. 26 C.F.R. §1.482-1(c)(2).

The completeness and accuracy of the data affects the ability to identify and quantify those factors which would affect the result under any particular method. The reliability of the results derived from a method depends on the soundness of any and all assumptions which may need to be made. 26 C.F.R. §1.482-1(c)(2)(ii)(A)(B).

The comparability of transactions and circumstances must be evaluated based on all the factors which could affect price or profits in arm’s-length dealings. Each method (see infra) requires an analysis of all the factors that affect comparability under that method. 26 C.F.R. §1.482-1(d)(1).

Treasury regulations under 26 C.F.R. §1.482-1 establish that the following factors should be considered when comparing controlled and uncontrolled transactions under any method.

Functional Analysis
1. Economically significant activities undertaken or to be undertaken, by both controlled and uncontrolled taxpayers.
(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;
(g) Transportation and warehousing; and
(h) Managerial, legal, accounting, finance and personnel services.
26 C.F.R. §1.482-1(d)(3)(i)(A)-(H).

2. Significant contractual terms which could affect results of both a controlled transaction and an uncontrolled transaction.
(a) The form of consideration charged or paid;
(b) Sales or purchase volume;
(c) The scope and terms of any warranties;
(d) Rights to updates, revisions and modifications;
(e) The duration of the agreement (if any);
(f) Ongoing business relationships; and
(g) Extension of credit and payment terms.
26 C.F.R. §1.482-1(d)(3)(ii)(A)(1)-(7).

3. Comparison of the significant risks which could affect the prices which would be charged or paid, or the profits that would be earned, in a controlled and an uncontrolled transaction.
(a) Market risks, including fluctuations in cost, demand, pricing, and inventory levels;
(b) Risks associated with the success or failure of research and development activities;
(c) Financial risks, including fluctuations in foreign currency rates of exchange and interest rates;
(d) Credit and collection risks;
(e) Product liability risks; and
(f) General business risks related to the ownership of plant, property and equipment.
26 C.F.R. §1.482-1(d)(3)(iii)(A)(1)-(6).

4. Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the significant economic conditions which would affect the prices that would be charged or paid, or the profit which would be earned in each of these transactions.
(a) Similarity of geographic markets;
(b) Relative size of each market;
(c) Level of the market;
(d) Relevant market share;
(e) Location specific costs;
(f) Extent of competition in each market;
(g) Economic condition of the particular industry; and
(h) Alternatives realistically available to buyer and seller.
26 C.F.R. §1.482-1(d)(3)(iv)(A)-(H).

5. Evaluating the degree of comparability between controlled and uncontrolled transactions requires a comparison of the property or services transferred in the transaction. 26 C.F.R. §1.482-1(d)(3)(v).

In some cases, application of a pricing method will produce a single result that is the most reliable measure of an arm’s-length transaction. 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 a governmental adjustment if the results fall within such an arm’s-length range. 26 C.F.R. §1.482-1(e)(1).

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. The use of more than one method may also be appropriate when determining range. 26 C.F.R. §1.482-1(e)(2)(i).

The arm’s-length range may only be derived from those uncontrolled comparable type transactions that have – or through adjustments can be brought to – a similar level of comparability and reliability. 26 C.F.R. §1.482-1(e)(2)(ii).

The arm’s-length range will consist of the results of all of the uncontrolled comparable type transactions which meet the following requirements: (1) the information regarding the controlled transactions and the uncontrolled comparables are sufficiently complete that it is likely that all material differences have been identified; (2) each such difference has a definite and reasonably ascertainable effect on price or profit; and (3) an adjustment is made to eliminate the effect of each identified difference. 26 C.F.R. §1.482-1(e)(2)(iii)(A).

If no uncontrolled comparables can be ascertained pursuant to 26 C.F.R. §1.482-1(e)(2)(iii)(A) (see supra), the arm’s-length range can be derived through the adjustment to any comparables that satisfy 26 C.F.R. §1.482-1(e)(2)(ii). Adjustments to comparables in determining range can be made more reliable through the application of a statistical method. The reliability of the arm’s-length range analysis under a statistical method typically attempts to establish a range of results in which the limits of the range will be determined such that there is a 75% probability of a result falling above the lower end of the range and a 75% probability of a result falling below the upper end of the range. This range is known as the interquartile range. It ordinarily provides an acceptable measure of this range; however, a different statistical method may be applied if it provides a more reliable measure. 26 C.F.R. §1.482-1(e)(2)(iii)(B)-(C).

26 C.F.R. §1.482-2 Determination of Taxable Income in Specific Situations
This section establishes that additional regulations (see infra) will address specific situations/transactions in controlled matters. These situations/transactions are as follows: (1) loans and advances; (2) rendering of services; (3) use of tangible property; (4) transfer of property; and (5) cost sharing agreements. 26 C.F.R. §1.482-2(a)-(e).

With regard to the first type of situation/transaction—loans and advances—26 C.F.R. §1.482-2 stresses the importance of interest income on bona fide indebtedness arising after June 30, 1988. 26 C.F.R. §1.482-2(a)(1)(iii)(A).

Lack of any interest charged between related parties—or interest which is lower than what would be expected in an arm’s-length transaction—will almost certainly cause the Treasury Department to look at the transaction(s) and the parties with a jaundiced eye. 26 C.F.R. §1.482-2(a)(2)(i).

26 C.F. R. §1.482-2 sets forth the timing in which interest payments must be made in different situations. 26 C.F.R. §1.482-2(a)(1)(iii)(A)-(D).

