4.61.3  Development of IRC section 482 Cases

4.61.3.1  (05-01-2006)
Development of IRC section 482 Cases

  1. IRC section 482 cases involve determining whether controlled transactions meet the arm’s length standard. This document provides general guidelines to IEs in the development of IRC section 482 cases. They are intended to apply both to inbound and outbound transactions. (The term "inbound" refers to the flow of goods or services into the United States. The term "outbound" refers to the flow of goods or services out of the United States.) IRC section 482 issues occur in the context of a large variety of factual patterns. Consequently, establishing specific guidelines for every type of factual pattern is impractical.

  2. IEs should exercise care and good judgment when recommending IRC section 482 adjustments. De minimis adjustments are not to be made. In this context, de minimis is not meant to be a specific dollar figure. Rather, IEs should look to those situations where there have been substantial deviations from the arm’s length standard, resulting in a significant shifting of income.

4.61.3.2  (05-01-2006)
The Final IRC section 482 Regulations

  1. Final regulations under IRC section 482 are applicable to taxable years beginning after October 6,1994. The general guidelines provided by this document reflect the final regulations. The final regulations further define and expand upon rules and methods previously established under IRC section 482. Previously established procedures and techniques for developing IRC section 482 cases may also still be applicable.

  2. The key components of the final regulations are as follows:

    1. Best Method Rule: The best method is the one that provides the most reliable measure of an arm’s length result.

    2. Comparability: Specific factors for determining comparability should be considered in applying and selecting different methods. Differences between controlled transactions and uncontrolled comparables should be adjusted for. Such adjustments will affect the reliability of the methods applied.

    3. Arm’s Length Range: The final regulations recognize that the application of a method may produce a number of results from which a range of reliable results may be derived. A tax will not be subject to adjustment if its results fall within such arm's length range.

4.61.3.3  (05-01-2006)
Economic Assistance

  1. Referrals for economic assistance are mandatory in the following circumstances:

    1. Coordinated Industry Cases Program (CIC) cases, if a pricing issue is present. .

    2. Non-CIC cases, if an issue has either a potential deficiency of more than $500,000, or significant precedential value.

  2. IEs are encouraged to seek economic assistance (either formal or informal) whenever a functional analysis is to be performed. Economists can provide expertise that may result in a stronger, more efficiently developed case.

4.61.3.4  (05-01-2006)
Approaching IRC section 482 Examinations

  1. IEs should use the following general guidelines in approaching IRC section 482 examinations. The guidelines cover three basic procedures:

    1. Preaudit Techniques

    2. Gaining an Understanding of the Taxpayer’s Operations

    3. Reviewing Balance Sheets and Income Statements

4.61.3.4.1  (05-01-2006)
Preaudit Techniques

  1. Preaudit techniques serve as a starting point for approaching IRC section 482 cases. This document describes the most common preaudit techniques.

  2. Review Forms 5471 (Information Return with Respect to a Foreign Corporation) for controlled transactions reported by the taxpayer. In addition, review Forms 5472 ( Information Return of a Foreign Owned Corporation) for controlled transactions reported by the taxpayer. The analysis of Forms 5471 and 5472 should consider multiple years.

  3. Review the tax return and take note of the following:

    1. Principal Industry Activity Code (PIAC)

    2. Business description

  4. Compute the following financial ratios based on both tax and financial data:

    1. Gross profit to net sales

    2. Operating profit to net sales

    3. Operating expenses to net sales

    4. Gross profit to operating expenses (Berry ratio)

    5. Operating profit to average total assets

  5. Financial ratio analysis applies to both inbound and outbound cases.

  6. Compare the taxpayer’s financial ratios to applicable standard industry ratios. Standard industry ratios can be found in the following publications:

    1. Robert Morris Associates

    2. Dun & Bradstreet

    3. Moody’s

  7. Consider comparing the taxpayer’s financial ratios to Statistics of Income (SOI) data.

  8. When comparing financial data, IEs should be familiar with the source of the data. Standard industry ratios are based on financial data. Comparisons to standard industry ratios should therefore be based on the taxpayer’s financial data. SOI data is based on tax data. Comparisons to SOI data should therefore be based on the taxpayer’s tax data.

  9. Substantial deviations from standard industry ratios or SOI data may indicate a transfer pricing problem. Substantial deviations may therefore suggest a need for further probe or inquiry.

4.61.3.4.2  (05-01-2006)
Understanding the Taxpayer’s Operations

  1. An IRC section 482 examination requires the IE to gain an understanding of the following:

    1. The U.S. taxpayer’s operations

    2. The operations of its affiliates (U.S. & foreign)

    3. The relationship between the taxpayer and its affiliates in other countries

    4. The role each entity plays in carrying out the activities of the controlled group

    5. The U.S. taxpayer's intangibles

  2. Gaining an understanding of the taxpayer’s operations and activities entails the review of:

    1. Annual reports

    2. Form 10–K or Form 20–F

    3. Articles about the taxpayer from trade publications and other sources

    4. Reports published by securities firms

    5. Internal publications

    6. Legal entity and functional organization charts

    7. Minutes of meetings of the following: Board of directors; Shareholders; Various departments; Committees reporting to the board of directors

    8. Policy and procedure manuals

    9. Books and records

    10. Customs entry documents

    11. Sales catalogs, brochures, and pamphlets

    12. E-mails, faxes and other written correspondence between the U.S. taxpayer and foreign affiliates

  3. Gaining an understanding of the taxpayer’s intangibles may require the review of:

    1. U.S. and foreign patents and prosecution files. U.S. Patent & Trademark Search Room (703) 308–9800

    2. Taxpayer’s licenses and assignments recorded and made available to the public at the U.S. Patent & Trademark Office (U.S. PTO (703) 308–9723)

    3. Patent litigation involving taxpayer

    4. U.S. and foreign trademark and tradename registrations and trademark litigation involving taxpayer

    5. Copyright registrations at U.S. Copyright Office (available also via Internet)

    6. State franchise registrations

    7. License agreements with U.S. and foreign affiliates and with uncontrolled parties.

  4. The IE should also gain an understanding of the taxpayer’s industry. This can entail the following procedures:

    1. Reviewing industry publications

    2. Reviewing industry guidelines contained in the various handbooks

    3. Consulting with the ISP specialist

    4. Consulting with the relevant LMSB Senior Industry Advisors and associated Technical Advisors

    5. Consulting with an IRS engineer

    6. Consulting with an outside industry expert

    7. Reviewing industry web sites

  5. The IE should consider reviewing sources of information such as those listed in Exhibits 4.61.2-6 and 2-7 . These sources of information may help provide an understanding of the taxpayer’s business but are not totally inclusive of every useful source of information.

  6. Gaining an understanding of the taxpayer’s business is an essential procedure. This procedure should involve issuing IDRs. Taxpayers sometimes do not fully or adequately respond to inquiries made in IDRs. Additional IDRs and follow-up IDRs are sometimes needed. Therefore, the IE should issue IDRs relating to this procedure early in the examination.

  7. Gaining an understanding of the taxpayer’s business may involve many inquiries. The following list provides examples and is not all-inclusive:

    1. Are affiliates manufacturing the same or similar products as the taxpayer?

    2. Are affiliates using the same or similar manufacturing intangibles? If so, were the manufacturing intangibles sold or licensed?

    3. How is technology transferred between affiliates and the taxpayer?

    4. Is there a cost sharing agreement?

    5. Did affiliates or the taxpayer buy into a cost sharing agreement?

    6. What members of the controlled group do research and development?

    7. How are the results of research and development disseminated among members of the controlled group?

    8. What research and development is conducted?

    9. Are marketing intangibles being used to market the product?

    10. What members of the controlled group developed the marketing intangibles?

    11. What members of the controlled group advertise?

4.61.3.4.3  (05-01-2006)
Reviewing Balance Sheets and Income

  1. An IRC section 482 examination requires the IE to review the following:

    1. Balance sheets of taxpayers engaged in controlled transactions

    2. Income statements of taxpayers engaged in controlled transactions

  2. The IE should obtain product line income statements for taxpayers engaged in controlled transactions. Product line income statements can identify transfer pricing issues relating to specific product lines. Consolidated income statements may not reveal transfer pricing issues relating to specific product lines. For example, a taxpayer may have one highly profitable product line that hides transfer pricing issues in another product line. Product line statements can help the IE identify the product lines that should be examined.

