Petition — E. I. du Pont de Nemours & Co. v. United States

Ne ae eg | , Auprems Cot, U. o

FILED

JAN 15 1980

Ney 9g - MICHAEL RODAK, JR., CLER

ae

IN THE

Supreme Court of the United States

OCTOBER TERM, 1979

E.I. Du PONT DE NEMOURS & COMPANY,

Petitioner,

V.

THE UNITED STATES,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF CLAIMS

DANIEL M. GRIBBON

HARRIS WEINSTEIN

MICHAEL R. LEvy

ALEX KOZINSKI

Covington & Burling

888 Sixteenth Street, N.W.

Washington, D.C. 20006

Atto;neys for Petitioner

Of Counsel:

Roy A. WENTZ

THOMAS M. Russo

Tenth and Market Streets

Wilmington, Delaware 19898

January 15, 1980

OS ARES a.

TABLE OF CONTENTS

Page

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I i ccna sn snswicbas sobuceecesenssoee 2

QUESTION PRESENTED ...................c.scccssssessscsees 2

STATUTE AND REGULATIONS INVOLVED... 2

AGN REEDS i ee A 2

REASONS FOR GRANTING THE WRIT ........... 6

eat akascdshsasaninyiessveysosossocvee 16

Appendices:

Ce Sd. can cuanecence A-1

B. Order Regarding Findings of Fact............. B-|

C. Statute and Regulations Involved .............. C-]

il

TABLE OF AUTHORITIES

CASES:

Baldwin-Lima-Hamilton Corp. v. United States,

BSS FAG. VEE 6 POA AEs PFI inesscspisnsccnshesscceroevensee

Boston & Maine R.R. v. Commissioner, 206 F.2d

es Be Ps ick cucnsshos sonrtaesicscadcnesobvervese fans

Brittingham v. Commissioner, 598 F.2d 1375 (Sth

Cir. 1979), aff’g, 66 T.C. 373 (1976)... eee

Cadillac Textiles Inc., 34 TCM 295 (1975).............

Polak’s Frutal Works, Inc., 21 T.C. 953 (1954)

acq. in, 1955-1 C.B. 6, acg. withdrawn, 1972-2

RR Mie cep ox teesusis tanscs sss on inceseeganasdeayp pruavuincavesie

PPG Industries, Inc., 55 T.C. 928 (1970) ................

Ross Glove Co., 60 T.C. 569 (1973), acq. in, 1974-

a laa aare hela os is indian nieg Van cesmusdintbene’

Service v. Dulles, 354 U.S. 363 (1957) su... eee

Southern Ry. v. United States, 585 F.2d 466 (Ct.

A eet he Be soci daasa aheatigaaiisioasnadVapinnyes owas

United States ex rel. Accardi v. Shaughnessy, 347

ie IMD acaiaccgs sak iclednenes ge ikivasabicdstepabenscatany

United States Gypsum Co. v. United States, 452

PUM PUN IRN AE Dios desesccacecosseascicosspsaacousne

STATUTES AND REGULATIONS:

De hi ls coitnetccncskssancsanentysdssendvcapveesaivsuns

eT eit bisicicsaknscoctieatapbinndabaterrntaanies

NC Te ORO DD caida hocinscscenhssvccaciasducoedsdernts

TE AIRS GPU IGE D ccvnccsccsecensconsscnasesecaescsees

BAe ee Ns FE NPIS D inecccsncssccsicicnecccssarcunseatsicces

31 Fed. Reg. 10,394 (1966) (proposed regu-

SSN RSERES RS EEE esa rey ee OL Lae

Page

6,12,13

14

10

10

10

6,13

passim

3

passim

3

3

te oe lll

MISCELLANEOUS:

Conf. Rep. No. 2508, 87th Cong. 2d Sess., re-

| ns gl in, [1962] U.S. Code Cong. & Ad. News

Fuller, Problems in Applying the 482 Intercompany

Pricing Regs. Accentuated by Du Pont Case, 52

Bc ee Aa I GE I ih a host wastecs dodaxacdeuerabren onde

Fuller, Section 482 Revisited, 31 Tax L. Rev. 475

EGRESS SORES cone RRR POIROT 7 Tee NO

Hammer, Morrione & Ryan, Concepts and Tech-

niques in Determining the Reasonableness of

Intercompany Pricing Between United States

Corporations and Their Overseas Subsidiaries,

30 N.Y.U. Inst. Fed. Tax. 1407 (1972)

Internal Revenue Service, Source Book of Statistics

OPN sti Be ee Bis ipl cakcabibbeictdocascs

Note, Multinational Corporations and Income Allo-

cation Under Section 482 of the Internal Reve-

nue Code, 89 Harv. L. Rev. 1202 (1976)

R. Rhoades, Income Taxation of Foreign Related

PIE OTN whisk cds inacnicdasanigheiacccsccokseesaes

Surrey, Treasury’s Need to Curb Tax Avoidance in

Foreign Business Through Use of 482, 28 J. Tax.

75 (1968)........ PST aR ER ae, SUNT MN OO

Penns. Dee. 3952, 1968-4 CB. 208 siissccicccccctecesices

U.S. Treasury Department, Summary Study of

International Cases Involving Section 482 of the

Internal Revenue Code (1973) ....ccccccccccccesccseeseeeee

eee eeeeeerere

Page

11

11

14

14

passim

9,15

14,15

14

NES we —s

Supreme Court of the United States

OCTOBER TERM, 1979

No.

E.I. Du PONT DE Nemours & COMPANY,

Petitioner,

Vv.

THE UNITED STATES,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF CLAIMS

Petitioner, E.1. Du Pont de Nemours and Company, prays

that a writ of certiorari issue to review a decision of the United

States Court of Claims.

OPINIONS BELOW

The majority and concurring opinions of the Court of

Claims, unofficially reported at 79-2 USTC { 9633, are set forth

in Appendix A, pp. Al-A26, infra. The opinion of the Tria!

Judge together with the findings of fact are unofficially reported

at 78-1 USTC 99374. The Court of Claims’ brief order

amending those findings is set forth in Appendix B, pp. B1-B2,

infra.

2

JURISDICTION

The decision of the Court of Claims was entered on

October 17, 1979. (Appendix A, p. Al, infra.) The jurisdiction

of this Court is invoked under 28 U.S.C. § 1255(1).

QUESTION PRESENTED

Whether, as the court below held, a taxpayer must dis-

charge the “very difficult, perhaps impossible” burden of

proving that the operations of other comparable companies are

not merely similar but essentially identical to those of its foreign

marketing subsidiary in order to obtain relief from allocations

made by the Internal Revenue Service in violation of the

Treasury Regulation that governs the manner by which income

may be allocated between companies under common control.

STATUTE AND REGULATIONS INVOLVED

Section 482 of the Internal Revenue Code, 26 U.S.C.

§ 482, and Treas. Reg. § 1.482-2(e), 26 CFR § 1.482-2(e),

which authorize and govern the allocation of income between

companies under common control, are reproduced in Anpendix

C hereto, pp. C1-C12, infra.

STATEMENT

In order to increase its sales in Europe and the British

Commonwealth countries, petitioner in 1959 established a

wholly-owned Swiss subsidiary, Du Pont International, S.A.

(“DISA”) to provide central management and advanced mar-

keting capability to its sales effort. 78-1 USTC { 9374, at

83,941. The success of this strategy is reflected in the dramatic

increase in sales of petitioner’s products for which DISA was

responsible.' As the court found, ““DISA was created to serve

1In 1958, the last full year before DISA’s creation, petitioner had

$58.9 million in sales in DISA’s territory. In 1960, DISA’s first full

year of operation, sales totalled $105.6 million. 78-1 USTC § 9374, at

83,947.

+. an rel

BEE oe

3

legitimate commercial objectives and . . . its operations benefit-

ed plaintiff's effort to successfully market its proprietary prod-

ucts in Europe,” and “sales of Du Pont products in the

Common Market area would not have achieved the levels that

were attained with DISA’s participation.” Jd. at 83,945, 83,951.

Among DISA’s tasks were the creation of new demand for

various of petitioner’s products, and policing widespread fraud

by local distributors to which petitioner previously had been

subjected—tasks well beyond the function and competence of

normal resellers. Jd. at 83,942-44.

The prices at which DISA purchased its products from

petitioner served to allocate overall sales revenues and profits

between the companies. This allocation, in turn, determined

their respective income tax liabilities, both in the United States

and abroad. At the time, 1959, the regulation under Section

482 of the Internal Revenue Code required that the income of

each related company be what it would have earned from arm’s

length transactions, but offered no specific allocation formula:2

However, a close analogue existed in Treas. Reg. § 1.863-

3(b)(2), dealing with intra-company allocations for purposes

of determining foreign source income. This regulation in

substance approves the assignment of a minimum of 50 percent

of the combined taxable income to the taxpayer’s selling

branch.

Guided by this regulation, petitioner set prices to allow

DISA 50 percent of the anticipated net profits calculated on the

basis of marginal cost. Jd. at 83,938-39. As matters turned out,

in 1959 and 1960 DISA received only about a third of such

218 Fed. Reg. 5886 (1953). This regulation was promulgated

under Section 45 of the Internal Revenue Code of 1939, but continued

in effect after the 1954 recodification. 26 U.S.C. § 7807.

The only decided case on the pricing question had approved

pricing between related companies based on manufacturer’s cost plus

10 percent, Polak’s Frutal Works, Inc., 21 T.C. 953, 964, 974 (1954).

The Service acquiesced in this decision, 1955-1 C.B. 6, but the

acquiescence was withdrawn on the eve of the trial of this case, 1972-2

C.B. 4. Under this formula, prices to DISA would have been

substantially lower and its profits accordingly much higher than they

were under the formula actually used.

4

profits, which amounted to 48.3 and 57.1 percent, respectively,

of the aggregate profits on a full cost basis. (P. A6, infra; 78-1

USTC 99374, at 83,941.)

In audits of petitioner’s 1959 and 1960 returns, the Service

claimed that petitioner had reported less income than it would

have received had it dealt with an unrelated reseller and

allocated virtually all of DISA’s 1959 income and almost three

quarters of its 1960 income to petitioner. These allocations

effectively reduced DISA’s share of total profits from about 50

percent to 15 perceit on a full cost basis.4

Petitioner paid the resulting deficiencies and brought these

refund actions in 1966. Thereafter, in 1968, the Treasury

promulgated a regulation under Section 482 prescribing three

specific methods for allocating income and made the regulation

effective retroactively. Treas. Dec. 5952, 1968-1 C.B. 218.

A long trial ending in June 1973 produced extensive data

on financial arrangements between unrelated manufacturers

and resellers.5 The Government, however, did not attempt to

3 DISA’s 1959 income was $3,073,000 of which $2,927,014 was

allocated to petitioner. DISA’s 1960 income was $20,400,000 of

which $15,066,558 was allocated to petitioner. 78-1 USTC { 9374, at

83,912, 83,947.

4 The Service limited DISA’s 1959 income to petitioner’s average

administrative and selling expenses in the United States expressed as

a percent of sales, plus DISA’s advertising expenses, plus 15 percent

of DISA’s outside advertising expenses. 78-1 USTC § 9374, at 83,912.

The method used for 1960—and for every year since—was to

limit DISA to the average pre-tax net profit, expressed as a percentage

of sales, that was earned by 39 companies whose tax returns provided

the basis for certain data set forth under the heading “United States

Wholesalers of Drugs, Chemicals and Allied Products” in the Source

Book of Statistics of Income for 1960, which is compiled from income

tax returns filed with the Service. See 78-1 USTC ¥ 9374, at 83,912.

5 Some of these transactions involved petitioner or DISA; many

involved neither. Some involved transactions in DISA’s territory.

Most, however, involved purchases for resale within the United States.

See 78-1 USTC ¥ 9374, at 83,952-61.

5

support the Service’s allocation methods but offered proof,

unrelated to the regulation, which allegedly showed that DIS-

A’s net profits as a percent of sales and its percentage return on

invested capital were excessive. 78-1 USTC ] 9374, at 83,961-

72.

In April 1978 the Trial Judge issued his opinion, holding

the latter evidence to be irrelevant under the regulation. Jd. at

83,910. He further held that the “resale price method”—the

second of the regulatory methods—had to be used and that

undisputed evidence showed that DISA’s gross profit margin,

the critical factor in the application of this method, compared

favorably to that normally earned by the most similar inde-

pendent resellers. Jd. at 83,909. Nevertheless, the Trial Judge

held against petitioner on the sole ground that petitioner had

failed to show an adjustment to DISA’s gross profit margin

that, in his view, was necessary to account for what he

“presumed” to be an absence of normal entrepreneurial risk in

DISA. Id. at 83,910.

