The Premature Death of the Comparable Uncontrolled Transaction (Price) Method
A recent TaxNotes piece called for a substantial rewrite of Section 1.482-4, which addresses the transfer of intangible assets. The author, Ryan Finley, suggests that the Comparable Uncontrolled Transaction (CUT/CUP) approach should be relegated to a much more limited role. While many of the his assessments are fair, we would urge caution before relegating CUT too far to the backbench. There are certainly situations where CUT approaches are not only useful, but necessary as part of a larger framework to capture the issues and facts of the specific intercompany issue, examples of which we note later on.
Finley is correct to note that:
The IRS’s attempts to prevent taxpayers from applying the comparable uncontrolled transaction method in a way that systematically underprices related-party intangible transfers has been the recurring theme in nearly all of the highest-profile transfer pricing cases over the past three decades. Although the CUT method is the most direct embodiment of the arm’s-length standard as stated in reg. section 1.482-1(b), the method has consistently allowed some of the highest profile tech companies in the world to undervalue highly valuable and unique intangible property transferred to a low-taxed foreign affiliate. The CUT method also allows taxpayers that would rarely, if ever, externally license their core intangible property to price the transfer using the far less valuable intangible licenses typically available in commercial databases as comparables.
Finley notes three recent U.S. federal tax cases, including Medtronic Inc. v. Commissioner. This litigation involved the intercompany royalty rate paid by a Puerto Rican affiliate to the U.S. owner of a certain product, process, and marketing intangibles. Even though consolidated profits represented 60% of sales, the multinational argued for a 20% royalty rate based on a very flawed application of CUT. The Appeals Court noted a host of comparability differences including the fact that the profit potential for the third party licensee was a mere 23% of sales.
While the issues in Medtronic are focused on what represents an arm’s length royalty rate, the other two cases referenced by Finley involve the valuation of a bundle of intangible assets. Both the taxpayer’s experts and the IRS experts used applications of CUT to separately determine the appropriate royalty rates for the Amazon trademark and the internet technology in Amazon.com v. Commissioner. The differences in the valuation estimates turned more on assumptions with respect to economic useful life of these two intangible assets as well as the appropriate discount rates. Technology companies such as Amazon often have high market valuation relative to their current operating profits for reasons noted in Finley’s discussion, which raise issues with respect to what are the other valuable intangible assets and who owns them:
The CUT method is also uniquely tailored for application on an individual asset-by-asset basis, which often disregards the additional value conveyed by transferring interrelated intangibles — such as product formulations, trademarks, and manufacturing know-how for some products — as part of a single package.
This insight that the value of an enterprise comes from not only tangible assets but also an entire bundle of intangible assets suggests a limited role for applications of CUT as part of an economic analysis that considers the entire value chain. We note this potential role of CUT applications in terms of transfer pricing issues for three consumer products starting with my recent comments regarding a customs valuation issue involving Armani:
Under various agreements, Trimil paid Armani both design fees and advertising fees, both calculated as a% of Trimil’s revenues. US customs authorities asserted that the customs valuation must include the third-party payment for apparel, the design and advertising fees, and trademark royalties. Trimil’s position was the customs valuation should be based on the cost of the apparel plus the design fees but not the advertising fees and trademark royalties … The first is whether the overall payments for design costs, advertising expenses, and royalties are arm’s length. The other issue is how much should be allocated to dutiable product intangible fees versus non-dutiable marketing intangible fees.
Armani is a privately held company so there is not publicly available information on its overall profitability. Even if an analyst had this information and was able to estimate the overall profits attributable to the overall bundle of intangible assets, this customs valuation issue would require being able to separately determine the value of the design intangibles versus the value of the marketing intangibles.
Eastpak designed, manufactured, and marketed travel gear including backpacks since its inception in 1952. Like Medtronic, it established Puerto Rican manufacturing affiliate during the era of section 936. Eastpak had multiple owners including the 2000 acquisition by VF Corporation. I was asked to assist on evaluating its intercompany pricing issues by one of the former owners. Table 1 presents a highly simplified version of the transfer pricing issue that makes the following assumptions:
- U.S. sales = $200 million per year.
- Production costs borne by the Puerto Rican affiliate = $120 million per year.
- Operating expenses = $50 million per year.