  3. The safe harbor provisions of Reg. 1.6038A–3 require U.S. taxpayers to provide the following:

    1. Material profit and loss statements for the U.S. market

    2. Material profit and loss statements for products or services exported from the U.S. market

  4. The IE should obtain balance sheets and income statements for a multiple year period. See Reg. 1.482–1(f)(2)(iii). Fluctuations and deviations from industry norms may occur for a particular year. Business cycles and product life cycles occurring over a multiple year period may provide an explanation.

  5. The IE should obtain internally prepared management reports, financial statements and budgets. The IE should also obtain internal audit reports. This information may provide a detailed description of the taxpayer’s operations. Accordingly, it may help the IE perform a functional analysis of the taxpayer.

  6. The IE should obtain information on affiliates, particularly foreign tax return information and bank records.

4.61.3.4.4  (05-01-2006)
Taxpayer Documentation

  1. Final regulations under IRC section 482 and IRC section 6662(e) provid that taxpayers that establish and maintain documentation of economic justification for their transfer prices at the time the return is filed, are not subject to otherwise applicable penalties under IRC 6662(e). Rev. Proc. 94–33 provides detailed guidance on the application of the regulations to specific years.

  2. IEs should request taxpayers to provide transfer pricing documentation and copies of all transfer pricing studies. IEs should make these requests at the outset of IRC section 482 examinations. If the documentation provided is not adequate, IEs should do the following:

    1. Consider using other means such as issuing a summons to obtain the necessary information. See Exhibits 4.61.3-1 and 3-2 at the end of this section.

    2. Consider imposing the IRC section 6662(e) penalty. For penalties under IRC section 6038A, see IRM 4.60.

  3. The final regulations under IRC section 6662(e) require taxpayers to provide the following documentation:

    1. An overview of the taxpayer’s business

    2. A description of the taxpayer’s organizational structure covering all related parties engaged in controlled transactions documentation explicitly required under IRC 482 and the treasury regulations thereunder.

    3. A description of the transfer pricing method selected; this description should include an explanation of why it was selected

    4. A description of the other transfer pricing methods considered; this description should include an explanation of why they were not selected

    5. A description of the controlled transactions

    6. A description of the comparables used; this description should include an explanation of how comparability was evaluated

    7. An explanation of the economic analysis and projections relied upon in developing the method

    8. A description of any relevant data obtained between the end of the year and the filing of the tax return

    9. A general index of the principal and background documents

4.61.3.4.5  (05-01-2006)
Transfers of Tangible Property

  1. Reg. 1.482–3 establishes five specified methods for determining an arm’s length charge for a controlled transfer of tangible property.

    1. The Comparable Uncontrolled Price (CUP) method

    2. The resale price method

    3. The cost-plus method

    4. The Comparable Profits Method (CPM)

    5. The Profit Split Method (PSM)

  2. The CUP method emphasizes product comparability. The resale price and cost plus method emphasize comparability of functions performed, risks borne, and contractual terms. The CPM emphasizes functional, resource, and risk comparability. The PSM allocates combined profit based on the relative value of controlled taxpayers’ contributions. The PSM emphasizes comparability based on functional, risk, resource, and contractual comparability.

  3. Reg. 1.482–1(c) establishes a best method rule for selecting the method that should be used. Under the best method rule, the method that provides the most reliable measure of an arm’s length result is the best method. The best method rule applies to all controlled transactions, including controlled transfers of tangible property. If a true comparable uncontrolled price exists, the CUP method is generally best.

  4. A taxpayer may have controlled transactions involving many different products or many separate transactions. Here, analyzing every individual transaction to determine its arm’s length price is impractical. Applying methods to overall results for product lines or other groupings is more appropriate. The grouping used should be consistent with the grouping used for the comparable. The grouping used should generally be a product line or product type. See Reg. 1.482–1(f)(2)(iv).

  5. IEs should consider the following issues when examining controlled transfers of tangible property.

    1. Product bundling (e.g., sale of a computer with software)

    2. Worldwide split of profits among the controlled taxpayers generated by the controlled activity

    3. Component products (e.g., parts assembled into a component product and an end product)

    4. Volume and price discounts

    5. Sales of products supplemented by other agreements (e.g., warranty and maintenance agreements)

    6. Exchange rates

    7. Replacement prices

4.61.3.4.6  (05-01-2006)
Transfers of Intangible Property

  1. Reg. 1.482–4 specifies the following methods for determining an arm’s length charge for a controlled transfer of intangible property:

    1. The Comparable Uncontrolled Transaction (CUT) method

    2. The Comparable Profits Method (CPM)

    3. The Profit Split Method (PSM)

  2. Reg. 1.482–1(c) establishes a best method rule for selecting the method that should be used. Under the best method rule, the method that provides the most reliable measure of an arm’s length result is the best method. The best method rule applies to all controlled transactions.

  3. Reg. 1.482–4 defines an intangible as an asset that comprises any of the following items:

    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

    6. Other similar items that are valuable because of their intellectual or intangible content

  4. Intangible property may have substantial value independent of the services of any individual.

  5. An intangible may be of great significance because the economic return on intangibles can be substantial. When income-producing intangibles are present, determining their arm’s length value is important.

  6. Sometimes, a parent may support its subsidiary in its manufacturing and marketing efforts. In doing so, the parent may transfer a bundle of intangibles to the subsidiary. A bundle of intangibles may consist of two or more individual intangibles. In these cases, IEs should identify the different individual intangibles that are being transferred.

  7. Determining arm’s length royalty amounts for controlled transfers of intangibles may require the support of the following specialists:

    1. Economists

    2. Engineers

    3. Industry experts

    4. Experts in the field of licensing intangibles

    5. Marketing experts

    6. Other inside and outside experts

  8. In examining a controlled transfer of an intangible, an IE should consider the following:

    1. What is the intangible?

    2. Who developed the intangible?

    3. Who owned the intangible?

    4. What were the terms of the license or sale?

    5. What were the amounts of payments paid under the license or sale? Did the controlled transferee use the intangible in its own manufacturing or marketing operations?

    6. Did the controlled tansferee re-transfer the intangible? If so, to whom? What were the terms of the secon transfer? What were the amounts of the payments under the second transfer?

    7. If royalties were based on sales, what were the amounts of those sales? If royalties were based on production, what were the amounts of such production?

  9. In examining a controlled transfer of an intangible, an IE should obtain the following documents:

    1. License agreements with all amendments

    2. Sublicense agreements with all amendments

    3. Any correspondence relevant to the substance of the license agreements

    4. Any correspondence relevant to the substance of the sublicense agreements

    5. License agreements with unrelated third parties involving the same or similar intangibles

    6. Any U.S. and foreign patent applications, recorded assignments of patents, prosecution files, and litigation history

    7. Any U.S. and foreign trademark registrations, assignments and licenses recorded at Patent & Trademark Office, and litigation history

    8. Any state registrations of franchises or business opportunities, and taxpayer’s disclosures to state governments

    9. Any U.S. and foreign copyright registrations

4.61.3.4.7  (05-01-2006)
Services

  1. See Reg. 1.482–2(b) and proposed Reg. 1,482-9. RESERVED

4.61.3.5  (05-01-2006)
Comparability

  1. The IE should perform a detailed analysis of the controlled transactions. The IE should perform this detailed analysis after the following is completed:

    1. Gaining an understanding of the taxpayer’s operations

    2. Identifying the controlled transactions

  2. Reg. 1.482–1(d) provides general rules for determining comparability. Reg. 1.482–1(d)(3) provides five factors for determining whether controlled and uncontrolled transactions are comparable. The factors are:

    1. Functions performed

    2. Risks assumed

    3. Contractual terms

    4. Economic conditions

    5. Property or services

  3. The relative importance of the five comparability factors depends on the method applied. Some methods emphasize product comparability. Other methods emphasize functional comparability. Still other methods emphasize broad product and functional comparability when comparing measures of profitability.

  4. Analyzing a controlled transaction begins with a functional analysis of the controlled transaction. In addition, a functional analysis of a potential comparable uncontrolled transaction must be performed.

  5. A functional analysis is not a pricing method. By itself, it does not determine the arm’s length result of the controlled transaction. A functional analysis instead determines the basis for identifying comparables.