On review, although the Court of Claims ruled for the

Government, it largely discarded the Trial Judge’s analysis.

The court held that the arm’s length transactions considered by

the Trial Judge were not sufficiently identical to those between

petitioner and DISA to warrant the comparisons mandated by

the regulation, thus relegating to total irrelevance the bulk of

the evidence. In sustaining the allocations made by the Service,

the court did not look to the methods used, as required by the

regulation, but took a “broad brush approach” in finding that

the results fell within a “zone of reasonableness” based on the

net profits and return on capital data that had been rejected by

the Trial Judge. (P. A21, infra.) These data in part were taken

from the evidence relating to the operations of the same

resellers which the court rejected as not sufficiently comparable

for application of the resale price method.

Petitioner was faulted for failing to come forward with

evidence of transactions between unrelated parties involving

the same products, geography and level of sales expenses as

6

were involved in DISA’s resales of petitioner’s products, even

though the parties and the Trial Judge had agreed that years of

intense litigation had disclosed no such precise arm’s length

analogue. (P. All, infra.) The court further held that the

petitioner could not use as evidence the IRS Source Book of

Statistics of Income, although it sustained the 1960 allocation

that the Service made on the basis of the Source Book.¢ In so

doing, the court questioned whether any taxpayer in petitioner’s

position could sustain the burden of proof that it believed the

regulation imposes on a taxpayer challenging a Section 482

reallocation. (Pp. A8, A18, infra.)

REASONS FOR GRANTING THE WRIT

The decision below so seriously misapplies the governing

regulation as to leave the Internal Revenue Service with

effectively unrestrained discretion to reallocate income resulting

from sales between manufacturers and their marketing affil-

iates. The decision conflicts with pertinent legislative history

and is at odds with decisions of the circuit courts and the Tax

Court interpreting Section 482. See, e.g., United States Gypsum

Co. v. United States, 452 F.2d 445 (7th Cir. 1971); PPG

Industries, Inc., 55 T.C. 928 (1970). This disarray in the

decisions of the lower courts introduces confusion into an area

of tax law where Congress has expressly directed clarity and

predictability, and renders impossible the orderly planning of

transactions. This important area of the law plainly requires

the review and clarification that only this Court can provide.

1. The decision of the court below sustaining the Service’s

reallocation of nearly all of DISA’s income to petitioner is so

clearly erroneous that customary standards for the adminis-

tration of justice call for correction by this Court.

Treas. Reg. § 1.482-2(e) provides three separate methods

for applying the arm’s length standard of Section 482 to sales

6 See p. 4, n.4, supra.

6 nan ie aiinced nla

7

between related companies, and mandates resort to each in a

stated order of priority. The first, the ““comparable uncontrolled

price” method, must be applied where there is evidence of

arm’s length transactions involving property and circumstances

which are “identical” to those of the controlled sale or “so

nearly identical” that any difference can be reflected by a

reasonable number of adjustments to the price. Treas. Reg.

§ 1.482-2(e)(2)(ii). When this standard cannot be met, the

resale price method “must be used” if specified circumstances

exist. Treas. Reg. § 1.482-2(e)(1)(ii). The “cost plus”

method is third, and comes into play only where neither of the

first two methods can be applied. Jd. Only where none of these

three methods can reasonably be applied may some other

“appropriate” method of pricing be used, a practice loosely

referred to as the “fourth” method. Treas. Reg. § 1 482-

2(e)(1)(ili).

The court below held the first method inapplicable in this

case (p. Al0O, infra), and therefore turned to the resale price

method. Under this method, petitioner may charge DISA that

price which gives DISA a gross profit margin’ equal to that

earned by the “n >st similar” independent reselling companies.

See Treas. Reg. § 1.482-2(e)(3); p. Al0, infra. The regulation

authorizes “adjustment” to this figure to reflect such “material

differences ... in functions or circumstances” between the

controlled and the uncontrolled purchases and resales as have

“a definite and reasonably ascertainable effect on price.” Treas.

Reg. § 1.482-2(e)(3)(ix). Although it accepted the Trial

Judge’s findings that the circumstances of this case are those

where the regulation states ““[t]he resale price method must be

7 The regulation uses the phrases “gross margin” and “markup

percentage” interchangeably. Treas. Reg. §1.482-2(e)(3)(vi).

8

used,” the court below, unlike the Trial Judge, concluded that

the record did not allow use of that method. (P. A18, infra.)

The court’s refusal to apply the resale price method was

based upon its conclusion that the arm’s length transactions

canvassed in the evidence were not sufficiently identical to those

between DISA and petitioner to warrant comparison. (P. Al2-

A15, infra.) This constitutes a fundamental error in the appli-

cation of the regulation. It is quite clear from the regulation

that the existence of identical, or near-identical, arm’s length

transactions is not a requisite of the resale price method. On the

contrary, the existence of such transactions would preclude

application of this method and require use of the comparable

uncontrolled price method. Treas. Reg. § 1.482-2(e)(2)(i1).

Since the resale price method comes into play only where

identical transactions cannot be found, the regulations import a

much less precise standard of comparability into this method by

calling only for a decision based on arm’s length transactions

that are “most similar” to the transaction under review. Treas.

Reg. § 1.482-2(e)(3)(vi). This approach of the regulation is

reflected in the contemporaneous analysis of Professor Surrey,

then the Treasury official responsible for the regulation, who

observed in a widely circulated article that the regulatory

methods were not expected to produce “absolute or precise

answers.” Surrey, Treasury’s Need to Curb Tax Avoidance in

Foreign Business Through Use of 482, 28 J. Tax. 75, 76, 77

(1968).

The regulation and its history, moreover, specifically reject

the bases on which the court refused to apply the resale price

method. The regulation states that differences in product sold

8 The regulation requires use of this method whenever there are

no comparable uncontrolled sales, the controlled reseller (in this case,

DISA) resells the property within a reasonable time at an ascertain-

able price, and the reseller has not added more than an insubstantial

amount to the value of the property by physically altering the product

before sale or by the use of intangible property. Treas. Reg. § 1.482-

2(e)(3)(ii); see 78-1 USTC ¥ 9374, at 83,942-43, 83,947-49, and p.

Al0, infra.

iii iiss asters crc rantiw tess «

9

or in geographical area served do not preclude use of the resale

price method. The regulation also provides for the use of

statistical averages for an industry where better data are not

available.? The Service has expressly instructed its agents that

“identical comparables” are not required, that they should “use

the best estimate available,” and that they should use data from

the Service’s Source Book in applying the regulatory methods. 10

The history of the regulation, moreover, shows that the Treas-

ury specifically considered and rejected net profits and oper-

ating expenses as pricing criteria under the resale price method.

Nonetheless, the court below relied on such data in concluding

that the operations of independent resellers were not suffi-

ciently comparable to those of DISA to warrant use of that

method."

The assertion of the court that petitioner failed to show

“adjustments” to arm’s length price to reflect any “material

differences” between DISA and uncontrolled resellers (pp.

A15-A18, infra) misconceives the limited scope of the adjust-

ments contemplated by the regulation. The regulation calls for

adjustments only for those differences between the controlled

and the uncontrolled resales that are “material” and that have a

“definite and reasonably ascertainable effect on price.” Treas.

Reg. § 1.482-2(e)(3)(ix). This contemplates that normally

there will be no adjustment in the absence of proof that the

difference is in fact material. No such showing was made in this

case, and the court fails to explain how the differences it cites

can be said to have a “reasonably ascertainable effect on price.”

Id. In any case, the record indicates that insofar as DISA

9 Treas. Reg. § 1.482-2(e)(3).

10 Internal Revenue Manual—Audit Techniques—International

Enforcement Program 623.8(4), 623.9(2), ex. 600-3, B.5.b.

11 As proposed in 1966, the regulation included net profits as a

standard secondary to, and corroborative of, gross profits in the

application of the resale price method. See Proposed Regs. § 1.482-

2(e)(3)(ili), 31 Fed. Reg. 10,394, 10,404 (1966). Even that limited

role for net profits was stricken from the regulation as finally adopted.

10

differed from the uncontrolled resellers, its functions and re-

sponsibilities were greater, thus justifying, if anything, a higher

gross margin. (See pp. 2-3, supra.)

The court’s serious misreading of the governing regulation

is reflected in two further aspects of its decision. The regulation

clearly governs the conduct of the Service in the administration

of Section 482, as well as that of the taxpayer. At no time,

however, has the Service attempted to use the pricing methods

prescribed in the regulations in connection with the allocation

in this case.12 The court not only condoned the Service’s refusal

to obey the regulations, it went on to devise a wholly novel

standard by which to uphold the allocations in question.

The “‘zone of reasonabieness” criterion by which the court

judged the results of the disputed allocations bears not the

remotest resemblance to a pricing method envisaged by the

regulation. In devising and applying this novel standard, the

court attached no significance whatsoever to the longstanding

use by the Service of the experience of wholesale chemical

companies, as reported in the Source Book, in allocating income

from DISA to petitioner for 1960 and every subsequent year.

In refusing to permit pet’*ioner to invoke, under the resale price

method, the comparisons long used by the Service itself, the

court rejected the salutary principle that in the administration

of the tax code the Service should be held to its own “professed

standard of rationality.” Boston & Maine R.R. v. Commissioner,

206 F.2d 617, 626 (Ist Cir. 1953), cited with approval in

Southern Ry. v. United States, 585 F.2d 466, 472 (Ct. Cl.

1978).

By fashioning so strict a standard of comparison, by

refusing to allow the taxpayer to use the same Source Book data

12Such disregard by Government agencies of their own regu-

lations has been held by this Court to be ground for reversal. See,

e.g., Service v. Dulles, 354 U.S. 363, 388-89 (1957), citing United

States ex rel. Accardi v. Shaughnessy, 347 U.S. 260 (1954).

DN ileal eet cia Nee BA ED Wa

11

on which the Service has relied, and by demanding that the

taxpayer prove the broad negative that there are no material

differences between its subsidiary and independent resellers, the

court below has read the resale price method out of the

regulation. The court, indeed, conceded that the very arrange-

ments between petitioner and DISA made it “very difficult,

perhaps impossible” to rely upon the resale price method. (P.

A8, infra.) Such a result contravenes the language of the

regulation, rejects the Service’s own views of how the regulation

is to be applied and denies the validity of the Service’s own

Source Book data while sustaining a reallocation that rests on

the application of a legally incorrect method to that very same

data. The court’s decision frustrates the use of the regulatory

methods not only in litigation but in the orderly process of tax

planning that is designed to minimize the necessity for litiga-

tion. See Fuller, Problems in Applying the 482 Intercompany

Pricing Regs. Accentuated by Du Pont Case, 52. J. Tax. 10 (Jan.

1980) (critiquing the opinion below).

2. The reading given the Treasury Regulation by the court

below conflicts with the congressional directive pursuant to

which those regulations were drafted. In 1962, the House of

Representatives passed an amendment to Section 482 providing

specific guidelines for allocating income thereunder. In agreeing

to the deletion of this amendment, the House-Senate Confer-

ence Committee specifically directed the Treasury to adopt

regulations which would provide “additional guidelines and

formulas for the allocation of income and deductions in cases

involving foreign income.” Conf. Rep. No. 2508, 87th Cong. 2d

Sess. 19, reprinted in, [1962] U.S. Code Cong. & Ad. News

3732, 3739.

The Treasury promulgated the current regulation in re-

sponse to this congressional mandate. As Professor Surrey

explained, deviation from the three regulatory methods “can

hardly be done without allowing a proliferation of described

methods, which in turn reduces the over-all guidance which these

Regulations must develop in order to accomplish their avowed

12

purpose ....” Surrey, Treasury’s Need to Curb Tax Avoidance

in Foreign Business Through Use of 482, 28 J. Tax. 75, 78

(1968) (emphasis supplied ).

As noted by the concurring opinion below, the decision

frustrates the intent of Congress by relieving the Service of the

need to bring its allocation within one of the specified regu-

latory pricing methods and, as in this case, permitting it to

change theories at all levels of the proceedings.'9 This creates

an impenetrable barrier in an action such as this one, unless the

taxpayer can show that one of the specified methods applies.

Yet, the lower court’s restrictive interpretation of the regulation

effectively precludes the taxpayer from reaching such a result.

This interpretation of the regulation removes all mean-

ingful restraint on action of IRS agents in reallocating income

under Section 482. As a result, the types of guidelines to

multinational taxpayers that were contemplated by Congress

are as nonexistent today as they were in 1962 when the

legislative directive was written.

3. Although the opinion below carefully avoids analysis of

the decisions of other courts, it is fundamentally at odds with

the approach taken by courts of appeals and the Tax Court. No

other court has so limited the application of the regulation,

dismissed so readily evidence painstakingly prepared in the

course of years of litigation, or given such uncontrolled dis-

cretion to the Service’s auditing agents.