26 C.F.R. §1.482-2 also sets forth a safe haven concerning interest rates related to certain types of loans made after May 8, 1986. 26 C.F.R. §1.482-2(a)(2)(iii).

With regard to the second type of situation/transaction—rendering of services—26 C.F.R. §1.482-9 establishes the parameters set forth by the Treasury Department. 26 C.F.R. §1.482-2(b).

With regard to the third type of situation/transaction—use of tangible property—where possession, use or occupancy of tangible property owned or leased by one member of a group of controlled entities is transferred by lease or other arrangement to another member of such group without charge or at a charge which is lower than what would be charged in an arm’s-length transaction, the Treasury Department may make appropriate allocations to properly reflect such arm’s-length change. 26 C.F.R. §1.482-2(c)(1).

With regard to the fourth type of situation/transaction—transfer of property—26 C.F.R. §1.482-3 through 26 C.F.R. §1.482-6 of the Treasury Regulations establish the guidance and interpretation of the Treasury Department. 26 C.F.R. §1.482-2(d).

26 C.F.R. §1.482-7 establishes the parameters, guidance and interpretation of the Treasury Department concerning the fifth and final type of situation/transaction – cost sharing arrangements. 26 C.F.R. §1.482-2(e).

26 C.F.R. §1.482-3 Methods to Determine Taxable Income in Connection with a Transfer of Tangible Property
This section of the Treasury Regulations introduces the various methods which may be used to determine the proper arm’s-length amount charged in a controlled transfer of tangible property. There are six methods:

1. Comparable uncontrolled price method;
2. Resale price method;
3. Cost plus method;
4. Comparable profits method (See 26 C.F.R. §1.482-5, infra);
5. Profit split method (See 26 C.F.R. §1.482-6, infra); and
6. Unspecified methods.
26 C.F.R. §1.482-3(a)(1)-(6).

Comparable Uncontrolled Price Method
The current Treasury regulations permit the use of the comparable uncontrolled price (CUP) method so long as it is the most reliable measure of an arm’s-length result under the best method rule. When certain circumstances permit its application, the CUP method is the most reliable method for determining an arm’s-length price for the transfer of tangible property. 26 C.F.R. §1.482-3(b)(2)(ii)(A). See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Whether results derived from the application of this method are the most reliable measure of an arm’s-length result must be determined using the factors described in 26 C.F.R. §1.482-1(d). Although all factors described in 26 C.F.R. §1.482-1(d)(3) must be considered, similarity of products will have the greatest effect on the concept of comparability. 26 C.F.R. §1.482-3(b)(2)(ii)(A).

The regulations enumerate eight factors of comparability that may be particularly relevant under the CUP method. They are primarily the same as those factors set forth in the corresponding provisions of the 1968 regulations. These factors are as follows: (1) quality of the product; (2) contractual terms (including warranty terms, sales or purchase volume, credit terms, and transportation terms); (3) level of the market (e.g., wholesale or retail); (4) geographic market in which the transaction takes place; (5) date of the transaction; (6) intangible property associated with the transaction; (7) foreign currency risks; and (8) alternative commercial arrangements realistically available to the buyer and the seller. 26 C.F.R. §1.482-3(b)(2)(ii)(B)(1)-(8). See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Because even minor differences in either contractual terms and/or economic conditions can materially affect the amount charged in an uncontrolled transaction, comparability under this method closely depends on close similarity with respect to the aforementioned eight factors or adjustments to account for any differences. The results derived from applying this 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 price, or if there are only minor differences that have a definite and reasonably ascertainable effect on the price and for which appropriate adjustments are made. 26 C.F.R. §1.482-3(b)(2)(ii)(A).

The regulations permit the use of the CUP method even when material product differences exist, but only if reliable adjustments for those differences can be made. In practice, many physical or functional differences will preclude comparability unless the difference is quantifiable by market data or expert testimony or is attributable to the inclusion or omission of a feature that can be provided separately in the marketplace or that is cosmetic in nature. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

When the application of the CUP method is based upon two or more uncontrolled transactions, each of which independently establishes an arm’s-length price, the arm’s-length range can be established based upon the principles described in 26 C.F.R. §1.482-1(e)(2). See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

The arm’s-length range will consist of results of all uncontrolled comparables that meet the following conditions: (a) the information related to both the controlled transaction comparables and the uncontrolled transaction comparables is sufficiently complete so that it is likely that all material differences have been identified; (b) each such difference has a definite and reasonably ascertainable effect on price or profit; and (c) an adjustment is made to eliminate the effect of each difference. 26 C.F.R. §1.482-1(e)(2)(iii)(A); 26 C.F.R. §1.482-3(b)(3).

The arm’s-length range (see 26 C.F.R. §1.482-1(e)(1)-(4)) may only be derived from those uncontrolled comparables that have – or through adjustments, may be brought to – a similar level of comparability and reliability. 26 C.F.R. §1.482-3(b)(3).

Resale Price Method
The resale price method is used to determine the arm’s-length price paid for property purchased by a distributor from a commonly controlled manufacturer or producer for resale to unrelated customers. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

The resale price method evaluates whether the amount charged in a controlled transaction is arm’s length by reference to the gross profit margin realized in comparable, uncontrolled transactions. 26 C.F.R. §1.482-3(c)(1).

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, repackaging, labelling and minor assembly do not ordinarily constitute physical alterations. 26 C.F.R. §1.482-3 (c)(1).

