P and S are controlled taxpayers. P licenses a proprietary process to S for S’s use in manufacturing product X. Using its sales and marketing employees, S sells product X to related and unrelated customers outside the United States. If the license between P and S has economic substance, the Commissioner ordinarily will not restructure the taxpayer’s transaction to treat P as if it had elected to exploit directly the manufacturing process. However, because P could have directly exploited the manufacturing process and manufactured product X itself, this realistic alternative may be taken into account under § 1.482-4(d) in determining the arm’s length consideration for the controlled transaction. For examples of such an analysis, see Examples 7 and 8 in paragraph (f)(2)(i)(E) of this section and the Example in § 1.482-4(d)(2) ... Read more

Couture, a U.S. apparel design corporation, contracts with Sewco, its wholly owned Country Y subsidiary, to manufacture its clothes. Costs of operating in Country Y are significantly lower than the operating costs in the United States. Although clothes with the Couture label sell for a premium price, the actual production of the clothes does not require significant specialized knowledge that could not be acquired by actual or potential competitors to Sewco at reasonable cost. Thus, Sewco’s functions could be performed by several actual or potential competitors to Sewco in geographic markets that are similar to Country Y. Thus, the fact that production is less costly in Country Y will not, in and of itself, justify additional profits derived from lower operating costs in Country Y inuring to Sewco, because the competitive positions of the other actual or potential producers in similar geographic markets capable of performing the same functions at the same low costs indicate that at arm’s length such ... Read more

The following example illustrates the principles of this paragraph (d)(4)(ii)(C) ... Read more

If an uncontrolled taxpayer operates in a different geographic market than the controlled taxpayer, adjustments may be necessary to account for significant differences in costs attributable to the geographic markets. These adjustments must be based on the effect such differences would have on the consideration charged or paid in the controlled transaction given the relative competitive positions of buyers and sellers in each market. Thus, for example, the fact that the total costs of operating in a controlled manufacturer’s geographic market are less than the total costs of operating in other markets ordinarily justifies higher profits to the manufacturer only if the cost differences would increase the profits of comparable uncontrolled manufacturers operating at arm’s length, given the competitive positions of buyers and sellers in that market ... Read more

A AB purchased manufacturing services of its subsidiary B AS, which had its headquarters in Estonia. The internal pricing of services had since July 2004 been under the net margin method. The price data beside B AS’s realized expenses also included half of the so-called location-savings. On taxation of A AB approved as deductible expenditure only B AS’s actual expenses plus a calculated profit margin. The Supreme Administrative Court stated that A AB in Finland did not have such manufacturing as B AS was conducted in Estonia during the tax year. B AS’s production of the products differed substantially from A ABs former manufacturing in Finland, where A AB had manufactured the products by hand. Most of the new working methods and stages developed in Estonia had never been used in Finland. Hence the situation was not comparable to the location savings by moving the activities as described in the OECD report, and the pricing of would not be judged ... Read more