4.61.3.5.1  (05-01-2006)
Functional Analysis

  1. Determining whether controlled and uncontrolled transactions are comparable requires a comparison of functions performed. lEs must therefore analyze the functions performed in both the controlled and uncontrolled transactions. See Reg. 1.482–1(d)(3)(l).

  2. A functional analysis identifies the economically significant activities performed in connection with the transaction. An economically significant activity is one that, at arm’s length, materially affects the following:

    1. The price charged in a transaction, and

    2. The profits earned from a transaction

  3. A functional analysis involves determining the following:

    1. What functions were performed by the transacting parties concerning the transaction?

    2. Who performed the functions?

    3. When were the functions performed?

    4. Where were the functions performed?

    5. How were the functions performed?

    6. Why were the functions performed?

    7. What intangibles were employed in the performance of functions?

    8. How were intangibles employed in the performance of functions?

    9. Why was the transaction structured the way it was?

  4. A functional analysis involves tracing the flow of products and services within the organization. Delivering products to a market generally involves various stages. These may include the following:

    1. Conceptualization

    2. Research and development

    3. Manufacturing

    4. Testing

    5. Marketing

    6. Sales

    7. Internal usage

  5. In performing a functional analysis, additional considerations include:

    1. Did the taxpayer or another affiliate sell product in the controlled entity's market: Before the controlled entity's formation? After the controlled entity's formation? If sales were to unrelated distributors, what resale margins did the unrelated distributors earn?

    2. Does the controlled entity actively perform sales or marketing functions?

    3. Does the controlled entity rely on a distribution network that was previously established by the parent?

    4. Did the subsidiary develop new customers for the product it purchases from the parent?

    5. Have sales of the parent’s product in the subsidiary’s market increased following the subsidiary’s formation?

    6. Has the subsidiary entered into any exclusive or nonexclusive distribution agreements with the parent?

    7. Are there any intangibles associated with the parent’s sales of products to the subsidiary?

    8. Has the subsidiary entered into any license agreements with the parent?

  6. Performing a functional analysis involves more than a review of the books and records. It involves active interaction with the taxpayer. Interaction with the taxpayer should go beyond the tax department. The tax department generally lacks the knowledge needed to complete a functional analysis. lEs should interview the taxpayer’s operational personnel most familiar with the taxpayer’s operations. lEs should also consider conducting on-site visitations. On-site visitations enable lEs to do the following:

    1. View the taxpayer’s operations and the functions performed

    2. Gain an understanding of the technical jargon used by the taxpayer

    3. Gain an understanding of the dependence or independence of the operation

    4. Discover additional facts

  7. Exhibit 4.61.3-1 provides general guidelines on how to conduct an on-site visitation. Exhibit 3.1 also provides general guidelines on how to interview taxpayers’ operational personnel.

  8. Exhibit 4.61.3-2 provides general guidelines on how to perform a functional analysis.

  9. Exhibit 4.61.3-3 provides general guidelines on how to present the findings of a functional analysis.

4.61.3.5.2  (05-01-2006)
Scope and Depth of Functional Analysis

  1. An IE should obtain a functional organization chart for each transacting party. This chart should identify departments, personnel and the functions they perform.

  2. Examining the functions performed by personnel involves examining their roles and credentials. Job titles often do not adequately describe the functions that personnel perform. Certain information sheds more light on the functions that personnel perform. An IE should therefore make inquiries about the following:

    1. The compensation paid to the personnel

    2. The way compensation is structured

    3. The level of skills, training and education possessed by the personnel

  3. An IE should obtain the following documents in examining the functions performed by various personnel.

    1. Job descriptions

    2. Performance evaluations

  4. An IE should identify the intangibles employed by the transacting parties. An IE should identify the transacting parties that own the intangibles. An IE should verify ownership if the IE is not sure who owns the intangibles. In doing so, an IE should identify and obtain documentation that establishes ownership. See Reg. 1.482–4(f)(3).

  5. An IE should identify the property, plant and equipment employed by the transacting parties. In addition, the following questions should be addressed:

    1. How was the equipment acquired?

    2. When was the equipment acquired?

    3. From whom was the equipment acquired?

    4. How much did the equipment cost?

    5. Is the equipment generic or custom-designed?

    6. If it is custom-designed, who designed it?

4.61.3.5.3  (05-01-2006)
Risk Analysis

  1. Another factor for determining whether controlled and uncontrolled transactions are comparable is risk. A risk analysis should be performed with the functional analysis. A proper risk analysis will normally require consideration of multiple year data.

  2. Risk is a position that will yield an outcome that is not known at the time the position is taken. Risk therefore entails exposure to the possibility of loss. If a company takes on more risk, it will have a greater expectation of profit. In other words, a company will seek greater compensation for taking on more risk. Consequently, a risk taker is in a position either to realize greater profits or suffer greater losses.

  3. Identifying the taxpayer that is the true bearer of risk is important. If a taxpayer is a true bearer of a risk, it should realize the profits or suffer the losses that result from taking on the risk. If one controlled taxpayer purports to take on a risk, another controlled taxpayer should not realize the profit or suffer the loss that results from taking on the risk.

  4. Generally, the contractual terms of a controlled transaction determine the controlled taxpayer that bears a particular risk. This allocation of risk specified or implied by the contractual terms should generally be respected. This allocation of risks, however, should conform with the economic substance of the controlled transaction. IEs should be aware of contractual terms that artificially manipulate the allocation of risks. In reviewing the substance of a controlled transaction, lEs should consider the following:

    1. Does the controlled taxpayer have the financial capacity to fund losses that may occur because of having assumed a particular risk? The controlled taxpayer that bears the risk is the controlled taxpayer that, at arm’s length, would suffer the consequences of resulting losses. See Reg. 1.482–1(d)(3)(iii)(B)(2).

    2. Does the controlled taxpayer have control over the business activities that involve a particular risk? At arm’s length, transacting parties bear risks of business activities that they control. See Reg. 1.482–1(d)(3)(iii)(B)(3).

    3. Is the actual conduct of the transacting controlled taxpayers consistent with the contractual terms? If not, the allocation of risks provided by the contractual terms should not be respected. See Reg. 1.482–1(d)(3)(iii)(B)(1).

    4. Are the risks assumed commensurate with the potential economic benefit of the controlled transaction? At arm’s length, the transacting party that can realize the benefit generally bears the risk.

    5. Is the controlled taxpayer engaged in the business activity to which the risk relates? Risk should generally be allocated to a controlled taxpayer engaged in the related business activity.

  5. Reg. 1.482–1(d)(3)(iii)(A) provides examples of risks that IEs should consider. They include the following:

    1. Market risks, including fluctuations in costs, demand, prices and inventory levels,

    2. Risks associated with the success or failure of research and development activities,

    3. Financial risks, including fluctuations in foreign currency rates of exchange and interest rates,

    4. Credit and collection risks,

    5. Product liability risks, and

    6. General business risks relating to the ownership of property, plant and equipment

4.61.3.5.4  (05-01-2006)
Contractual Terms

  1. Another factor for determining whether controlled and uncontrolled transactions are comparable is contractual terms. IEs must therefore analyze the contractual terms of both the controlled and uncontrolled transactions.

  2. Controlled taxpayers often enter into written sales, distribution, licensing, cost sharing and other agreements. IEs should obtain copies of all written agreements between the taxpayer and related parties. Written agreements may include amendments and correspondence as well as the original agreement. IEs should also consider obtaining documents relating to the negotiation of related party agreements.

  3. IEs should respect contractual terms of written agreements between controlled taxpayers if they are consistent with the economic substance of the underlying transactions. In evaluating economic substance, IEs should give greatest weight to the following (see Reg. 1.482–1(d)(3)(ii)(B)):

    1. The actual conduct of the contracting parties, and

    2. The respective legal rights of the contracting parties.

  4. Reg. 1.482–1(d)(3)(ii)(A) provides examples of contractual terms. They include the following:

    1. The form of consideration charged or paid,

    2. Sales or purchase volume,

    3. The scope and terms of warranties provided,

    4. Rights to updates, revisions or modifications,

    5. The duration of the agreement, including termination or renegotiation rights,

    6. Collateral services relating to the agreement, and

    7. Extension of credit and payment terms.

4.61.3.5.5  (05-01-2006)
Economic Conditions

  1. Another factor for determining whether controlled and uncontrolled transactions are comparable are economic conditions. Economic conditions may affect the prices charged in controlled and uncontrolled transactions. Economic conditions may also affect the profit earned from controlled and uncontrolled transactions. IEs must therefore analyze the economic conditions affecting both the controlled and uncontrolled transactions.