The pivotal element of the opinion below is the court’s

refusal to look to the gross profit margins enjoyed by dis-

tributors admittedly similar to DISA on the grounds that the

activities and circumstances of these distributors were not

13 The Government’s proclivity for changing theories during the

course of Section 482 proceedings was noted with disapproval in PPG

Industries, Inc., 55 T.C. 928, 991 (1970).

ne me

13

proven to be identical to those of DISA.'4 This view conflicts

with that of the Seventh C. -cuit in United States Gypsum Co. v.

United States, 452 F.2d 445 (7th Cir. 1971), where one of the

questions decided was whether the taxpayer’s shipping subsidi-

ary had charged the taxpayer an arm’s length rate. The court

of appeals affirmed the finding that the rates established by the

parties under common control sufficiently approximated arm’s

length rates, and rejected the Service’s reallocation of income.

As in the present case, the court was faced with a transaction

reflecting the special relationship between parent and subsidi-

ary, with no evidence of precisely comparable arm’s length

transactions. '5 A similar result was reached by the Tax Court in

Cadillac Textiles Inc., 34 TCM 295, 305-06 (1975).

The decision below also is inconsistent with the decisions

of the Seventh Circuit in Baldwin-Lima-Hamilton Corp. v.

United States, 435 F.2d 182, 186 (7th Cir. 1970), and the Tax

Court in PPG Industries, Inc., 55 T.C. 928, 997 (1970). In both

cases the courts based their decisions on evidence that the

division of profits between parent and subsidiary was equiva-

lent to the division of profits that would have taken place in an

14 The differences deemed material by the opinion below were

totally different from those deemed material by the Trial Judge, or,

indeed, the respondent. While the Court of Claims is not constrained

to accept the findings and conclusions of its Trial Judge, this shift in

emphasis underscores the subjective nature of the factors deemed ‘

relevant by the court, and the unfairness of placing the burden upon

the taxpayer to present specific adjustment formulae for whatever

factual differences the court ultimately deems relevant years after the

trial record has closed.

'S The district court in U.S. Gypsum had found: (1) the ships

used by the subsidiary were unique in size and speed; no comparable

ships existed by which an arm’s length rate could be established; (2)

the rate set between taxpayer and its subsidiary expressly disregarded

certain factors that would have been considered material in an arm’s

length transaction; and (3) the subsidiary was assured of all of the

taxpayer’s shipping business, thus avoiding at least some of the risks

an arm’s length shipper would have borne.

14

arm’s length transaction.'6 Petitioner introduced similar evi-

dence, but it was wholly ignored by the opinion below.

The court’s analysis also contrasts sharply with Ross Glove

Co., 60 T.C. 569, 604-06 (1973). There the Tax Court relied on

evidence of industry-wide markup percentages adopted by the

Customs Bureau. The court below, however, refused to accept

industry-wide statistics in the Service’s own Source Book as

evidence of an appropriate gross margin. This conflicts not

only with the position of the Service, which has acquiesced in

Ross Glove, 1974-2 C.B. 4, but also with that of the Fifth

Circuit, which has announced its approval of the case. See

Brittingham v. Commissioner, 598 F.2d 1375, 1381 (Sth Cir.

1979), quoting the Tax Court’s opinion, 66 T.C. 373 (1976).

These clear and essential divergences between the opinion

below and those of other federal courts alone demonstrate that

this Court should resolve at this time the important question of

how Section 482 and its regulation should be interpreted.

4. Few issues of business taxation have greater impor-

tance. Although there is no public information as to the

number of such cases now pending, a 1973 Treasury study

showed that in a two-year period (1968-1969) auditing agents

made adjustments in 174 intercompany pricing cases involving

over $300 million in incOme.'7 The presence of the issue in this

16 See also Fuller, Section 482 Revisited, 31 Tax L. Rev. 475,

512-14 (1976) (courts have made review of the reasonableness of

profit divisions between parent and subsidiary a standard tool in

reviewing price allocations under Section 482); Hammer, Morrione &

Ryan, Concepts and Techniques in Determining the Reasonableness of

Intercompany Pricing Between United States Corporations and Their

Overseas Subsidiaries, 30 N.Y.U. Inst. Fed. Tax. 1407, 1426 (1972)

same).

17 U.S. Treasury Dep’t, Summary Study of International Cases

Involving Section 482 of the Internal Revenue Code 4-6 (1973),

reprinted in, 2 R. Rhoades, Income Taxation of Foreign Related

Transactions 7-89, 7-95, 7-100 (1979). See also, Note, Multinational

(footnote continued)

PCr ECR ERE AR POL 0 OD Cat 6 Ca Pt NORE eo CR het

Bo ee ieee a OU" TAA Boo te os

15

case on the Service’s “prime issue list” indicates its “major

importance” in the administration of the tax laws.18 That the

present case has been chosen as a “test case” by the Govern-

ment only underscores the appropriateness of review by the

Court at this time.

The proliferation of disputes in this area and the poten-

tially dramatic financial consequences attached to them testify

to the unsettled status of the law and the need of business for

reliable guidelines. This is particularly true of corporations that

are engaged in international business and -have special need for

certainty and predictability in the tax rules under which they

operate in order to allow them to plan, adjust to and meet the

demands of laws and business conditions abroad. In this vein,

one commentator has noted that allowing the Service untram-

melled discretion in this area deprives taxpayers of notice of the

standards by which their transactions will be judged, frustrates

tax planning and increases the administrative burdens of the

Internal Revenue Service. Note, Multinational Corporations

and Income Allocation Under Section 482 of the Internal

Revenue Code, 89 Harv. L. Rev. 1202, 1215 (1976). The effect

of the opinion below, in permitting complex transactions to be

restructured years after the fact by exercise of “the almost if not

wholly unreviewable discretion of the Treasury” (p. A26,

infra), is an unwarranted obstacle to the proper interpretation

and administration of Section 482 and the regulation there-

under.

(footnote continued)

Corporations and Income Allocation Under Section 482 of the

Internal Revenue Code, 89 Harv. L. Rev. 1202, 1213 & n.54 (1976).

It is impossible to determine from publicly available data how

many of the hundreds of pending cases under Section 482 involve

intercompany pricing problems.

18 The Service’s National Office List of Prime Issues is a summary

of “legal questions of major importance” in the administration of the

internal revenue laws that the Service wishes to test in litigation.

Internal Revenue Manual 4555.2(1) and 1277.8.

16

CONCLUSION

The petition for a writ of certiorari should be granted.

Respectfully submitted,

DANIEL M. GRIBBON

HARRIS WEINSTEIN

MICHAEL R. LEvy

ALEX KOZINSKI

Covington & Burling

888 Sixteenth Street, N.W.

Washington, D.C. 20006

Attorneys for Petitioner

Of Counsel:

Roy A. WENTZ

THOMAS M. Russo

Tenth and Market Streets

Wilmington, Delaware 19898

January 15, 1980

A-1

APPENDIX A

IN THE

UNITED STATES COURT OF CLAIMS

Nos. 256-66, 371-66

(Decided October 17, 1979)

E.I. DU PONT DE NEMOURS AND COMPANY V. THE

UNITED STATES

Daniel M. Gribbon, attorney of record, for plaintiff. Harris

Weinstein, Coleman S. Hicks, Michael R. Levy, Roy 4. Wentz,

William F. Loftus, Thomas M. Russo, and Covington & Burling,

of counsel.

Gilbert W. Rubloff, with whom was Assistant Attorney

General M. Carr Ferguson, for defendant. Theodore D. Peyser

and Donald H. Olson, of counsel.

Before FRIEDMAN, Chief Judge, Davis, NICHOLS,

K ASHIWA, KUNZIG, BENNETT, and SMITH, Judges, en banc.

OPINION

Davis, Judge, delivered the opinion of the court:

Taxpayer Du Pont de Nemours, the American chemical

concern, created early in 1959 a wholly-owned Swiss marketing

and sales subsidiary for foreign sales—Du Pont International

S.A. (known to the record and the parties as DISA). Most of

A-2

the Du Pont chemical products marketed abroad were first sold

by taxpayer to DISA, which then arranged for resale to the

ultimate consumer through independent distributors. The

profits on these Du Pont sales were divided for income tax

purposes between plaintiff and DISA via the mechanism of the

prices plaintiff charged DISA. For 1959 and 1960 the Commis-

sioner of Internal Revenue, acting under section 482 of the

Internal Revenue Code which gives him authority to reailocate

profits among commonly controlled enterprises, found these

divisions of profits economically unrealistic as giving DISA too

great a share. Accordingly, he reallocated a substantial part of

DISA’s income to taxpayer, thus increasing the latter’s taxes for

1959 and 1960 by considerable sums. The additional taxes

were paid and this refund suit was brought in due course. Du

Pont assails the Service’s reallocation, urging that the prices

plaintiff charged DISA were valid under the Treasury regu-

lations implementing section 482. We hold that taxpayer has

failed to demonstrate that, under the regulation it invokes and

must invoke, it is entitled to any refund of taxes.

I. Design, Objectives and Functioning of DISA‘

A. Du Pont first considered formation of an international

sales subsidiary in 1957. A decreasing volume of domestic

sales, increasing profits on exports, and the recent formation of

the Common Market in Europe convinced taxpayer’s president

of the need for such a subsidiary. He envisioned an inter-

national sales branch capable of marketing Du Pont’s most

1We adopt (with minor modifications) Trial Judge Willi’s

findings of fact (see our order of this date). Because of their length

the findings are not reproduced with this opinion. Plaintiff has

requested numerous changes in the findings, almost all designed to

down-grade the trial judge’s findings with respect to (a) taxpayer's

purpose to allocate as much income as possible to DISA, (b)

taxpayer’s establishment of a pricing system for sales to DISA

designed to further that objective, and (c) the aspects and functioning

of DISA which differentiate it from other selling and merchandising

agencies. We are satisfied, however, that the trial judge’s findings

properly reflect the evidence on these points.

wey Oe pee ane —"

A Diath ae le

POT Gere ee ey TAM Tee Een ae en eek aan

A-3

profitable type of products—Du Pont proprietary products,

particularly textile fibers and elastomers? specially designed for

use as raw materials by other manufacturers. Du Pont had

utilized two major marketing techniques to sell such customized

products. One mechanism consisted of technical sales services:

an elaborate set of laboratory services making technical im-

provements, developing new applications, and solving customer

problems for Du Pont products. The other was “indirect

selling,” a method of promoting demand for Du Pont products

at every point in the distribution chain. These two techniques

were to be developed by DISA, Du Pont’s international branch

in Europe. DISA was not to displace plaintiffs set of independ-

ent European distributors, but rather to augment the dis-

tributors’ efforts by the two marketing methods and to police

the independents adequately.

B. Neither in the planning stage nor in actual operation

was DISA a sham entity; nor can it be denied that it was

intended to, and did, perform substantial commercial functions

which taxpayer legitimately saw as needed in its foreign

(primarily European) market. Nevertheless, we think it also

undeniable that the tax advantages of such a foreign entity were

also an important, though not the primary, consideration in

DISA’s creation and operation. During the planning stages,

plaintiff's internal memoranda were replete with references to

tax advantages, particularly in planning prices on Du Pont

goods to be sold to the new entity. The tax strategy was simple.

If Du Pont sold its goods to the new international subsidiary at

prices below fair market value, that company, upon resale of

2 An elastomer is “an elastic rubberlike substance (as a synthetic

rubber or a plastic) having some of the physical properties of natural

rubber.” WEBSTER’S THIRD INTERNATIONAL DICTIONARY 730 (una-

bridged ed. 1968).

3 Du Pont also had several other types of products which did not

require the specialized sales effort contemplated for DISA. These

products included direct “commodity-type” goods (such as household

paints) or standard chemical products (e.g., sulphuric acid ).

A-4

the goods, would recognize the greater part of the total profit

(i.e., manufacturing and selling profits). Since this foreign

subsidiary could be located in a country where its profits would

be taxed at a much lower level than the parent Du Pont would

be taxed here, the enterprise as a whole would minimize its

taxes. Cf. Baldwin-Lima-Hamilton Corp. v. United States, 435

F.2d 182, 184 (7th Cir. 1970). The new company’s accumu-

lated profits would be used to finance further foreign in-

vestments. The details of this planning are set forth in the

findings, and they leave us without doubt that a significant

objective of plaintiff was to create a foreign subsidiary which

would be able to accumulate large profits with which to finance

Du Pont capital improvements in Europe.‘

4Du Pont is divided into a series of semi-autonomous depart-

ments which report to the Executive Committee. An early draft of a

memorandum on this subject to the Executive Committee from the

international Department (then known as the Foreign Relations

Department) stated that the Treasury Department (responsible for

Du Pont’s tax planning) was considering the possibility of a “transfer

of goods to a tax haven subsidiary at prices less than such transfers

would be made to other subsidiaries or industrial Depart-

ments * * * *” A memorandum from the Treasury Department re-

- viewed the possibility of an IRS attack on such pricing and concluded:

“It would seem to be desirable to bill the tax haven

subsidiary at less than an ‘arm’s length’ price because: (1) the

pricing might not be challenged, by the revenue agent; (2) if the

pricing is challenged, we might sustain such transfer; (3) if we

cannot sustain the prices used, a transfer price will be negotiated

which should not be more than an ‘arm’s length’ price and might

well be less; thus we would be no worse off than we would have

been had we billed at the higher price.”