This method is not typically used in cases where the controlled taxpayer uses its intangible property to add substantial value to the tangible goods. 26 C.F.R. §1.482-3(c)(1).

The gross profit margin realized in the transaction (or series of transactions) is to be stated in terms of a percentage of sales revenue. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

The resale price method measures an arm’s-length price by subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction. 26 C.F.R. §1.482-3(c)(2)(i).

The appropriate gross profit is computed by multiplying the applicable resale price by the gross profit margin (expressed as a percentage of total revenue derived from sales) earned in comparable uncontrolled transactions. 26 C.F.R. §1.482-3(c)(2)(iii).
The 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. If the 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 resales of the same property is made. 26 C.F.R. §1.482-3(c)(2)(ii).

Pursuant to the Treasury regulations, once: (1) the specific purchases and resales under examination have been identified; (2) the applicable resale price and the controlled distributor’s gross margin have been determined; and (3) the gross margins realized in one or more controlled transaction have been calculated, the next step is to determine whether adjustments, if any, must be made to the margins realized in the uncontrolled transactions in order to reflect the differences in the factors or standards of comparability between the controlled and uncontrolled transactions. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Once the gross profit margin in the controlled transaction has been determined, it is compared with the gross profit margin realized in the uncontrolled transactions. The preferred comparable is an uncontrolled purchase and resale by the distributor whose purchase price is at issue. It is preferred because adjustments with respect to comparability factors as well as accountability standards will be fewer and more accurate. Lacking such transactions however, uncontrolled comparable purchase-resale transactions by third-party distributors may be used. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law; see also 26 C.F.R. §1.482-3(c)(3)(ii)(A).

The resale price method measures an arm’s-length price by subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction at issue. 26 C.F.R. §1.482-3(c)(2)(i).

The applicable resale price is equal to either: (1) the resale price of the particular item of property involved in the controlled transaction; or (2) the price at which contemporaneous resales of the same property were made. 26 C.F.R. §1.482-3(c)(2)(ii).

If the property purchased in a 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 resales of the same property are made. In such a case, the determination of the appropriate gross profit will consider the functions of all of the members of the group participating in the series of controlled sales. 26 C.F.R. §1.482-3(c)(2)(ii).

Whether results derived from the application of this method are the most reliable measure of an arm’s-length result must be determined using the factors outlined in §1.482-1(d)(3)(i)-(iv). 26 C.F.R. §1.482-3(c)(2)(ii).

The Treasury Department has provided that the following factors are of particular importance when utilizing this method and when the need for adjustments between the controlled transaction and comparison uncontrolled transactions arise: (1) inventory levels and turnover rates, and corresponding risks, including any price protection programs offered by the manufacturer; (2) contractual terms (scope and terms of warranties provided, sales or purchase volume, credit terms, transport terms); (3) sales, marketing, advertising programs and services; (4) level of the market (i.e., wholesale; retail, etc.); and (5) foreign currency risks. 26 C.F.R. §1.482-3(c)(3)(ii)(C)(1)-(5).

26 C.F.R. §1.482-1(e)(2) governs the application of the arm’s-length range in the resale price method. The only comparables whose adjusted results will automatically be included in the arm’s-length range under the resale price method are those designated as Class A comparable resellers. Class A comparable resellers are those resellers who satisfy the following three-part, conjunctive test: (1) it is unlikely that there are unidentified material functional, asset or data-related differences between the tested party and the comparable; (2) any identified material differences between the comparable and the tested party have a definite and reasonably ascertainable effect on gross profit; and (3) adjustments for material differences have been made. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Absent one or more Class A comparables, the results of all other comparable resellers (Class B) should be ranked in terms of comparability and reliability. Results will only be recognized if functional, asset and product comparability, as well as data completeness and accuracy, are considered. Comparables that are not considered outliers will be utilized from the Class B pool in order to determine arm’s-length range. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Cost Plus Method
The cost plus method evaluates whether the amount charged in a controlled transaction is arm’s-length by reference to the gross profit markup realized in comparable, uncontrolled transactions. This method is ordinarily used in cases involving the manufacture, assembly, or other production of goods that are sold to related parties. 26 C.F.R. §1.482-3(d)(1).

This method measures an arm’s-length price by adding the appropriate gross profit to the controlled taxpayer’s costs of producing the property involved in a controlled transaction. 26 C.F.R. §1.482-3(d)(2)(i).

The appropriate gross profit is computed by multiplying the controlled taxpayer’s cost of producing the transferred property by the gross profit markup. 26 C.F.R. §1.482-3(d)(2)(ii).

The gross profit markup is the percentage by which the manufacturer’s cost is marked up in arriving at the sales price. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

When performing a cost plus method analysis, it is important to bear in mind the difference between gross margin and gross markup during pre-adjustment calculations. With gross margin, sales revenue is in the denominator while with gross markup (the percentage by which the manufacturer’s cost is marked up in order to reach the sales price), the denominator is represented by the cost of goods sold. Thus, if the cost is $100 and the sales price is $150, the gross margin would be 50/150 (33.33%), while the gross markup would be 50/100 (50%). See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Moving on from the fundamental differences between gross margin and gross markup, the following example is helpful in understanding how gross profit markup is utilized in the cost plus method.