  2. Reg. 1.482–1(d)(3)(iv) provides examples of economic conditions. They include the following:

    1. The geographic location of the market,

    2. The size of the market,

    3. The level of the market,

    4. The market share of the relevant product or service,

    5. Location-specific costs of the factors of production and distribution,

    6. The competition in the market, and

    7. The economic condition of the industry.

4.61.3.5.6  (05-01-2006)
Property or Services

  1. Another factor for determining whether controlled and uncontrolled transactions are comparable is the property or services involved. IEs must therefore analyze the property or services involved in both the controlled and uncontrolled transactions.

  2. IEs should consider obtaining the following information to analyze property or services.

    1. Sales catalogs, brochures, pamphlets and other sales literature,

    2. Technical literature describing the property or services, and

    3. Descriptions of competing products or services.

  3. IEs should consider interviewing sales and marketing personnel employed by the taxpayer. Sales and marketing personnel can generally describe the taxpayer’s products or services in detail.

4.61.3.6  (05-01-2006)
Searching for Comparables

  1. An uncontrolled transaction need not be identical to the controlled transaction to be considered comparable. To be considered comparable, an uncontrolled transaction should be sufficiently similar to the controlled transaction. In other words, it should facilitate a reliable measure of an arm’s length result. Material differences with the controlled transaction reduce the comparability of the uncontrolled transaction.

  2. The availability of comparables will vary from case to case.

  3. The search for a comparable should begin with a review of the taxpayer’s operations. The taxpayer may have engaged in uncontrolled transactions potentially comparable to the controlled transactions. This type of comparable is known as an internal comparable. Reviewing the taxpayer’s operations may also reveal unrelated parties that engage in comparable uncontrolled transactions. These types of comparables are known as external comparables.

  4. Exhibit 4.61.2-6 lists reference materials that may be helpful in searching for external comparables. Many of these reference materials are available in public libraries.

  5. The U.S. Customs Service has a data base relating to imports into the United States. The source of the information is Form 7501 (Entry Summary) filings for imports into the U.S. Form 7501 contains the following information:

    1. Description of the product imported into the U.S.,

    2. Value of the product imported into the U.S.,

    3. Number of units of the product into the U.S.,

    4. Country of export, and

    5. Import duties paid.

  6. The U.S. Customs Service will provide import information to the Service upon request. Import information may be helpful in establishing an arm’s length transfer price, with appropriate adjustments.

  7. Requests for U.S. Customs information should be directed to Director, International (LMSB) for referral.

4.61.3.7  (05-01-2006)
Selecting the Method

  1. Reg. 1.482–1(c) establishes a best method rule for selecting the method that should be used. Under the best method rule, the best method is one that provides the most reliable measure of an arm’s length result.

  2. The best method rule looks to two factors in determining which method is best:

    1. The comparability between the controlled transaction and the uncontrolled comparables

    2. The quality of the data and assumptions

  3. Material differences with the controlled transaction reduce the comparability of uncontrolled comparables. Adjustments to uncontrolled transactions to account for these differences may increase the comparability of uncontrolled comparables. This depends on the number, size and reliability of those adjustments.

  4. IEs should select uncontrolled comparables based on the comparability criteria relevant to the method used. If the uncontrolled comparables are sufficiently comparable, the CUP and CUT methods are generally best. If the comparability of the uncontrolled comparables is less, IEs should consider other methods.

  5. In some cases, available information may permit the application of more than one method. Selecting the best of the available methods may not always be so clear-cut. Selecting the best method may require lEs to consider confirmation by another method. For example, one method may produce results consistent with results of another method, while a second method may not. If both methods are equally reliable, lEs should select a method with confirmable results. A similar selection process applies to the review of variations of the same method.

  6. Before selecting the best method, lEs should complete the following:

    1. Functional and risk analysis

    2. Analysis of the relevant economic conditions, contractual terms, and property or services

    3. Search for comparables

4.61.3.8  (05-01-2006)
Computing the Adjustment

  1. Applying the best method to two or more uncontrolled comparables generally determines an arm’s length range. An IRC section 482 adjustment is not appropriate if the taxpayer’s results fall within an arm’s length range.

  2. If the taxpayer’s results fall outside an arm’s length range, an IRC section 482 adjustment is appropriate. Based on the facts and circumstances, lEs can adjust the taxpayer’s result to any point within the arm’s length range. In some cases, such as when differences between the comparable uncontrolled transactions and the controlled transactions cannot be reasonably quantified or adjusted, the arm’s length range will consist of the interquartile range. In the case of an interquartile arm's length range, an IRC section 482 adjustment should generally be to the median point of the results.

  3. IEs will clearly document and explain IRC section 482 adjustment computations. IRC section 482 adjustment computations will specifically identify the uncontrolled comparables used. IRC section 482 adjustment computations will also explain how the uncontrolled comparables were factored into the computations.

  4. Refer to IRM 4.60 for cases affected by Rev. Proc. 65–17 and also for the treatment of conforming adjustments under IRC section 482. Rev. Proc 65-17 is superseded by Rev. Proc. 99-32, 1999-2 C.B. 296.

4.61.3.9  (05-01-2006)
Assistance from Counsel

  1. Counsel can provide advice to IEs from a litigating perspective.

  2. Counsel can provide the following assistance to IEs:

    1. Reviewing summonses and IRC section 6038A summonses for appropriate wording

    2. Reviewing IRC section 982 formal document requests for appropriate wording

    3. Recommending that certain information be obtained, e.g., through information exchange under the applicable income tax treaty

    4. Interpreting regulations and case law

    5. Interpreting contracts governing controlled or uncontrolled transactions

    6. Researching intellectual property law, foreign law, or any other area of law underlying the contracts or otherwise related to the facts of the case