A subsequent Treasury Department report on “Use of a Profit

Sanctuary Company by the Du Pont Company” advised pricing goods

to the “profit sanctuary” at considerably lower levels than other

intercorporate sales, suggesting that such prices could probably be

sustained against an IRS challenge. In the spring of 1958, an

International Department memorandum stated that the principal

advantages of a “profit sanctuary trading company” (dubbed by its

initials as a “PST company”) depended “largely upon the amount of

(footnote continued)

A-5

C. Consistently with that aim. nlaintiffs prices on its

intercorporate sales to DISA were deliberately calculated to

give the subsidiary the lion’s share of the profits. Instead of

allowing each individual producing department to value its

goods economically and to set a realistic prices Du Pont left

pricing on the sales to DISA with the Treasury and Legal

Departments. Neither department was competent to set an

economic value on goods sold to DISA, and no economic

(footnote continued)

profits which might be shifted (through selling price) from Du Pont

to the ‘PST company.’” The report concluded that Du Pont could

find “‘a selling price sufficiently low as to result in the transfer of a

substantial part of the profits on export sales to the ‘PST company.’ ”

A corporate task force selected Switzerland as the best location for the

foreign trading subsidiary, principally because of Swiss tax incentives.

The two industrial departments expected to provide the main source

of DISA’s sales were not overly enthusiastic about a new layer of

company organization. However, both departments agreed to forma-

tion of DISA for tax reasons. The Elastomer Department concluded:

“The decisive factor in our support of the organization is the potential

tax saving.” The Textile Fibers Department recognized that tax

considerations “will command the establishment of lowest practical

transfer prices from the manufacturing subsidiaries to Du Pont Swiss

{ DISA] * * * *” A memorandum to the Executive Committee in late

1958 (shortly before the Committee approved DISA) spoke of the

modest mark-up (emphasis in original) of goods sold to the foreign

trading subsidiary. A prior draft of the memorandum used the phrase

“the ‘artificially’ low price.”

5 The individual industrial departments which manufactured

goods sold to DISA had little reason to care about the pricing of such

goods. Under a special accounting system DISA was ignored in

computing departmental earnings, bonuses, etc. All profits from

DISA were attributed to the department manufacturing the respective

goods. This internal treatment of DISA’s profits conflicted with Du

Pont’s standard practice of treating each subsidiary as a distinct profit

center.

A-6

correlation of costs to prices was attempted.6 Rather, an official

of the Treasury Department established a pricing system de-

signed to leave DISA with 75 percent of the total profits. If the

goods’ cost was greater than DISA’s selling price, the depart-

ment would price the item at its cost /ess DISA’s selling

expense. This latter provision was designed to insulate DISA

from any loss. On the whole, the pricing system was based

solely on Treasury and Legal Department estimates of the

greatest amount of profits that could be shifted to DISA without

evoking IRS intervention.’

As it turned out, for the taxable years involved here, 1959

and 1960, the actual division of total profits between plaintiff

and DISA was closer to a 50-50 split. In 1959 DISA realized

48.3 percent of the total profits, while in 1960 its share climbed

to 57.1 percent. This departure from the original plan was the

result of the omission of certain intercorporate transfers—a

result not contemplated in the initial pricing scheme.

D. In operation, DISA enjoyed certain market advantages

which helped it to accumulate large, tax-free profits. For its

technical service function, the subsidiary did not develop its

own extensive laboratories (with resulting costs and risks), but

could rely on its parent’s laboratory network in the United

States and England. DISA was not required to hunt intensively

(or pay as highly) for qualified personnel, since in both 1959

and 1960 it drew extensively on its parent’s reservoir of talent.

The international company’s credit risks were very low, in part

because of a favorable trade credit timetable by Du Pont.

DISA also selected its customers to avoid credit losses, having a

bad debt provision of less than one-tenth of one percent of

sales. Unlike other distributor or advertising service agencies,

6 The responsible official did not solicit the views of the manufac-

turing departments as te an appropriate pricing system.

7 Finding 71 summarizes the testimony of the key Treasury

Department official, who conceded he would have set prices sc as to

shift 99 percent of total profits to DISA if he had thought such an

allocation would have survived IRS scrutiny.

A-7

DISA, because of its special relationship to the Du Pont

manufacturing departments, had relatively little risk of termina-

tion. And as explained supra, Du Pont’s pricing formula was

intended to insulate DISA from losses on sales.?

In operating DISA, Du Pont also maximized its subsidi-

ary’s income by funneling a large volume of sales through

DISA which did not call for large expenditures by the latter.

Many of the products Du Pont sold through DISA required no

special services, or already had ample technical services pro-

vided. Du Pont routed sales to Australia and South Africa

through DISA although the latter provided no additional

services to sales in these non-European countries. DISA made

sales of commodity-type products and opportunistic spot sales

to competitors temporarily short in a raw material, although

neither type of sale required DISA’s specialized marketing

expertise. Du Pont also routed all European sales of elastomers

through DISA, even though the parent had a well-established

English subsidiary which had all the necessary technical ser-

vices and marketing ability.

E. We have itemized the special status of DISA—as a

subsidiary intended and operated to accumulate profits without

much regard to the functions it performed or their real worth

—not as direct proof, in itself, supporting the Commissioner’s

reallocation of profits under Section 482, but instead as suggest-

ing the basic reason why plaintiff's sales to DISA were unique

8 Du Pont’s individual Industrial Departments could terminate

sales with DISA, and two smaller departments did terminate. How-

ever, there is no evidence that Du Pont as an entity, particularly the

important Elastomer and Textile Fiber Departments, would have

seriously considered terminating DISA, a child of their own creation.

Further, any such termination would have imposed less financial risk

to DISA than for an independent distributor.

9In actual fact, the pricing system malfunctioned to some extent

and DISA incurred some minor losses. As in the case of profit

allocation (see supra), this discrepancy was the product of a mis-

calculation in selling costs for a few low-volume goods. The design of

Du Pont’s pricing policy was to prevent any loss.

A-8

and without any direct comparable in the real world. As we

shall see in Part II; infra, taxpayer has staked its entire case on

proving that the profits made by DISA in 1959 and 1960 were

comparable to those made on similar resales by uncontrolled

merchandizing agencies. DISA’s special status and mode of

functioning help to explain why that effort has failed. It is not

that there was anything “illegal” or immoral in Du Pont’s plan;

it is simply that that plan made it very difficult, perhaps

impossible, to satisfy the controlling Treasury regulations under

Section 482.10

II. Section 482 and the “Resale Price Method” of

Allocating Profits.

A. Section 48211 gives the Secretary of the Treasury (or his

delegate) discretion to allocate income between related corpo-

rations when necessary to “prevent evasion of taxes or clearly to

reflect the income” of any of such corporations. The legislative

history parallels the general purpose of the statutory text to

prevent evasion by “improper manipulation of financial ac-

counts”, “arbitrary shifting of profits,” and to accurately reflect

“true tax liability.” See H.R. Rep. No. 350, 67th Cong., Ist

10 The regulations make it clear (§ 1.482—1(c)) that they apply,

not only to sham, fraudulent, or shady cases, but “to any case in which

either by inadvertence or design the taxable income, in whole or in

part, of a controlled taxpayer, is other than it would have been had

the taxpayer in the conduct of his affairs been an uncontrolled

taxpayer dealing at arm’s length with another uncontrolled taxpayer.”

11“Sec. 482. Allocation of income and deductions among tax-

payers.

In any case of two or more organizations, trades, or businesses

( whether or not incorporated, whether or not organized in the United

States, and whether or not affiliated) owned or controlled directly or

indirectly by the same interests, the Secretary or his delegate may

distribute, apportion, or allocate gross income, deductions, credits, or

allowances between or among such organizations, trades, or busi-

nesses, if he determines that such distribution, apportic. ment, or

allocation is necessary in order to prevent evasion of taxes or clearly to

reflect the income of any of such organizations, trades, or businesses.”

A-9

Sess. 14 (1921) (section 240(d) of 1921 Act); S.REp. No. 275,

67th Cong., Ist Sess. 20 (1921) (same section); H.R. Rep. No.

2 70th Cong., Ist Sess. 16 (1928) (predecessor section to §

482); Young & Rubicam, Inc. v. United States, 187 Ct. Cl. 635,

654, 410 F.2d 1233, 1244 (1969). See generally BiTTKER &

EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND

SHAREHOLDERS, {| 1506 (4th ed. 1979) (hereinafter BITTKER &

EusTice). The overall aim is to enable the IRS to treat

controlled taxpayers as if they were uncontrolled. See Eli Lilly

& Co. v. United States,178 Ct. Cl. 666, 372 F.2d 990 (1967);

Young & Rubicam, Inc. v. United States, supra; Morton-

Norwich Products, Inc. v. United States, Ct. Cl. No. 83-77, (July

18, 1979). 12

B. We do not, however, have the inital problem of

considering this case on the words of Section 482 alone, or on

comparable broad criteria. In 1968 the Secretary of the Trea-

sury issued revised regulations governing action under the

statute, and setting forth rules for certain specific situations.

Treas. Reg. § 1.482-1, et seg. These regulations, which were

issued before the trial here, were made retroactive to cover the

taxable years before us (1959-1960) and both sides agree that

the regulations must control. In some quarters these regulations

have been faulted as not giving enough meaningful guidance in

specific situations, or as being too narrow in the specific

situations they do cover, but there is here no challenge to the

validity of the regulations and we have to apply them as they

are, with fidelity to both their words and their spirit.

For sales of tangible goods, the directive mandates

determination of an arm’s length price for sale by one con-

trolled entity to the other, and then sets out (in order of

preference) four methods for calculating such an arm’s length

price: the comparable uncontrolled price method, the resale

price method, the cost plus method, and any other appropriate

12In this case there is, of course, no question that the two

organizations involved were controlled by the same interests.

A-10

method. The parties correctly agree upon the inapplicability of

the comparable uncontrolled price method (which calls for

comparison with an uncontrolled sale of an almost identical

product). Plaintiff makes no argument as to the possible

application of the cost plus method. Instead it posits its whole

case on the resale price method (Treas. Reg. § 1.482-

2(e)(3))—which we now consider. '3

.C. Essentially, the resale price method reconstructs a fair

arm’s length market price by discounting the controlled resel-

ler’s selling price by the gross profit margin (or markup

percentage) rates of comparable uncontrolled dealers.'4 Thus,

if DISA’s gross profit margin for resale was 35% and the

prevailing margin for comparable uncontrolled resellers was

25%, the Commissioner could reallocate 10% of DISA’s gross

income. But the vital prerequisite for applying the resale price

method is the existence of substantially comparable uncon-

trolled resellers. Subpart (vi) of Section 1.482-2(e)(3) requires

determination of the “most similar” resale or resales, consid-

ering the type of property, reseller’s functions, use of any

intangibles, and similarity of geographic markets. 15 Cases which

_ have considered the regulation uniformly require substantial

13 The provisions of the Treasury Regulation on the resale price

method are reproduced in the Appendix, infra.

14Subpart (vi) of Section 1.482—2(e)(3) declares that the

proper markup, described as “the appropriate markup percentage,” is

“equal to the percentage of gross profit (expressed as a percentage of

sales) earned by the buyer (reseller) or another party on the resale of

property which is both purchased and resold in an uncontrolled

transaction, which resale is most similar to the applicable resale of the

property involved in the controlled sale.”

1S Subpart (vii) directs that, “[w]henever possible markup

percentages should be derived from uncontrolled purchases and resale

of the buyer (reseller) involved in the controlled sale [here, DISA]

* ** In the absence of [such] resales by the same buyer (reseller)

* * * evidence of an appropriate markup percentage may be derived

from resales by other resellers selling in the same or a similar market

in which the controlled buyer (reseller) is selling, providing such

resellers perform comparable functions.” [emphasis added ]

CRSA a FOR LR PEF LIRR EY

A-11

comparability. See, e.g.. Woodward Governor Co. v. Commis-

sioner, 55 T.C. 56, 65 (1970) (resale price method applicable

only when evidence shows uncontrolled purchases and resales

by same or similar reseller); American Terrazzo Strip Co. v.