Example: If producer (P’s) cost to manufacture a widget is $70 and P sells the widget to a controlled entity for $100, the $30 in gross profit is expressed as a percentage of the cost, in this case 42.86%; this percentage, when multiplied by $70, is $30. Gross markup is thus determined by the following formula: [(sales price/cost) – 1], which is equivalent to (gross profit/cost). Thus, the gross markup percentage would be 42.86%, determined either by [($100/$70 – 1] or ($30/$70). If P manufactured a product similar to a widget (Product Z) for $130 and then sells Z to uncontrolled parties for $172, these sales would incur a 32.31% gross profit markup for P. Assuming no adjustments to the uncontrolled markup when applied to P’s sales of widgets to controlled entities, and further assuming no other uncontrolled transactions are considered, the arm’s-length price would be $92.62 ($70 x 1.3231). Thus, the price charged the controlled entity would exceed an arm’s-length price by $7.38 ($100 - $92.62). See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Whether results derived from the application of this method are the most reliable measure of the arm’s-length result must be determined using the functional comparability factors outlined in 26 C.F.R. §1.482-1(d)(3)(i)-(iv). 26 C.F.R. §1.482-3(d)(3)(ii)(A).

Close physical similarity of property involved in the controlled and uncontrolled transactions is not required. Rather, under the cost plus method, it is typically sufficient that the products involved are in the same product category. 26 C.F.R. §1.482-3(d)(3)(ii)(B). See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Treasury regulations establish that although physical similarity may not be critical under the cost plus method, significant differences between the value of the products in the controlled and uncontrolled transactions due to trademark or other differences will affect the reliability of the comparable results as indicators of an arm’s-length transaction. This could possibly mean that even products in the same category may not be sufficiently similar to serve as a comparable product. This issue is particularly relevant in a situation where one producer affixes its trademark to the product, but the other producer does not. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Comparability under this method is particularly dependent on the following: (1) similarity of functions performed; (2) risks borne; and (3) contractual terms. 26 C.F.R. §1.482-3(d)(3)(ii)(A).

The Treasury Department provides that when the need for adjustments between the controlled transaction and uncontrolled transactions arise, then the following factors are of particular importance when utilizing this method: (1) complexity of manufacturing or assembly; (2) manufacturing, production and process engineering; (3) procurement, purchasing, and inventory control activities; (4) testing functions; (5) selling, general and administrative expenses; (6) foreign currency risks; and (7) contractual terms, which include warranties, sales and purchase volume, credit terms and transport terms. 26 C.F.R. §1.482-3(d)(3)(ii)(C)(1)-(7).

The cost plus method utilizes the same range requirements (26 C.F.R. §1.482-1(e)(2)) which are required when utilizing both the CUP method and the resale price method. 26 C.F.R. §1.482-3(d)(2)(iii).

Similar to the resale price method, when two or more comparable uncontrolled transactions are utilized in a transfer pricing analysis under the cost plus method, a range of arm’s-length markup percentages may be applied to determine whether the price charged in the controlled transaction is in fact arm’s length. Class A comparables will automatically be included in the adjusted range under the cost plus method. Absent one or more Class A comparables, the results of all other comparable producers must be ranked in terms of both comparability and reliability. Moreover, only the results of those comparables – taking into account functional, structural and product comparability and data completeness as well as overall accuracy – will be considered when determining the arm’s-length range. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

Unspecified Methods
Any unspecified method must be applied in accordance with the provisions outlined in 26 C.F.R. §1.482-1. 26 C.F.R. §1.482-3(e)(1).

26 C.F.R. §1.482-4 Methods to Determine Taxable Income in Connection with a Transfer of Intangible Property
This section of the Treasury regulations addresses how the arm’s-length amount charged in a controlled transfer of intangible property is determined.Four methods are permitted: (1) the comparable uncontrolled transaction method; (2) the comparable profits method; (3) the profit split method; and (4) unspecified methods. 26 C.F.R. §1.482-4(a)(1)-(4).

The Treasury regulations define intangibles as: (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; and (6) other similar items. 26 C.F.R. §1.482-4(b)(1)-(6).

Comparable Uncontrolled Transaction Method
26 C.F.R. §1.482-4(c)(ii) provides that when the same type of intangible is transferred both in a controlled transaction and an uncontrolled transaction, the comparable uncontrolled transaction method (CUT) should be utilized if certain conditions exist. The CUT method will provide the most reliable means of determining the arm’s-length consideration for a controlled transfer if the same circumstances underlie both transactions and sufficient data concerning the two transactions is available. Circumstances will substantially be the same if there are no more than minor differences that have a definite and ascertainable impact on price and for which adjustments can be made. See Maruca, 6900 T.M., Foreign Income: Transfer Pricing: The Code, The Regulations and Selected Case Law.

The utilization of this method in a controlled transaction involving intangibles must adhere to the data and assumption requirements established in the best method rule under 26 C.F.R. §1.482-1(c). 26 C.F.R. §1.482-4(c)(2)(iv).

Continuing, the use of this method in a controlled transaction involving intangibles must also adhere to the arm’s-length range requirements established in 26 C.F.R. §1.482-1(e)(2). 26 C.F.R. §1.482-4(c)(3).