Exhibit 4.61.3-1  (05-01-2006)
On-Site Visitations

1. Why should an on-site visitation be conducted?
  a. IEs may be able to identify issues that are more difficult to identify without an on-site visitation. One issue, for instance, may involve the performance of services for a foreign affiliate. This issue may be easier to identify by visiting the foreign affiliate’s operation.
  b. An on-site visitation may enhance the credibility of an IE report. Personal observations and interviews, for instance, may improve explanations of functions. An IE report with a better description of facts conveys better understanding. Better understanding helps Appeals and Counsel if they become involved with the case.
  c. IEs can gain a better understanding of a function by seeing it. Taxpayers will often use technical jargon to explain functions. Technical jargon conveys complexity that can often confuse IEs. Personal observation is often the best way to understand the true meaning of technical jargon.
  d. An on-site visitation can help an IE gain a better understanding of the taxpayer’s position. It may help the IE identify factual shortcomings in the Service's or taxpayer’s position.
2. Who should attend an on-site visitation?
  a. The purpose of an on-site visitation is to identify and develop potential issues. Thus, the Service personnel responsible for identifying and developing issues should attend the on-site visitation.
  b. Service personnel should gather as much information as possible when making an on-site visitation. Ordinarily, more than one person is needed to successfully accomplish this task.
  c. The IE has primary responsibility for development of international issues. The IE’s presence is therefore critical to the success of the on-site visitation.
  d. The economist assigned to the case should also attend the on-site visitation.
  e. The international manager is ultimately responsible for the development of international issues. The international manager can participate directly in interviews of taxpayer personnel with the IE. This participation may enhance the Service’s position in subsequent resolution discussions. The international manager should therefore consider attending the on-site visitation. Generally, the attendance of international managers is more imperative than the attendance of other managers. The international manager is, therefore, usually the first choice of managers to attend.
  f. Managerial support of on-site visitations is important in dealing with the taxpayer. Taxpayers will respond more positively to examiners when managers support the effort. Managers can also play an active role in resolving disagreements with taxpayers if they arise. The selection of managers to attend the on-site visitation depends on what must be accomplished.
  g. If the taxpayer’s operations are highly technical, an engineer should attend the on-site visitation. Engineers are skilled at understanding the technology used in a taxpayer’s operation. If already involved with the case, Counsel should consider attending the on-site visitation. Counsel can assist in identifying and developing issues. Counsel should attend an on-site visitation if the taxpayer’s attorneys are present.
  h. Other Service personnel can help make an on-site visitation successful. These include other international examiners, outside experts and team coordinators.
3. Where should an on-site visitation take place?
  a. Selecting the location for the on-site visitation is an important decision. Gaining an understanding of the taxpayer’s functions is the primary consideration in making this decision.
  b. Examiners should consider visiting the following locations:
   (1)  Manufacturing Plants. Visiting a manufacturing plant may help develop an understanding of how the following are produced:
    a. Raw Materials
    b. Intermediate Components
    c. Finished Goods
   (2)  Marketing Offices. Visiting a marketing office may help develop an understanding of the following:
    a. Marketing and advertising functions performed by the taxpayer and its affiliates
    b. The development and exploitation of marketing intangibles
    c. The degree of parental support and control
   (3)  Distribution Centers and Warehouses. Visiting a distribution center or a warehouse may help develop an understanding of the following:
    a. Distribution, warehousing and other functions performed by the taxpayer and its foreign affiliates
    b. The goods being distributed
    c. The extent to which an inventory of the goods is maintained
    d. Inventory-related risks assumed by the taxpayer and its affiliates
   (4)  Research and Development Centers. Visiting a research and development center may help develop an understanding of the following:
    a. Research and development functions performed by the taxpayer and its affiliates
    b. The direction of research and development efforts
    c. The degree of support provided by and to other research and development centers
    d. The exploitation of the technology and know-how generated by the research and development center
   (5)  Quality Control Locations. Visiting a quality control location may help develop an understanding of the following:
    a. Quality control functions performed by the taxpayer and its affiliates.
    b. The degree of control by affiliates over quality control standards.
    c. The sophistication of personnel and equipment utilized in the manufacturing process.
4. What should be done to prepare for an on-site visitation?
  a. Preparing for an on-site visitation is critical to its success. If the IE fails to make essential inquiries, a follow-up visitation may not be possible. Everything that needs to be done during the on-site visitation must be done. The IE should not make a prematurely planned on-site visitation.
  b. The IE should make sure that enough time is allowed for the on-site visitation.
  c. Before going on the on-site visitation, the IE should consider obtaining the following information:
    (1) Diagrams of the physical layouts of manufacturing plants and other facilities to be visited
    (2) Photographs and videos of the facilities to be visited
    (3) Flowcharts that diagram manufacturing processes performed
    (4) Personnel charts (including affiliate for which employee works),
    (5) Resumes and job descriptions for key personnel
    (6) Lists of patents owned by or licensed to the manufacturing plant during the tax years under examination
    (7) Litigation history of each patent licensed or owned during those years
  d. The IE should identify positions of interest and personnel to be interviewed in advance. The current personnel may not have worked for the taxpayer during the years under examination. If this is the case, the IE should request to interview personnel that currently occupy the positions of interest.
  e. The IE should prepare a list of topics to be covered during the interviews. The IE should prepare an outline of questions to be asked for each interview.
  f. The IE and the taxpayer should agree on a timetable for the interviews. The IE should ensure that enough time is allowed for preparation of notes and follow-up questions. IEs should avoid the placement of time constraints on the interviews. Flexibility should be maintained.
  g. The Service personnel attending the on-site visitation should choose a primary interviewer for each interview. Service personnel that will not act as the primary interviewer should plan on taking notes. The entire Service team should plan on formulating and asking follow-up questions. Interviews are more productive when performed as a team. Responsibility should be shared. One person cannot do everything.
  h. An on-site visitation may involve a tour of a plant and other facilities. The IE should get a description of what will be toured. The IE should know who the guide will be.
  i. The IE should obtain and review written functional analyses prepared by the taxpayer.
  j. The IE should consider making arrangements to photograph or videotape the location. Videotapes and photographs can convey a much better description than a written report. The IE should consider asking the taxpayer to participate in the videotaping or photographing. A joint effort may result in a more balanced presentation. The IE should also consider making arrangements to have the interviews recorded.
  k. The IE should consider discussing on-site visitation plans with Counsel and outside experts. Counsel and outside experts can help the IE determine the inquiries that should be made.
  l. The IE should consult with other IEs who have attended similar on-site visitations. Shared experiences may help the IE identify issues and inquiries that should be made.
5. What should be done during an on-site visitation?
  a. The Service personnel attending the on-site visitation should conduct interviews and observe the facilities. All Service personnel attending the on-site visitation should take notes during interviews and tours. Service personnel attending the on-site visitation should compare notes daily.
  b. The taxpayer may refer to specific documents during an interview. The IE should obtain the name of these documents and ascertain the location of the documents. The IE should inquire about the existence of these documents during the years under examination. The IE should ask the taxpayer to provide copies of documents that will be needed.
  c. The IE should consider reviewing the books and records at the location visited. A review of sales and purchases journals may identify potential comparables. A review of detailed asset records may describe the property employed at the location visited. A review of the books and records may identify unrelated license agreements.
  d. The timing of the on-site visitation will not coincide with the years under examination. During prior years, the taxpayer may not have performed the functions that it currently performs. The IE should determine the differences in functions performed between the past and present. In conducting interviews, the IE should understand what time period the discussion relates to.
  e. The IE should request to look at U.S. and international registrations of trademarks and brand names as well as trademark development files, records or other evidence of first use, marketing plans and expenditures.
  f. The IE should consider making visits to local industry organizations to identify possible comparables. The IE should consider scanning the local telephone book for possible comparables. The IE should consider visiting local government organizations. In doing so, the IE can find out if local industrial development incentives are available.
  g. The IE should also request to review patent prosecutions files for all patent applications, whether the patent was granted or denied. The patent prosecution files will discuss competing technologies and their advantages and disadvantages over the technology covered in the patent. A patent is often denied because the patent examiner finds the invention obvious when compared with the competing technology. The patent prosecution files are therefore another source for potential comparables. If these files are not available from the taxpayer, the IE may request them from the U.S. Patent & Trademark Office.
  h. The IE should also research recorded licenses and assignments of any patents or trademarks. The U.S. Patent & Trademark Office makes all recorded assignments and licenses available to the public. Call (703) 308–9723 for more information. This may prove a valuable source for comparable uncontrolled transactions. (CUT §1.482–4).
6. How should an on-site visitation be arranged?
  a. IRM 4.62, Foreign travel provides general guidelines for foreign travel. See Document 10976 (8-2000), Internal Revenue Service Foreign Travel Procedures for complete instructions.
  b. The IE should obtain a written invitation from the foreign entity. The office of Director, International (LMSB) will need to share this invitation with the foreign government involved to document its permission.

Note:

Obtaining foreign government competent authority approval can take up to 6 (six) weeks

  c. The IE should request permission to travel overseas well in advance. Foreign travel requests should be filed:
    (1) At least 30 days in advance, if the traveler has an official passport
    (2) At least 45 days in advance, if the traveler does not have an official passport
  For assistance with foreign travel requests, contact the Foreign Travel Coordinator at FTS or commercial (202) 874–1810.
   

Exhibit 4.61.3-2  (05-01-2006)
Development of IRC section 482 Cases — General Audit Procedures and Techniques