Commissioner, 56 T.C. 961, 972-73 (1971) (uncontrolled sales

must be comparable in terms of similar goods and circum-

stances of sale); Edwards v. Commissioner, 67 T.C. 224, 236

(1976) (rejecting use of industry gross profit statistic when no

evidence that such sales were comparable to taxpayer). Com-

mentators agree on the need for close similarity of uncontrolled

sales, and some criticize the regulation when no uncontrolled

sales by the same party exist. See, Fuller, Section 482 Revisited,

31 Tax L. Rev. 475, 505-07, 510-11 (1976); Jenks, Treasury

Regulations under Section 482, 23 Tax LAyYwer 279, 310

(1970) [hereinafter cited as Jenks]; Note, Multinational Cor-

porations Income Allocation under Section 482 Of the Internal

Revenue Code. 89 Harv. L. Rev. 1202, 1220 (1976). It is quite

plain from the text of the regulation itself that the evident

purpose for the use of the particular resale price method, as set

forth in the regulation, is to proffer a relatively precise. mecha-

nism for determining a realistically comparable, uncontrolled,

arm’s-length resale price—not to leave the taxpayer, the Ser-

vice, or the courts to grope at large for some figure drawn out of

overly general indices or statistics.

The common starting point for our search in this case for a

comparable meeting the requirements of the regulation is our

finding 101 which states: “The parties agree, and their agree-

ment is supported by the record, that there is not known to

exist, presently or heretofore, an independent organization

circumstanced as DISA was during the period in suit and

performing the marketing functions that were assigned to it by

plaintiff.” That being so, the regulation requires us (§ 1.482-

2(e)(3) (vi) (a), (b), and (d)) to look for the “most similar”

resales and “in determining the similarity of resales” to consider

>

A-12

as the “most important characteristics” the type of property

sold, the functions performed by the seller with respect to the

property, and the geographic market in which the functions are

performed by the reseller. There is also special stress on the

performance of “comparable functions” by the seller making

the “most similar” resales. See subpart (vi).

Taxpayer tells us that a group of 21 distributors, whose

general functions were similar to DISA’s, provides the proper

base of comparison.'6 Beyond the most general showing that

this group, like DISA, distributed manufactured goods, there is

nothing in the record showing the degree of similarity called for

by the regulation. No data exist to establish similarity of

products (with associated marketing costs), comparability of

functions, or parallel geographic (and economic) market condi-

tions. Rather, the record suggests significant differences. De-

fendant has introduced evidence that the six companies plaintiff

identifies most closely with DISA all had average selling costs

16 The twenty-one companies were selected by defendant from a

group of 32 businesses. Defendant chose the 32 from a much larger

random sample of the three types of organizations functionally

comparable (in general) to DISA—management consultant firms,

advertising agencies, and distributors. Defendant introduced this

group of 32 solely to demonstrate its general economic thesis that

companies with higher profits also incurred higher selling costs.

Taxpayer asserts that at trial defendant conceded that these com-

panies were in fact sufficiently comparable to DISA for use in

applying the resale price method. A review of the trial transcript

reveals no such concession. Similarly, taxpayer’s reliance on the

finding that of the three types of organizations, the distributors “are

most functionally comparable to DISA * * *” is misplaced. That

statement means merely that, as between management consultant

firms, advertising agencies, and distributors, the latter are closest to

DISA. Moreover, a mere finding of general functional similarity does

not provide precise enough data to allow use of the resale price

method.

:

x

&

g

%

%

A-13

much higher than DISA.'7 Because we agree with the trial

judge and defendant’s expert that, in general, what a business

spends to provide services is a reasonable indication of the

magnitude of those services, and because plaintiff has not

rebutted that normal presumption in this case, we cannot view

these six companies as having made resales similar to DISA’s.

They may have made gross profits comparable to DISA’s but

their selling costs, reflecting the greater scale of their services or

17 Defendant’s comparison is derived from data in various exhib-

its and is summarized in the following table:

Average Annual

Average Annual Operating Expenses

Markup (percentage

Reseller Percentages of net sales )

AIC Photo 38% 27.5%

Superscope 33% 20.5%

Lloyd Electronics 26% 20.5%

DISA 26% 6.7% or 7.1%*

Soundesign 23% 20.0%

Interphoto 20.5% 16.0%

Telecor 19.5% 11.5%

* The trial judge used a 6.7% figure while our own computation

shows 7.1% (both figures have been adjusted to exclude certain

one-time starting costs in 1959; including such costs our result

would be the slightly higher average figure of 7.8%.

Finding 123 summarizes the evidence on DISA’s unusually low

selling costs: “The evidence shows that DISA so dramatically ex-

ceeded the profitability of the independent distributor community

[the sample of 21 firms taxpayer relies on] * * * * because to earn the

dollars represented by that [gross profit] margin it did not have to

spend nearly so many dollars to provide service and otherwise operate

its business as did the distributors who bought and sold their products

and services at prices determined by free market forces.”

A-14

efforts, were much higher in each instance.'8 Moreover, the

record shows that these companies dealt with quite different

products (electronic and photographic equipment) and func-

tioned in different markets (primarily the United States).

Other industrial group or individual resales relied on by

taxpayer also fall short of comparability to DISA. We are cited

to the gross profit margin of certain drug and chemical whole-

salers contained in the Internal Revenue Service’s SOURCE

BOOK OF STATISTICS OF INCOME for 1960. Because the gross

profit for this group of undisclosed companies’? in 1960 aver-

aged 21 percent, taxpayer infers that DISA’s gross profit of 26

percent was reasonable. Again, the lack of any data estab-

lishing comparability between DISA and the category of Source

Book companies precludes any such conclusion. The fact that,

within the wholesaler category, gross profits varied from 9 to 33

percent indicates that to take a mere arithmetic average,

without considering underlying factual details, would risk a

total distortion. See Simon, Section 482 Allocations, 46 TAXES

254 (1968) (criticising lack of relevance, unavailability of third

party data in gauging arm’s length prices); Edwards v. Commis-

sioner, 67 T.C. 224, 236-37 (1976) (industry average of

uncertain reliability in determining arm’s length sale price); cf.

Major Coat Co. v. United States, 211 Ct. Cl. 1, 34, 543 F.2d 97,

116 (1976) (Source Book statistics on profitability of firms in

same manufacturing category rejected in renegotiation case; no

showing of relative character, efficiencies or risks of other

companies). Plaintiff tells us that the IRS itself used these

Source Book figures for 1960 and later years (not now before

18 Taxpayer itself compensated its independent distributors by a

system of price discounts ranging from 4% for textile fibers and 5% for

elastomers (the two product lines accounting for more than 90% of

DISA’s sales and earnings) to 35% for photo products and agricul-

tural chemicals, depending on the amount of effort and expense

taxpayer thought necessary for the proper merchandising by the

independent of the product involved (finding 81).

19 Defendant is precluded by statute from disclosing the names of

companies contained in the Source Book.

Poe

se ie ayn Tran

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A-15

us). But the Service utilized net profit figures, not those for

gross profit or gross markup. Whether or not this use of net

profit computations contravened the regulations (which call for |

comparisons of gross profits in using the resale price method )

or means that the IRS was following the “fourth method” (see

Part III infra), we cannot say, as plaintiff wants us to, that the

Service must have considered these drug and chemical whole-

salers as comparable companies making similar resales, but that

the IRS simply made a mistake in using net profits. The little

we have on the IRS practice does not permit us to conclude

anything as to the Service’s position on comparability of these

companies for the purposes of the resale price method.20

The lack of any significantly comparable resale (or group

of resales) in this record is underscored by taxpayer’s failure to

suggest any means for adjusting for differences between DISA

and the uncontrolled resellers. Subpart (ix) of section 1.482-

2(e)(3) requires “appropriate adjustment” for “any material

20 Subpart (vii) of the regulation says that “[i]n the absence of

data on markup percentages of particular sales or groups of sales, the

prevailing markup percentage in the particular industry involved may

be appropriate” (emphasis added), but we do not consider that this

record (with its wide range of markups and variation in products)

shows, with respect to these Source Book companies, the “prevailing”

markup in DISA’s own “particular industry.”

Taxpayer also invites comparison of DISA’s gross profits with

several other uncontrolled transactions, none of which is apposite.

The contract for marketing of film between Du Pont and Bell &

Howell involved minimal volume requirements, the expectation of

initial marketing losses, and a gross profit contingent on meeting

maximum selling cost levels. Such risks are so different from DISA’s

as to make Bell & Howell’s propcsed compensation rate “irrelevant

for comparative purposes.” Finding 105. The rate of return by a Du

Pont subsidiary marketing urea herbicides involved special tech-

nology loans and missing details which preclude “a meaningful

analogy.” Finding 109. The sale of a “commodity-type” NA—22

elastomer (not requiring DISA’s special selling skills) at a very low

volume also precludes the use of such sales as a meaningful com-

parison. Finding 108. See also Findings 106, 107, 110 (discussing in

detail other purported comparable profits introduced by taxpayer at

trial).

A-16

differences between the uncontrolled purchases and resales

used as the basis for the calculation of the appropriate markup

percentage and the resales of property involved in the con-

trolled sale.” Such material differences must be “differences in

functions or circumstances” and must have a “definite and

reasonably ascertainable effect on price.” The trial judge prem-

ised his rejection of plaintiff's case on the failure to suggest

appropriate adjustments under this subpart, particularly for

DISA’s lack of “entrepreneurial risk.” Taxpayer mounts a

vigorous assault on this position, arguing that DISA was

exposed to all normal risks, including shipping and warehouse

risks, sudden European market declines, or termination by

manufacturing departments of Du Pont. Even if we assume

arguendo that DISA did assume full market risks,21 we think

taxpayer cannot escape the ultimate point of subpart

(ix )—assuming a roughly comparable uncontrolled reseller (or

resellers), taxpayer still bears the burden of showing adjust-

ments to arrive at an arm’s length price.22 However, plaintiff

proposes no adjustments for differences in marketing locations,

selling functions, or production differences between DISA and

the “comparable” 21 distributors. Taxpayer’s brief selects one

of the distributors, Superscope, as the company “most similar in

function” to DISA, but fails to suggest the appropriate adjust-

ments for such aspects as Superscope’s different product line

21 This is not an easy assumption to accept, since Du Pont’s

pricing system for DISA was designed to protect the latter from losses,

and DISA’s operations seemed geared to help it make profits with

little risk. See Part I, supra. Furthermore, the risk of complete

termination by the parent which established and operated DISA for a

number of particular purposes (including profit accumulation ), seems

substantially less than that of a wholly independent distributor.

22 Plaintiff should have been aware at trial that this was consid-

ered its burden. Before the trial, the trial judge ruled that taxpayer

could not rest on a showing that the IRS determination was erro-

neously computed, but had to prove that it owed either nothing at all

or a lesser amount than the Service had determined. Plaintiff did not

seek court review of this ruling.

a eA ALLIS aAaE IR let Oe RENE REG Drte GRMN

fi Supa

A-17

(tape recorders), different geographic market (the United

States), or contractual obligation to make minimum purchases

from the manufacturer.

This failure to proffer adjustments reflects the stark fact

that, on this record, there is no company or group of companies

so near and so comparable to DISA that the few material

differences can be properly adjusted for under the regulatory

pattern. Subpart (ix) and the example given under it (the

same reseller selling two very similar products with only a

difference in warranty coverage between the controlled and

uncontrolled transactions) reinforce the view that under the

resale price method the resales of uncontrolled companies must

be substantially similar to those of the controlled reseller before

that method can be used. And even if there is greater initial

latitude in finding a comparable reseller than seems to us

appropriate, subpart (ix) demands “appropriate adjustment

* * * to reflect any material differences” which “have a

definite and reasonably ascertainable effect on price.” Plaintiff,

which urges that the resale price method be used, bears the

burden of fulfilling all the requirements of the regulation, but

has failed to do so.

Plaintiff contends, finally, that requiring it to prove the

proper amount of adjustment is an unfair burden. The

suggestion is that once Du Pont shows that its prices were arm’s

length prices (by demonstrating that DISA’s gross profit mar- —

gin was equivalent to that of uncontrolled distributors) any

further readjustment should be left to the courts (or perhaps

defendant). Our first response is, as we have said above, that

taxpayer has not shown that, even apart from subpart (ix), any

of its alleged comparables can be accepted as such under the

resale price method portion of the regulation. And if we

surmount that hurdle, we see no good reason why a taxpayer

should be free from suggesting the appropriate adjustments

under subpart (ix). As the opening words of the paragraph

show, the adjustments called for by the subpart are integral to

A-18

the determination of an ‘“‘arm’s length price,” and the determi-

nation of an “arm’s length price” is the essence of the resale

price method which plaintiff invokes.?3

D. The upshot is that plaintiff has failed to bring itself

within the resale price method. The record before us does not

support use of that formula for this case.24 Indeed, it may very

well be that, because of DISA’s unique position, the showing

required by the regulation could simply not be made. At any

rate, we have to conclude that, on this record, it is not possible

to apply the resale price method.