In evaluating the comparability of the circumstances of the controlled and uncontrolled transactions, although all the factors described in 26 C.F.R. §1.482-1(d) must be considered, specific factors that may be particularly relevant under this method include:

1. the terms of the transfer, including the exploitation rights granted in the intangible, the exclusive and nonexclusive character of any rights granted, any restrictions on use, or any limitations on the geographic area in which the rights may be exploited;
2. the stage of development of the intangible (including, where appropriate, necessary governmental approvals, authorizations, or licenses) in the market in which the intangible is to be used;
3. rights to receive updates, revisions, or modifications of the intangible;
4. the uniqueness of the property and the period for which it remains unique, including the degree and duration of protection afforded to the property under the laws of the relevant countries;
5. the duration of the license, contract or other agreement, and any termination or renegotiation rights;
6. any economic and product liability risks to be assumed by the transferee;
7. the existence and extent of any collateral transactions or ongoing business relationships between the transferee and transferor; and
8. the functions to be performed by the transferor and transferee, including any ancillary or subsidiary services.
26 C.F.R. §1.482-4(c)(2)(iii)(B)(2)(i)-(viii).

The Comparable Profits Method
See 26 C.F.R. §1.482-5 (infra).

The Profit Split Method
See 26 C.F.R. §1.482-6 (infra).

Unspecified Methods
Any unspecified method must be applied in accordance with the provisions outlined in 26 C.F.R. §1.482-1. 26 C.F.R. §1.482-4(d)(1).

26 C.F.R. §1.482-5 Comparable Profits Method
This method evaluates whether the amount charged in a controlled transaction is arm’s length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers who engage in similar business activities under similar circumstances. 26 C.F.R. §1.482-5(a).

Specifically, the determination of an arm’s-length result is based on the amount of operating profit that the tested party would have earned in a related party transaction if its profit level indicator ratios were equal to that of the comparable uncontrolled operating profit. 26 C.F.R. §1.482-5(b)(1).

Operating profit is defined as gross profit less operating expenses. This includes all income derived from the business activity being evaluated under the comparable profits method. 26 C.F.R. §1.482-5(d)(4).

Gross profit is the sales revenue less cost of goods sold. 26 C.F.R. §1.482-5(d)(2).

Sales revenue, in this context, is the amount received from the sale of goods and provision of services, less returns and allowances. 26 C.F.R. §1.482-5(d)(1).

Operating expenses include all expenses not included in the cost of the goods sold, except for: (1) interest expenses; (2) foreign income taxes; (3) domestic income taxes; and (4) any other expense not related to the operation of the relevant business. 26 C.F.R. §1.482-5(d)(3).

Operating assets are equal to the value of all assets used in the relevant business activity of the tested party and include cash and its equivalent, accounts receivable, inventories as well as fixed assets. 26 C.F.R. §1.482-5(d)(6).

The tested party will be the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest adjustments, and for which reliable data regarding uncontrolled comparables can be located. 26 C.F.R. §1.482-5(b)(2)(i).

Profit level indicators are ratios that measure relationships between profits and costs incurred or resources employed. A variety of profit level indicator ratios may be used in any given case. 26 C.F.R. §1.482-5(b)(4).

Whether a specific indicator is appropriate for a given transaction depends on a number of factors, including: (1) the nature of the activities; (2) the reliability of the available data with respect to uncontrolled comparables; and (3) the extent to which the indicator is likely to produce a reliable measure of the income that the tested party would have earned had it dealt with the controlled taxpayers in an arm’s-length transaction. 26 C.F.R. §1.482-5(b)(4).

Profit level indicators can include the rate of return of capital employed as well as financial ratios.

1. Rate of Return of Capital Employed:
(a) The rate of return on capital employed is the ratio of operating profit to operating assets.
(b) The reliability of this indicator increases as operating assets play a greater role in generating operating profits for both the tested party and the uncontrolled comparable. 26 C.F.R. §1.482-5(b)(4)(i).

2. Financial Ratios:
(a) This ratio measures the relationship of profits to both costs and/or sales revenue. Considering functional differences generally have a greater effect on the relationship between profits and costs or sales revenue than does the relationship between profit and operating assets, financial ratios are more sensitive to functional differences than the rate of return of capital employed.
(b) Closer functional comparability is required under this ratio than is functional comparability under the rate of return on capital employed.
(c) Financial ratios which may be appropriate include:
(i) Ratio of operating profit to sales; and
(ii) Ratio of gross profits to operating expenses.
26 C.F.R. §1.482-5(b)(4)(ii)(A)-(B).

The degree of comparability between an uncontrolled taxpayer and the tested party is determined by applying the provisions of 26 C.F.R. §1.482-1(d)(2) and the factors outlined in 26 C.F.R. §1.482-1(d)(3)(i)-(iv). 26 C.F.R. §1.482-5(c)(2)(i).

The comparable profits method compares the profitability of the tested party, measured by a profit level indicator ratio (generally based on operating profit), with the profitability of uncontrolled taxpayers in similar circumstances. As with all methods that rely on external market benchmarks, the greater the degree of comparability between the tested party and the uncontrolled taxpayer, the more reliable the results. The determination of the degree of comparability between the tested party and the uncontrolled taxpayer depends upon all relevant facts and circumstances, including the relevant lines of business, the product or services markets involved, the asset composition employed, the size and scope of operations, and the stage of the business or product cycle. 26 C.F.R. §1.482-5(c)(2)(i).

Because operating profit is generally less sensitive than gross profit to product differences, reliability under the comparable profits method is not as dependent on product similarity as the resale price method or cost plus method. However, reliability of profitability measures based on operating profit may be adversely affected by factors that have less effect on results under the CUP method, resale price method, and cost plus method. 26 C.F.R. §1.482-5(c)(2)(iii).