This exhibit lists procedures for developing IRC section 482 cases in specific inbound and outbound situations.Specific fact patterns will always determine the procedures that examiners should follow.
1. Inbound Situation
  Taxpayer is a U.S. corporation owned by a foreign parent. Taxpayer acts as a U.S. distributor of three product lines manufactured by the foreign parent. There are no comparable uncontrolled prices relating to purchases from the foreign parent. Taxpayer’s fiscal year is the calendar year.
  Developing an IRC section 482 case in this situation involves the following procedures:
  a. Preaudit Techniques
   (1) Review the following:
    a. Permanent file
    b. Prior examination reports
    c. Prior Appeals reports for identification and disposition of IRC section 482 issues
   (2) Analyze Form 1120 and attachments, especially Form 5472, noting all controlled transactions.
   (3) Calculate key financial ratios, preferably for three or more years.
   (4) Compare the taxpayer’s financial ratios to published financial ratios for the same industry. Determine if the taxpayer’s financial ratios differ significantly from the industry ratios.
   (5) Determine whether a potential IRC section 482 pricing issue exists.
  b. Gaining an Understanding of the Operations
   (1) Review the following:
    a. The taxpayer’s annual reports
    b. The taxpayer’s audited financial statements
    c. Securities and Exchange Commission (SEC) Forms 10–K filed on behalf of the taxpayer, if filed
   (2) Review the following:
    a. The foreign parent’s annual reports
    b. The foreign parent’s audited financial statements
    c. SEC Forms 20–F filed on behalf of the foreign parent, if filed
   (3) Review newspapers, journals and periodicals for specific information on the taxpayer and its foreign parent. Review company profiles prepared by security analysts about the taxpayer and its foreign parent.
   (4) Obtain a worldwide legal entity organization chart for the foreign parent. This chart should show dates of incorporation. It should also explain the effect of mergers, acquisitions, and reorganizations.
   (5) Obtain a functional organization chart for the taxpayer.
   (6) Ask for reports on investigations and examinations of the taxpayer such as:
    a. U.S. Customs Service import duty investigations
    b. U.S. Department of Commerce anti-dumping investigations
    c. U.S. International Trade Administration anti-dumping investigations
    d. Examination reports of state and foreign government taxing authorities
   (7) Review minutes of meetings of the Board of Directors and corporate committees.
   (8) Obtain a listing of all corporate policy and procedure manuals.
   (9) Obtain sales catalogs, brochures and pamphlets relating to each of the taxpayer's product lines.
   (10) Review e-mails, faxes and other written correspondence between the U.S. taxpayer and foreign affiliates.
  (11) Review web sites maintained by U.S. taxpayer and foreign affiliates.
  c. Reviewing Balance Sheets and Profit and Loss Statements
   (1) Obtain the most detailed balance sheets.
   (2) Obtain the most detailed profit and loss statements. Obtain a breakdown of each of the major income and expense items.
   (3) Obtain periodic internal financial statements and budget reports.
   (4) Request profit and loss statements for each of the taxpayer’s product lines.
   (5) Calculate key financial ratios on a product line basis.
   (6) Compare the taxpayer’s product line financial ratios to published ratios for the same industry.
   (7) Determine the scope of the examination. Determine whether the scope of the examination needs to be limited to specific product lines.
  d. Examination of Controlled Transactions — Purchases of Tangible Property
   (1) Obtain a copy of the intercompany pricing policy. Request an economic explanation that justifies the policy.
   (2) Request a copy of a transfer pricing study, if any, prepared by the taxpayer. A transfer pricing study may provide much of the information that is required by an IRC section 482 examination. This request should therefore be limited to years beginning after 1993, when the IRC 6662(e) documentation provisions took effect.
   (3) Obtain copies of all fully executed agreements between the taxpayer and its foreign parent. Obtain copies of all amendments to those agreements. The following types of agreements between the taxpayer and its foreign parent may exist, among others:
    a. Distribution agreements
    b. Warranty and service agreements
    c. Advertising and marketing agreements
    d. License agreements relating to the use of trade names and trademarks or franchises
    e. License agreements relating to the use of technology protected as a trade secret; the manufacture, use, or sale of a patented invention; or the reproduction, use, or sale of copyrighted materials
   (4) Analyze controlled transactions with respect to the following factors:
    a. Functions performed, such as the following:
     1. Regulatory administration (e.g., medical devices)
     2. Marketing/advertising
     3. Sales
     4. Warehousing
     5. Distribution
     6. Minor assembly
     7. Shipping
     8. Customization
     9. Installation
     10. Credit and collection
     11. After-sale servicing
     12. Warranty administration
    b. Risks assumed, such as the following:
     1. Market risks
     2. Financial risks, including fluctuations in foreign currency rates of exchange and interest rates
     3. Credit and collection risks
     4. General business risks
     5. Litigation risk (e.g., patent infringement, product liability, antidumping)
    c. Contractual terms, such as the following:
     1. Form and time of payment
     2. Discounts
     3. Shipment
     4. Purchase commitments
     5. Product returned by the customer
     6. Supportive services
    d. Economic conditions, such as the following:
     1. Level of market
     2. Size of market
     3. Geographical location
     4. Relevant market shares for the products distributed
    e. Property or services, such as the following:
     1. Products distributed
     2. Intangible property associated with the products distributed such as patents, trade names, and trademarks
   (5) Conduct interviews with the taxpayer’s personnel knowledgeable about the taxpayer’s operations and policies. The following inquiries should be made:
    a. Operating History
     1. How did the foreign parent market its products in the U.S. prior to the taxpayer’s formation?
     2. Has the taxpayer consistently experienced operating losses? If so, why?
     3. When does it expect to make a profit?
     4. What will bring about the turnaround?
    b. Functional and Risk Analysis
  1. Is the taxpayer the exclusive distributor in the U.S. for the foreign parent? If the taxpayer is non-exclusive the following questions still apply.
     2. What functions does the taxpayer perform as the exclusive (or non-exclusive) distributor for the foreign parent?
     3. What risks does the taxpayer bear as the exclusive (or non-exclusive) distributor for the foreign parent?
    c. Products and Markets
    1. Who are the taxpayer’s largest customers?
    2. Who are the taxpayer’s major competitors?
    3. What is the outlook for the taxpayer’s products in the U.S. marketplace?
    4. How important are manufacturing intangibles in marketing and selling the products?
    5. How important are marketing intangibles in marketing and selling the products?
   (6) Conduct an on-site visitation of the taxpayer’s operations using the guidelines provided by Exhibit 3–1.
   (7) Prepare a functional analysis based on information obtained from the taxpayer. Use the guidelines provided by Exhibit 3–3.
   (8) Determine the arm’s length result of the taxpayer’s controlled transactions by performing the following steps:
    a. Search for potential internal and external comparables.
    b. Conduct a functional risk analysis of each of the potential comparables.
    c. Adjust the comparables for differences between the comparables and the controlled transactions.
    d. Determine an arm’s length range from the comparables discovered.
    e. Determine whether an IRC section 482 adjustment should be made.
2. Outbound Situation
  U.S. taxpayer owns a controlled foreign corporation (CFC). U.S. taxpayer has licensed the CFC to manufacture its proprietary products. The foreign country where the CFC conducts operations grants an income tax exemption to manufacturers. Accordingly, the CFC pays no income tax in the foreign country. The CFC sells a substantial portion of the products it manufactures back to U.S. taxpayer. U.S. taxpayer distributes these products in the U.S. market. The CFC also sells products to unrelated foreign distributors. The CFC reported substantial operating profits during the years under examination.
  Developing an IRC section 482 case in an inbound situation involves the procedures described above. Developing an IRC section 482 case in an outbound situation involves the same basic procedures. Additionally, the examiner should request the following information specifically relevant to the outbound situation:
  a. History and Background
    1. Date the CFC was formed
    2. Date the CFC commenced manufacturing activities
    3. The CFC's profit and loss statements and balance sheets for the years under examination
    4. The CFC's audited financial statements
    5. All internal audit reports relating to the CFC
    6. Form 5471 and supporting schedules
  b. Formation of the CFC
  1. Minutes of Board of Directors meetings relating to the formation of the CFC.
  2. All documents relating to the formation of the CFC. These documents may include the following:
     f. Business plans
     g. Reports and studies
     h. Financial analyses and budget forecasts
     i. Any documents prepared for the purpose of evaluating the formation of the CFC
  c. Government Benefits and Incentives Provided to the CFC
    1. Applications for tax exemption submitted to the foreign country on behalf of the CFC
    2. The foreign country’s official response to this application
    3. Applications for financial assistance submitted to the foreign country on behalf of the CFC
    4. The foreign country’s official response to this application
    5. Any other documents relating to tax exemptions financial assistance granted to the CFC
  d. Manufacturing Facilities
    1. Blueprints of the CFC’s manufacturing facility
    2. Summaries of allocations of floor space by functional activity
    3. Fixed asset records
  e. Personnel
    1. Total headcount for the CFC
    2. Headcount for each of the CFC’s departments
    3. Personnel chart for the CFC which identifies departments, department managers, and reporting relationships
  f. Products
    1. Sales catalogs, brochures, and price lists relating to the products manufactured by the CFC
    2. Bills of materials for products manufactured by the CFC
    3. Standard cost sheets for products manufactured by the CFC
    4. Description of the manufacturing activities performed by the CFC
    5. Listing of the leading manufacturers of competing products
  g. Transfers of Intangibles
    1. License agreements relating to controlled transfers of manufacturing intangibles to the CFC
    2. The amount of royalties paid by the CFC pursuant to these agreements
    3. Copies of all research and development cost sharing agreements between the CFC and affiliates
    4. The amount of cost sharing payments paid by the CFC pursuant to these agreements
    5. License agreements relating to controlled transfers of marketing intangibles to the CFC
    6. The amount of royalties paid by the CFC pursuant to these agreements
  h. Development of Manufacturing Intangibles
    1. The amount of research and development expenses incurred by the U.S. taxpayer and the CFC
    2. A listing of research and development projects undertaken by the U.S. taxpayer and the CFC
    3. The amount of engineering expenses incurred by the U.S. taxpayer and the CFC
    4. A listing of engineering projects undertaken by the U.S. taxpayer and the CFC
  i. Purchases of Raw Materials
    1. The amount of materials purchased by the CFC
    2. The amount of materials purchased from each affiliated vendor
    3. Intercompany pricing policy relating to purchases of raw materials from affiliated vendors
  j. Sales of Finished Product
    1. The amount of sales of finished products
    2. The amount of sales of finished products (number of units and dollar amount) to each affiliated customer
    3.The amount of sales of finished products (number of units and dollar amount) to each unaffiliated customer
    4. Distribution agreements with both affiliated and unaffiliated customers
    5. Sample of sales invoices for finished products shipped to both affiliated and unaffiliated customers
    6. Sample of U.S. Customs documents (e.g. U.S. Customs Form 7501) relating to sales of finished products to the U.S. taxpayer