As we have intimated in Part I, D, supra, this total failure

of proof is no surprise. Taxpayer’s prices to DISA were set

wholly without regard to the factors which normally enter into

an arm’s length price (see Part I, c. supra), and it would have

been pure happgnstance if those prices had turned out to be

equivalent to arm’s length prices. This is not a case in which a

taxpayer does attempt, the best it can, to establish inter-

corporate prices on an arm’s length basis, and then runs up

against an IRS which disagrees with this or that detail in the

calculation. Plaintiff never made the effort, and it would have

23 Insofar as the trial judge may have indicated in his opinion

that, apart from adjustment for entrepreneurial risk under subpart

(ix), Du Pont’s prices to DISA were fully comparable to arm’s length

prices, we disagree—as seen from the foregoing portions of this

opinion.

24Defendant says, somewhat weakly, that, although plaintiff

made insufficient proof, the Government itself presented adequate

evidence to comply with the resale price method by using as

comparables Du Pont’s independent distributors in Europe (to whom

DISA resold )-—and whose markup margins were normally much less

than DISA’s. But these “comparables” were not shown to be similar

to DISA, which performed many other functions, and no effort was

made by defendant to adjust upward for the differences. Therefore,

we do not believe that the evidence as to the margin of these

independent resellers enables us to apply the resale price method

here.

a eh

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Dest calaabk taint tets

A-19

been undiluted luck—which under the regulation it probably

could enjoy—if it had managed to discover comparable resales

falling within the resale price method as set forth in the

regulation (including adjustments to be made under subpart

(ix)).

III. Validity of the Commissioner’s Allocation under the

Regulation

In reviewing the Commissioner’s allocation of income

under Section 482, we focus on the reasonableness of the result,

not the details of the examining agent’s methodology. See Eli

Lilly & Co. v. United States, 178 Ct. Cl. 666, 676, 372 F.2d 990,

997 (1967); Young & Rubicam, Inc. v. United States, 187 Ct.

Cl. 635, 654-55, 410 F.2d 1233, 1245 (1969).25 Plaintiff

contends that the Commissioner’s result does not conform to

any of the specific methods under the regulations and is

therefore unreasonable per se. But the regulations (§ 1.482-

2(e)(1)(iii)) specifically allow for another appropriate meth-

od—‘“some appropriate method of pricing other than those

described * * * * or variations on such methods”—when, as

here, none of the three specific methods can properly be used.

That alternative “fourth method”-now comes into play, and we

consider the reasonableness of the Commissioner’s result under

its very broad delegation. This other “appropriate method of

pricing” must, of course, conform to the general directives

(stated at the outset of the regulation): “‘to place a controlled

taxpayer on a tax parity with an uncontrolled taxpayer” and “‘in

every case” to apply the standard “of an uncontrolled taxpayer

dealing at arm’s length with another uncontrolled taxpayer.”

See § 1.482-1(b)(1) and (c).26

25 On July 7, 1969, before the trial, the court denied taxpayer’s

motion for summary judgment which was based on the ground that,

once it is shown that the IRS computation is erroneous in method, the

taxpayer must necessarily prevail. Our order cited Eli Lilly and Young

& Rubicam.

Defendant does not now contend that the Service’s method of

calculating the reallocations was correct, but does support the result.

26 Again, plaintiff has the burden of showing that the IRS result

is unacceptable under the “fourth method.”

A-20

That some reallocation was reasonable is demonstrated by

recalling the facts of DISA’s operation. See Part I, supra.

Several of the products sold through DISA received none of its

special marketing or technical services. Nonetheless, DISA

obtained its usual profit from Du Pont for minimal work on

these goods—a result contrary to selling practices in the real

world. Examples include: (1) opportunistic sales and sales of

commodity-type products; (2) sales to South Africa and Aus-

tralia routed through DISA; (3) sales of elastomers produced

and serviced by Du Pont’s British subsidiary. DISA’s selling

“expertise” was not employed on any of these goods, and the

sole reason to sell them through DISA seems to have been to

increase the volume of profits for that special subsidiary.27

Above all of these specific indications that DISA did not earn its

profits is the overriding fact (discussed in Parts I and II, supra)

that Du Pont’s prices to DISA were deliberately set high and

with little or no regard to economic realities.

The amount of reallocation would not be easy for us to

calculate if we were called upon to do it ourselves, but Section

482 gives that power to the Commissioner and we are content

that his amount (totalling some $18 million) was within the

zone of reasonableness. The language of the statute and the

holdings of the courts recognize that the Service has broad

discretion in reallocating income. See, e.g., Eli Lilly & Co. v.

United States, 178 Ct. Cl. 666, 676-77, 372 F.2d 990, 997

(1967); Edwards v. Commissioner, 67 T.C. 224, 230 (1976);

Lufkin Foundry & Machine Co. v. Commissioner, 30 Tax CT.

Mem. Dec. 400, 437-38 (1971), rev'd on other grounds, 468

F.2d 805 (Sth Cir. 1972); PPG Industries, Inc. v. Commission-

er, 55 T.C. 928, 990-91 (1970). Once past the three specific

27 An early memorandum to the Executive Committee during the

formative stages of DISA stated that the amount of export profits to

be realized by the tax haven subsidiary would depend (in part)

“upon the extent to which export sales can be funnelled through the

trading company * * *” In operation, taxpayer set out to maximize

sales “funnelled through” DISA, even though DISA’s skills contrib-

uted minimally to such sales.

LS Sor ee ae ee ee

Betas,

A-21

methods for computing intercompany prices of tangible proper-

ty, the determiner of realistic intercompany prices is hardly

exercising an economic art susceptible of precision. A “broad

brush” approach to this inexact field seems necessary and

conforms with this court’s experience up to now under the

Renegotiation Act, requiring post hoc and de novo determina-

tion of excessive profits on war and “:fense Government

business. See, e.g., A.C. Ball. Co. v. United States, 209 Ct. Cl.

223, 229, 531 F.2d 993, 996 (1976); Bata Shoe Co. v. United

States, 219 Ct. Cl. , 595 F.2d 9, 25 (1979) (and

cases cited). Du Pont has not convinced us, on this record, that

the Commissioner abused the broad discretion he possessed

(the specific methods being inapplicable), or that he acted

unreasonably.

On the contrary, two economic indices presented by de-

fendant support the result of the Commissioner’s reallocation.

One index compares DISA’s ratio of gross income to total

operating costs with the ratios for the 32 advertising,

management-consultant, and distributor firms functionally sim-

ilar, in general, to DISA. These are the results:

Average gross income/ total

Organization cost percentage

6 management-consultant firms.................. 108.3%

5 CO III ences tsepinsiccrennesnininnressscies 123.9%

FE OT 129.3%

DISA (before reallocation ) * ................... 281.5 (1959); 397.1% (1960) **

DISA (after reallocation ) * ................:.0006+ 108.6 (1959); 179.3% (1960)

* DISA’s percentages are not averages, but its actual returns for

1959-1960.

** The 281.5% figure for 1959, if readjusted to exclude one-time

start-up costs, would be over 336%.

Only twice in over a hundred years of these companies’

experience did any of the distributing firms attain income/cost

ratios of over 200%, and no distributor ever achieved the 280-

400% range experienced by DISA.

A-22

The second index does not rely at all on general functional

similarities, but rests solely on a very comprehensive study of

the rates of return (along with margin and turnover ratios) of

over 1,100 companies. The following table illustrates the

results:

10-year

average of

1,133 DISA before DISA after

Index companies allocation allocation

1959 1960 19591960

Return on capital.................0006 9.47% 450% 147.2% 20% 38%

II Si sccstinsstaciinnyeserioviniiiaien 7.12% 13.1% 17.3% = --

TREE ihc ptictaciivlarnvesnteantiias 1.33 34.0 8.516 — —

Whether measured by income/cost ratios of functionally

similar forms or by capital return rates for industry as a whole,

DISA’s profits, before reallocation, vastly exceeded the up-

permost limits. After reallocation, DISA’s return on capital

would still be better than over 96% of the 1133 companies

surveyed. Using the two indices as a general measure of

economic profits, DISA stands supreme before reallocation.28

Plaintiff attacks the validity of the two studies, arguing that

return on capital is an inaccurate measuring rod, and that the

income/cost ratio is inappropriate because profits vary with the

skills of the individual companies. Whatever the general limits

of any particular gauge of industry profitability, plaintiff cannot

escape the basic thrust of defendant’s proof. Defendant has

shown that DISA made extraordinarily high profits which the

Commissioner reallocated to an economically reasonable level.

28 We do not understand the regulation’s catch-all (i.e. “fourth

method”) of “some appropriate method of pricing,” to outlaw

consideration of net profits in appraising the realism of prices charged

by one controlled company to another in the circumstances we have

here. The net profits index helps in “plac[ing] a controlled taxpayer

on a tax parity with an uncontrolled taxpayer” and aids in applying

the “standard” “of an uncontrolled taxpayer dealing at arm’s length

with another uncontrolled taxpayer” (§ 1.482—1(b)(1) and (c),

supra. ).

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Laitinen Lana

A-23

Plaintiff has not shown any specific comparable transactions

refuting the general trend, and the record reveals none. See

Part II, supra. Given the Commissioner’s general discretion

and the necessary inexactitude of such economic allocations, we

conclude that the Commissioner’s allocation was reasonable

and should be accepted.

CONCLUSION OF LAW

Upon the findings of fact, which are made a part of the

judgment herein, and the foregoing opinion, the court con-

cludes as a matter of law that plaintiff is not entitled to recover,

provided that plaintiff is accorded the opportunity to demon-

strate in further proceedings in the Trial Division that it is

entitled to relief under the provisions of Rev. Proc. 64-54, 1964-

2 Cum. BuLL. 1008. The cases are returned to the Trial

Division for such further proceedings.

[ APPENDIX TO THE OPINION OMITTED IN PRINTING AS

IDUPLICATIVE OF PETITIONER’S APPENDIX C, pp. C1-C12, Infra]

_NICHOLS, Judge, concurring:

I join in the opinion and in the judgment of the court but

add a few observations for reasons that will appear.

The court says in Part I that plaintiff staked its entire case

on proving that the profits made by DISA were comparable to

those made on similar resales by uncontrolled merchandising

agencies, the “resale price method.” That is correct: a study of

the briefs and record reveals no effort by plaintiff to sustain its

burden by presentation of a fact-based and reason-illuminated

case on any alternative theory as a backup if its above theory

might fail, as it has, to convince the court. The incorrectness of

the methods the Commissioner used when he made the alloca-

tions Originally is irrelevant by “law of the case,” as shown in

fin. 22, and I believe under accepted practice in tax litigation

A-24

could not have been made relevant, for the taxpayer must

prove he has overpaid, not that the Commissioner erred. Our

concern is more with the ultimate results than with his method.

Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 372 F.2d 990

(1967). Thus Part III of the opinion is really superfluous and

we could have come to our “Conclusion of Law” at the end of

Part II. I join in Part III because I believe it is well to show,

when happily we can, that the result we reach is not only

correct, but also fair and just.

The evidence referred to supports that conclusion, how-

ever, in the weakest possible way. In our renegotiation cases

under 50 U.S.C. app. §§ 1211-1233 we have elected to make

determinations of excessive profits on the basis of proofs as

weak, or weaker, where that is all the parties have offered to us.

Bata Shoe Co. v. United States, 219 Ct. Cl.___., 595 F.2d 9

(1979); Manufacturers Service Co. v. United States, 217 Ct. Cl.

—___., 582 F.2d 561 (1978); Mills Manufacturing Corp. v.

United States, 215 Ct. Cl. 536, 571 F.2d 1162 (1978); A. C.

Ball Co. v. United States, 209 Ct. Cl. 223, 531 F.2d 993 (1976).