If there are differences between the tested party and an uncontrolled comparable which would materially affect the profits determined under the relevant profit level indicator, adjustments should be made according to comparability provisions of 26 C.F.R. §1.482-1(d)(2) and the factors outlined in 26 C.F.R. §1.482-1(d)(3)(i)-(iv). 26 C.F.R. §1.482-5(c)(2)(iv).

Comparability under the comparable profits method is particularly dependent on both resources employed and risks assumed. 26 C.F.R. §1.482-5(c)(2)(ii).

Moreover, because resources and risks are usually directly related to functions performed, it is also important to consider functionality when determining the degree of comparability between the tested party and an uncontrolled taxpayer. 26 C.F.R. §1.482-5(c)(2)(ii).

The comparable profits method utilizes the same range requirements which are required when utilizing the CUP method (see 26 C.F.R. §1.482-1(e)(2), supra). 26 C.F.R. §1.482-5(b)(3).

26 C.F.R. §1.482-6 The Profit Split Method
This 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 that combined operating profit or loss. 26 C.F.R. §1.482-6(a).

The allocation of profit or loss under this method must be made in accordance with one of the two following allocation processes: (1) comparable profit split allocation analysis; or (2) residual profit split allocation analysis. 26 C.F.R. §1.482-6(c)(1)(i)-(ii).

Under the comparable profit split allocation analysis, a comparable profit split is derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are similar to transactions and activities of the controlled taxpayers at issue. 26 C.F.R. §1.482-6(c)(2)(i).

As to the issue of comparability between controlled and uncontrolled taxpayers under the comparable profit split allocation analysis, the comparability provisions outlined in 26 C.F.R. §1.482-1(d)(2) and the factors outlined in 26 C.F.R. §1.482-1(d)(3)(i)-(iv) are applicable. (See supra). 26 C.F.R. §1.482-6(c)(2)(ii)(B)(1).

Contractual term factors are especially relevant under the comparable profit split allocation analysis. 26 C.F.R. §1.482-6(c)(2)(ii)(B)(1).

As to data and assumptions, the reliability of the allocation of costs, income, and assets between the relevant business activity and the participants’ other activities will affect the accuracy of the determination of combined operating profits and its allocation among the participants. 26 C.F.R. §1.482-6(c)(2)(ii)(C)(1).

It is noteworthy that the Treasury Department did not address the issue of range with regard to the application of the comparable profit split allocation analysis.

Under the residual profit split allocation analysis, the combined operating profit and loss from the relevant business activity is allocated between the controlled taxpayers pursuant to the following two-step procedure: (1) allocation of income into routine contributions; and (2) allocation of residual profit. 26 C.F.R. §1.482-6(c)(3)(i)(A)-(B).

Under the first step (allocating income into routine contributions), operating income is allocated to each party of the controlled transaction in order to provide a market return based on routine contributions. Routine contributions are contributions of the same or a similar kind (tangible property, intangible property and/or services) when compared to those made by uncontrolled taxpayers involved in similar business activities for which it is possible to identify market returns. 26 C.F.R. §1.482-6(c)(3)(i)(A).

Under the second step (allocation of residual profit), the residual profit is based on non-routine contributions. Unfortunately, the Treasury regulations do not provide a precise definition of non-routine contributions. In cases where such non-routine contributions are present, there normally will be an unallocated residual profit after the allocation noted in the first step (allocation of income into routine contributions) is made. 26 C.F.R. §1.482-6(c)(3)(i)(B)(1).

The residual profit should be divided among the controlled taxpayers based on the relative value of their non-routine contributions to the relevant business activity. 26 C.F.R. §1.482-6(c)(3)(i)(B)(1).

Whether the results derived from the residual profit split allocation analysis are the most reliable measure of the arm’s-length result is determined using the factors described under the best method rule of 26 C.F.R. §1.482-1(c), the comparability provisions under 26 C.F.R. §1.482-1(d)(2) and the factors outlined in 26 C.F.R. §1.482-1(d)(3)(i)-(iv). 26 C.F.R. §1.482-6(c)(3)(ii)(A).

As to the issue of comparability between controlled and uncontrolled taxpayers under the residual profit split allocation analysis, the first step of this process relies on market benchmarks of profitability. Thus, the comparability considerations that are relevant for the first step of the residual profit split allocation analysis are those that are relevant for the methods that are used to determine market returns for the routine contributions. 26 C.F.R. §1.482-6(c)(3)(ii)(B).

The second step of the residual profit split allocation analysis, however, may not rely so directly on market benchmarks. Thus, the reliability of the results under this method is reduced to the extent that the allocation of profits in the second step does not rely on market benchmarks. 26 C.F.R. §1.482-6(c)(3)(ii)(B).

As to data and assumptions under the residual profit split allocation analysis, the reliability of the allocation of costs, income, and assets between the relevant business activity and the participants’ other activities will affect the accuracy of the determination of combined operating profits and its allocation among the participants. In addition, accounting consistency is also very important. 26 C.F.R. §1.482-6(c)(3)(ii)(C)(1)-(3).

It is noteworthy that the Treasury Department did not address the issue of range with regard to the application of the residual profit split allocation analysis.

26 C.F.R. 1-482-7 Methods to Determine Taxable Income in Connection with Cost Sharing Arrangements
A cost sharing arrangement is an arrangement in which controlled participants share the costs and risks of developing cost shared intangibles in proportion to the benefits each could reasonably anticipate (RAB Shares). 26 C.F.R. §1.482-7(b); 26 C.F.R. §1.482-7(a)(1).

