BAUSCH & LOMB Inc (B&L Inc) and its subsidiaries were engaged in the manufacture, marketing and sale of soft contact lenses and related products in the United States and abroad.
B&L Ireland was organized on February 1, 1980, under the laws of the Republic of Ireland as a third tier, wholly owned subsidiary of petitioner. B&L Ireland was organized for valid business reasons and to take advantage of certain tax and other incentives offered by the Republic of Ireland.
Pursuant to an agreement dated January 1, 1981, petitioner granted to B&L Ireland a nonexclusive license to use its patented and unpatented manufacturing technology to manufacture soft contact lenses in Ireland and a nonexclusive license to use certain of its trademarks in the sale of soft contact lenses produced through use of the licensed technology worldwide.
In return, B&L Ireland agreed to pay B&L Inc. a royalty equal to five percent of sales.
In 1981 and 1982, B&L Ireland engaged in the manufacture and sale of soft contact lenses in the Republic of Ireland. All of B&L Ireland’s sales were made either to B&L Inc or certain of B&L Inc’s wholly owned foreign sales affiliates at a price of $7.50 per lens.
The tax authorities determined that the $7.50 sales price did not constitute an arm’s-length consideration for the soft contact lenses sold by B&L Ireland to B&L Inc.
Furthermore the authorities determined that, the royalty contained in the January 1, 1981 license agreement did not constitute an arm’s-length consideration for the use by B&L Ireland of B&L Inc’s intangibles.
A. Determination of Arm’s-Length Prices Between B&L Inc and B&L Ireland for Soft Contact Lenses
The market price for any product will be equal to the price at which the least efficient producer whose production is necessary to satisfy demand is willing to sell. During 1981 and 1982, the lathing methods were still the predominant production technologies employed in the soft contact lens industry. American Hydron, an affiliate of NPDC and a strong competitor in the contact lens market, was able to produce 466,348 and 762, 379 soft contact lenses using the lathing method in 1981 and 1982, for $6.18 and $6.46 per unit, respectively. It is questionable whether any of B&L Ireland’s competitors, save B&L, could profitably have sold soft contact lenses during the period in issue for less than the $7.50 charged by B&L Ireland. The fact that B&L Ireland could, through its possession of superior production technology, undercut the market and sell at a lower price is irrelevant. Petitioners have shown that the $7.50 they paid for lenses was a ‘market price‘ and have thus ‘earned the right to be free from a section 482 reallocation.‘ United States Steel Corp. v. Commissioner, supra at 947.
Finally, respondent argues that B&L COULD HAVE produced the contact lenses purchased from B&L Ireland itself at lesser cost. However, B&L DID NOT produce the lenses itself. The mere power to determine who in a controlled group will earn income cannot justify a section 482 allocation of the income from the entity who actually earned the income. Bush Hog Mfg. Co. v. Commissioner, 42 T.C. 713, 725 (1964); Polak’s Frutal Works, Inc. v. Commissioner, 21 T.C. 953, 976 (1954). B&L Ireland was the entity which actually produced the contact lenses. Respondent is limited to determining how the sales to B&L by B&L Ireland would have been priced had the parties been unrelated and negotiating at arm’s length. We have determined that the $7.50 charged was a market price. We thus conclude that respondent abused his discretion and acted arbitrarily and unreasonably in reallocating income between B&L and B&L Ireland based on use of a transfer price for contact lenses other than the $7.50 per lens actually used. When conditions for use of the comparable uncontrolled price method are present, use of that method to determine an arm’s-length price is mandated. Sec. 1.482-2(e)(1)(ii), Income Tax Regs. Therefore, we need not consider petitioner’s alternative position — that application of the resale price method supports the arm’s-length nature of the $7.50 transfer price. We note, however, that application of such method lends further support to the arm’s-length nature of B&L Ireland’s $7.50 sales price. Uncontrolled purchases and resales by American Optical, Southern, Bailey-Smith, and Mid-South indicate gross profit percentages of between 22 and 40 percent were common among soft contact lens distributors. This is confirmed by the testimony of Thomas Sloan, president of Southern, who testified that he tried to purchase lenses from manufacturers at prices which allowed Southern to maintain a reasonable profit margin of between 25 and 40 percent. Applying a 40- percent gross margin to B&L’s average realized price of $16.74 and $15.25 for domestic sales in 1981 and 1982, respectively, indicates a lens cost of $10.04 and $9.15, respectively — well above the $7.50 received by B&L Ireland for its lenses and also above the $8.12 cost to B&L when freight and duty are added.”
B. Determination of Arm’s-Length Royalty Payable by B&L Ireland for use of B&L’s Intangibles
Obviously, no independent party would enter into an agreement for the license of intangibles under circumstances in which the royalty charged would preclude any reasonable expectation of earning a profit through use of the intangibles. We therefore find respondent’s section 482 allocation with respect to the royalty to be arbitrary, capricious and unreasonable.
Our rejection of the royalty rate advocated by respondent does not, however, require that we accept that proposed by petitioners. G.D. Searle v. Commissioner, 88 T.C. at 367. Both Dr. Arons and Dr. Plotkin testified that in their opinion a royalty of five percent of the transfer price charged for the contact lenses sold by B&L Ireland was inadequate as arm’s-length consideration. On brief, petitioners recalculated the royalty due from B&L Ireland based on five percent of the average realized price (ARP) of Irish-produced lenses, arriving at royalties of $1,072,522 and $3,050,028 for 1981 and 1982, respectively.
This translates to a royalty of $0.9611 and $0.8257 per lens in 1981 and 1982, respectively. As stated previously, we do not consider ARP to be an appropriate base on which to calculate the royalty due. The fact that the royalty per unit payable in 1981 and 1982 declined despite the fact that B&L Ireland earned the same $7.50 per lens in each year is further evidence that a royalty based on ARP is inappropriate. Expressed as a percentage of the $7.50 transfer price received by B&L Ireland, the royalty conceded by petitioners is 12.81 and 11.01 percent in 1981 and 1982, respectively. Using the same analysis as was applied to respondent’s royalty, we find that even a royalty of 15 percent of the price received from the sale of products produced using the licensed intangibles is too low to constitute an appropriate arm’s-length consideration in this case for use of the licensed intangibles. At a royalty of 15 percent of sales price, an investor in the position of B&L Ireland at the time the license agreement was being negotiated could have anticipated the following earnings through exploitation of the licensed intangibles:
We thus hold that a royalty of 20 percent of B&L Ireland’s sales price for soft contact lenses constitutes arm’s-length consideration for use of B&L’s intangibles. At arm’s length B&L would thus have received royalties of $1,674,000 and $5,541,000 from B&L Ireland in 1981 and 1982, respectively.”
Judgement of the Court of Appeal
The Court of Appeal upheld the decision of the tax court.
US vs Bausch & Lomb Inc Court of Appeal