Exhibit 4.61.3-3  (05-01-2006)
Presentation of Findings

A. Functional Analysis    
  A functional checklist can be used to present the following information:
  • Functions performed by taxpayers engaged in controlled transactions  
  • Intangible property owned by controlled taxpayers    
  The functional checklist does not present the arm’s length result for the controlled transactions. It instead presents information that is needed to determine the arm’s length result.
 
Example 1 — Offshore Manufacturing    
A foreign subsidiary manufactures apparel for its U.S. parent. The U.S. parent and the foreign subsidiary performed the following functions:
  Functions Performed Subsidiary Parent
  a. Product Design   X
  b. Product Specification   X
  c. Process Engineering:    
     1. Small Scale Production   X
     2. Large Scale Production X  
  d. Purchasing:    
     1. Selection of Materials and Trimmings   X
     2. Purchase of Materials and Trimmings from    
      Unrelated Vendors   X
  e. Inventory Control X  
  f. Production Scheduling X  
  g. Apparel Production:    
     1. Marking X  
     2. Spreading X  
     3. Cutting X  
     4. Sewing X  
     5. Packaging X  
  h. Quality Control X  
  i. Distribution:    
     1. Sales of Finished Product to U.S. Parent X  
     2. Resales of Finished Product Under Brand Name     to Authorized Dealers and Distributors   X
     3. Resales of Finished Product Under Private      Labels to Major Retail Chains   X
  j. Marketing   X
  k. Advertising   X
  l. Warranty Administration   X
  m. Accounting and Finance X X
  n. Data Processing X X
  o. Engineering X X
  p. Human Resources X X
Example 2 — Offshore Manufacturing and Distribution    
 A U.S. parent established both a manufacturing branch and a distribution subsidiary in a foreign country. The branch and subsidiary share the same facility. The branch sells its output of personal care products to the subsidiary. The U.S. parent, the branch and the subsidiary perform the following functions:
  Functions Performed U.S.
Parent
Foreign
Branch
Foreign
Subsidiary
  a. Developed formula for product X    
  b. Owns U.S. patent X    
  c. Owns foreign country patent X    
  d. Manufactures personal care product   X  
  e. Transfers product title to the subsidiary
 when subsidiary pulls product to fill
 shipping orders
  X  
  f. Owns U.S. trade name X    
  g. Owns foreign country tradename X    
  h. Establishes marketing strategy     X
  i. Implements marketing plan     X
  j. Sells product to unrelated parties     X
  k. Reimburses subsidiary for all budgeted
 advertising, promotion, and market
 research expenses
  X  
B. Risk Analysis      
 A risk checklist can be used to present information about risks and the assumption of risks. Like the functional checklist, it does not present the arm’s length result for the controlled transactions. It instead provides information that is needed to determine the arm’s length result.
 For example, manufacturers producing similar consumer electronic products may assume varying degrees of risk as illustrated in the general examples below. These examples are not all-inclusive.
  Risk Assumed Contract
Manufacturer
Private Label
Manufacturer
Brand Name
Manufacturer
  Research and Development No Yes Yes
  Raw Materials Inventory No Limited Yes
  Finished Goods Inventory No No Yes
  Market No No Yes
  Advertising and Promotion No No Yes
  Credit and Collection Limited Limited Yes

Exhibit 4.61.3-4  (05-01-2006)
Transfer Pricing Functional Analysis Questionnaire

For guidance in performing a functional analysis of a business this questionnaire sets out a list of generic questions which might be used to gain an understanding of the various functions, risks and intangibles. The list is not intended to be exhaustive and should be tailored to suit the needs of the specific business entity being reviewed.

ANALYSIS OF FUNCTIONS

I. Manufacturing

  1. Materials purchasing

    1. What materials or partly finished goods are purchased?

    2. From Whom are purchases made?

    3. Are any purchases made from related companies?

    4. Where and how are raw materials purchases?

    5. Who performs the purchasing function?

    6. Who plans purchasing schedules?

    7. Who negotiates purchasing arrangements?

    8. Who approves the vendor as being of acceptable quality?

    9. Do purchasing decisions require head office approval?

    10. What are the other approvals required? Who makes these approvals?

    11. Are any purchases made on consignment?

    12. What are your major risks?

  2. Inventory

    1. Where is inventory held?

    2. Who controls the levels of inventory?

    3. How are inventory levels controlled?

    4. Is there a computer system?

    5. Are any purchases made on consignment?

    6. How many days of inventory are on hand?

    7. Has there ever been a case, for whatever reason, where you were stuck with excess inventory?

    8. Who bears the cost of obsolete inventory?

    9. What are your major risks?

  3. Production Equipment

    1. Who determines the purchasing budget?

    2. Who negotiates purchasing?

    3. Who maintains the plant?

    4. Who has expenditure authority for capital equipment?

    5. Who writes specifications for the plant?

    6. From whom is production equipment purchased?

    7. Are any purchases made from related companies?

    8. Do you have discretion over the equipment used?

    9. Can you modify the equipment?

    10. What decisions require head office approval?

    11. What are the approvals required?

  4. Production Scheduling

    1. Who is responsible for production scheduling decisions?

    2. What factors enter the decisions?

    3. When are the decisions made?

    4. Is a computer system used?

    5. What decisions require head office approval?

    6. What are the approvals required?

    7. What are your major risks?

    8. Does your distributor buy everything you manufacture?

  5. Manufacturing and process engineering

    1. What products are produced?

    2. Who designed the products and who owns the technology?

    3. What is the manufacturing process?

    4. Who developed the original process?

    5. Have any improvements been made locally?

    6. Is it possible to compare productivity between the subsidiaries in the group?

    7. Have you ever utilized a third party to produce your products?

  6. Package and labeling

    1. What packaging and labeling is done?

    2. Where is it done?

    3. Who makes the decisions in relation to packing and labeling?

    4. Have you complete autonomy to make such decisions?

  7. Quality control

    1. What form does quality control take?

    2. Who sets finished product quality standards and procedures?

    3. Who performs the quality control and who bears the cost?

    4. Who provides the equipment and techniques for quality control?

    5. How much product is lost because it fails quality and control checks?

    6. What are your major risks?

    7. What decisions require head office approval?

    8. What are the approvals required?

  8. Shipping of products

    1. Who pays freight charges for product in and out?

    2. Who arranges shipping of products?

    3. Who ships your products?

    4. Where are the products shipped?

    5. How are they shipped?

    6. Who is responsible for the selection of shippers?

    7. Who is responsible for shipping deadlines?

    8. What are your major risks?

    9. What decisions require head office approval?

    10. What are the approvals required?

II. Research and Development

    1. What research and development do you carry out?

    2. Is any research and development carried out on you behalf by related companies?

    3. Do you commission third parties to carry out research and development on your behalf?

    4. Where are products designed?

    5. What input do distributors have on manufacturing, product design or product modifications?

    6. How important is the development of patents in the industry?

    7. What patents do you own? Describe the unique products created by each patent.

    8. What unpatented technical know-how have you developed that might differentiate your products from competitors, create import cost efficiencies, or give you an advantage in increasing your market share?