In order for an arrangement to be considered a cost sharing arrangement for purposes of this section of the Treasury regulations, the following requirements must be met:

1. All controlled participants must engage in cost sharing transactions (CSTs). In CSTs, the controlled participants make payments (CST payments) to each other as appropriate so that in each taxable year every controlled participant’s intangible development cost (IDC) share is proportional to its taxable respective RAB share. 26 C.F.R. §1.482-7(b)(1)(i).
(a) A controlled participant’s IDC share for a taxable year is equal to the
participant’s cost contribution for the taxable year, divided by the sum of all IDCs for the taxable year. 26 C.F.R. §1.482-7(d)(4).

2. All controlled participants must engage in platform contribution transactions (PCTs) to the extent there are any platform contributions. 26 C.F.R. §1.482-7(b)(1)(ii).
(a) A platform contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to (independently of) the intangible development activity that is reasonably anticipated to contribute to developing cost shared intangibles. 26 C.F.R. §1.482-7(c)(1).
(b) In a PCT, each controlled participant (PCT Payor) must make arm’s-length payments to each controlled participant (PCT Payee) that provides a platform contribution. 26 C.F.R. §1.482-7(b)(1)(ii).

3. Each controlled participant must receive a non-overlapping interest in the cost sharing intangible without further obligation to compensate another controlled participant. 26 C.F.R. §1.482-7(b)(4)(i).
(a) The CST may divide all interests in cost shared intangibles based either on a territorial basis or a field of use basis. 26 C.F.R. §1.482-7(b)(4)(i)-(iii).

The arm’s-length amount charged in a controlled transaction reasonably anticipated to contribute to developing intangibles pursuant to a cost sharing arrangement (CSA) must be determined under either:

1. RAB share method for CSTs (see supra); or
2. Platform contribution transactions (PCTs)(see supra).
26 C.F.R. §1.482-7(a)(1)-(2).

This section of the Treasury regulations also permits additional methods which apply in the following situations:

1. Contribution to a CSA by a controlled taxpayer that is not a controlled participant. 26 C.F.R. §1.482-7(a)(3)(i); 26 C.F.R. §1.482-7(j)(1)(i); 26 C.F.R. §1.482-4(f)(4);
2. Transfer of interest in a cost shared intangible. 26 C.F.R. §1.482-7(a)(3)(ii);
3. Cross-operating contribution(s). 26 C.F.R. §1.482-7(a)(3)(iii); 26 C.F.R. §1.482-7(g)(2)(iv); 26 C.F.R. §1.482-7(j)(1)(i);
4. Make-or-sell rights. 26 C.F.R. §1.482-7(a)(3)(iii); 26 C.F.R. §1.482-7(g)(2)(iv); 26 C.F.R. §1.482-7(c)(4); and
5. Controlled transactions in the absence of a CSA. 26 C.F.R. §1.482-7(a)(3)(iv).

These additional methods – which are limited in application to cost sharing arrangements – are as follows: (1) the comparable uncontrolled transaction method; (2) the income method; (3) the acquisition price method; and (4) the market capitalization method. 26 C.F.R. §1.482-7(g)(1)(i)-(iv).

A detailed examination of these four methods is beyond the scope of this article. However, it is noteworthy that each method must be applied in accordance with the provisions of 26 C.F.R. §1.482-1. This includes: (1) the best method rule (26 C.F.R. §1.482-1(c)); (2) the comparability provisions of 26 C.F.R. §1.482-1(d)(2); (3) the comparability factors of 26 C.F.R. §1.482-1(d)(3)(i)-(iv); and (4) the arm’s-length range of 26 C.F.R. §1.482-1(e). 26 C.F.R. §1.482-7(g)(2)(i).

Although all the factors under the best method rule (see §1.482-1(c)-(d), supra) must be considered, specific factors may be particularly relevant in the context of a CSA. 26 C.F.R. §1.482-7(g)(2)(ii)(A).

The relative reliability of an application of any method depends on the degree of consistency of the analysis of the applicable contractual terms and allocation of risk under the CSA. 26 C.F.R. §1.482-7(g)(2)(ii)(A).

26 C.F.R. §1.482-1(e) regarding determination of arm’s-length range applies in evaluating the arm’s-length amount charged in a PCT under a transfer pricing method. 26 C.F.R. §1.482-1(e)(2)(i) provides that 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. 26 C.F.R. §1.482-7(g)(2)(ix)(A).

26 C.F.R. §1.482-8 Examples of the Best Method Rule
See 26 C.F.R. §1.482-8.

26 C.F.R. §1.482-9 Methods to Determine Taxable Income in Connection with a Controlled Services Transaction
The arm’s length amount charged in a controlled services transaction must be determined under one of the methods noted below.

1. The services cost method;
2. The comparable uncontrolled services price method;
3. The gross services margin method;
4. The cost of services plus method;
5. The comparable profits method;
6. The profit split method; and
7. Unspecified methods.
26 C.F.R. §1.482-9(a)(1)-(7).

The services cost method evaluates whether the amount charged for certain services is arm’s length by reference to the total services costs with no markup. 26 C.F.R. §1.482-9(b)(1).

Specified covered services under the services cost method are controlled services transactions that the IRS Commissioner specifies by revenue procedure. 26 C.F.R. §1.482-9(b)(3)(i).