See my concurrence in Manufacturers Service Co., v. United

States, 217 Ct. Cl. at ___, 582 F.2d at 578, where I said we

were making bricks without straw. Examination of the record

in this case will convince anyone that the task of properly

reallocating income from subsidiary to parent under § 482,

where, as here, one of the Commissioner’s express formulae is

not applicable, is no whit less difficult or complex than

determining how much of the profits a company derived from

defense contracts was excessive, while the statutory and regu-

latory guidelines that are a little help in the renegotiation case

are absent here. There are possible for use as many methods as

there are experts the parties can afford to hire, and no two

methods will lead to the same result. “Whenever a price

problem is discussed * * * , divergent figures are likely to be

recommended without a semblance of consensus.” 38

Harv.Bus.REViEW 125 (1960) as quoted in Eli Lilly & Co. v.

United States, 178 Ct. Cl. at 668, 372 F.2d at 992. The theory

Pan edhe a Carats au

A-25

that one in charge of a controlled group knows exactly the

monetary difference between the transactions he engineers, and

what they would have been if conducted at arm’s-length, will

not stand analysis. See my dissent in Morton-Norwich Products,

Inc. v. United States, No. 83-77 (Ct. Cl. July 18, 1979), slip op.

at Il.

, Assuming, still, that no formula prescribed by regulation

can be used, if the Commissioner adheres in court to his original

method, it would seem we would have ‘to affirm him unless we

thought his choice of method arbitrary and capricious. If he

abandons his original method and through his counsel sup-

ported by expert witnesses, urges the court to adopt another,

the taxpayer’s task is not much facilitated. Young & Rubicam,

Inc. v. United States, 187 Ct. Cl. 635, 655, 410 F.2d 1233, 1245

(1969). If the new method justifies the same reallocation or

more, and does not look unreasonable, the taxpayer cannot

refute it just by showing that other experts, using other

methods, would reallocate a lesser amount, or none at all.

Where we know from our renegotiation experience that there is

no one sure formula to determine excessive profits, and that all

methods, or all permitted by law, must be considered and

balanced one against another, here, to hold for the taxpayer, it

looks as if we would have to hold that no acceptable method

supports the Commissioner’s result. The taxpayer to win, as a

practical matter, would have to show that some method favored

by him was so much more convincing than others than no such

other was reasonable. Rarely will he do it.

The Commissioner it seems to me gets the best of both

worlds: as in more ordinary types of tax litigation, his counsel is

not committed to having to defend the Commissioner’s basic

fact finding and reasoning, as in most cases of judicial review of

discretionary action; and on the other hand, the determination

stands as not arbitrary and capricious, or an abuse of discretion,

if any reasonable looking approach sustains it. In Young &

Rubicam, Inc., supra, a § 482 reallocation was invalidated, but

it did not involve issues of pricing judgment.

A-26

It is not surprising, therefore, that taxpayer’s able counsel

here put all his chips on the regulatory resale price method, to

the virtual exclusion of any reliance on any “fourth method,”

really a chaos of any and all methods. After Part II, the

sustaining of the determination in Part III involves no real

difficulty, their being nothing of substance to oppose it.

Whether the involved regulations leave too many cases for

the fourth method is a question the court touches on lightly.

The congressional request to write regulations to govern these §

482 reallocations is one sentence long:

It is believed that the Treasury should explore the

possibility of developing and promulgating regulations

under this authority [§ 482] which would provide addi-

tional guidelines and formulas for the allocation of income

and deductions in cases involving foreign income. [1962]

U.S. CopE Conc. & AbD. News 3732, 3739.

Clearly the result of our decision is that this has not been done

in respect to the reallocation here involved, and it remains in

the almost if not wholly unreviewable discretion of the Trea-

sury, as it was when the suggestion was made. The Treasury

wisely believes, or in the past has believed, that it should not

have discretion to decide how much money anyone should have

to pay to support the government. It was for this reason that it

always urged, and always successfully, that the duty of adminis-

tering the various Renegotiation Acts, now all defunct, should

devolve elsewhere than on Treasury. So it is somewhat an

anomaly that in the matter of § 482 it is in a position that out

renegotiates renegotiation with respect to deciding a taxpayer’s

liability by exercise of discretion.

B-1

APPENDIX B

IN THE UNITED STATES COURT OF CLAIMS

Nos. 256-66, 371-66

E.I. du Pont de Nemours & Co.

V.

THE UNITED STATES

Order re findings of fact

Daniel M. Gribbon, attorney of record, for plaintiff. Harris

Weinstein, Coleman S. Hicks, Michael R. Levy, Roy A. Wentz,

William F. Loftus, Thomas M. Russo, and Covington & Burling,

of counsel.

Gilbert W. Rubloff, with whom was Assistant Attorney

General M. Carr Ferguson, for defendant. Theodore D. Peyser

ind Donald H. Olson, of counsel.

Before FRIEDMAN, Chief Judge, Davis, NICHOLS,

K ASHIWA, KUNZIG, BENNETT, and SMITH, Judges, en banc.

ORDER

The findings of fact by Trial Judge Willi (submitted with

his recommended opinion filed April 18, 1978) are hereby

adopted with the following modifications by the court:

(1) Finding No. 83, last paragraph, line 6 (Trial Judge

report, page 126)—correct typographical error in “practie” to

read “practice.”

(2) Finding No. 102, fifth paragraph, line 7 (Trial Judge

report, page 145)—‘“25 percent increase” changed to “15

percent increase.”

B-2

Finding No. 102, fifth paragraph, line 14 (Trial Judge

report, page 146)—in the sixth sentence (beginning “Accord-

ingly, whereas ...”) the part reading “. . . a margin little more

than one-third that amount, ...” is changed to read: “... a

margin of approximately 11 percent of that amount, .. .”

Finding No. 102—fifth paragraph, line 32 (Trial Judge

report, page 146)—the sentence beginning “In sum, as con-

trasted ... would consume 17 percent ...” is changed to “In

sum, as contrasted ... would consume 15 percent...”

(3) Finding No. 108, fifth paragraph, line 4 (Trial Judge

report, page 158)—the typographical error in “accelarators” is

changed to read “accelerators”.

(4) Finding No. 122, first paragraph, first line (Trial

Judge report, page 175)—strike fizt word and comma

“Aithough,” and begin sentence with “As indicated above, . . .”

(5) Finding No. 123 (Trial Judge report, page 176)—add

the following second paragraph before the present second

paragraph (beginning “The evidence shows ...”), which be-

comes the third paragraph of finding No. 123: (new second

paragraph):

“The annual gross profit margins earned by the 21 dis-

tributors ranged from 12 to 50 percent during the years for

which evidence is available. The average of all of the annual

margins for these companies is 24.98 percent.”

In addition, the court adopts, as part of its findings of fact,

any statement of fact contained in its opinion (filed today)

which is not also contained in the formal findings of fact.

IT IS SO ORDERED.

By THE COURT

/s/ DANIEL M. FRIEDMAN

Daniel M. Friedman,

Chief Judge

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APPENDIX C

STATUTE AND REGULATIONS INVOLVED

Internal Revenue Code § 482, 26 U.S.C. § 482:

“Allocation of income and deductions among taxpayers. In

any case of two or more organizations, trades, or businesses

(whether or not incorporated, whether or not organized in the

United States, and whether or not affiliated) owned or con-

trolled directly or indirectly by the same interests, the Secretary

may distribute, apportion, or allocate gross income, deductions,

credits, or allowances between or among such organizations,

trades, or businesses, if he determines that such distribution,

apportionment, or allocation is necessary in order to prevent

evasion of taxes or clearly to reflect the income of any of such

organizations, trades, or businesses.”

Treasury Regulations § 1.482-2, 26 CFR § 1.482-2:

“(e) Sales of tangible property—(1) In general. (i)

Where one member of a group of controlled entities (referred

to in this paragraph as the “‘seller”) sells or otherwise disposes

of tangible property to another member of such group (referred

to in this paragraph as the “buyer”) at other than an arm’s

length price (such a sale being referred to in this paragraph as a

“controlled sale”), the district director may make appropriate

allocations between the seller and the buyer to reflect an arm’s

length price for such sale or disposition. An arm’s length price is

the price that an unrelated party would have paid under the

same circumstances for the property involved in the controlled

sale. Since unrelated parties normally sell products at a profit,

an arm’s length price normally involves a profit to the seller.

(ii) Subparagraphs (2), (3), and (4) of this paragraph

describe three methods of determining an arm’s-length price

and the standards for applying each method. They are, respec-

tively, the comparable uncontrolled price method, the resale

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price method, and the cost-plus method. In addition, a special

rule is provided in subdivision (v) of this subparagraph for use

(notwithstanding any other provision of this subdivision ) in

determining an arm’s-length price for an ore or mineral. If there

are comparable uncontrolled sales as defined in subparagraph

(2) of this paragraph, the comparable uncontrolled price

method must be utilized because it is the method likely to result

in the most accurate estimate of an arm’s-length price (for the

reason that it is based upon the price actually paid by unrelated

parties for the same or similar products). If there are no

comparable uncontrolled sales, then the resale price method

must be utilized if the standards for its application are met

because it is the method likely to result in the next most

accurate estimate in such instances (for the reason that, in such

instances, the arm’s-length price determined under such method

is based more directly upon actual arm’s-length transactions

than is the cost-plus method). A typical situation where the

resale price method may be required is where a manufacturer

sells products to a related distributor which, without further

processing, resells the products in uncontrolled transactions. If

all the standards for the mandatory application of the resale

price method are not satisfied, then, as provided in subpara-

graph (3) (iii) of this paragraph, either that method or the

cost-plus method may be used, depending upon which method

is more feasible and is likely to result in a more accurate

estimate of an arm’s-length price. A typical situation where the

cost-plus method may be appropriate is where a manufacturer

sells products to a related entity which performs substantial

inanufacturing, assembly, or other processing of the product or

adds significant value by reason of its utilization of its in-

tangible property prior to resale in uncontrolled transactions.

(iii) Where the standards for applying one of the three

methods of pricing described in subdivision (ii) of this

subparagraph are met, such method must, for the purposes of

this paragraph, be utilized unless the taxpayer can establish

that, considering ali the facts and circumstances, some method

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of pricing other than those described in subdivision (ii) of this

subparagraph is clearly more appropriate. Where none of the

three methods of pricing described in subdivision (ii) of this

subparagraph can reasonably be applied under the facts and

circumstances as they exist in a particular case, some appropri-

ate method of pricing other than those described in subdivision

(ii) of this subparagraph, or variations on such methods, can be

used.

(iv) The methods of determining arm’s length prices

described in this section are stated in terms of their application

to individual sales of property. However, because of the

possibility that a taxpayer may make controlled sales of many

different products, or many separate sales of the same product,

it may be impractical to analyze every sale for the purposes of

determining the arm’s length price. It is therefore permissible

to determine or verify arm’s length prices by applying the

appropriate methods of pricing to product lines or other

groupings where it is impractical to ascertain an arm’s length

price for each product or sale. In addition, the district director

may determine or verify the arm’s length price of all sales to a

related entity by employing reasonable statistical sampling

techniques. .

(v) The price for a mineral product which is sold at the

stage at which mining or extraction ends shall be determined

under the provisions of §§ 1.613-3 and 1.613-4.

(2) Comparable uncontrolled price method. (i) Under

the method of pricing described as the “comparable uncon-

trolled price method”, the arm’s length price of a controlled

sale is equal to the price paid in comparable uncontrolled sales,

adjusted as provided in subdivision (ii) of this subparagraph.

(ii) “Uncontrolled sales” are sales in which the seller and

the buyer are not members of the same controlled group. These

include (a) sales nade by a member of the controlled group to

an unrelated party, (b) sales made to a member of the

controlled group by an unrelated party, and (c) sales made in

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which the parties are not members of the controlled group and

are not related to each other. However, uncontrolled sales do

not include sales at unrealistic prices, as for example where a

member makes uncontrolled sales in small quantities at a price

designed to justify a nonarm’s length price on a large volume of

controlled sales. Uncontrolled sales are considered comparable

to controlled sales if the physical property and circumstances

involved in the uncontrolled sales are identical to the physical

property and circumstances involved in the controlled sales, or

if such properties and circumstances are so nearly identical that

any differences either have no effect on price, or such differ-

ences can be reflected by a reasonable number of adjustments

to the price of uncontrolled sales. For this purpose, differences

can be reflected by adjusting prices only where such differences

have a definite and reasonably ascertainable effect on price. If

the differences can be reflected by such adjustment, then the

price of the uncontrolled sale as adjusted constitutes the

comparable uncontrolled sale price. Some of the differences

which may affect the price of property are differences in the

quality of the product, terms of sale, intangible property

associated with the sale, time of sale, and the level of the

market and the geographic market in which the sale takes

place. Whether and to what extent differences in the various

properties and circumstances affect price, and whether differ-

ences render sales noncomparable, depends upon the particular

circumstances and property involved. The principles of this

subdivision may be illustrated by the following examples, in

each of which it is assumed that X makes both controlled and

uncontrolled sales of the identical property:

EXAMPLE (1). Assume that the circumstances surrounding

the controlled and the uncontrolled sales are identical, except

for the fact that the controlled sales price is a delivered price

and the uncontrolled sales are made f. 0. b. X’s factory. Since

differences in terms of transportation and insurance generally

have a definite and reasonably ascertainable effect on price,

such differences do not normally render the uncontrolled sales

noncomparable to the controlled sales.