    9. What decisions require corporate head office approval?

    10. What are the approvals required?

    11. Who formulates the budget?

    12. Are license agreements in existence between you and related companies or third parties?

    13. Is there a cost sharing agreement in force and if so, what are the details?

    14. Provide a copy of the cost sharing agreement and the relevant details.

III. Marketing

  1. Strategic

    1. Do you carry out your own marketing?

    2. Are market surveys performed? Do you monitor market demand?

    3. What decisions require head office approval?

    4. What are the approvals required?

    5. Who are your competitors?

    6. Who assesses demand in foreign markets?

    7. What are the risks related to demand for your products?

    8. Who formulates the marketing budget?

    9. Does your distributor always buy what your manufacturer produces?

    10. Has your manufacturer ever refused to fill an order?

    11. Do related companies carry out marketing on your behalf?

    12. Are third party distributors used?

    13. Who chooses, authorizes and controls third party distributors?

  2. Advertising, trade shows, etc.

    1. What forms of marketing do you utilize?

    2. What forms of advertising are used? Who pays for it?

    3. Are trade shows used and if so, who organizes them and who pays for them?

    4. Are samples provided to distributors?

    5. Who produces product brochures, specification sheets, etc.?

    6. What marketing assistance do you receive?

    7. What decisions require head office approval?

    8. What are the approvals required?

IV. Sales and distributions

  1. Sales

    1. How are sales made and who is involved?

    2. Who issues the invoice to the customer?

    3. Who issues the invoice to you?

    4. Who formulates the projections and sets targets?

    5. Where are sales orders received?

    6. Who is responsible for the achievement of sales targets?

    7. Who negotiates sales contracts? Do they operate autonomously?

    8. Does your distributor always buy what your manufacturer produces?

    9. How much is sold to related companies?

    10. Are only finished goods shipped from here?

    11. Who are your competitors?

    12. What are the risks related to demand for your products?

    13. What decisions require corporate head office approval?

    14. What are the approvals required?

    15. Are products exported? If so, who is responsible for the export function?

    16. What are the major risks in selling products in foreign countries?

  2. Quality Control

    1. What form does quality control take?

    2. Who sets finished product quality standards and procedures?

    3. Who performs the quality control and who bears the cost?

    4. Who provides the quality control and who bears the cost?

    5. How much product is rejected by customers as below standard?

    6. Who bears the loss on defective products?

    7. What are your major risks?

    8. What decisions require head office approval?

    9. What are the approvals required?

  3. Freight

    1. Who pays freight charges for product in and out?

    2. Who arranges shipping of products?

    3. Who ships your products? To where? How?

    4. Who is responsible for the selection of shippers?

    5. Who is responsible for shipping deadlines?

    6. What are your major risks?

    7. What decisions require head office approval?

    8. What are the approvals required?

  4. Inventory

    1. Do you actually receive the goods and hold stock?

    2. Where is stock held?

    3. Who controls the levels of inventory?

    4. How are inventory levels controlled? Is there a computer system?

    5. Are any purchases made on consignment?

    6. How many days of inventory are on hand?

    7. Has there ever been a case, for whatever reason, where you were stuck with excess inventory?

    8. Who bears the cost of obsolete inventory?

    9. What are your major risks?

  5. Installation and after-sales services

    1. Do you instal your products?

    2. Do you provide after-sales services? If so, describe the service.

    3. Does any company carry out product repairs and who bears the cost?

    4. Who bears the cost of installation and after-sales service?

    5. Do you provide product guarantees?

    6. Who bears warranty costs?

V. Administration and Other Services

  1. General Administration

    1. Is there a complete administration function?

    2. Do related companies perform any administration for you?

    3. What decisions require corporate head office approval?

    4. What are the approvals required?

    5. Who is responsible for administrative codes of practice?

  2. Pricing Policy

    1. Who determines the product pricing?

    2. What is the pricing policy for the various goods and services?

    3. What are your major risks?

    4. What decisions require corporate head office approval?

    5. What are the approvals required?

  3. Accounting

    1. What accounting functions are carried out? By whom?

    2. Where are the financial reports prepared?

    3. What decisions require head office approval?

    4. What are the approvals required?

    5. Is a bank account maintained? For what purpose?

    6. Who has check signatory authority? What are the authority limits?

    7. Do you bear the credit risk on sales to customers?

    8. Who pays product liability insurance premiums?

    9. Who arranges and pays for other insurance?

  4. Legal

    1. Who is responsible for legal matters?

    2. What decisions require head office approval?

    3. What are the approvals required?

  5. Computer Processing

    1. Is computer processing and programming done here? If not, by whom and where?

    2. Who developed the software and is any charge made for it?

    3. Who has expenditure authority for capital equipment?

    4. What decisions require head office approval?

    5. What are the approvals required?

  6. Finance / Loans / Credit

    1. Are there any intercompany loans or long-term receivables and, if so, is interest charged?

    2. What trade credit terms are received and given?

    3. Is interest paid or charged if credit periods are exceeded?

    4. Who is responsible for borrowing requirements?

    5. What are your major risks?

    6. What decisions require head office approval?

    7. What are the approvals required?

  7. Personnel

    1. Are there any compensation to or from overseas affiliates?

    2. What positions do they hold in the company?

    3. What training do you provide your employees?

    4. What is the length of the training period?

    5. Is there on-the-job training?

    6. Where is management training done?

    7. What is the staff turnover rate?

    8. Are all employees on your payroll?

    9. Who is responsible for the employment of staff?

    10. What decisions require head office approval?

    11. What are the approvals required?

  8. Use of Property / Leasing

    1. Is property owned or leased from affiliates?

    2. Do you lease property to affiliates?

    3. Who is responsible for this function?

VI. Executive

    1. To whom does the general manager report?

    2. Does anyone report to the parent company besides the general manager?

    3. Who is responsible for dealing with government agencies?

    4. What are some of the regulatory requirements?

    5. Has the parent ever told you to use more procedures than you have developed?

    6. How does manufacturing site selection occur?

    7. Where does the initial impetus in relation to corporate decisions come from?

    8. What decisions require head office approval?

    9. What are the approvals required?

ANALYSIS OF RISKS

I. Market Risk

    1. What are the market risks?

    2. Do you bear the market risks? If not, who does?

    3. How significant are the market risks?

II. Inventory Risk

    1. Does inventory become obsolete?

    2. Who bears the cost of obsolete inventory?

    3. Do you provide warranties in relation to finished goods?

    4. Who bears the cost of returns under warranty?

III. Credit and bad debt risk

    1. What credit terms are given and received?

    2. Do you bear the cost of bad debts? If not, who does?

    3. Is this a significant risk?

IV. Foreign exchange risk

    1. Are you exposed to foreign exchange risk? If so, explain the risks.

    2. How significant is the risk?

    3. What steps do you take to minimize foreign exchange risk?

    4. Do you have a manual that outlines your procedures / policies for dealing with foreign exchange risk? If so, provide a copy.

    5. Do you engage in hedging of foreign exchange risk? If so, provide an explanation of your hedging activities.

ANALYSIS OF INTANGIBLES

I. Manufacturing

  1. Research and development

    1. Have you developed your own products? Are they unique?

    2. Have you developed manufacturing processes?

    3. How important are these processes to your business? Are they unique?

  2. Manufacturing processing / technological know-how

    1. Do you possess technological know-how?

    2. If so, what is its nature?

    3. How important to your business is the know-how?

    4. Is the know-how unique?

  3. Trademarks / patents, etc.

    1. Do you own any trademarks / patents?

    2. How significant are they to your business?

  4. Product quality

    1. Within your industry, and as compared to your competition, how would you rate the quality of your product?

  5. Other

    1. Are there any other manufacturing intangibles?

    2. Request copies of all licensing agreements.

II. Marketing

  1. Trademarks / trade names

    1. Do you own any trademarks / trade names?

    2. How significant are they to your business?

  2. Corporate reputation

    1. Do you consider that you have a corporate reputation?

    2. What is the nature of this reputation?

    3. Is corporate reputation significant in your business?

  3. Developed marketing organization

    1. Do you have a developed marketing organization?

  4. Ability to provide service to customers

    1. Within your industry, and as compared to your competitors, how would you rate the quality of the services you provide to customers?


More Internal Revenue Manual