If a taxpayer applies the services costs method in accordance with the following, then it will meet the requirements of the best method rule of 26 C.F.R. §1-482-1(c):

1. Services fall within the specified covered services;
2. The interquartile median range requirements established under 26 C.F.R. §1.482-1(e)(2)(iii)(C) are observed; and
3. Services which contribute significantly to fundamental risks of business success or failure are not included in the analysis.
26 C.F.R. §1.482-9(b)(1)-(7).

The following activities do not fall under the services cost method:

1. Manufacturing;
2. Production;
3. Extraction, exploration, or processing of natural resources;
4. Construction;
5. Reselling, distribution, acting as a sales or purchasing agent, or acting under commission;
6. Research, development or experimentation;
7. Engineering or scientific; and
8. Financial transactions and insurance.
26 C.F.R. §1.482-9(b)(4)(i)-(ix).

The comparable uncontrolled services price method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the amount charged in a comparable uncontrolled services transaction. 26 C.F.R. §1.482-9(c)(1).

Whether results derived from the application of this method are the most reliable measure of an arm’s-length transaction must be determined using factors described under the best method rule outlined in 26 C.F.R. §1.482-1(c). 26 C.F.R. §1.482-9(c)(2)(i).

The degree of comparability between controlled and uncontrolled transactions is determined through the application of the requirements set forth in 26 C.F.R. §1.482-1(d). 26 C.F.R. §1.482-9(c)(2)(ii)(A).

The comparable uncontrolled services price method allows for adjustments between controlled and uncontrolled transactions.Factors for determining adjustments include:

1. Quality of services rendered;
2. Contractual terms;
3. Intangible property used in rendering the services;
4. Geographic market in which services are rendered;
5. Risks borne;
6. Duration or quantitative measure of services rendered;
7. Collateral transactions or ongoing business relationships between renderer and the recipient of services; and
8. Realistic alternatives.
26 C.F.R. §1.482-9(c)(2)(ii)(B)(1)-(8).

The comparable uncontrolled services price method is controlled by 26 C.F.R. §1.482-1(e)(2) as to range. 26 C.F.R. §1.482-9(c)(3).

The gross services margin method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the gross profit margin realized in comparable uncontrolled transactions. 26 C.F.R. §1.482-9(d)(1).

The gross services margin method is typically used in cases where a controlled taxpayer performs services or functions in connection with an uncontrolled transaction between a member of the controlled group and an uncontrolled taxpayer. 26 C.F.R. §1.482-9(d)(1).

The appropriate gross services profit under this method is computed by multiplying the applicable uncontrolled price by the gross services profit margin in comparable, uncontrolled transactions. 26 C.F.R. §1.482-9(d)(2)(iv).

Although all the factors outlined in 26 C.F.R. §1.482-1(d)(3) are applicable, comparability under the gross services margin method is particularly dependent on similarity of services performed, risks borne, intangible property (if any) used in providing the services, and contractual terms. 26 C.F.R. §1.482-9(d)(3)(ii)(A).

The reliability of the results derived from the gross services margin method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply to this method. 26 C.F.R. §1.482-9(d)(3)(iii).

The arm’s-length range under this method is to be derived by utilizing §1.482-1(e)(2). 26 C.F.R. §1.482-9(d)(2)(v).

The cost of services plus method measures an arm’s-length price by adding the appropriate gross services profit to the controlled taxpayer’s comparable transactional cost. 26 C.F.R. §1.482-9(e)(2)(i).

Comparable transactional costs under the cost of services plus method consist of the costs of providing the services under review that are considered as the basis for determining the gross services profit markup in comparable, uncontrolled transactions. Examples may include: (1) employee compensation; and (2) materials and supplies consumed or made available in rendering such services. 26 C.F.R. §1.482-9(e)(2)(iii).

The degree of comparability between controlled and uncontrolled transactions under the cost of services plus method is determined by applying the provisions of 26 C.F.R. §1.482-1(d). 26 C.F.R. §1.482-9(e)(3)(ii)(A).

Although all the factors outlined in 26 C.F.R. §1.482-1(d)(3) are applicable, comparability under the cost of services plus method is particularly dependent on similarity of services performed, risks borne, intangible property (if any) used in providing the services and contractual terms. 26 C.F.R. §1.482-9(e)(3)(ii)(A); 26 C.F.R. §1.482-1(c).

The reliability of the results derived from this method is affected by the completeness and accuracy of the data used and the reliability of the assumptions applied to this method. 26 C.F.R. §1.482-9(e)(3)(iii)(A).

The arm’s-length range under the cost of services plus method is to be derived utilizing 26 C.F.R. §1.482-1(e)(2). 26 C.F.R. §1.482-9(e)(2)(iv).

The comparable profits method and the profit split method have already been discussed in this article. 26 C.F.R. §1.482-9(f) does modify certain portions of 26 C.F.R. §1.482-5 (comparable profits method). These modifications are beyond the scope of this article and therefore will not be identified and evaluated.

The next article in this series will discuss the transfer pricing methodologies under Dutch law.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Patrick Beattie‘s practice areas include tax planning, tax controversy, estate planning, insurance coverage actions, toxic tort litigation, and commercial litigation in the Philadelphia area.

This article, initially prepared as a continuing legal education class at the Jenkins Law Library in Philadelphia in 2022, has been extensively modified and additional sections, including content on the revised OECD Guidelines and the Dutch Ministry of Finance’s new decree replacing Decree 2018/6865, have been added prior to publication. The information contained herein is of a general nature and based on authorities that are subject to change. This article represents the views of the authors only and are for informational purposes only.

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