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EXAMPLE (2). Assume that the circumstances surrounding

the controlled and uncontrolled sales are identical, except for

the fact that X affixes its valuable trademark in the controlled

sales, and does not affix its trademark in uncontroiied sales.

Since the effects on price of differences in intangible property

associated with the sale of tangible property, such as trade-

marks, are normally not reasonably ascertainable, such differ-

ences wouid normally render the uncontrolled sales noncompa-

rable.

EXAMPLE (3). Assume that the circumstances surrounding °

the controlled and uncontrolled sales are identical except for

the fact that X, a manufacturer of business machines, makes

certain minor modifications in the physical properties of the

machines to satisfy safety specifications or other specific

requirements of a customer in controlled sales, and does not

make these modifications in uncontrolled sales. Since minor

physical differences in the product generally have a definite and

reasonably ascertainable effect on prices, such differences do

not normally render the uncontrolled sales noncomparable to

the controlled sales.

(iii) Where there are two or more comparable uncon-

trolled sales susceptible of adjustment as defined in subdivision

(11) of this subparagraph, the comparable uncontrolled sale or

sales requiring the fewest and simplest adjustments provided in

subdivision (ii) of this subparagraph should generally be

selected. Thus, for example, if a taxpayer makes comparable

uncontrolled sales of a particular product which differ from the

controlled sale only with respect to the terms of delivery, and

makes other comparable uncontrolled sales of the product

which differ from the controlled sale with respect to both terms

of delivery and terms of payment, the comparable uncontrolled

sales differing only with respect to terms of delivery should be

selected as the comparable uncontrolled sale.

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(iv) One of the circumstances which may affect the price of

property is the fact that the seller may desire to make sales at

less than a normal profit for the primary purpose of establishing

or maintaining a market for his products. Thus, a seller may be

willing to reduce the price of a product, for a time, in order to

introduce his product into an area or in order to meet com-

petition. However, controlled sales may be priced in such a

manner only if such price would have been charged in an

uncontrolled sale under comparable circumstances. Such fact

may be demonstrated by showing that the buyer in the

controlled sale made corresponding reductions in the resale

price to uncontrolled purchasers, or that such buyer engaged in

substantially greater sales promotion activities with respect to

the product involved in the controlled sale than with respect to

other products. For example, assume X, a manufacturer of

batteries, commences to sell car batteries to Y, a subsidiary of

X, for resale in a new market. In its existing markets X’s

batteries sell to independent retailers at $20 per unit, and X

sells them to wholesalers at $17 per unit. Y also sells X’s

batteries to independent retailers at $20 per unit. X’s batteries

are not known in the new market in which Y is operating. In

order to engage competitively in the new market Y incurs

selling and advertising costs substantially higher than those

incurred for its sale of other products. Under these circum-

stances X may sell to Y, for a time, at less than $17 to take into

account the increased selling and advertising activities of Y in

penetrating and establishing the new market. This may be

done even though it may result in a transfer price from X to Y

which is below X’s full costs of manufacturing the product.

(3) Resale price method. (i) Under the pricing method

described as the “resale price method”, the arm’s length price

of a controlled sale is equal to the applicable resale price (as

defined in subdivision (iv) or (v) of this subparagraph),

reduced by an appropriate markup, and adjusted as provided in

subdivision (ix) of this subparagraph. An appropriate markup

is computed by multiplying the applicable resale price by the

C-7

appropriate markup percentage as defined in subdivision (vi)

of this subparagraph. Thus, where one member of a group of

controlled entities sells property to another member which

resells the property in controlled sales, if the applicable resale

price of the property involved in the controlled sale is $100 and

the appropriate markup percentage for resales by the buyer is

20 percent, the arm’s length price of the controlled sale is $80

($100 minus 20 percent X $100), adjusted as provided in

subdivision (ix) of this subparagraph.

(11) The resale price method must be used to compute an

arm’s length price of a controlled sale if all the following

circumstances exist:

(a) There are no comparable uncontrolled sales as defined

in subparagraph (2) of this paragraph.

(b) An applicable resale price, as defined in subdivision

(iv) or (v) of this subparagraph, is available with respect to

resales made within a reasonable time before or after the time

of the controlled sale.

(c) The buyer (reseller) has not added more than an

insubstantial amount to the value of the property by physically

altering the product before resale. For this purpose packaging,

repacking, labeling, or minor assembly of property does not

constitute physical alteration.

(d) The buyer (reseller) has not added more than an

insubstantial amount to the value of the property by the use of

intangible property. See § 1.482-2 (d) (3) for the definition of

intangible property.

(iii) Notwithstanding the fact that one or both of the

requirements of subdivision (ii) (c) or (d) of this subpara-

graph may not be met, the resale price method may be used if

such method is more feasible and is likely to result in a more

accurate determination of an arm’s length price than the use of

the cost plus method. Thus, even though one of the require-

ments of such subdivision is not satisfied, the resale price

method may nevertheless be more appropriate than the cost

C-8

plus method because the computations and evaluations re-

quired under the former method may be fewer and easier to

make than under the latter method. In general, the resale price

method is more appropriate when the functions performed by

the seller are more extensive and more difficult to evaluate than

the functions performed by the buyer (reseller). The principle

of this subdivision may be illustrated by the following examples

in each of which it is assumed that corporation X developed a

valuable patent covering product M which it manufactures and

sells to corporation Y in a controlled sale, and for which there is

no comparable uncontrolled sale:

EXAMPLE (1). Corporation Y adds a component to

product M and resells the assembled product in an uncontrolled

sale within a reasonable time after the controlled sale of

product M. Assume further that the addition of the component

added more than an insubstantial amount to the value of

product M, but that Y’s function in purchasing the component

and assembling the product prior to sale was subject to

reasonably precise valuation. Although the controlled sale and

resale does not meet the requirements of subdivision (ii) (c) of

this subparagraph, the resale price method may be used under

the circumstances because that method involves computations

and evaluations which are fewer and easier to make than under

the cost plus method. This is because X’s use of a patent may

be more difficult to evaluate in determining an appropriate

gross profit percentage under the cost plus method, than is

evaluation of Y’s assembling function in determining the

appropriate markup percentage under the resale price method.

EXAMPLE (2). Corporation Y resells product M in an

uncontrolled sale within a reasonable time after the controlled

sale after attaching its valuable trademark to it. Assume further

that it can be demonstrated through comparison with other

uncontrolled sales of Y that the addition of Y’s trademark to a

product usually adds 25 percent to the markup on its sales. On

the other hand, the effect of X’s use of its patent is difficult to

C-9

evaluate in applying the cost plus method because no reason-

able standard of comparison is available. Although the con-

trolled sale and resale does not meet the requirements of

subdivision (ii) (d) of this subparagraph, the resale price

method may be used because that method involves computa-

tions and evaluations which are fewer and easier to make than

under the cost plus method. This is because, under the

circumstances, X’s use of a patent is more difficult to evaluate in

determining an appropriate gross profit percentage under the

cost plus method, than is evaluation of the use of Y’s trademark

in determining the appropriate markup percentage under the

resale price method.

(iv) For the purposes of this subparagraph the “‘applicable

resale price” is the price at which it is anticipated that property

purchased in the controlled sale will be resold by the buyer in

an uncontrolled sale. The “applicable resale price” will

generally be equal to either the price at which current resales of

the same property are being made or the resale price of the

particular item of property involved.

(v) Where the property purchased in the controlled sale is

resold in another controlled sale, the “applicable resale price” is

the price at which such property is finally resold in an uncon-

trolled sale, providing that the series of sales as a whole meets

all the requirements of subdivision (ii) of this subparagraph or

that the resale price method is used pursuant to subdivision

(iii) of this subparagraph. In such case, the determination of

the appropriate markup percentage shall take into account the

function or functions performed by all members of the group

participating in the series of sales and resales. Thus, if X sells a

product to Y in a controlled sale, Y sells the product to Z in a

controlled sale, and Z sells the product in an uncontrolled sale,

the resale price method must be used if Y and Z together have

not added more than an insubstantial amount to the value of

the product through physical alteration or the application of

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intangible property, and the final resale occurs within a reason-

able time of the sale from X to Y. In such case, the applicable

resale price is the price at which Z sells the product in the

uncontrolled sale, and the appropriate markup percentage shall

take into account the functions performed by both Y and Z.

(vi) For the purposes of this subparagraph, the appropri-

ate markup percentage is equal to the percentage of gross profit

(expressed as a percentage of sales) earned by the buyer

(reseller) or another party on the resale of property which is

both purchased and resold in an uncontrolled transaction,

which resale is most similar to the applicable resale of the

property involved in the controlled sale. The following are the

most important characteristics to be considered in determining

the similarity of resales:

(a) The type of property involved in the sales. For

example: machine tools, men’s furnishings, small household

appliances.

(b) The functions performed by the reseller with respect to

the property. For example: packaging, labeling, delivering,

maintenance of inventory, minor assembly, advertising, selling

at wholesale, selling at retail, billing, maintenance of accounts

receivable, and servicing.

(c) The effect on price of any intangible property utilized

by the reseller in connection with the property resold. For

example: patents, trademarks, trade names.

(d) The geographic market in which the functions are

performed by the reseller.

In general, the similarity to be sought relates to the probable

effect upon the markup percentage of any differences in such

characteristics between the uncontrolled purchases and resales

on the one hand and the controlled purchases and resales on

the other hand. Thus, close physical similarity of the property

involved in the sales compared is not required under the resale

price method since a lack of close physical similarity is not

necessarily indicative of dissimilar markup percentages.

aa ee a Da te ee

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(vii) Whenever possible, markup percentages should be

derived from uncontrolled purchases and resales of the buyer

(reseller) involved in the controlled sale, because similar

characteristics are more likely to be found among different

resales of property rnade by the same reseller than among sales

made by other resellers. In the absence of resales by the same

buyer (reseller) which meet the standards of subdivision (vi)

of this subparagraph, evidence of an appropriate markup

percentage may be derived from resales by other resellers

selling in the same or a similar market in which the controlled

buyer (reseller) is selling, providing such resellers perform

comparable functions. Where the function performed L, the

reseller is similar to the function performed by a sales agent

which does not take title, such sales agent will be considered a

reseller for the purpose of determining an appropriate markup

percentage under this subparagraph and the commission

earned by such sales agent, expressed as a percentage of the

sales price of the goods, may constitute the appropriate markup

percentage. If the controlled buyer (reseller) is located in a

foreign country and information on resales by other resellers in

the same foreign market is not available, then markup per-

centages earned by United States resellers performing com-

parable functions may be used. In the absence of data on

markup percentages of particular sales or groups of sales, the

prevailing markup percentage in the particular industry in-

volved may be appropriate. :

(viii) In calculating the markup percentage earned on

uncontrolled purchases and resales, and in applying such

percentage to the applicable resale price to determine the

appropriate markup, the same elements which enter into the

computation of the sales price and the costs of goods sold of the

property involved in the comparable uncontrolled purchases

and resales should enter into such computation in the case of

the property involved in the controlled purchases and resales.

Thus, if freight-in and packaging expense are elements of the

cost of goods sold in comparable uncontrolled purchases, then

C-12

such elements should also be taken into account in computing

the cost of goods sold of the controlled purchase. Similarly, if

the comparable markup percentage is based upon net sales

(after reduction for returns and allowances) of uncontrolled

resellers, such percentage must be applied to net sales of the

buyer (reseller).

(ix) In determining an arm’s length price appropriate

adjustment must be made to reflect any material differences

between the uncontrolled purchases and resales used as the

basis for the calculation of the appropriate markup percentage

and the resales of property involved in the controlled sale. The

differences referred to in this subdivision are those differences in

functions or circumstances which have a definite and reason-

ably ascertainable effect on price. - The principles of this

subdivision may be illustrated by the following example:

EXAMPLE. Assume that X and Y are members of the same

group of controlled entities and that Y purchases electric mixers

from X and electric toasters from uncontrolled entities. Y

performs substantially similar functions with respect to resales

of both the mixers and the toasters, except that it does not

warrant the toasters, but does provide a 90-day warranty for

the mixers. Y normally earns a gross profit on toasters of 20

percent of gross selling price. The 20-percent gross profit on the

resale of toasters is an appropriate markup percentage, but the

price of the controlled sale computed with reference to such rate

must be adjusted to reflect the difference in terms (the war-

ranty ).”