Consolidated operating profits = $30 million per year or 15% of sales. These profits would be allocated between the U.S. distributor and the Puerto Rican affiliate by the transfer pricing policy, which in this case set the transfer price at $140 million per year. As such, the U.S. distributor retains profits = $10 million per year or 5% of sales leaving the Puerto Rican affiliate with $20 million per year.
Table 1: Eastpak Financials
|Cost of goods||$120||$140||$120|
Eastpak had just been purchased for $300 million with $80 million in tangible assets being booked by the U.S. affiliate, $160 million in tangible assets being booked by the Puerto Rican affiliate, and $60 million recorded as goodwill.
The concern of Eastpak’s advisers was that the IRS would characterize the Puerto Rican affiliate as a contract manufacturer entitled to only a 10% return to its tangible assets. Under this approach, the transfer pricing could be lowered to $136 million increasing U.S. income to $14 million per year. This approach implicitly assumed that the U.S. affiliate owned all valuable intangible assets.
The records showed, however, that the Puerto Rican affiliate had paid for $20 million of this recorded goodwill. The advisers noted that under section 936 the Puerto Rican affiliate could own only manufacturing intangibles; suggesting that if goodwill was in fact comprised of marketing intangibles, the IRS could assert this contract manufacturing approach. Goodwill in terms of a purchase price allocation under current US and international accounting standards, however, does not mean marketing intangibles but rather the portion of the purchase price not specifically allocated to any identified intangible assets. We were able to use applications of CUT to show that the profits attributable to the U.S. owned marketing intangibles represented 1% of sales while the profits attributable to the manufacturing intangibles represented 2% of sales.
Table 2 presents another illustration of this problem based on the jewelry multinational Tiffany. The U.S. parent does much of the manufacturing activities to convert diamonds sourced from third parties into finished products. The largest foreign markets for their products are China and Japan along with other Asian markets, which collectively represent 43% of worldwide sales. Table 2 assumes:
- Asian sales equal $2 billion per year.
- U.S. incurred production and other costs represent 40% of sales.
- Asian incurred sales and marketing costs represent 40% of sales.
Consolidated operating profits equal 20% of sales, which are allocated evenly between the U.S. parent and the Asian distributors if the distributors are afforded a 50% gross margin.
Table 2: Illustration of Tiffany Asia Transfer Pricing
|Cost of goods||$800||$1000||$800|
A 10% operating margin for the Asian distribution affiliates might be seen as high if all intangible assets were owned by the U.S. parent. The Chinese and Japanese tax authorities, however, might assert that their local affiliates own marketing intangibles by virtue of incurring local advertising expenses.
Any application of the Residual Profit Split Method would require the analyst to first identify the routine returns to distribution and production and then decide on how to allocate residual profits. If residual profits represent a significant percentage of sales, this allocation would be key to evaluating the appropriate gross margin for the distribution affiliate. The key question becomes how to determine the value of the Tiffany marketing intangibles versus its design intangibles. The following passages from their 10-K filing may be useful:
The Company receives earnings from a licensing agreement with Luxottica Group S.p.A., for the development, production and distribution of TIFFANY & CO. brand eyewear, and from a licensing agreement with Coty Inc., for the development, production and distribution of TIFFANY & CO. brand fragrance products … Since 1974, Tiffany has been the sole licensee for the intellectual property rights necessary to make and sell jewelry and other products designed by Elsa Peretti and bearing her trademarks.
The Luxottica and Coty agreements are examples where Tiffany derives licensing income for the use of its marketing intangibles. The Elsa Peretti agreement represents a potential CUT where Tiffany pays a third party for the use of her designs and trademarks while Tiffany owns any process intangibles.
Even in transfer pricing inquiries where consolidated profitability is substantial, a complete analysis may have to separately evaluate the profits derived from marketing intangibles versus process or product intangibles. The U.S. regulations note that residual profits may be allocated using:
the relative value of nonroutine intangible property contributed by taxpayers may be measured by external market benchmarks that reflect the fair market value of such intangible property.
Third party agreements are one form of external market benchmarks that can assist in the evaluation of the market value for these various forms of intangible assets. We should not prematurely bury the CUT approach.
Harold Mcclure, “Medtronic’s Intercompany Royalty Rate: Bad CUT or Misleading CPM?” Journal of International Taxation, February 2019.